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Where are we in the business cycle?

For financial professionals only

The business cycle is the recurring sequence of economies expanding to a peak followed by a contraction to a trough. While this series of events is predictably reoccurring, it’s not periodic. Since 1857 the length of an expansion or contraction has historically ranged from less than 12 months to over 10 years, as seen in the chart below.

While the business cycle is simple in theory, multiple factors make it difficult to pinpoint current positioning with any precision. We have to make judgements based on current market conditions coupled with future expectations and how they might differ with what the market is pricing.

Recession looming?

The Covid pandemic caused 2020 to mark the end of the longest expansion phase in history, swiftly followed by the shortest contraction. Another expansion phase has since emerged, but there are suggestions this could be short lived. If so, it could be one of the shortest in history.

Recessionary signals

Investors, market commentators and economists generally have a poor track record of predicting market inflections. Some quip that economists successfully predicted 9 of the last 5 recessions! But one indicator with a good track record is the shape of the yield curve. A normal yield curve slopes upwards to the right. Typically, short-term bond yields are lower than long-term bond yields, compensating for the extra risk of lending for a longer period.

However, with global inflation remaining persistently high, labour markets as tight as they are and geopolitical risks increasing inflationary pressures, central banks are speaking more aggressively about interest rate hikes. This has led the short end of the curve to rise much quicker than the long end, resulting in an inversion of the yield curve. This has traditionally been a strong precursor of a recession.

Non-recessionary signals

However, there are plenty of factors opposing a traditional recessionary environment. Firstly, expected growth rates for 2022 are above historical averages in major economies. Traditionally growth rates would be below long-term averages as we move later in the cycle.

Central banks are at the start of a monetary tightening cycle, implying policy is currently loose.  Again, this is not a natural environment for a recession. The question is whether they can navigate the tightening cycle without creating one.

We’re not experiencing major deterioration in credit quality of corporates – in fact quite the opposite. This year the ratio of rating agency upgrades to downgrades has been very healthy, indicating we’re closer to early/mid cycle than running up against a recession.

Finally, the labour market is extremely tight, especially in the US where unemployment is at extreme lows, leading to wage growth which isn’t a classic signal of a looming recession.

Future is always uncertain

It’s impossible to know exactly what the next 12 to 24 months will bring. At one extreme we could see central banks induce a recession by being too aggressive while not solving the inflation problem, leading to a 1970’s style period of stagflation. Alternatively, inflation could be controlled either naturally or as a result of central bank action. So suddenly we’re in a world of more normal inflation levels, above average growth, and healthier levels of interest rates.

While the yield curve inversion has been a solid recessionary predictor historically, it gives no indication of how long that might take. Often stock markets have performed pretty well in the meantime. Of course, unexpected events and shocks to markets occur and we can’t completely rule out a downturn.