At a fundamental level, the business cycle arises in response to the interaction of uncertainty, expectational errors, and rigidities that prevent instantaneous adjustment to unexpected events. It reflects decisions that
- Are made based on imperfect information and/or analysis with the expectation of future benefits,
- Require significant current resources and/or time to implement, and
- Are difficult and/or costly to reverse.
The phases of the business cycle vary in length and amplitude. It is not always easy to distinguish between cyclical forces and secular forces acting on the economy and the markets. Although the connection between the real economy and capital market returns is strong, it is subject to substantial uncertainty
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. Recovery is often supported by an upturn in spending on housing and consumer durables.
- Duration of a few months.
- Business confidence rising.
- Government stimulus provided by low interest rates and/or budget deficits.
- Falling inflation.
- Large output gap.
- Low or falling short-term interest rates.
- Bond yields bottoming out.
- Rising stock prices.
- Cyclical, riskier assets such as small-cap stocks and high yield bonds doing well.
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.
- Duration of a year to several years.
- Increasing growth with low inflation.
- Increasing confidence.
- Rising short-term interest rates.
- Output gap is narrowing.
- Stable or rising bond yields.
- Rising stock prices.
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.
- High confidence and employment.
- Output gap eliminated and economy at risk of overheating.
- Increasing inflation.
- Central bank limits the growth of the money supply.
- Rising short-term interest rates.
- Rising bond yields.
- Rising/peaking stock prices with increased risk and volatility.
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.
- Duration of a few months to a year or longer.
- Declining confidence.
- Inflation still rising.
- Short-term interest rates at a peak.
- Bond yields peaking and possibly falling, resulting in rising bond prices.
- Possible inverting yield curve.
- Falling stock prices.
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.
- Duration of 12 to 18 months.
- Declining confidence and profits.
- Increase in unemployment and bankruptcies.
- Inflation topping out.
- Falling short-term interest rates.
- Falling bond yields, rising prices.
- Stock prices increasing during the latter stages, anticipating the end of the recession.
