Each of the four economic cycles has its characteristics. Two major schools of thought 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 in economics throughout time. Instead, we will look at the data surrounding all four cycles.
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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: Rapid economic growth and 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. As a result, some imbalances are created and need to be addressed.
Contraction: This is where a correction occurs, and some issues must 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 few years until the trend reverses.
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. So 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 growth.
European and Asian countries dominate the GDP per capita statistics. But, 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%. The economy usually does well when the actual rate is below the target. 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 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. As a result, it becomes more attractive to outsource production.
Inflation: We have seen 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: The economy performs well when there aren’t any uncertainties. Recently, political issues, such as war, and 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 between an expansion and a peak. Unfortunately, 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 likely increase them shortly.
Once we can return to a pre-pandemic world and the war between Russia and Ukraine stops, things might get more stable regarding 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 necessary items and foods.
The situation may not seem positive despite many factors. Things might worsen if we reach a peak and an eventual contraction. Let’s jump to our next section to understand better how each sector performs during various economic cycles.
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.
Certain sectors perform better than others during each of the 4 phases of an economic cycle.
Credit markets are the first to boom in the early days of an economic recovery. Overall, stocks have the strongest growth during this period, which lasts about one 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. As a result, 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. In addition, luxury goods, travel, home improvement, and other categories of stocks also rise.
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.
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 everyday needs.
During the contraction/recession cycle, stocks perform the poorest. Thankfully, it is historically the shortest cycle, lasting on average about one 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 sensitive to the economy tend to perform poorly during this period. They include most 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. Therefore, taking advantage of the economic cycle with a sector rotation strategy is possible.
Many investors attempt to time the market with sector rotation. The goal is to purchase stocks or ETFs from a sector in the early growth steps and sell when the peak is approaching. It may seem easy on paper, but it isn’t easy 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. Therefore, it may be wiser to keep some diversity. Please visit the following article for a more detailed analysis of each sector and the best investments.
To conclude, each phase of the economic cycle has its peculiarities. The expansion phase is the longest. It can be further divided into three sections (early, mid, and late). Some stocks perform better during certain periods.
As an investor, knowing which economic cycle we are in is important. This is especially important for active investors constantly chasing the next industry poised for growth.