The economic cycle is the process of economic expansion through to economic contraction. That is, the rising and falling of GDP above and below a structural trendline. This article breaks down the cycle to make it simpler to digest and analyse.
Structural Cycles Though not the focus of our work, there are three very important structural GDP drivers which often play out of an entire investors career, or even lifetime. These are:
Workforce growth is stable and the rate of growth shifts slowly through time. In simple terms, the workforce growth drives more workers earning more income which drives more economic consumption, with a multiplier effect. This drive of long term growth is gradually decelerating over time. Decades ago, children were an asset to the family as they provide cheap labour to the family business/farm. The cost to house and feed them was reasonable in respect of the value they would provide the family. As decades past, and lifestyles improved, education systems advanced and the cost of living - most notably housing - climbed, the value of have children shifted from a net asset to a net liability. As a result, the rate of childbirth per family declined. This has resulted in falling workforce growth structurally, a trend still likely to continue in most developed markets.
Productivity growth is an offsetting factor to falling labor market growth. In simplest terms, it is the output per worker. That is, how productive each unit of the labor market is on average. As technology continues to advance allowing revolutions in: a) speed of travel; b) information access; c) cost of energy; d) utilization of spare capacity in people's time & equipment, the output per worker is likely to continue to increase. Finally, the perhaps most misunderstood economic structural driver is the term coined by famous Hedge Fund manager, Ray Dalio: the debt super-cycle. Rather than reinvent the wheel, we point you to his video explaining how this works:
Cyclical components The focus of our work is the 7-10 year economic cycle, and the cyclical underlying components. The main cyclical components on which we focus are the:
Business investment cycle
The first point of note is how these cycles are deeply intertwined and not entirely independent of each other. The second point of note is how crucial the shorter term credit cycle is to each component and that this should not be underestimated. If you haven't already watched Ray Dalio's above video, we strongly recommend it.
The credit cycle is a function of interest rates. In short, as interest rates fall, capital for project investment becomes cheaper for businesses, which in turn encourages new investment and new jobs. Discretionary income increases for consumers with variable rate debts, increasing discretionary purchases. New mortgages become more affordable for home owners and investors which drives demand for new and existing housing, driving the construction markets, renovation markets and home furnishings markets. This cycles are most frequently driven in unison with the cost of money and credit as the core driver.
Business investment cycles are often responsive to current economic conditions. If business is stable, profitability is growing, confidence is high and capital available, businesses will invest in new expansions and new projects. This in turn increases jobs and spending within the economy (which is income for other businesses).
When economic expansion is building strength, businesses will accumulate inventories in anticipation of rising future sales. This restocking of inventory throughout supply chains creates a multiplier effect the further one goes along that supply chain. This is known as the inventory cycle.
For example, as an economy recovers, retailers will look to hold more inventory on hand. This increases the demand for goods sold by the wholesaler to the retailer, as the retailer is buying not only their normal monthly volume of sales but also buying more to gradually restock their inventory. The wholesaler, who is now enjoying higher sales, also decides to increase their inventory on hand given their improving cashflow position. This in turn means the manufacturer who sells to the wholesaler, will not only make their normal volume of sales, but enjoy increased demand as the wholesalers buy more to make their normal sales to the retailer, plus satisfy the retailers demand to grow their inventory, plus accumulate their own inventory. Finally, the manufacturer which has very high sales thanks to demand from the retailer flowing through the wholesaler is responding to these improved demand conditions and has to increase production to satisfy all this demand AND may look to hold more raw materials on site to satisfy better economic conditions. The manufacturer consequently increases their orders from the commodity producer.
I short, through this inventory restocking process, you can begin to see the multiplier effect this has on volume demand as we move further and further up the supply chain. The reverse "de-stocking" also eventually occurs in bad markets, as orders along the supply chain reduce and each part of the supply chain relies more heavily on selling down their inventory (so as to not have to replace those orders) to better manage their cashflow. A process known as releasing working capital. This is why the commodity producers, which sit right at the top of the supply chain, exhibit very cyclical sales volumes, much more so than their downstream industries.
Finally, we focus on the consumption cycle. This element has a lot to do with the interest rate cycle and the wealth effect. The interest rate cycle determines how much discretionary income is available to consumers with variable rate debts (ie, some mortgages, credit card debt) as their interest repayments fall, or those with fixed rate mortgages that can refinance at lower rates. This increased discretionary income ultimately is saved, or spent, often a combination of both. Furthermore, asset prices (ie, house prices and stock markets) rising tend to cause a wealth effect. People feel better about their wealth status and are comfortable to spend more and save less, or alternatively, consumers may increase the debts against their asset to access funding for new cars or luxury expenses. Finally, economic strength drives job security which results in a comfort to spend more and save less.
One can see how all these factors can tip into reverse when the economic cycle tips into decline. Rising interest rates & deteriorating sales environments for businesses has many knock on effects, such as inventory de-stocking, less jobs, less job security, decreasing confidence and thus decreasing business and consumer spending. Many of these factors are self-reinforcing which is why when the economic momentum moves in a certain direction, it begins to trend in that direction for some time. We aim to anticipate turning points in the economic cycle by focusing on liquidity based economic leading indicators, recession probability models and economic cycle models. Download the free white paper below to learn more.
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