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The previous article describes two phases of the market, namely the phase of crisis and recession. In this part two more will be described, recovery and expansion. These are definitely better periods for the functioning of economies and the exchanges than the previous two. However, this does not mean that all financial instruments behave just as well. Therefore, let us look closely at these phases of the business cycle.


Business cycle

The business cycle is the period in which the economy slows down or accelerates. In certain periods we will observe a decline in the economic growth rate, inflation, investment, etc., and in others we will see increased economic activity, which will be characterized by increasing the pace of economic growth, rising inflation, investment, etc.

The business cycle can divide into four phases, crisis, recession, recovery, and expansion. In each phase, other assets will be more profitable compared to others, or even some should be avoided.

In the first phase of the business cycle, crisis, economic growth reaches its culmination point, also unemployment does not want to continue falling, inflation is often increasing, but not as fast as before. Central banks most often increase interest rates for some time to prevent overheating of the economy and the outflow of inflation out of control. Stock market players are often in good moods and only a few see impending problems. It is best to stay outside the market in this phase, or to multiply the capital on bank deposits due to high interest rates.

In the second phase of the business cycle, i.e. the recession, all macroeconomic indicators depress, GDP, inflation, unemployment, often in this period there are stronger drops in the stock markets. In response to the crisis, central banks are beginning to lower interest rates and it is a good period to get interest in fixed-rate bonds.

Phase III – recovery of

Finally, the recovery awaited by investors is coming. Central banks, in response to the recession, have cut interest rates, and this has encouraged enterprises to borrow more extensively in the form of loans. Households also look favorably on the possibility of borrowing due to the low cost of money. In turn, bank deposits are much less attractive than in the previous phase and fewer people use them. The economic growth rate reaches its bottom and accelerates the increase in the GDP ratio. The decline in the GDP indicator for the next quarters is no longer observed, which shows the signs of economic recovery. Many definitions describe the recession as a decline in the GDP indicator for at least two quarters in a row. In turn, inflation may still go down, but this decline will probably be much milder than in the recession.

In this phase, the central bank will probably end the further loosening of monetary policy, although it may maintain very low interest rates for years, as the economic growth rate will not continue to fall, although it may not be at a satisfactory level.

Federal Fund Rate 2009 – 2016

Source: chart based www.federalreserve.gov/monetarypolicy/openmarket

In the recovery phase, investors may slowly start to be interested in the stock market, which should slowly go up. It may be a horizontal movement for some time, but it should not go to bigger falls. This period by traders is called accumulation. More experienced speculators are slowly starting to enter the stock market, which has more prospects for growth than bonds, whose prices have been going up for some time. Less experienced players still remember the heavy losses they suffered during the recession and for now they do not even think about entering the stock market. Inflation may fall for some time, but slower than in the recession.

We had such a situation in 2009 – 2016 in the United States. In 2009, the Fed lowered the federal funds rate to practically zero – ranging from 0% to 0.25% – keeping such a cost of money until the end of 2015. The S&P 500 index in March 2009 has reached the bottom and has climbed ever since. However, it should be remembered that even very experienced traders find it difficult to catch the bottom, but as you can see on the S&P 500 chart in the monthly interval, there was a lot of time for the bull market in the US before the train started out.

Summarizing in the phase of recovery, we are dealing with the following situation:

  • the economic growth rate ceases to decline,
  • inflation may fall for some time, but slower than in the recession phase,
  • the central bank ends with further lowering of interest rates,
  • the stock market is slowly returning to investors’ favor, bond prices have been growing for some time.

S&P 500 2007 – 2018

Source: TradingView.com

Phase IV – expansion

In this phase, bad news has long been replaced by good ones. The economic growth rate is growing, inflation is close to or above the inflation target of 2%, unemployment has dropped to a very low level. Central banks have been starting to raise interest rates for some time.

Stock indices are rising due to the growing profits of companies, but it should be remembered that stock markets usually overtake events in economies, so stock markets in the expansion phase may already be quite overvalued. In the end, they may react more strongly to an increase in interest rates. Stock markets behave best at a low cost of money and vice versa. A better group of assets in which one can invest are raw materials, whose prices will grow due to the very good economic situation.

Copper 2016 – 2018

Source: TradingView.com

We have been dealing with this situation since 2016. In the end, the world economies started to move up, the rate of economic growth started to grow and, above all, inflation increased, which has just started to be driven by the increase in commodity prices. The main global economies entered the fourth phase of the business cycle, i.e. expansion. When economies get too fast, the central banks will press the brakes again and we will enter a phase of crisis and another cycle will begin.

Summarizing in the expansion phase, we deal with:

  • high and constantly growing economic growth rate,
  • quite high inflation, around 2% or above,
  • low unemployment,
  • the beginning of interest rate increase,
  • in this phase, commodity prices should be the best.

Summary

In the first phase, economic growth reaches its climax, unemployment also does not want to go down, inflation is often increasing, but not so much as before. Central banks most often raise interest rates for some time. During this period, one should start thinking about making profits and investing capital on bank deposits due to raised interest rates.

In the second phase, a recession is coming. All macroeconomic indicators depress, GDP, inflation, unemployment, often in this period there is a stronger drop in the stock markets. In response to the crisis, central banks are beginning to lower interest rates and this is a good period to get interested in bonds.

In the third phase of the business cycle – a recovery – the economic growth rate reaches its bottom and accelerates the increase in the GDP ratio. Inflation may fall for some time, but slower than in the recession. The main central banks end with further lowering of interest rates. The stock market is slowly returning to investors’ favor, bond prices have been growing for some time.

In the fourth phase of the business cycle – expansion – we are dealing with a high economic growth rate and still growing, quite high inflation, around 2% or above, very low unemployment, started by the cycle of interest rate increases by major central banks. In the expansion phase, raw materials should be the best. The stock market may also gain – which is noteworthy – but in comparison with the commodity market it is certainly much more overheated.

In the presented article and the first part, the general patterns of the impact of the business cycle on the prices of individual asset classes are discussed. Of course, knowing how individual instruments behave in certain periods is not enough to make profits. What is needed is an in-depth valuation of the instruments in which we want to invest.

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