In recent years there has been more and more focus on the business cycle, and the cyclical nature of events in general. While it’s true that Ray Dalio has contributed to the democratization of cycles in the retail investing world with his well known “How the Economic Machine Works“, similar findings have been discovered long ago by Joseph Schumpeter and, in the 1900s, by the interdisciplinary work of Edward Dewey.
We now know that there is a business cycle that lasts around 8-9 years and it is driven mostly by credit expansion and contraction. Today we will explore the “asset price approach” to the business cycle, which is most convenient for traders because it is chart-based.
The Credit Cycle
The following snapshot from the FRED database should be somewhat familiar. It is the visual description of what Dalio talks about: the burgundy line represents credit expansion/contraction in the US. It’s evident how it correlates to other key measures such as unemployment, capacity utilization and GDP.
But alas, as traders we have a natural inclination to watch asset prices and not really leading indicators or board macro variables. Fortunately there is a well known approach that uses probabilistic analysis to identify the shifting phases of the economy, which provides a framework for allocating to sectors according to the probability that they will outperform or underperform.
The Asset Price Approach to the Business Cycle
Certain types of investments perform better in different phases of the business cycle. Of course, due to progress and the changes in the underlying economy, this sector rotation does not work like clockwork, but it is still very effective and relevant.
There are broadly 4 phases to the business cycle:
- Early Recovery/Expansion: this is the “v-shape” recovery from recession, marked by an acceleration in economic activity (rising GDP, rising Industrial Production, rising Employment) as credit becomes more available via accomodative Monetary Policy.
- Mid-Cycle: this is the longest phase and is characterized by a positive but more moderate rate of growth. Monetary policy goes from accomodative to neutral, credit growth is strong, and economic activity is strong.
- Late-Cycle: this is where the economy shows signs of overheating with above average rates of inflation. Monetary policy becomes more restrictive, credit availability starts to drop and corporate profits drop.
- Recession: the contraction of economic activity. Credit is scarce and monetary policy becomes accomodative.
Fidelity has put together a very good summary of their findings and the signals seem clearest during the early recovery phase and the late-cycle & recession phases. Let’s explore the main signals together, for the US, China and Europe, using ETFs.
Our first chart is the ratio between a US Consumer Discretionary ETF and a Utilities ETF. The vertical lines are the material changes in trend for the ratio, and it’s interesting to see how they correlate to the leading indicator of the business cycle: the ISM PMI.
When the economy is doing well, interest-rate sensitive and economically sensitive sectors (like Consumer Discretionary and Financials) should naturally outperform defensive sectors (like Utilities and Consumer Staples). Vice-Versa, when things are going sour, the opposite should happen.
Below is the ratio between Consumer Staples and Industrials for the USA.
So it would appear that only now in October 2018 is something starting to change in the US. The economy is finally starting to feel the pinch of higher interest rates and is perhaps working at full capacity.
But how are China and Europe doing? Below is the ratio of China’s Consumer Sector to the Energy Sector. It seems China has been slowing down since early 2018.
And finally Europe. Europe has evidently NOT benefitted from any kind of recovery over the years because we have been in a broad range in the Consumer Discretionary vs Consumer Staples sectors. Notice the remakable difference in this chart compared to the US an China. Europe dippes into contractionary territory during the Greek Crisis, then emerged but dipped again into 2015-2016, and is dipping again as we speak.
Over to You
To be fair, this quick analysis doesn’t really help pinpoint where we are in the business cycle. Then again, that’s not as important as knowing whether conditions are broadly favourable or whether the tide is turning. After all, we’re not in the business of predicting trends; we’re in the business of reacting and riding trends.
Along with the Monthly Macro Monitor, a peek at these key ratios can help ascertain how much stress is in the system and better direct your focus towards defensive or aggressive trades.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.