Cycles are all around us. The seasons operate in an annual cycle based on Earth’s orbit around the sun. Biological cycles drive our sleep-wake times, our appetites and our desire for physical activity versus intellectual focus. Even what’s considered fashionable has proven to be cyclical – whether you like it or not, the mullet has made a resurgence in recent years.

Cycles are unavoidable. However, they allow us to prepare for the future. We plan our holidays, our wardrobes, and in many cases work or business, around the seasons. We plan our meal, sleep and work times around our ‘biological clock’.

The economy also moves in cycles, characterised by periods of expansion and contraction, resulting in peaks and troughs. Understanding these cycles can help you better prepare for your financial future.

We may not know exactly when we will enter the next phase of an economic cycle, how long it will last or the size of a given fluctuation, but the fact there will be a ‘next phase’ is almost a certainty.
With this in mind, we look at the phases of an economic cycle, the hallmarks of each and considerations to assist investors prepare accordingly. The mullet, on the other hand, nothing can prepare us for…

What are economic cycles?

An economic cycle, also commonly known as a business cycle, is the fluctuation of an economy between periods of expansion (or growth) and contraction (recession).

The concept has been around for some time. French statistician, Clement Juglar, studied the rise and fall of interest rates and prices in the 1860’s. Juglar discovered boom and bust waves which ranged from nine to 11 years in length, identifying four stages of each wave – prosperity, crisis, liquidation and recession.

Juglar is responsible for developing the earliest known example of economic cycles, the core principles of which have remained true to present day.

Phases of the economic cycle

Although they’re not quite those that Juglar put forth in the 1860’s, there are still four main phases that categorise an economic cycle – expansion, peak, contraction and trough.

Expansion

If we lean on Earth’s seasonal cycles for an analogy to economic cycles, the expansion phase would closely resemble spring. Green shoots begin to emerge before rapidly blossoming. During the expansionary phase, the economy typically experiences fairly rapid growth in a number of key areas, but namely gross domestic product (GDP).

When the economy expands, output increases, which has a far-reaching flow on effect. Businesses produce more goods and services, resulting in companies requiring more hands on deck to sustain increased output. This leads to more people being fully employed, which puts money in people’s pockets, leading them to spend and invest more – thus driving further growth.

During this phase, corporate profits grow, driving dividend growth which in turn drives share price growth. This is great for long term share investors, but it often also has the effect of driving speculative investment. As other investors look on to the growing share market, they gain the confidence to speculate that the growth will continue, and they pile in. This in turn drives further share price growth.

Interest rates are often low during this phase which can decrease borrowing costs and drive property price growth.

Higher profits can also lead to lower vacancies in commercial property, and low interest rates can also lead to low cap rates – which are associated with high asset values.

It can seem to an investor that life is great for everyone during this phase – but expansion doesn’t last forever.

Peak

While a growing economy is great for most people – it can have its drawbacks.

For instance, if consumer spending increases rapidly, companies may need to compete for labour resources to keep up with demand, leading to wage growth. This puts upward pressure on prices more broadly, in addition to spurring further demand growth. If wage growth and consumer spending outpace production growth, inflation results. Furthermore, exuberant investment into particular asset classes can lead to bubbles (a point where asset prices are inflated beyond their fundamental values).

This is sometimes referred to as an overheating economy, and it is unsustainable – you could argue that the ‘summer’ of the economic cycle is short.

To slow growth in an economy that is expanding too quickly, the central bank of a given country may raise interest rates to encourage individuals and businesses to spend less and save more.

At the peak, prices and economic indicators may stabilise for a short period before growth slows down – sometimes to a halt, and sometimes even reversing into negative growth.

Rising interest rates increase borrowing costs, which can impact property values. Increased borrowing costs can also slow down business growth which can flow through to poorer share market returns. Higher interest rates also result in falling bond values.

The peak is short – and it is unclear when it is occurring until after some of these negative trends start to emerge.

Contraction

Where the expansion phase is represented by spring, the contraction is autumn, characterised by a period of decline. As you may expect, the performance of the key indicators outlined in the expansionary phase is the opposite here.

As output decreases, businesses require fewer employees, raising the unemployment rate. Given the heightened competition for fewer jobs, wages decrease, with the flow on effect of this a decline in consumer spending. Consequently, prices decrease, resulting in deflation.

If an economy contracts too much, the recessionary environment may devolve into a depression. In an effort to avoid this, a central bank may look to reduce interest rates to encourage businesses and individuals to increase spending. It can take time for consumer and investor confidence to grow, so expansionary monetary policy (reducing interest rates) won’t always have an immediate effect.

Trough

A trough marks the bottoming out of economic activity. At this point in the cycle, GDP, employment, consumer spending and confidence, as well as business investment are all typically at their lowest. If there was a fashion analogy for the trough, it would be the mullet – the lowest of lows, where the only way is up.

While economic winters can last for some time, the absolute trough, like the peak, is a turning point. The silver lining of a trough is that it is the end of a decline and marks the beginning of a new expansion phase, kicking off the economic cycle again.

Falling interest rates have inspired investor and consumer confidence. People and businesses are more willing to borrow – driving business and asset growth. Falling cap rates can lead to increased commercial property values and even bonds increase in value as interest rates fall.

The catch? Just as nobody can know for sure when we’ve found the peak, nobody can know for sure when we’ve found the bottom.

The importance of diversification

Understanding the economic cycle means understanding it will continue – you can’t avoid it. But you can avoid reacting in fear when things turn for the worse, or reacting in greed when things turn for the better.

Instead, it is vital to build and maintain a diversified investment strategy that suits your unique needs. Therein lies the importance of understanding cycles and the impact of each stage.

This article is issued by Trilogy Funds Management Limited ABN 59 080 383 679 AFSL 261425 (Trilogy Funds) and does not take into account your objectives, personal circumstances or needs, nor is it an offer of securities. Investments in Trilogy Funds’ products are only available through the relevant Product Disclosure Statement (PDS) and by considering the Target Market Determination (TMD) issued by Trilogy Funds and available at www.trilogyfunds.com.au. All investments, including those with Trilogy Funds, involve risk which can lead to no or lower than expected returns, or a loss of part or all of your capital. See PDS and TMD for details. Investments with Trilogy Funds are not bank deposits and are not government guaranteed. Past performance is not a reliable indicator of future performance.