What are the business cycles and how do they affect economy and our life?

Business cycles are the fluctuations in economic activity that occur over time. They are characterised by alternating periods of expansion and contraction, which affect various aspects of the economy, such as output, employment, income, prices, and profits. In this post, we will explore the five different stages of a typical business cycle and how they relate to each other.

Phases of The Business Cycle

1. Initial Recovery

We will start with initial recovery. This period is usually a short phase of a few months beginning at the trough of the cycle in which the economy picks up, business confidence rises, stimulative policies are still in place, the output gap is large, and inflation is typically decelerating. The recovery is usually driven by some stimulus or correction that boosts aggregate demand or supply. For example, a decrease in oil prices, a monetary or fiscal policy intervention, a technological innovation, or a peace agreement could increase consumer spending, business investment, or exports. Alternatively, a reduction of excess capacity, inventories, or debt could lead to an increase in production or lending. As a result, the economy starts to speed up and expand.

What is happening to the capital markets during this time? Short-term rates and government bond yields are typically low. Bond yields may continue to decline in anticipation of further disinflation but are likely to be bottoming. Stock markets may rise briskly as fears of a longer recession (or even a depression) dissipate. Cyclical assets—and riskier assets, such as small stocks, higher-yield corporate bonds, and emerging market equities and bonds—attract investors and typically perform well.

2. Early expansion

The economy is gaining some momentum, unemployment starts to fall but the output gap remains negative, consumers borrow and spend, and businesses step up production and investment. Profits typically rise rapidly. Demand for housing and consumer durables is strong. The economy is approaching its potential again, and there is a general sense of optimism and confidence among businesses and consumers.

In respect to capital markets, the short rates are moving up as the central banks start to withdraw stimulus put in place during the recession. Longer-maturity bond yields are likely to be stable or rising slightly. The yield curve is flattening, the equity markets tend to trend upward.

3. Late expansion

During the late expansion, the output gap has closed, and the economy is increasingly in danger of overheating. A boom mentality prevails. Unemployment is low, profits are strong, both wages and inflation are rising, and capacity pressures boost investment spending. Debt coverage ratios may deteriorate as balance sheets expand and interest rates rise. The central bank may aim for a “soft landing” while fiscal balances improve. This is the highest point of economic activity in a cycle. The economy is running at or near its full potential, and there is a general sense of optimism and confidence among businesses and consumers.

The capital markets impact involves rising interest rates as monetary policy becomes restrictive. Bond yields are usually rising, more slowly than short rates, so the yield curve continues to flatten. Private sector borrowing puts pressure on credit markets. Stock markets often rise but may be volatile as nervous investors endeavour to detect signs of looming deceleration. Cyclical assets may underperform while inflation hedges such as commodities outperform.

4. Slowdown

The economy is slowing and approaching the eventual peak, usually in response to rising interest rates, fewer viable investment projects, and accumulated debt. It is especially vulnerable to a shock at this juncture. Business confidence wavers. Inflation often continues to rise as firms raise prices in an attempt to stay ahead of rising costs imposed by other firms doing the same. The downturn is usually triggered by some external shock or internal imbalance that causes a decline in aggregate demand or supply. For example, a sudden increase in oil prices, a financial crisis, a war, or a pandemic could reduce consumer spending, business investment, or exports.

At this time, short-term interest rates are high, in some cases still rising, but likely to peak. Government bond yields top out at the first clear sign of a slowing economy and may then decline sharply. The yield curve may invert, especially if the central bank continues to exert upward pressure on short rates. Credit spreads, especially for weaker credits generally widen. The stock market may fall, with interest-sensitive stocks such as utilities and “quality” stocks with stable earnings performing best.

5. Contraction

Recessions typically last 12 to 18 months. Investment spending, broadly defined, typically leads the contraction. Firms cut production sharply. Once the recession is confirmed, the central bank eases monetary policy. Profits drop sharply. Tightening credit magnifies downward pressure on the economy. Recessions are often punctuated by major bankruptcies, incidents of uncovered fraud, exposure of aggressive accounting practices, or a financial crisis. Unemployment can rise quickly, impairing household financial positions. This is the lowest point of economic activity in a cycle. The economy is operating below its potential, and there is a general sense of pessimism and uncertainty among businesses and consumers.

Short-term interest rates drop during this phase, as do bond yields. The yield curve steepens substantially. The stock market declines in the earlier stages of the contraction but usually starts to rise in the later stages, well before the recovery emerges. Credit spreads typically widen and remain elevated until signs of a trough emerges and it becomes apparent that firms will be able to roll over near-term debt maturities.

Conclusion

These five stages form a complete cycle that repeats itself over time. However, it is important to note that not all cycles are identical in terms of duration, magnitude, or shape. Some cycles may be longer or shorter than others; some may be more or less severe than others; some may be more symmetrical or asymmetrical than others. Moreover, different sectors or regions of the economy may experience different phases of the cycle at different times. Therefore, it is essential to monitor and analyse various indicators of economic activity to understand where the economy stands in the cycle and what challenges or opportunities it may face in the future.

Please note, none of the information on this blog represents the opinion of my employer and all information does not represent a financial advice.