Business Cycle Basics
Understanding the business cycle and being able to identify where we are within a cycle is an important part of top-down analysis as it lets an analyst predict economic activity and fiscal and monetary policy. CFA Level 1 exam questions could ask you to (1) identify where we are in the business cycle based on certain facts, (2) to identify what happens to GDP, prices, employment, investment, or inventories during a given stage, or (3) discuss the theories of the business cycle.
The business cycle represents the cyclical ebb and flow of economic activity. Below we unpack the stages of the cycle and the various impacts of each stage on asset returns.
But before we do it is important to remember that different businesses will respond differently to the cycle. Some are far more cyclical and more correlated with the cycle while others are more defensive. Basically:
- During Downturns: Inflation is decreasing, so real assets will decrease in value. Hold (longer duration) bonds or defensive stocks.
- During Upswings: Inflation is increasing, so real assets will increase in value. Hold cyclcical assets such as equities and commodities. Decrease bond portfolio duration.
Phases of the Business Cycle
The business cycle has four main phases: Expansion, Peak, Contraction, and Trough:
How GDP and the Business Cycle are Related
It can be helpful to contextualize these ebbs and flows relative to the AS/AD model. When the economy is humming it is actually above the long-term rate of GDP growth (above the red line on the graph) and there is inflationary pressure. If an economy is below the long term growth rate there is an output gap, where potential GDP > actual GDP, which causes a deflationary gap.
- Expansion (real GDP is increasing)
- Peak (real GDP flatlines)
- Contraction/Recession (rGDP decreasing)
- Trough (stops decreasing, starts increasing)
And as we know, increasing or decreasing GDP has cascading effects on other economic variables:
- When Output ↑ : Employment, Consumption, Investment, and inflation increasing
- When Output ↓ : Employment, Consumption, Investment, and inflation decreasing
Characteristics of the Four Phases of the Business Cycles
Let’s unpack the characteristics of each of the four phases a bit more.
Characteristics of the Expansion Phase
- GDP growth rate increasing
- Unemployment decreasing
- Investment in capital increases
- Inflation likely to be rising
- Imports likely to increase
Characteristics of the Peak Phase
- GDP growth rate decreasing and may turn negative
- Unemployment rate decreasing but hiring is slowing
- Consumer spending and business investment start to slow
- Inflation increases
Characteristics of the Contraction/Recession Phase
- GDP growth rate is negative
- Unemployment increasing (Labor hours decrease, overtime decreases)
- Consumer spending, housing construction, and business investment decrease
- Inflation rate decreases (but is lagging due to sticky prices)
- Imports decrease as domestic income growth lowers
Characteristics of the Trough
- GDP growth changes from negative to positive
- High unemployment rate, will start to see more overtime and use of temp workers
- May see increase in spending on consumer durables and housing
- Moderate or decreasing inflation
- Inventory/Sales ratios decreasing
Leading and Lagging Indicators
You should also be aware that when thinking about economic activity we use a variety of data points. Some of these data points are predictive of what will happen, others are descriptive of what is happening, and others only tell us after the fact that the cycle has entered a different phase. None of them are bullet-proof. Formally:
- Leading indicators have turning points before peaks or troughs in the business cycle. They can be used ahead of time to identify turns
- Lagging indicators, or confirming indicators, have a turning point after a change in the business cycle
- Coincident indicators occur at the same time as the business cycle
No indicator is perfect and they can change over time so at a minimum analysts should seek to use more than one indicator.
The Inventory/Sales Ratio
In determining where we are in the cycle we often look at company inventories. Inventories provide us with an important leading indicator of business cycle fluctuations. As the cycle goes up, businesses become more confident and therefore increase inventory ahead of demand (the ratio goes up). An up cycle can also be characterized by higher employment rates and often greater costs as overtime pay increases.
At some point there is a shift in confidence and we enter a down cycle. The down cycle has the opposite characteristics of the upswing so businesses cut back production and attempt to reduce inventories
Thus the Inventory/Sales ratio typically increases in later stages of expansion as unsold inventory begins to accumulate. The opposite occurs (the ratio decreases) when a contraction hits its trough as firms deplete their inventories and have to begin to ramp up their production again.
Note that within a business cycle firms also adjust how they use labor and capital. Rather than add/subtract workers, which is expensive and not good for morale, firms will adjust how they use people, usually by eliminating or adding overtime. The same is true with capital, which they will idle etc., and only add or eliminate over time if the contraction or expansion seems likely to persist.
Within the CFA Level 1 curriculum this section ends with a conversation around the different theories of the business cycle before turning to the types of unemployment and the calculations involved with calculating unemployment.