The Nature of the Economic Cycle
This excerpt, taken from Balentine’s 2019 Capital Markets Forecast, details the four phases which make up the typical business pattern: expansion, peak, contraction, and trough. Want to learn more? Don’t miss Balentine’s full 2019 Capital Markets Forecast, our signature research piece that serves as the foundation of our investment process.
Economists break down the economic cycle into four phases: 1) expansion, 2) peak, 3) contraction, and 4) trough. An expansion is typically characterized by month-over-month economic growth (with adjustments necessary sometimes to account for seasonality) until such growth peaks and activity begins to contract. After the contraction concludes, expansion begins anew. Such activity typically occurs on a secular growth trajectory with each successive contraction bottoming at a higher level than the prior cycle, as depicted in Figure 3.
This oversimplification conveys a high-level understanding of an economy’s current positioning, which will suffice for standard inquiries on questions such as, “How is the economy?” Of course, the economic cycle is far more complex, advancing in fits and starts rather than via a smooth cadence of progress. In fact, while the term “cycle” implies phases occur at predictable intervals, the opposite is actually the case; economic cycles are irregular in both duration and magnitude. Put differently, within a cyclical expansion phase, there will often be episodes of expansion, stagnation, and contraction. The duration of these episodes is usually short in nature and the magnitude typically does not take away from the overall cyclical trend. As such, separate cycles will typically play out differently at a micro level even if they generally rhyme on a macro level. This explains why the beginning and ending dates of different phases are known only in hindsight; just because we experience modest deceleration in economic activity does not necessitate the start of a contraction. Economic indicators categorized as leading, coincident, or lagging are used to help assess the ongoing phase. Because it often takes more prolonged periods of declines (or growth at the end of a contraction), the underlying economic phase is often known only after we are already well into it.
Digging deeper, historical economic cycles provide insight into the current cycle and our positioning therein. Economies have a growth trajectory which tends to follow a regular trend for decades, as seen by the gray trendline in Figure 3. Economies in the earlier stages of a lifecycle often exhibit stronger, yet more volatile, trend growth. Conversely, more established economies will exhibit less, but more consistent, growth. Finally, in rare cases, an economy will show secular decline—Japan’s last few decades serve as a recent example. The economic cycle is, quite simply, the measurement of volatility around a growth trend. Think of it as a pendulum in which the pendulum’s equilibrium (i.e., the point where the pendulum is at rest) is the growth trend and the phases of the economic cycle reflect the swings around that equilibrium. The greater magnitude the pendulum swings in one direction (i.e., the greater the economic boom), the greater the pendulum will swing in the other direction to offset it (i.e., the greater the economic bust).
During periods of positive growth, the growth rate tends to surpass the secular growth trend. Alternately, during periods of negative growth, the trend will not only fall short of the secular trend but also will decline, as demonstrated in Figure 3. What drives these fluctuations has been the subject of much debate over the years (often between “demand siders” and “supply siders”), serving as the basis for policy formulation. Further explanation of each phase of the cycle follows.
- Economic growth is the default state of the economy; thus, expansions are the longest and largest stage of the cycle. During expansions, the economy is strong and company profits are rising as demand for goods and services is robust. Real GDP is rising and the unemployment rate is generally falling, both of which drive higher disposable income stemming from increases in wages and appreciation in the value of capital as corporate earnings grow.
- Higher incomes drive an increase in the velocity of money as both consumers and businesses begin to spend more. As a result, companies’ revenues grow even further, and a feedback loop ensues wherein an increase in corporate revenues begets an increase in money for other companies and consumers, which begets a further increase in corporate revenues, and so on.
- Income growth also leads to an increase in consumer confidence and business confidence as employment is strong and earnings growth is consistent, which leads both consumers and businesses to forecast even more strength into the future. As a result, consumers and businesses take on additional debt; consumers borrow to fund “big ticket” items and corporations borrow to fund projects they deem additive to corporate earnings. In both cases, consumers and businesses would not make purchases without confidence in the future.
- The combination of strong velocity of money, growth in corporate earnings and labor wages, and increased borrowing typically drive prices higher as aggregate demand consistently stays one step ahead of aggregate supply. Initially, this price inflation is typically benign, as it actually produces further strength in the economy. However, at a certain level, inflation becomes detractive as corporate margins shrink and consumers experience less discretionary income since more of their wages are applied to food, transportation, housing, and clothing costs.
- Once inflation becomes detrimental, the central bank feels the need to get involved. Central banks usually try to be proactive in advance of such an inflection point. In practice, however, they are typically behind the curve because they are leery of proactively slowing the expansion (proverbially speaking, they are loath to take away the punch bowl while the party is still going). When the central bank decides it is time to quell a rise in inflation, they raise short-term interest rates. Long-term interest rates frequently rise in concert as bond markets anticipate inflation and corresponding central bank response. The expansion continues, albeit at a slower pace, as the cost of funds begins to rise.
- At some point in the economic expansion, interest rates have risen enough not only to mitigate inflation but also to dampen consumer demand and make corporate projects infeasible. At this point, interest rate increases have reached their inflection point.
- At a macroeconomic level, GDP stops increasing, unemployment stops decreasing, and inflation generally peaks.
- At a corporate level, managers are more meticulous in their stewardship of corporate capital as they see fewer projects able to surpass more stringent hurdles brought on by higher rates. Concurrently, consumers begin to reduce borrowing and spending as they revise their heretofore optimistic outlook on personal wealth and income situations. Thus, the expansionary feedback loop which drove growth higher starts to reverse.
- Other factors can also contribute to an economic peak, notably negative shocks to the economy (e.g., commodity price spikes in the 1970s, terrorist attacks such as in 2001).
- Not all contractions become recessions or, in more severe cases, depressions. A recession is defined as two consecutive quarters of contraction. Most recently, GDP contracted during the first quarter of 2014, but the weakness lasted only one quarter—hence there was no recession. The genesis of a contraction comes from rising prices and higher interest rates which drive corporations and consumers to retrench, thus slowing the velocity of money and leading to decelerating corporate revenue growth. As sales slow, inventories rise with waning demand for products. Elevated inventories lead to lower gross margins from price cuts, production cutbacks, and employee layoffs.
- A new feedback loop ensues, a mirror image of the expansionary loop; decreased revenues beget less money in the economy as monetary velocity slows, which begets even fewer corporate revenues. As corporate expenses begin to outgrow revenues, companies cut costs in labor, production, and capital spending.
- GDP is decreasing, unemployment is rising, and inflation is falling. To offset declines in aggregate demand, it is common for the federal government to step in with fiscal stimulus to limit declines in monetary velocity. Ideally, the federal government could spend enough to offset the decline in corporate and consumer spending; however, because the size of the economy is larger than the size of the federal government’s ability to spend, fiscal stimulus serves to stem the tide of economic weakness but cannot halt the decline in its entirety. Put differently, the government fiscal stimulus may be able to limit the magnitude of a contraction, but it will be unable to prevent or end the contraction.
- Because demand for money has decreased, interest rates decline. Pullbacks occur in short-term rates due to central bank actions to combat deflationary pressure and in long-term rates as the bond market focuses on lower-trend growth. The interest rate declines on top of government fiscal stimulus serve to lessen the gap between relatively depressed aggregate demand and relatively abundant aggregate supply, thus setting the stage for an eventual end of the phase.
- As economic contraction evolves, the combination of monetary policy and fiscal policy creates a second-derivative effect: the economy begins to decline at a slower pace. With interest rates at cyclical lows, expansion in money from the central bank spurs additional consumer and corporate borrowing to invest in projects which heretofore were not profitable. Additionally, the federal government continues fiscal stimulus until there is clarity about whether the economy is beginning to recover.
- Much of the demand to initiate a recovery comes from the need to maintain and/or replace antiquated capacity, leading to increased capital expenditures. This spurs a recovery as monetary velocity begins to accelerate, leading to growth in personal and corporate income. At this point, growth changes from negative to positive, signaling a hallmark of an economic trough. Since inflationary pressure has all but disappeared, increased spending has a limited effect on prices, so inflation remains tame.
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