The Morningstar Dictionary: Economic cycle

Explaining the delicate balancing act between economic growth and inflation

Christian Charest 2 April, 2018 | 5:00PM
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Christian Charest: The cycle, cyclical stocks, non-cyclicals, expansion, recession. These are all words you've likely heard before, but how much do you know about the economic cycle?

The cycle refers to the pattern that growth in the gross domestic product usually follows. It's rarely this clear cut in real life, but this simplified graph shows its four phases: expansion, peak, recession and trough.

Gross domestic product, or GDP, is the total value of everything a country produces over a certain period. This includes the production of goods in sectors such as manufacturing, agriculture and mining, as well as services such as banking, education, health care and so on.

What determines where we are in the cycle is whether the value of the GDP is increasing or decreasing relative to the previous period. Most of the time the trend for the GDP is to increase, which is what we call the expansion phase. This phase is usually accompanied by lower unemployment, higher consumer spending and higher capital investment by companies.

Unfortunately, those elements which are good for the economy also contribute to inflation. One of the goals of our central bank, the Bank of Canada, is to promote "low, stable and predictable inflation," and one of the tools at its disposal to fight inflation is interest rates.

When inflation gets a bit too heated for the central bank's taste, it will raise the general level of interest rates to slow down the economy, since higher rates add to companies' costs, and makes consumption more expensive.

Eventually, as the economy slows down, it reaches a tipping point and the growth turns negative. And if you have two consecutive quarters of negative GDP growth, you're officially in a recession.

During a recession, consumers reduce their spending and companies produce less. This inevitably leads to layoffs and of course, rising unemployment. It also leads to a decrease in inflation, which continues until the Bank of Canada decides inflation is sufficiently under control and it's safe to reduce interest rates.

Eventually, the economy starts to pick up again, companies hire more people, who in turn have more money to spend on goods and services, and the cycle starts over.

Why is all this relevant to investors?

Because the stock market usually follows the same trends as the economic cycle, though not always at the same time or in the same magnitude.

Because stock prices reflect what investors believe will happen in the future, those prices start to go down before economic output actually starts to slow down. That's why stock prices are what's known as a leading indicator of economic growth.

For example, the last recession we had in Canada was in the fourth quarter of 2008 and the first quarter of 2009, meaning the peak of the last cycle was sometime in the fall of 2008 – right around the time the S&P/TSX Composite Index started its descent. Note that at that time, we didn't know yet that we were in a recession, since the GDP data wouldn't come out for several months.

For investors and portfolio managers who follow a more tactical approach, identifying those inflection points ahead of time and adjusting your portfolio accordingly is a great way to make a lot of money. It's also something that's extremely hard to do, and very few investors manage to do it even once, let alone continuously. For most investors, it's better to keep a diversified portfolio of investments that behave differently from each other.

Which brings us to "cyclical" and "noncyclical" stocks. Certain sectors tend to rise and fall at predictable times within the economic cycle; those are referred to as "cyclicals." For example, Canadian energy producers are a cyclical sector, since demand for their product is very much tied to the health of the economy. At the other end, consumer staples such as food or household items, usually enjoy steady demand regardless of economic conditions: These are noncyclical stocks.

Of course, there's no guarantee that things will work out this way. Cyclicals and noncyclicals can react to factors other than the economic cycle. And as I've mentioned, it's practically impossible to predict when the economy will shift from expansion to recession and vice-versa.

So, the takeaway here is that understanding the economic cycle may be useful to explain why the market behaves a certain way, but it's best for investors to stick with a diversified allocation instead of market-timing stock sectors and asset classes.

For Morningstar, I'm Christian Charest

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Christian Charest

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