Recession Watch: Understanding the business cycle
Head of Equity Strategy
Summary: Policymakers worldwide, from the Fed to the Chinese government, have understood that the risk of recession is heightening and have therefore implemented various evasive strategies. But are these actions enough, or does the very nature of the business cycle mean that recession is inevitable and unavoidable?
Over the course of the past two centuries the economy has grown at around a positive trend. The business cycle is defined as economic activity against that trend. As a result, the business cycle can be categorised into two large phases (above or below trend growth) and then subdivided into contracting and expanding. An economy growing faster than trend and expanding is typically characterised as booming. When the economy is still above trend growth but contracting then the economy is in a slowdown.
The critical point is when the economy begins to operate below trend and is also contracting. This phase is often when policy responses emerge as policymakers begin to realise that the economy is potentially slipping into a recession. An economy can operate under trend growth and contracting but still not be in a recession. However, if policy responses such as fiscal stimulus and monetary easing are implemented too late relative to evolving downside dynamics, then the economy will continue to contract and deviate further from trend growth. In that case the economy typically slips into a recession with all its negative consequences.
When the business cycle turns again into expanding while growing below trend growth then the economy is recovering and the business cycle repeats. It is not always the case that the business cycle travels orderly through the various phases. In some cases policy responses or external shocks can make the business cycle deviate from its normal sequence.
Where is the economy now?
Saxo Bank uses OECD’s Composite Leading Indictors amplitude adjusted as an indicator for where the economy is headed. This time series measures the business cycle using leading indicators relative to an estimated trend growth. According to the OECD, the latest available data as of November 2018 suggest that the OECD countries are growing below trend and contracting. The change in the time series suggests that the business cycle has not yet reached its turning point and the downside deviation from trend growth suggests that OECD countries have alarmingly high probability of entering a recession within the foreseeable future.
Acknowledging this contraction, policymakers ranging from the Fed to the Chinese government have implemented stimulus polices in order to avoid a hard landing and recession scenario. Whether policymakers have acted fast enough to changing conditions will determine whether the economy enters a recession in 2019 or not.
In order to measure which sectors are best or worst during the different business cycle phases we have gathered MSCI World sector indices data. The analysis is carried out by lagging the OECD leading indicators by two months corresponding to the lag between when data is available and when it’s used for decision making. For each phase we measure the average return in the subsequent month.
A clear picture emerges from historical patterns. Whenever the economy is contracting it’s bad for stocks. Not a big surprise. But many may be surprised about the extent to which equities fall while the economy is growing fast (above trend) but contracting (slowing) which is in line with the more severe phase when the economy is below trend growth and contracting. Another interesting fact of our analysis is that Consumer Staples and Healthcare have not, on average, seen negative returns during any of the various business cycle phases since 1995.
This rotating makes sense because in this phase financial conditions are being eased (lower interest rates) by policymakers and the yield curve is steeping, improving profitability for banks, and the lower interest rates stimulate long-duration assets such as real estate (housing) and industrial machinery.