Economic Cycles and the 4 Phases

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Economies run around economic cycles of varying degrees. In this Wiki, we are going to take a look at how economic cycles revolve around the 4 phases.

This Wiki is part of our Economic Cycles Wiki. Be sure to check that out HERE.

Economic Cycles and the 4 Phases

There are 4 phases to an economic cycle. These phases are:

  • Expansion
  • Peak
  • Recession
  • Trough

Different textbooks refer to each of these phases with slightly different names but the important thing to understand is that the economy goes up, tops out, goes down, and then bottoms out. The economic cycle is the natural fluctuation of the economy between periods of expansion and contraction. Factors such as gross domestic product, interest rates, levels of employment, and consumer spending can help give us clues as to what current stage of the economic cycle we are in.

Let’s take a deeper look at each of these phases now.

1 Expansion

  • In this phase consumer purchasing is growing. This is especially true for purchases of big ticket items such as houses, appliances and cars. These are typically durable goods which are expensive and have a long usable lifespan.
  • Although interest rates are relatively low at the beginning of the expansion phase they will generally rise as the economy grows and the central bank attempts to keep inflation from getting too high.
  • Stocks that perform well during the expansion include technology, durable goods producers, luxury producers, and cyclical industries. However, a rising tide tends to raise all boats and this can be true of the stock market as well. Most stocks will perform well except those that are fundamentally broken.
  • The currency tends to strengthen during this phase as the smart money traders anticipate economic prosperity and potentially higher rates of interest to come. This is true for both speculative trading and gaining a better yield on investment for large investment firms such as pension funds.
  • Economies that are performing will tend to attract foreign investment which strengthens the local currency and increases the rate of expansion within the economy.

2 Peak

  • Once the expansion is underway the economy will eventually reach a peak in output and productivity.
  • At this point businesses in the economy are thriving. However, interest rates typically climb because investors and Central banks are concerned about the risk of rising inflation getting too high.
  • Rising interest rates start to make new homes less affordable for some consumers. This causes layoffs in the housing sector and other interest sensitive sections of the economy.
  • The stock market typically tries to anticipate economic peaks 3-6 months in advance and is usually declining by the time that the economic indicators prove the peak has arrived. This is because most economic indicators of importance are lagging by nature. Think of GDP for example, this doesn’t change in real time; it’s a slow process that develops over time.
  • The currency starts to top out as traders try and anticipate the start of the next phase of a recession which then leads to interest rate cuts by the central bank.

3 Recession

  • Early in this period sales on items such as cars and kitchen appliances begin to fall causing manufacturing companies to cut production. Because manufacturers are producing less they have no choice but to lay off employees because they are no longer financially competitive. If companies want to survive the recession they must reduce costs any way they can which typically starts with letting go employees. Employees are the easiest cost to reduce so we will tend to see employment numbers turn negative fairly early in this phase.
  • When unemployment starts to rise this means that personal incomes start to fall. This goes back to the point that companies need to cut costs to remain in business.
  • Interest rates are generally higher at the beginning of a recession but fall quickly throughout the recession as the central bank attempts to get the economy back on track. By cutting interest rates the central bank is basically trying to incentivize companies to borrow money and invest in expansion projects using the lower interest rates. If companies are incentivized to expand this means that they will hire more people which we know is incredibly important for a healthy economy.
  • Most stocks perform poorly during a recession. However stocks of consumer staple companies such as those that produce food, beverages, household personal care products, pharmaceuticals, utilities, and dividend paying companies often hold their value because these firms sells goods and services that people need or must have even when economic times are tough. People might cut back on luxury products but they still need to have food, shelter and electricity to survive. The companies that sell that type of stuff tend to hold their values much better.
  • The currency will typically sell off as the market begins to anticipate how low the interest rate will be cut. The market will try and discover what the new fair value should be.
  • Speculation about what the central bank will do next starts to pick up. The central bank will be forced to combat the recession and the market will try and anticipate the bank's actions ahead of time. This is exactly the type of thing that traders will be doing as well. This also highlights why understanding the expectations of the market is probably more important than what actually happens because major price moves are created by speculation around what Central banks will do next.

There are many different causes of a recession but there are also a few things that will happen over and over again. This makes it worth taking the time to go over these reasons now.

The first thing that can have an impact is rising interest rates that are created by the central bank. If the economy gets too strong inflation will get out of control so the central bank needs to keep a close eye on this and step and make changes to the interest rate if it needs to. They do this by raising interest rates and trying to balance interest rates with economic growth so that the economy doesn’t grow too quickly or get out of control in the first place.

However, the central bank doesn’t always get this right. For example, in 1982 the Federal Reserve in the US caused a major recession because they decided to hike interest rates too quickly in order to combat inflation which had skyrocketed up to 13% per year. Many economists say that the Fed waited far too long to act which resulted in the recession.

Another cause of recessions is when businesses build up too much inventory. This is mainly due to an overly optimistic view of the economy. This causes manufacturers to produce way more goods than the economy or exports can naturally support. It could also be that demand naturally dropped which happens all the time in various industries. When the production buildup occurs manufacturers then cut production to bring it back in line with what the market can support at that time. This then lowers employment and consequently the income levels of the nation’s citizens. This then spreads to other sectors throughout the economy and results in an overall slowdown.

There is another cause of recessions that happens from time to time that is not only incredibly interesting but is definitely something that you need to be aware of. What we are referring to are asset bubbles.

Asset Bubbles

Asset bubbles happen when irrational demand drives up prices of certain assets well beyond what would normally be considered reasonable. This usually happens when investors buy something just because everyone else is buying it rather than carefully analyzing the benefits of buying it for themselves. You may have heard this kind of behaviour referred to as the Herd Mentality.

In the past, many recessions have been caused by these asset bubbles forming and then selling off sharply when market participants realize what is actually happening. These sharp sell-offs lead to a severe drop in confidence. This lack of confidence causes credit markets to dry up because lenders become very suspicious of the value of the assets behind the loans they have made. Banks will pull back loans and become very suspicious of the ability of the entity or person who borrowed to pay back the debt. The banks basically stop lending because they need to protect their balance sheets from losses.

For example, in the U.S. a massive sell-off in the housing market was one of the main reasons for the recession that started in 2007. Many lenders were giving out very large loans to people who had absolutely no ability to pay them back. Some lenders were giving out million-dollar loans to people on something called Stated Income. This one is a mind-blower. Stated income basically means the borrower only had to tell the lender that he or she makes enough money to pay back the loan without actually providing any proof of their ability to repay.

Can you actually imagine walking into a bank a telling them you make a million dollars per year, without providing any proof at all, and then asking them for a 5 million dollar loan for a new mansion? This seems ridiculous. But this is exactly the kinds of things that were happening all throughout this real estate bubble in the U.S. These kinds of loans are what most people have come to learn are called Subprime Lending. When the bubble burst it caused a huge influx of houses to hit the market in a short period of time. This huge amount of supply was far beyond the market's natural demand so prices came crashing down to find a new relative fair value. This was a time in some areas of the United States where houses that were bought for 5 million dollars sold for less than 10% of that by the time the bottom hit.

Oil prices shocks can also be a common hindrance to the economic stability and growth of a nation that is dependent on importing oil. This can occur when a spike in oil prices cut into consumer spending power and increases business costs which can of course lead to a recession. People need oil to heat their homes and fill the gas tanks in their cars. If the prices of oil goes up too much it takes away disposable income because people still need the oil regardless of how high the prices is.

Finally, a decrease in exports can be a common reason to cause a recession. This is especially true for nations that rely heavily on selling their products abroad. If exporters are losing money then this has a negative impact on the country’s income or tax base, and therefore, its ability to grow. For example, in 2008 one of the major causes of recession in Germany and Japan was the significant drop in exports that occurred due to the financial crisis spreading around the world.

As you can see, there can be many reasons for a recession and many common causes that we should always be on the lookout for so that we can position ourselves to profit as early as possible.

4 Trough

Ok let’s get back to the economic cycle and talk about the trough phase.

  • This is the final phase of the economic cycle.
  • During an economic trough businesses have lowered prices for big ticket products enough to start attracting bargain hunters to start buying again.
  • The economy starts to find its footing as consumer spending starts to pick up again.
  • Sales of new homes often start to rise as qualified buyers lock in attractive home prices and low interest rate mortgages.
  • The stock market will start to anticipate the coming economic expansion as transportation and cyclical stocks begin to rise. Transportation stocks start to rise because when manufacturing increases more goods need to be moved around and shipped.
  • Currency traders now try to predict the start of the expansion phase which means that interest rates will start going up in the medium term as the economy heads back into an expansion phase.
  • This time can be volatile for the currency prices as the market tries to find the fair value based on upcoming expectations.

The National Bureau of Economic Research in the United States is the definitive source of setting official dates for U.S. economic cycles. Measured by changes in the gross domestic product they measure the length of economic cycles from trough to trough or peak to peak. Since the 1950s, U.S. economic cycles have lasted about 5 and a half years. However, there is wide variation in the length of cycles, ranging from just 18 months during the peak to peak cycle in 1981-1982, up to 10 years as was the case from 1991 to 2001.

The key to understanding the current economic situation is identifying when an economic expansion is over, when the peak has occurred, or when a new expansion is about to begin after the trough has occurred.

Although the periods of peak and trough can be relatively brief and difficult to pinpoint, understanding economic indicators can help you identify them which is exactly what we will look at next.

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