Just a Phase? What the Economic Cycle Means for Investors

The expression "history doesn't repeat itself, but it often rhymes" applies as much to business cycles as it does to fashion trends. As consumers, it's tough to avoid fashion trends, but as investors, should we pay attention to the business cycle?

Economic shifts, typically measured by gross domestic product (GDP), affect everything from employment to interest rates to stock markets. So, the short answer is yes — it can be important to pay attention. There are five key stages in a business cycle and the economy tends to shift from one to the next in irregular intervals. Recognizing each stage can help investors understand the position the economy is in and how a potential shift to the next stage might occur.

To qualify as a true shift in the business cycle, a change must be self-perpetuating and affect the economy as a whole. One tough quarter due to bad weather followed by another related to a different, but isolated cause is not enough to signal the start of a recession. Referring to this pattern as a "cycle" can be deceiving as it implies a regular and predictable passage from one phase to the next, but in practice the duration and severity can vary widely from peak to trough.

The five stages of the business cycle

What goes down, must come up, right? Well, yes, history has shown this to be true for economic output. The major global economies tend to work their way through each stage of the business-cycle stages below — to varying degrees and with different timing. Here's what each stage looks like:

Expansion

Economic growth rates are normal, inflation is stable and stock activity is robust. Corporate profits rise, and businesses invest in growth initiatives such as labour and materials to meet growing demand. More new businesses launch and there are fewer bankruptcies than in other stages.

Peak

Demand is greater than businesses can supply. Labour and product shortages push prices up, boosting inflation. Higher interest rates compress both stock market valuations and bond prices. Both individuals and businesses postpone big-ticket purchases that require debt financing, such as homes or heavy machinery.

Contraction

Corporate profits are under pressure, leading to layoffs. Both households and businesses decrease spending, which creates a vicious cycle of reduced profits and higher unemployment which drives the economy into a recession.

Trough

The economy is growing at its slowest rate, so governments reduce interest rates to spur investment and spending. As interest rates decrease, bond prices and stock markets start recovering and the lower cost of borrowing pushes consumers and businesses to start spending again.

Recovery

As consumers begin to buy interest-rate sensitive goods like homes and cars again, businesses gradually increase production while maintaining lower labour costs. Once the economy surpasses the peak of its previous growth level, a new cycle of expansion is underway.

The Business Cycle in Canada

Some of the main influences on Canada's business cycle are:

• Consumer demand (especially housing)
• Business investment
• Global commodity prices
• Synchronization with the United States, our largest trading partner

Historically, stock prices have not immediately reflected a shift in the business cycle. For example, a C.D. Howe report noted that just ahead of the Great Depression that started in 1929, Canada experienced a 25 per cent drop in farm harvests (which represented a large part of our GDP), yet, during that same period, the Toronto stock market index tripled.

Recessions vary in duration and severity, and can have different triggers. Here are a few examples:

• The 1974 recession in Canada was triggered by reduced U.S. demand for lumber and autos.
• The 1981-82 recession was driven by extremely high interest rates (over 20 per cent!) and the S&P/TSX dropped nearly 21 per cent.
• In 1990-91, the new federal goods and services tax (GST) in Canada, combined with the Gulf War, triggered a steep depression and the S&P/TSX dropped 14.80 per cent.
• A massive credit crisis was the catalyst for the global recession in 2008-09, which reduced demand for homes, autos and commodities and caused a 33 per cent drop in the S&P/TSX.

Where does the economy sit today? We'll leave that for the economists to determine, but there are lots of opinions, reports and resources out there that can help you stay on top of economic changes. You can be sure that economists and investors alike are keeping an eye out for the start of the next phase.

*The title of this article was changed on November 6, 2018.