Economic cycles (also called business cycles) refers to the shifts in the economy between periods of economic growth and slowdown, often referred to as periods of expansion and contraction. The stages of the business cycle are highlighted in figure 1 below.
Figure 1. Stages of the Business Cycle. An expansion begins at the trough (or bottom) of a business cycle and continues until the next peak, while a recession starts at a peak and continues until the following trough. From the Federal Reserve Bank of St Louis (2023).
Shifts between periods of growth and expansion throughout the business cycle are usually measured by tracking gross domestic product (GDP), which is the monetary value of all finished goods and services made within a country during a specific period.
Summary of the business cycle
Expansion phase
During the expansion phase, growth in economic output is met with increasing consumer demand. While it would be nice if the economy expanded continuously, with limited resources available to produce goods and provide services, and only so many people and businesses on the planet available to to consume these goods and services, the expansion phase will often reach a peak before the downward movement begins.
At the peak of the business cycle, there is a high level of aggregate demand, which leads to high inflation, low unemployment and accelerated growth in GDP. This typically leads to increased demand for real-estate and an increase in property prices.
Contraction phase
During the contraction phase, businesses often cut back on spending, resulting in a reduction in demand for goods and services. This typically drives down the value of said goods and services, which can lead to declines in GDP.
Upon seeing declines in GDP, investors may start to focus on preserving their capital by shifting their focus away from potentially volatile growth assets and replacing them with more stable investments, such as cash and fixed income assets.
When business investment falls, firms may slow down on hiring and start laying off staff to reduce labour costs, and to mitigate the risk of not being able to meet their payment obligations to their employees. Rising unemployment leads to reduced consumer spending. As spending declines, firms that produce goods may see declinings sales and increased inventories, forcing them to cut back on production and potentially lay off workers.
Contractions in the economy can often have a particularly large impact on growth assets, such as shares and property. This is because investors will often seek to preserve the capital growth they achieved during market expansion by selling their volatile growth assets and replacing them with more stable assets, such as cash or fixed income, which typically contributes to higher levels of volatility for growth assets.
Continuing the cycle
Eventually, the contraction in the economy will typically end as consumers and businesses reduce debt and increase their ability to spend. Producers seeking to reduce accumulated inventories may also lower their prices, fuelling further consumer spending. Additionally, with reduced levels of business and consumer debt throughout the economy, the risk of negative impacts arising from borrowers defaulting on their loans is reduced. This puts lenders in a better position to start issuing loans at lower interest rates, which makes investment and spending more attractive. As consumer spending increases, businesses increase production and employment, leading to the next expansion.
During periods of expansion, financial market confidence is often high due to many assets providing strong returns. On the other hand, during periods of contraction, financial market confidence is often low due to many assets declining in value, eroding returns that may have been previously made during the previous period of expansion.
How long do economic cycles last?
Since the 1950s, a U.S. economic cycle lasted about five and a half years on average according to the National Bureau of Economic Research (NBER). However, the timing between peaks in the business is not regular and often varies considerably, which can have a particularly large impact for investors who are looking to plan for their retirement.
What causes economic cycles?
Business cycles are thought to be triggered by demand shocks (often the case) and supply shocks. There are multitude of complex factors that could trigger demand shocks, such as the introduction of new technologies that drive down labour costs and increase production rates, or the commencement of war between or across regions and nations.
Seeing as business cycles are measured by tracking GDP, it is possible to observe both local and international business cycles, which will be strongly influenced by the primary industries that make up a given country’s GDP.
Local and international business cycles
Because Aotearoa New Zealand has a narrow range of commodities that are exported to only a few markets, we are very susceptible to changes in the global economy.
Additionally, due to the small size of the New Zealand stock exchange and its relatively low trading volumes in comparison to other global markets, fund managers that invest in growth assets will typically allocate a large proportion of their holdings to internationally listed equities or property to achieve satisfactory diversification across their portfolio.
Final takeaways
Economic cycles refer to the cyclical fluctuations experienced by the economy. The economy undergoes an expansion phase until it reaches its peak, then transitions into a contraction, leading to a trough, and begins to expand once again.
Accurately predicting the timing and duration of business cycles is a challenging task due to the vast range of unpredictable contributing factors. As a result, being able to perfectly time the dip in the business cycle to maximise gains is unlikely to be achieved consistently, and more or less comes down to educated guesses and lucky gambles. On the plus side, having an awareness of business cycles can enable us to better recognize the hallmarks of periods of expansion and contraction, helping us to make better investment decisions in line with our needs, goals and risk profiles.