How We Explain the Business Cycle Differently

It’s well understood that financial markets are heavily influenced by the macroeconomic environment.

For instance, common wisdom suggests that recessions typically lead to underperformance in risky assets. But we’ve found that the evidence doesn’t necessarily confirm this.

As the economy continued to contract towards the end of 2009, both the high yield and equity markets were up significantly. So, why the disconnect?

Although it’s not an official designation, the most widely used definition of a recession is two consecutive quarters of declining GDP growth. But we argue that macro regime analysis is more nuanced than simply measuring whether growth is positive or negative.

A better approach, in our view, is to determine how growth is performing versus its long-term trend and, most importantly, assessing its direction, i.e. the change in growth.

The combination of these two factors carries major implications for asset prices and portfolio decisions. We’ve broken down the business cycle into four phases:

  • Recovery – Growth is below trend and accelerating
    Recovery is the stage that occurs when the economy is coming out of a recession, with a growth rate that is below trend but improving. Although the definition of recovery is often limited to when GDP growth is positive, we also include periods when it’s negative, but showing improvement from readings that were even more negative.
  • Expansion – Growth is above trend and accelerating
    Earnings growth and profit margins expand rapidly, leading to strong business and consumer confidence, falling unemployment and rising consumption. Credit growth continues to expand. Consequently, inflationary pressures begin to emerge and monetary policy enters a gradual, but steady tightening cycle aimed at containing inflation and excessive credit creation.
  • Slowdown – Growth is above trend and decelerating
    Although growth remains solidly above trend, it starts decelerating due to lagged effects from monetary policy tightening. Credit growth begins to slow and profit margins are no longer expanding, while labor markets remain tight. Financial market performance is also mixed, with insignificant, risk-adjusted returns.
  • Contraction – Growth is below trend and decelerating
    Growth deteriorates rapidly due to tightening lending standards, credit contraction and excessive inventories. Unemployment steadily rises as companies shed workers due to falling profitability, while central banks ease aggressively, and governments respond with fiscal spending to support employment.

In the next section, see how we use recent history as a guide to the business cycle, or download our full paper on dynamic asset allocation.

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