Understanding the Business Cycle
While you may get wrapped up in news headlines and short-term swings in the markets, the reality is long-term investment performance is highly dependent on the business cycle.
The business cycle (alternatively called the economic cycle) is defined as a period of economic expansion followed by recession. The business cycle is defined by four distinct phases: Early Cycle, Mid Cycle, Late Cycle, and Recession. While stages of the business cycle vary in length, Gross Domestic Product (GDP) growth is viewed as a key indicator of the stage of the business cycle.
Corporate profits fluctuate depending on the stage of the business cycle, and as a result investment performance is driven largely by the business cycle. Additionally, different sectors may outperform the broader market depending on the stage of the business cycle. Understanding where we are in the business cycle can help level set investment return expectations and ensure investment portfolios are positioned optimally.
Early Cycle: This phase is characterized by a return to positive GDP growth after a recession, although growth is typically below the long-term trend. Growth is aided by Federal Reserve with loose monetary policy, such as low interest rates and ample credit availability. Economically sensitive sectors including real estate, consumer discretionary, and industrials tend to outperform versus the broader market as demand improves.
Mid Cycle: This phase, also referred to as the Expansion phase, is characterized by accelerating GDP growth. During this phase, unemployment is typically declining and inflation remains low (although likely increasing). This combination of fa-vorable dynamics is often referred to as a “Goldilocks” economy and generally is favorable for stock market performance. Mid Cycle is often the longest of the phases, potentially lasting for years.
Late Cycle (Peak): At this point, GDP growth is likely still positive but slowing. Unemployment is typically at its lowest, while inflation reaches its peak. Defensive and inflation-resistant sectors such as materials, consumer staples, healthcare, and energy tend to outperform, given inflation is relatively high and investors may begin to position their portfolios for a downturn.
Recession: The phase is defined as a contraction in GDP for two or more consecutive quarters. During a recession, un-employment rises while inflation declines. The Federal Reserve will often cut interest rates in an attempt to stimulate the economy. Not surprisingly, equity markets are negatively affected as growth slows. Non-cyclical stocks such as consumer staples and healthcare tend to outperform during this time, although returns still may be negative.