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The Anatomy of Business Cycles

We reflect on how economics, interest rates, mean revision and human behaviour can impact business cycles.

We often hear references to the “business cycle” or the “economic cycle” or the “interest rate cycle”. For example, when Chancellor Osborne talks of his long-term economic plan and achieving a structural fiscal balance over the course of the economic cycle, the implicit assumption is that the economic cycle is a frequently-changing, dynamic concept which has an impact on the government’s fiscal balances. Gordon Brown, the former Chancellor, famously even hinted at an end to boom and bust – a reference to the episodes of buoyant economic activity alternated with periods of sluggish economic activity implicit within the definition of a cycle.

What is the business cycle? How does it occur? Can it be eliminated? Is it synonymous with the economic cycle and/or the interest rate cycle or any other cycle? Ultimately, what is its impact on investment strategy and portfolio composition?

Background and context

The notion of economic and business cycles has existed for some time and has been the focus of considerable scholastic attention since at least 1925 when Russian economist Nikolai Kondratieff hypothesised that the global economy evolved in a cyclical fashion, with intervals of high growth alternating with intervals of low growth in what Kondratieff termed a “Supercycle” lasting forty to sixty years. Mainstream economics, however, does not regard this as an acceptable framework for analysis and Kondratieff himself was sent to a Soviet gulag and executed for his efforts in 1938.

Modern macro-economics does, however, accept the concept of the relatively shorter-term business cycle and considerable academic research has been done on this by the likes of the Economic Cycle Research Institute (ECRI) in the US.

Intuitively, of course, the idea of cyclicality appeals to human beings – both, as psychological succour that “the bad times will not last” as well as the sombre realisation that “the good times won’t, either”. We see it in nature – tidal waves in seas and oceans, for example, or the migratory patterns of birds.

There is, however, a theoretical under-pinning to cycles in the context of economics – it is built on concepts of supply, demand, marginal profit, rational expectations, the search for equilibrium and mean reversion.

Theoretical framework

Consider each of the constituent elements described earlier:

Supply and demand – demand refers to the quantity of goods and services consumed by participants within an economy and supply refers to the response from manufacturers of those goods and services to that demand.

The law of demand and supply postulates that higher the price, lower the demand and higher the supply. Conversely, lower the price, higher the demand, and lower its supply.

Marginal profit – in a scenario of under-supply, or scarcity, prices of goods can rise. The profit earned from this higher price can attract new participants to add to supply on the rational expectation of earning the same high level of profit.

The profit can, of course, never be the same – additional supply lowers prices and alters the profit margin. Each marginal (additional) unit of supply is produced at a certain cost – the Marginal Cost – and sold at a certain price – the Marginal Revenue. The difference is Marginal Profit. In perfect market equilibrium conditions Marginal Profit is zero.

Rational behaviour, equilibrium and mean-reversion – theoretical economics assumes the behaviour of participants in an economy is based on rational expectations i.e. derived purely from measurement of costs, profits etc. and not coloured with human emotions like greed, fear, envy etc. Equilibrium models are built on the basis of this assumption.

Equilibrium is the elusive point in the dynamic interaction of counter-parties within an economy at which price levels are perfectly matched to a certain level of demand and an exactly equal level of supply e.g. in a scenario of under-supply, or scarcity new supply enters to take advantage of high profit margins but the same new supply lowers prices and margins, discourages additional new supply but drives demand higher which, unless further new supply enters, will result in higher prices again. At some point in the equilibrium framework, prices, supply and demand mutually adjust to levels where further adjustment is not necessary and the system is balanced.

Mean-reversion is precisely the behaviour of economies seeking that elusive equilibrium, frequently over-shooting to levels that result in over-supply/under-demand (glut) or under-supply/over-demand (scarcity) which then creates the conditions for the system to self-correct. This ability of the economy to self-correct away from points of excess, towards a point of equilibrium is referred to as mean-reversion.

How it all comes together

Business cycles thus become the interplay of supply, demand, expectation, profits, equilibrium and mean-reversion. In the real world, of course, the picture is further complicated with taxes, policy, international trade, competitor tactics and technology.

Demand growth leads to higher prices and profits, additional investment for more supply, lower prices, more demand etc. and, for a while, the economy experiences the benign effects of growing demand, job creation, moderate inflation and rising investment to increase supply – the growth phase of the cycle.

Inevitably, the system continues adding new supply even past the point of zero Marginal Profit. This results in over-supply, falling prices, business losses, bankruptcy, job losses, falling supply and general economic weakness – the recession phase.

The human factor

The ultimate complication, the undoing of most theoretical models, is human behaviour. The tenuous assumption of rational expectation is rarely the basis of human decision-making.

Consider investment decision-making: the ‘rational expectation’ assumption tells us that when prices fall, demand (buyers) should increase and supply (sellers) should decline. What we see is the opposite – as prices fall, investors get fearful and increase supply (selling their holdings) to avoid larger losses. Demand, on the other hand, almost disappears because buyers are fearful of gaining exposure to an asset that is falling in value.

Conversely, as prices rise, demand rises as more investors are keen to buy an asset that is rising in value but supply decreases as existing holders, keen to maximise profit, await higher prices. Thus, greed and fear colour investors’ rational expectations.

Occasionally, the tendency towards “irrational” behaviour can be influenced by past behaviour. Academic research on this is sketchy, but anecdotal evidence suggests there may be some effect on the quality of decision-making arising from past experience. Thus, senior decision-makers who have, in earlier, formative years, been through turbulent economic and business conditions are aware of the dangers of excessive risk-taking and tend to take measured responses to changes in market conditions.

In sufficient numbers – contemporaries who have risen to levels of authority after experiencing extremes of market/economic dislocation – these cohorts of leaders can potentially raise the aggregate quality of decision-making in the private and public sector, potentially making equilibrium more durable by reducing the economic volatility resulting from over- or under-investment.

Unfortunately, what this also brings is a higher probability that the next generation of senior decision-makers – those that have cut their teeth in periods of relative calm and high-quality growth – might not be possessed of the same ability to deliver sustainable growth as their predecessors. The human factor can thus influence, and in turn be influenced by, the economic cycle.

Cycle indicators: leading, coincident and lagging

In broad terms, different economic variables serve as ‘leading’, ‘coincident’ or ‘lagging’ indicators of the economic cycles. Leading indicators start to turn ahead of, or in advance of, any turn in the underlying economy itself e.g. bank credit growth. Changes in coincident indicators are more closely timed with changes in the underlying economy e.g. company profits. Lagging indicators – such as jobs and wages – typically follow changes in the economy.

Impact on portfolio construction and strategy

The stock market is a pretty potent leading indicator of the economy. A well-researched view on changes to the economic cycle is central to formulating investment strategy.

For instance, during the growth phase, a reasonable strategy might be to position the portfolio towards pro-growth, cyclical sectors, companies and investment themes e.g. equities.

Near the peak of the growth phase, a typical strategy might remain over-weight higher-risk asset classes like equities, but move away from ‘growth-‘ and towards ‘value-based’ strategies. Inflation too can become a key consideration, so a strategy favouring asset classes like index-linked Gilts could be potentially rewarding.

Awareness of economic cycles thus becomes a necessary (no success without it) but not sufficient (i.e. success is not assured with “awareness” alone) condition for successful investing.

Important information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise.

No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed in this content.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions.

Any views expressed within this report are our in house views as at 24th April 2015 and should not be relied upon as fact and could be proved wrong.

The information contained in this content has been derived from sources which we consider to be reasonable and appropriate.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

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