Wed 30 May, 2018
Business Cycles and How They Affect Your Investments
Much like the four seasons in a year, businesses and economies work in periodic cycles. Understanding these cycles and the effects they have on investment performance is a clever tool for making expectations of future returns. While there is no accurate method of predicting the future, business cycle analysis is one way investors can make informed decisions. In this Squirrel blog, we explain how business cycle investing can work for you and your self-managed superfund.
Nuts of wisdom: investments are rather like the weather. While we can make predictions based on past experience, indications from other sources and technical forecasting, we can never be 100% certain of an outcome. Consider business cycle investing a little like your nightly weather forecast – cloudy with a chance of significant returns.
What Are Business Cycles?
According to experts, business cycles tend to last 5-10 years. They begin with expansion, reach a peak, begin to regress into recession, before recovering and cycling round to expansion once again.
The way this relates to investing, is that some industries or commodities perform better at different stages of the cycle. By understanding this, investors can make informed decisions on the best time to buy in. What’s more, becoming au fait with how business cycles work can indicate the lead time on a return.
How do Business Cycles Work?
While nothing is ever entirely predictable, it’s a natural phenomenon in developed economies that cycles tend to work in the same way each time. Cycles begin with expansion – businesses create new products, seize new opportunities and create jobs in this phase. Consumers then establish purchasing power, spending is high and demand therefore follows. Eventually, markets mature, supply meets demand, and business activity peaks. Innovations and improvements have lesser impact at this stage, causing consumer spending to slow and eventually decline into a recessive economy. Companies and consumers suffer in this stage, and spending is curbed to survive the recession. As a result, supply outweighs demand, and businesses must reorganise operations and strategic planning to respond. Once this response happens, the cycle begins again.
Identifying Where We Are in the Business Cycle
Investors and economists can use different measures to establish the current stage of the business cycle. Inflation, employment and growth of Gross Domestic Product (GDP) are the key indicators. Employment is one of the first signs of expansion, followed shortly by consumer spending – people are earning more, pushing up purchasing power and demand for goods and services.
Nuts of wisdom: inflation refers to the cost of goods and services. Inflation figures will rise at the late-expansion stage of the business cycle. This will soon be followed by interest rates in a bid to curb consumer spending, causing GDP to fall – this is where the recession stage of the cycle begins.
Using Business Cycles to Make Investment Decisions
In general an expanding economy tends to lift all businesses, but smart investing involves knowing which businesses perform best during this time. Well-performing businesses benefit, by extension, their investments.
Typically, an investors’ appetite for risk moves in line with the prospect for growth – the highest of which is generally seen in the early stages of expansion. Stocks of SMEs can perform well in this early phase, as can emerging market equities. When growth moderates and expansion is a mid-peak level, stocks of larger organisations often perform well, and satisfy an investor’s appetite for slightly lower risk investments. Investors should then note that recession is the next stage of the business cycle. At this point, it may be beneficial to allocate more of their portfolio to lower-risk investments.
Investing by Sector
Different sectors perform better at different stages of the business cycle, too. Think about how demand changes throughout the business cycle, and apply these principals to the sectors you consider investing in.
For example, the early stages of the business cycle lend themselves to growth-oriented industries like technology and industrial businesses. Resumed business activity in this stage also stimulates borrowing, evidencing the case for investment in financial stocks. When expansion is solidified, so too does consumer confidence. At this point, demand for discretionary goods accelerates, before peaking and eventually moving into decline. In recessive stages of the business cycle, more essential sectors like healthcare and energy often outperform tech and non-essential consumer goods.
Investor Due Diligence
Business cycle investing is one tool used to attempt to predict how well an investment will perform. It is based on the cyclical model and often on historical performance of similar investments – and unfortunately, nothing can ever be guaranteed.
The key point to remember is that risk creates opportunity, and throughout the business cycle, different investments carry different risk profiles. Take a look at how these risk profiles relate to the business cycle, and in turn, how they align with your overall investment strategy. Remember to balance your portfolio with a healthy spread of asset and risk diversity, and link your short and long term investments to business cycles. For example, while consumer-staple industries may be safer investments during recession, a clever investor may deliberately invest at a different point of the cycle, with the understanding that a long lead time is expected.
In summary, an overall awareness of the business cycle can be a supplementary tool for investors looking to make strategic decisions. That said, such decisions should not be made on the assumption of certainty.