By Vaidas Alisauskas & Matas Poska
What are the best ways to secure an investment? As nowadays different financial institutions, well-known economists are speculating about the upcoming recession and areas to invest, it is difficult to choose whether to trust them or not. Therefore, the main goal of our article is to educate and help people to make self-conscious decisions in the future that would increase the probability not only of saving the invested capital but increasing it as well.
In this article, an overview of different phases of the business cycle and their features will be provided, the current situation of the economy will be discussed, and the future forecast will be given.
Business cycle is a representation of fluctuations and changes that the economy experiences over time. It consists of four stages: trough, expansion, peak and recession. The duration of business cycles differs and can only be determined when it gets through all stages.
Early-cycle phase (Trough)
The major features of an early-cycle phase are credit markets recovering and growing, interest rates falling and increase in consumer spending.
During early-stage outperforming sectors are those that benefit the most from early indications of economic growth and the decline in the interest rates. Therefore, interest rate sensitive sectors such as consumer discretionary, financials, and real estate tend to outperform the broader market. That is due to the plethora of industries that benefit from increased volumes of borrowers that is usual in early-cycle phase. On the contrary, utilities and healthcare tend to underperform because of their defensive orientation due to inelastic demand throughout all the phases. Moreover, as energy prices drop (due to inflationary pressures), energy sectors also seem to perform poorly.
Mid-cycle phase (Expansion)
Mid-cycle phase is known as the longest phase of the business cycle. During this phase, the overall economy is stronger (GDP growth rate is between 2% to 3%), but it grows at a less extreme pace. Also, inflation is about 2 percent, while Corporate Earnings are at their peak.
During the expansion, the usual outperformer is information technology sector, as some of its industries, such as semiconductors and hardware, tend to gain confidence in the economic recovery period and are willing to make capital expenditures. Also, communication services sector has historically shown relatively good performance, mostly because of its media industry which shows strength during the mid-cycle phase. The poor performance comes from utilities and materials sectors. During expansion, it is not recommended to invest based purely on sectors’ performances due to lack of clear sector leadership.
Late-cycle phase (Peak)
The main characteristics considering late-cycle phase are slowing economic growth, overheated inflation and expensive pricing of stocks compared to their earnings.
As the signs of economic decline become more notable, defensively-oriented sectors tend to perform the best compared with the overall market. These least sensitive sectors that showed the best performance during the late-cycle phase are mostly producing necessity items and, accordingly, are facing inelastic demand. Therefore, customers continue purchasing items or services provided by healthcare, utilities, consumer staples sectors. Elsewhere, as economic recovery matures, the energy sector, whose performance strictly depends on the prices of raw materials, showed the best performance during the late-cycle, even outperformed defensively-oriented sectors.
The recession phase is known for its decline in corporate profits, drop in GDP growth (below 2%), major corrections in the stock market and peaking interest rates.
The overall economic decline negatively affects the most economically sensitive sectors, while defensively-oriented sectors still maintain the best performance even during a recession. While consumer staples tend to perform the best during recession phase, utilities and healthcare seem still to outperform the broader market. On the contrary, economically and interest rate-sensitive sectors, such as information technology, industrials and real estate tend to suffer a significant economic decline during this phase.
To identify the current business cycle one has to analyze various indicators, such as Real GDP growth, inflation rate, Corporate Earnings and stock prices compared to earnings (S&P500 index P/E will be considered as a representation of it).
Real GDP Growth in the World
According to IMF (International Monetary Fund), Real GDP Growth in the World has been decreasing since 2010. A small correction was recognized in 2018, however, the overall trend continued to be downwards. As IMF stated in their report on the 15th of October 2019: “…economic activity remains weak” (World Economic Outlook, 2019).
Global inflation rate
Since 2016, inflation rate (compared to the previous year) has been increasing until 2018 and during that period it went from 2.77% to 3.64%. After that, there was a small correction in 2019 (3.58%), nevertheless, no significant changes have been recognized. According to Eurostat, forecast for the upcoming years (until 2024) is that there should not be any major movements and Global inflation rate will remain stable at around 3.50% in annual increase.
According to J.P. Morgan, Corporate Earnings have been increasing in the U.S., Japan, and Emerging Markets since 2009 and by now these markets have almost doubled their Corporate Earnings. Corporate Earnings in Europe have been rising as well, but not as significantly. In addition, there was a correction in 2016, however, all the mentioned above markets overcame it and continued to rise.
Stock prices compared to earnings
Considering the reported earnings and market price, since the all-time high in May of 2009 (when S&P 500 PE ratio reached 123.73), S&P 500 P/E ratio got nowhere near over the 10-year period. Since 2010, the S&P 500 P/E ratio has been constantly increasing with some corrections along the way, however, the overall trend kept increasing. Current value of the before-mentioned ratio is 23.36 (based on the data of December 6th, 2019).
Before jumping into conclusions, we must acknowledge that each stage of the business cycle has its own peculiarities and can differ throughout history. Considering the analysis, a statement can be made that currently peaking Corporate Earnings, Real GDP growth being around 3% are indicators of the mid-cycle phase. Also, according to Barchart.com, information technology and communication services sectors are booming, while the energy sector is underperforming compared with the broader market. On the other hand, the inflation rate is over 3% and Real GDP growth seems to be declining. Therefore, it gives an impression to be late stage of the expansion and we can expect the economy to advance into a late-cycle phase in the near future.