Investors are now bracing for a recession amidst historical volatility, inflationary pressures, tight monetary & fiscal policy, and supply chain issues.
However, before investors start panicking about the prospects of a prolonged recession, it is important to understand that a recessionary economic environment is only part of the broader economic cycle, which has historically lasted for a decade on average.
To understand the impact of the upcoming recession, what comes next, and how different asset classes would perform, it is important to understand what economic cycles are and how they impact each asset class.
So let's get started!
Economic Definition of Cycles
Economic cycles are simply the regular movements of an economy from a period of expansion to a period of contraction and back again. Expansions are growth periods characterized by increased sales and production.
Contraction or recession is the opposite—a downturn characterized by decreased sales and production.
Factors that Determine an Economic Cycle
Historically, every economic cycle is different but has broadly followed the same patterns. While each cycle may have variations, the timing depends on factors such as the corporate profit cycle, the employment cycle, and the consumer confidence cycle, in addition to changes in the monetary and fiscal policy over the long term.
Sometimes, large events—such as natural disasters, the outbreak of wars, or shifts in fiscal or monetary policy—can cause economic trends to shift before typical economic indicators give a warning. However, patterns in economic indicators can help recognize the four stages of a cycle.
The four stages of an economic cycle include Expansion, Peak, Contraction, and Recession. For investors to understand how different asset classes perform under each stage, it is important to look at the characteristics of each stage.
The Stages of an Economic Cycle
Economy Expansion
An expansion is often driven by a strong recovery from a recession, as demonstrated by a shift from negative to positive growth in economic activities such as GDP and industrial output, eventually leading to an accelerated growth rate.
Furthermore, credit conditions are no longer tightening due to the loose monetary policy, producing a favorable atmosphere for rapid revenue growth and margin development.
Business inventories remain low, yet sales growth is dramatically improving, leading to a broader expansion. A recent example of an economic expansion is the months that followed the Covid-induced temporary recession in March 2020, after the fiscal stimulus and zero rates led to a rebound in demand.
Economic Peak
Typically, the peak is the longest portion of the economic cycle. This cycle stage is distinguished by a positive but more modest pace of growth than the expansion phase.
Economic activity gains traction, credit expansion accelerates, and profitability improves amid a backdrop of accommodative—though more neutral—monetary policy.
Inventories and sales rise in tandem, eventually reaching a point of balance. The US Economy experienced a peak between the latter half of 2020 and 2021, as consumers and businesses benefited from easy economic conditions.
Economic Contractions
A contraction frequently occurs during the pinnacle of economic activity, suggesting that growth stays positive but decreases. The contraction phase may be described as an overheated period for the economy, with limited capacity and growing inflationary pressures.
While inflation rates are not always high, growing inflationary pressures and a tight labor market compress profit margins and cause the monetary policy to tighten.
Investors and markets are currently experiencing the contraction stage as they brace for the one-two punch of inflation and increasing interest rates.
Recession Defined
A recession is characterized by a decrease in economic activity. Corporate earnings are declining, and credit is becoming scarce. Monetary policy becomes more accommodating, and inventories decline steadily despite low sales levels, laying the groundwork for the next expansion phase.
The US economy is expected to witness a recession in the coming quarters as consumers & businesses brace for deteriorating conditions.
How Assets Perform in Different Stages of an Economic Cycle
Looking at US equities, bonds, and cash performance over the previous seven decades, investors can observe how changes in economic cycle phases cause asset price performance to differ.
In general, the performance of economically sensitive assets such as equities is best when growth accelerates early in the cycle, then moderates over the rest of the cycle until returns begin to drop during recessions.
Defensive assets such as bonds and cash-like short-term debt, on the other hand, have shown the opposite tendency, with the best returns during a recession and the worst relative performance early in the cycle.
To understand the best performing asset of each stage in an economic cycle, it is important to look at how each sector performs in different cycles.
Stocks in an Expansion
The expansion phase, which lasts an average of one to four years (assuming ten-year economic cycles), has historically provided the most robust stock performance (and most recently, other risky assets such as cryptocurrencies) on an absolute basis.
Low-interest rates, the first hints of economic growth, and a rebound in corporate profitability have historically favored stocks more than bonds and cash. Interest rates remain low throughout this period, providing investors more confidence to invest in riskier assets and sell more protective asset classes early in the cycle.
Stocks During a Peak
The leadership of economically sensitive assets such as equities and cryptocurrencies has historically declined as the economy advances past its initial stage of recovery, and growth rates moderate throughout the peak.
The peak phase tends to last between three to five years, with Stock and cryptocurrency performance being fairly solid in absolute terms but not as robust as during the expansion era. Bonds and cash, on the other hand, have continued to underperform equities and cryptocurrencies during this period.
Stocks in a Contraction
On average, the contraction phase lasts about one to two years. As the economy matures, inflationary pressures increase, monetary policy tightens, and investors begin to flee risky assets (as is the case currently).
On a per-capita basis, stock and cryptocurrency performance is essentially comparable to cash. Rising inflation, which is often associated with this cycle phase, hurts longer-term bond performance, which trails the absolute returns on shorter-term cash assets.
Stocks in a Recession
The recession period has typically been the shortest, lasting around a year on average. As economic growth slows and decreases, assets that are more economically sensitive fall out of favor, while those that are defensively oriented rise to the top of the performance line.
During this period, the stock market (and, more lately, cryptocurrencies) has done poorly. Cash has continued to serve a defensive role, while the decreasing interest rate environment typical of recessions is a significant tailwind for bonds.
Conclusion
As investors brace for a severe recession in the coming months, it is important to consider that markets have historically recovered relatively quickly.
Stocks and cryptocurrencies have taken a big hit in the past few quarters, with investors fleeing to fixed-income securities currently. But like all economic cycles, the sectoral rotation will eventually lead to a shift back to equities, which have been the best performing asset through most of an economic cycle.
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