The main driving forces of the business cycle
There are three main types of economic indicators: leading, coincident and lagging. Lagging indicators are the most important for investors, because they determine the length of the economic cycle and the severity of the economic correction necessary to bring them down so that the economy can grow again.
Inflation, interest rates and labor costs are the most important lagging indicators. A rise in inflation reduces the purchasing power of consumers. Rising interest rates make purchases of everything less affordable – housing and automobiles in particular. Rising labor costs are hampering profitability. Consumers react to rising inflation and interest rates by first reducing the purchase of big-ticket items. This is also the time when the University of Michigan’s consumer confidence drops sharply.
Slowing home and auto sales are early developments reflecting the slowing economy. These slowdowns are reflected in stock prices. Coincident indicators such as employment and sales are also starting to tumble.
The opportunity to invest in equities arises when the leading indicators – those that were the first to signal the slowdown – will pick up.
One of the most important tenets of the business cycle is that the downturn will continue until the causes that created it are brought under control.
The main causes of the slowdown are the rise in the main lagging indicators: inflation and interest rates. The slowdown will continue as consumers cut spending until their purchasing power recovers. This happens when inflation and interest rates go down. This is also the time when labor costs decrease, improving business profitability.
As retail sales increase due to increased consumer purchasing power, the other coincident indicators also increase: employment, production and income. These developments will strengthen and the positive loop will continue until the economy overheats.
This is the time when the lagging indicators rear their heads and the business cycle begins again.
Where are we now?
Lagging indicators are up. Consumer prices continue to rise – up more than 8%. Interest rates – both short-term and long-term – have reached new highs for this business cycle. The yield on the two-year Treasury rose from 0.2% to 2.6% over the past 12 months. The stock market, an important leading indicator, is showing no gains since June 2021 at the time of this writing. Auto and home sales weakened after several months of rising inflation and interest rates.
Consumers reduce spending on big-ticket items first when income after inflation declines, as it is now (see University of Michigan survey shopping conditions charts below ). In other words, an increase in lagging indicators (inflation and interest rates) leads to a spike in consumer buying conditions of the leading indicator (see chart above).
The business cycle has just passed point 7 (see the first chart above). The next trends will be slower growth of coincident indicators. Retail sales and income after inflation are already contracting. Production and employment are still strong. They will need to weaken to reflect production cuts to reduce inventory.
Inflation and interest rates will decline following further weakness in the coincident indicators (sales, income, production and employment). In the meantime, growth in business activity will continue to slow until inflation and interest rates come down enough to increase consumer purchasing power. It will be a long and tedious process.
Economic growth boosts sector performance
The environment facing financial markets is one of slower economic growth. This is an important trend because the sectors that outperform the market when the business cycle turns down, reflecting slower economic growth, are the non-cyclical sectors (XLP, XLU, XLV, XLRE) (see chart below , energy being the exception). The graph shows the percentage change over the last 200 days. During a period of stronger growth, cyclical stocks (XLRE, XLI, IYT, XLF, XLE, XLB, XME) outperform the market. The good performance of the non-cyclical sectors confirms that the stock market has come out of its phase of rapid growth.
High beta, low volatility stocks react to economic forces
High beta (NYSEARCA: SPHB) and low volatility stocks (NYSEARCA:SPLV) move in different ways depending on the trend of the business cycle, as shown in the following chart.
The table above shows two sets of graphs. The upper panel represents the graph of the SPHB/SPLV ratio. The economic indicator calculated in real time from market data and reviewed in each issue of Strategy and portfolio management Peter Dag is in the bottom panel.
Stocks with high beta (SPHB) outperform stocks with low volatility (SPLV) (the ratio in the top panel increases) when the economic cycle increases, reflecting stronger economic growth due to inflation and interest rates declining or stable.
However, low volatility (SPLV) stocks outperform high beta stocks (the ratio in the top panel decreases) when activity declines due to rising inflation and interest rates – as happens since the end of 2021.
Key points to remember
- Leading indicators will continue to decline, reflecting rising inflation and interest rates.
- During this period, low volatility (SPLV) stocks will continue to outperform high beta (SPHB) stocks.
- Leading indicators, such as stock prices, autos, housing, consumer sentiment from the University of Michigan, will bottom out and pick up again after inflation and interest rates fall.
- The fall in inflation and interest rates will be preceded by a fall in the coincident indicators (sales and income after inflation, production and employment).
- This will be when high beta (SPHB) stocks begin to outperform low volatility (SPLV) stocks.