Transcript

Unit 2: The Economy

Lecture 4: Business Cycle Phases

Unit 2 The Economy. Lecture 4 Business Cycle Phases.

All economies experience cycles in economic activity. These are recurring intervals of economic
expansion followed by times of recession. These cycles are termed business cycles and are
defined as current but non-periodic fluctuations in the general business activity of an economy.
Now each cycle consists of four phases. You have a lower turning point, or trough, and this is
when the economy has bottomed out in terms of the recession. You have an expansion and this
is when you have a recovery in economic activity. You have an upper turning point, or peak, this
is essentially when the economic recovery has peaked so economic activity has peaked out and
then you have a contraction, this is when the economy goes into recession or decline. In this
slide you have a graph of the various phases of a business cycle.

Because we are interested in financial markets we are interested in how the business cycle, the
various phases of the business cycle, influence the financial markets. So if we look at one this is
where we coming up into an economic recovery, there is low economic activity, low interest
rates and what that means is that consumption should be stimulated and there should be strong
demand but unfortunately at this stage investors don't recognize that this is beneficial to them.
As we have the economic recovery increasing there will be a strong growth in earnings and
investors will recognize this and react rather enthusiastically which will cause the financial
markets to increase. Now as we reach the peak and the cycle turns, demand in the economy
will start to come under pressure, there will be inflationary pressures which means increases in
inflation and this will have a knock-on effect on interest rate, increasing interest rates, but it
seems investors will still react enthusiastically not realizing that they've actually reached a
turning point. As you move down and you get to the bottom, the economy will become stagnant,
earnings will disappoint and investors will become negative and realize losses they'll move their
money back to the money market and this will have a negative impact on financial markets and
then the whole cycle moves back again to one where investors won't be interested in financial
markets and will remain in the money market.
Now we're going to focus on each of the various phases of the business cycle and what that
means for the economy and we're going to start with the expansion phase. So the expansion
phase is when the economy is in recovery. What this means is that aggregate demand will
increase, firms inventories will run down, production will increase at a faster rate than aggregate
demand as inventories are rebuilt and business will employ unemployed workers, so the labour
market will start to improve who spend their income on consumer goods. This generates more
demand and businesses employ more people, so as the expansion phase continues the
process will continue until businesses encounter capacity constraints, essentially the process of
producing more goods and services will continue until businesses realise that they don't have
the plants, the equipment, they need to increase production. If firms expect continued increasing
demand then they will invest in capital goods such as plants, factories, machinery, equipment,
consumer demand will increase on the back of the increased demand for capital goods as firms
producing capital goods employ more labor. In addition, there'll be an increase in the demand
for investment funds. But an expansion phase can't last forever. So eventually the production
will reach a ceiling due to supply constraint and bottlenecks and we will reach the upper turning
point. The demand for investment funds will put pressure on interest rates thereby increasing
interest rates and new investment will no longer be profitable.

So now we're moving into the contraction phase. This is where economic activity decreases and
the economy moves into recession. So as invested demand, or investment demand, falls,
producers of capital goods will lay off workers, there will be increased unemployment and this
will result in decreased consumption spending or consumer spending. Businesses producing
consumer goods and services will cut down on production and employment because there's no
longer demand for the goods and services and the contraction or the recession will gain
momentum. So much as the expansionary phase could not continue forever, a recession or
contractionary phase, cannot continue forever and eventually the recession will reach a trough,
or lower turning point, when production decreases to some minimum level. At this level
consumer demand will remain steady as workers employed by the government or in industries
producing essential goods and services such as food and utilities retain their jobs. So as a result
of the fact that there was poor demand for investment funds this would have had an impact on
interest rates, which would have fallen at this point, and so with lower interest rates it would
make new or replacement investment profitable again, at least for firms providing essentials and
this is where the economy will start to move up again, recover, with steady consumer demand
and increase in investment demand will begin to lift the economy again.
So essentially, the Merrill Lynch investment clock summarizes, using an actual clock, the
phases of a business cycle and the assets that would be most attractive to invest in during
those phases. So now we're going to look at how the different asset classes perform during the
different phases of the business cycle. Looking at shares or equity, they tend to perform best
during both the recovery and expansion phases and this is because as the economy goes into
recovery as it starts to expand there's an increase in the demand for goods and services, there
is also an increase in investment spending and all of this contributes to an increase in company
profits which is good for shares. But as you get closer to the peak, so as you get closer to the
top of the cycle, profits starting to peak and investors become less certain about what's going to
happen to the profitability of companies. This lack of certainty shows up in the volatility of share
prices. So, during the contraction phase of the business cycle when economic conditions are
deteriorating and corporate profits are falling, share prices will decline. Bonds are likely to
perform best during the contraction phase and the lower turning point because when interest
rates are declining bond prices are rising. Bond prices, or bond values, are inversely related to
interest rates, so higher interest rates mean lower bond values, lower interest rates mean higher
bond values. So, during the contraction phase when interest rates are low, bonds will perform
best. As we've previously mentioned, bond prices, or bond values, are inversely related to
interest rates so when interest rates are high, which tends to happen during the late expansion
phase in upper turning point, bond values will be low. So, bonds will pretend to perform less well
during these phases of the business cycle. With property, it tends to perform well during
recovery and expansion when interest rates are relatively low and employment in economic
conditions are improving. Since commodities tend to be inputs into the production process, as
the economy goes into recovery and as we go into the expansion phase of the business cycle,
demand for goods and services are increasing and when companies are increasing their
production, commodities are likely to perform well because there'll be a high demand for them.
Commodities don't perform well during contraction because manufacturers are cutting back
because there is less demand for goods and services so they're reducing their production
capacity as they go into a contraction. So precious metals such as gold and platinum and silver
which are used as a hedge against inflation tend to perform best during the upper turning point
when inflation is actually quite high. So, during the contraction phase when inflation is low and
industrial demand is low, precious metals won't perform as well.

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