The term Business Cycle refers to economy-wide fluctuations in production or economic activity over several years. These fluctuations are often measured using the rate of growth of the real gross domestic product.
However, in US the National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”. Most of these fluctuations in economic activity do not follow a strictly or predictable periodic pattern.
In this document we aim to explain how the Business Cycle affect the Intermarket correlations and vice versa. In order to do so we highlight two key assumptions:
- Business Cycles are driven by human activity which, with its optimism and pessimism, influences the developmental process of the economy; and
- Investors buy and sell financial assets based on their expectations of the results of business activity.
We highlight this because financial markets lead the Business Cycle, and investor expectations tend to discount the future of the economy. This is well known and appreciated. Our aim in this document however, is to bring of something more specific to your attention.
The Business Cycle and its phases
Some economists divide the Business Cycle into phases. Some of them break the economic activity down into four phases: start up, growth, maturity and recession. However, seeing that the average recession length is 14 months and the average expansion length is 44 months (see tables 4.1 and 4.2) we have found it more appropriate to break the recessions down into two parts and the expansions into four parts. We believe this is a good way to represent the development of the Business Cycle.
As expansions are almost always longer than contractions, for a better analysis, we have chosen to have at least a minimum of two stages of contraction, and to represent expansions by a least four stages. Please note that this is simply a theoretical approach.Our research and modelling do not involve any fundamentals as our approach assumes that, as we will see in the Intermarket section, all the required information comes from bond, stock and commodity market prices: the Intermarket analysis.
We can represent the unfolding of a Business Cycle with the real GDP line which occurs at the end of a contraction or recession, signalling the beginning of recovery (figure 4.1).
The line continues its upward trend as the economy grows and will spend most of its time in this position. When the economy grows faster and faster inflation begins to hurt the economic expansion. This is the moment when the rate of expansion of business activity declines and soon begins a general slowdown in economic activity.
Sooner or later, we will experience a new recovery and expansion of a new Business Cycle.When there is a prolonged slowdown, we might enter a phase called recession. Depending on many factors, the economy tends to start a new recovery with a new Business Cycle.
Sometimes when the economy is strong, it does not go into recession (figure 4.2), or it happens that a recession phase goes on for a longer period resulting in an economic depression (figure 4.3).
Figure 4.1: The Business Cycle.
Figure 4.2: The strong Business Cycle
Figure 4.3: The weak Business Cycle
In our analysis we have also measured the performance of Bonds, Stock and Commodities according to the Business Cycle phases. Here below we present the results of our test which aims to show the performance of the three assets at the different phases of the economy (figures 5.4 and 5.5).
Figure 4.4: Annualised performance in Business Cycle and its six phases 1900-2017
Figure 4.5: Annualised performance in Business Cycle and its six phases 1900-2017