Governments and central banks craft their policies to incentivize certain behaviour and disincentivize others. They accomplish this through taxes and treaties, laws and regulations. So government fiscal policy and central banker’s monetary policy impact the global economic cycle (but not always in the ways they expect). Policies have intended and unintended consequences that are stimulative for some industries and countries and de-stimulative (and even economically punitive) for others. These policies provide the framework for trade that investors and consumers depend on to make the best decisions possible for their families. In the absence of a clearly articulated policy framework, we have economic chaos.
The global business cycle is like a weather system that is constantly shifting. Economic activity ebbs and flows as the market economy adjusts to countless variables of supply and demand, and fiscal and monetary policy on a minute-by-minute basis.
Seasons are a great analogy for the business cycle. The global economy has always been cyclical and it always will be.
Sometimes it’s hard to discern which season we are in. Sometimes we’ll experience an economic winter immediately after an economic spring or summer, foregoing a gradual slowing of growth that characterizes the economic fall. Each cycle is different, and to a large extent, unpredictable, but there are historical similarities to each one.
Economic Winter is a recession or contraction. It is characterized by high unemployment. Emotions that are prominent include fear, anxiety and pessimism. Stock prices are usually depressed, as are the people that own them. This is also the best time to invest, especially in a 401k or IRA account each month.
Economic Spring is the beginning of new growth. Sometimes it’s gradual, sometimes it happens quickly. People become more hopeful, but guardedly so. They still remember the privations of economic winter and fear its return.
Economic Summer is when signs of prosperity are prominent. Economic winter has been forgotten. Sometimes the economy is booming, sometimes it’s just plugging along. Central bankers prefer steady, 3% GDP growth, to a booming economy and they deploy all their resources and monetary tools to maintain this equilibrium. If the economic summer gets too hot, with GDP growth around 5% or more, inflation becomes a significant risk. Inflation is a massive risk during Economic Summer. It could throw us into Economic Fall or economic winter because it undermines the stability of our financial system.
Economic Fall is a global slowdown. We don’t necessarily see negative growth, but a slowing in the growth rate. So rather than growing at 3%, we might see the economy growing at 1%. It’s still expanding, just not at the higher rate. In some economic cycles, we’ll teeter between summer and fall, and back again, for years.
We guess at where we are in the business cycle by looking at historic statistical data, which by definition is backward-looking, not forward-looking. It’s like sailing a boat while looking in the rear view mirror to discern what the seas ahead of us might be. Sometimes the seas in the rear view mirror are very similar to what we would see in the immediate future. Other times we’re sailing into a hurricane unsuspectingly as we monitor the calm seas we have left behind us.
The key to enduring the economic seasons is asset allocation. 90% of the variability of our investment returns come from asset allocation. Usually there is one asset class that is doing quite well, one that is doing quite horrible and three or four somewhere in the middle. On a month by month basis, this changes. We’ll see different asset classes struggle, and then turn around, and vice versa. Over the long-term the variability in the returns for these asset classes average out and the overall performance of the portfolio is better and the volatility is lower.
Economic Spring is coming (if it hasn’t already arrived) and global asset prices will rise. Although 2009 has been tough, March was a great month for capital markets. Hopefully it is the beginning of a new weather pattern.