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What happened to the traditional business cycle?
24 Mar 2020
Financial theory has defined a business cycle by categorising it into five phases, distinguished by different economic characteristics. These five phases are initial recovery; early expansion; late expansion; slowdown and contraction. Economic growth increases during the first three phases, pushing inflation higher, with the support of rising business confidence (Figure 1). At the end of the third phase, economic growth peaks leading the way to a slowdown that results in lower business confidence and continued rise in inflation, pushing companies to raise prices to cover the rising costs. Once economic growth turns negative, the contraction phase takes place, and central banks generally intervene by lowering short-term interest rates to stimulate the economy back to a recovery. The cycle starts again. 

The main use of the business cycle is to determine the level of growth the economy will generate, and in turn be able to set expectations for financial markets. Moreover, one can determine the best performing sectors within the overall market by identifying the phase of the business cycle expected going forward, and in turn deliver higher performance by allocating more exposure towards these sectors. As can be seen in Figure 1, an economic bottom drives outperformance of cyclical sectors like Consumer Discretionary, Financials, Technology and eventually Industrials, in anticipation of a recovery. On the other hand, a peak in economic growth suggests that defensive sectors like Consumer Staples, Utilities and Health care, which produce basic necessities and offer greater visibility of their stable earnings, perform better.  

Nevertheless, this textbook-cast-in-stone method that has been continuously studied and relied upon, has been tested, with the period from 2019 to date representing the longest period of inconsistency, where a mixture of defensive and cyclical sectors are both delivering top performance – an irrational phenomenon to the sector categories deemed as opposites. This performance featured more prominently in Europe last year, with both Healthcare and Utilities (defensive sectors) and Industrials, Consumer Discretionary and Materials (cyclical sectors) performing better than the overall market. To add to the mix, economic figures being released at the time showed signs of slowing growth leading to the conclusion that the economy is in a peak stage, which would suggest that defensive sectors ought to perform better. The same has been the case in the start of this year, with Utilities and Technology being the top performers across both Europe and the US, despite analysts’ expectations showing real GDP growth to remain at a flat growth rate of 0.3% in the Eurozone and 1.9% in the US for the next five quarters. The outlier among sectors is Financials. Though most sectors delivered double-digit performance last year, Financials in Europe ranked at the bottom three, underperforming the market by 3.7%. In contrast, US Financials were able to register good gains as interest rates in the US are much higher than Europe.

A justification for this situation is central banks’ decision to hold short-term interest rates at low levels for a prolonged period. Historically, short-term interest rates are lowered during a contractionary phase and remain low during the initial recovery, after which central banks start to withdraw stimulus in response to improved economic activity. However, central banks’ mandate includes the main culprit for this decision – inflation. With inflation remaining low, central banks have decided to maintain low rates in an attempt to normalise the level of inflation towards their 2% target. At the expense of banks’ margins getting squeezed, companies enjoyed much lower funding costs and in turn found it attractive to increase their debt levels to support their operations and growth. As a result, businesses benefitted from a ‘low funding cushion’ when economic growth started to flatten and thus were still able to report good earnings despite lower revenues, with markets ignoring the increased risk from higher leverage. Markets remained steadily on the rise, prolonging a bull market, and pushing cyclical stocks upwards. Nevertheless, this extended bull market has led investors to question its endurance, developing an element of complacency where investors remained exposed to equities to be present in the market rally but also entered into defensive positions to protect themselves against a possible downturn. The end result is that both risky and safe-haven assets including defensive and cyclical sectors performed well.

So does this make the concept of a business cycle obsolete? Should we throw all theories of business cycles out the window? One can argue that this is the case. But on the other hand, this scenario may just show that we are living in interesting times where financial theories are being tested against drivers moving in opposition directions in response to economic factors that are far from textbook material. 
One cannot negate the assurance given in the past century that markets mean revert towards their long-term average, leading to the conclusion that some form of normalisation will prevail towards behaviour that is more rational to the economic state at play. 

This article was first published on Sunday Times of Malta on 22 March 2020. It was written by Christabel Saliba, CFA, Portfolio Manager at Wealth Management, Bank of Valletta plc.

This article is not, and nothing in it should be construed as an offer, invitation or recommendation in respect of investment products or services offered by the BOV Group.  Any views, assumptions or opinions expressed in this article are those of the author. Value of investments may go down as well as up and may be affected by changes in currency exchange rates. Past performance is not a guide to future performance. Issued by Bank of Valletta p.l.c., 58, Triq San Żakkarija, il-Belt Valletta VLT 1130.  Bank of Valletta p.l.c. is a public limited company regulated by the MFSA, licensed to carry out the business of banking and investment services in terms of the Banking and Investment Services Acts (Cap.370, 371 of the Laws of Malta).  
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Bank of Valletta p.l.c. is a public limited company regulated by the MFSA and is licensed to carry out the business of banking and investment services in terms of the Banking Act (Cap. 371 of the Laws of Malta) and the Investment Services Act (Cap.370. of the Laws of Malta).