Each of the four economic cycles has its own characteristics. There are two major schools of thought that attribute different causes to the cycles. Monetarists believe the credit cycle (interest rates, debt, spending etc.) influences the economic cycle. On the other hand, Keynesians suggest it is linked to investment demand. We won’t analyze each school of thought in detail, but it is relevant to know about the different beliefs among economics throughout time. Instead, we will take a look at the data surrounding all four cycles.

Understanding Economic Cycles

Companies and consumers react differently at each stage. The economy affects everyone’s spending, savings and revenue.

Some sectors perform better and worse at each stage of the economic cycle. Let’s take a look.

As we established earlier, there are four economic cycles. What are the main characteristics of each stage?

Four Stages of the Economic Cycle

Expansion: There is rapid growth in the economy, interest rates are low to stimulate borrowing, production and spending increase. This phase can last a few years.

Peak: The economy grows until it hits its peak. Economic growth reached its apex. This is where the total output begins to drop and the trend reverses. Some imbalances are created and need to be addressed.

Contraction: This is where a correction occurs and some issued need to be addressed. The output levels drop below the trend. Growth is much slower and interest rates and unemployment increase. This phase can last from a few months to a couple of years until the trend reverses once again.

Trough: The economy reaches its lowest point and begins to recover into an expansion phase. This cycle repeats itself constantly.

Certain factors were mentioned above. Each influences the economy in a certain direction. Let’s take a deeper look.

Factors Influencing the Economy

GDP: GDP growth is often used to measure the progress of a country. However, the disparity between the rich and the poor isn’t shown.

GDP per capita (per person) becomes a much better indicator of a country’s growth. The US dominates in terms of GDP as a country, but remains outside the top 10 for GDP per capita and for growth.

European and Asian countries dominate the GDP per capita statistic. Over time, life seems to get better outside the US.

Interest Rates: Lower interest rates incentivize borrowing. The funds can be reinvested into the economy through spending, or investments (real estate, stock market, infrastructure etc.). Higher interest rates lead to higher prices and less spending. Interest rates determine the liquidity of an economy. 

Unemployment: Most developed countries have a target unemployment rate. In the US, it is around 5%. When the actual rate is below the target, the economy usually does well. We want as many people as possible working, paying taxes and contributing to the development of the economy. So it does affect economic cycles.

Spending: This part includes both personal and government spending. Governments spend on infrastructure, health and communities for a better lifestyle. When there is a lot of growth, it stimulates a lot of spending. 

Economic Cycle Factors

Output: Domestic output is a good measure of our economy. If employers can’t pay all their employees, shortages will occur. With the recent events, this is intensified. It becomes more attractive to outsource production.

Inflation: We are currently seeing the highest inflation rate in the last 40 years. In the first months of 2022, inflation reached over 7% in the US. Historically, we have been trying to keep it between 1 and 2%. Prices across many, if not all sectors, are soaring. This is due to many factors such as shortages, disruption of chain supply and economic uncertainties. Our money is worth less and our usual basket of goods costs more. Unless wages and salaries increase, it becomes more difficult to maintain our lifestyles. 

External Factors: When there aren’t any kind of uncertainties, the economy performs well. Recently, political issues such as war as well as global issues such as the pandemic created many issues worldwide. Until they are resolved, the economy will experience many ups and downs with economic cycles.

Where Are We Now?

Despite many global uncertainties, rising interest rates and high inflation, we are currently somewhere between an expansion and a peak. The stock market may not always reflect this reality as there are a lot of ups and downs.

However, there is strong growth and credit conditions remain favorable. Historically, interest rates are near an all-time low even if the US and the Canadian governments will most likely increase them shortly. 

Once we can go back to a pre-pandemic world and the war between Russia and Ukraine will stop, things might get more stable in terms of prices and inflation. Currently, governments around the world are spending a lot for freedom in Ukraine.

Additionally, the chain supply for major essential goods is disrupted. This leads to longer wait times and increased prices for many necessary items and foods. 

The situation may not seem positive despite many factors. If we are heading towards a peak and an eventual contraction, things might get worse. To better understand how each sector performs during various economic cycles, let’s jump to our next section.

The Best Sectors for Each Economic Cycle

There are 11 sectors in the stock market: Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Real Estate and Utilities.

During each of the 4 phases of economic cycles, certain sectors perform better than others. 

Early Expansion

In the early days of an economic recovery, credit markets are the first to boom. Overall, stocks have the strongest growth during this period, which lasts about 1 year. Quarterly earnings also begin to strengthen.

As interest rates drop and liquidity increases, financial and real estate stocks grow quickly. Investments and spending are on the rise. Bank stocks can quickly become attractive. 

Stocks that heavily rely on consumer spending also begin to rise. Which helps economic cycles. These are called consumer discretionary products. They include retail, entertainment, housing retail and other categories. Luxury goods, travel, home improvement and other categories of stocks also rise.

Mid Expansion

This is the longest period of the expansion phase with an average length of 3 years. The economy is strong. However, growth is slower and steadier than initially. Furthermore, quarterly earnings are much more positive than earlier. Industrials, tech and basic materials stocks dominate growth among stocks. Consumers buy newer electronic devices, companies spend more on research & development and new products are created. 

According to many analysts, we are currently between the mid and late expansion phase.

Late Expansion

As the peak is approaching, growth is almost to an end. This period lasts about 18 months. Stock prices are above many analysts’ expectations. Investors begin to separate themselves from economically sensitive investments. This is a good period to begin to accumulate more cash reserves. However, energy and utility stocks generally perform well during this period. The demand for these products is still high as they are necessary for our everyday needs. 

Contraction/Recession

During the contraction/recession cycle, stocks perform the poorest. Thankfully, it is historically the shortest cycle, lasting on average about 1 year. Bonds and gold perform the best during this cycle, as they are usually recession-proof. They usually outperform stocks. Defensive stocks hold their ground during a recession. What are those? They are products that consumers won’t cut back on during a recession. They include food, household basics, healthcare, electricity and other utility stocks. 

Dividend-paying stocks also perform well during this phase. They offer some financial security and income during a difficult period. On the other hand, stocks that are sensitive to the economy tend to perform poorly during this period. They include most of the sectors mentioned in the early/mid/late expansion phase.

This is a general guide. Over time, every cycle is different and is due to different events. It is possible to take advantage of the economic cycle with a sector rotation strategy.

Sector Rotation

Many investors attempt to time the market with sector rotation. The goal is to purchase stocks or ETFs from a sector when it is in the early steps of growth and sell when the peak is approaching. It may seem easy on paper, but it is difficult in real life. Timing the market has never been an easy task. Even the most knowledgeable investors have a hard time predicting the ups and downs of a sector and of the economy as a whole. It may be wiser to keep some diversity. For a more detailed analysis of each sector and the best investments in each, please visit the following article.

Conclusion

To conclude, each phase of economic cycles has its peculiarities. The expansion phase is the longest. It can be further divided into 3 sections (early, mid and late). Some stocks perform better during certain periods.

As an investor, it is important to be aware of which economic cycle we are in. This is especially important for active investors who are constantly chasing the next industry poised for growth. 

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