The Cycle of Life
6 Apr, 2021
 |
READ TIME 6 mins
Max Pacella
Investment Analyst

As we close out the first quarter for CY2021 and a flurry of economic updates enter our inboxes, now seems like an appropriate time to take a closer look at the business cycle and its relationship to markets and the economy.

Whilst the business cycle is closely linked to the peaks and troughs of capital markets, it is more accurately described as fluctuations in an overall trend in aggregate economic activity – that is to say, the business cycle represents how the economy (represented here by firms) reacts to short-to-medium term shocks to their growth trend.

In much the same way, those firms which are reacting to economic shocks are the same ones which make up the equity/fixed income markets, so their reactions may then translate into the performance of their securities.



A stylised representation of the business cycle

Source: University of Sydney, Hoover

Understanding the factors that influence the business cycle offer us greater insight into the behaviour and patterns of capital markets – as investors, this kind of clarity and understanding is yet another edge for market analysts.

Leading Indicators

Leading indicators are activity across the market which ‘pre-empt’ the business cycle, corresponding with some future movement or shift in sentiment.

Stock market movements

Capitalistic forces in markets are some of the fastest agents to react to changes in sentiment, perceived economic conditions or demand/supply shocks to the system. With equities being so liquid, the movements of the stock market often precede changes to mid-term economic conditions.

Money growth

Overall money supply represents the level of money in various levels of the economy (we will define two measures shortly) – the level of supply is a leading indicator for the business cycle. The logic goes that if money is abundant on household balance sheets or in savings accounts, then it is available for consumption or investment and the cycle will enter an expansion. The reverse holds for if there is relatively little money in the economy.

Credit spreads

Credit spreads – being the difference between the risk-free rate (e.g. the U.S. Treasury rate) and the rate of another debt instrument with the same duration – are another leading indicator relating to market health and confidence.

When spreads widen, this is treated as a poor indicator for economic health, because investors will only buy the instrument when paid more for the risk. In other words, the market has less confidence and less willing to take on risk.

As spreads widen, institutions are also willing to lend less, and this increases the cost of servicing debt/leverage.

Lagging Indicators

Lagging indicators, conversely, are items of economic activity which only eventuate after a shift in the business cycle has occurred. These act as confirmations of the trends established by the leading indicators.

Inflation

The buzzword on everyone’s mind at the moment, inflation tends to be a lagging indicator which appears after a prolonged period of economic expansion in the cycle. As the economy improves, consumption increases and demand is built up in the market, so the price of goods and services tends to increase and lead to inflation. Inflation is of a concern primarily because it can erode the underlying value of assets.

Unemployment rate

The unemployment rate is a lagging indicator, since companies will generally wait to gain confidence that the economy has recovered before they start hiring and adding fixed costs to their bottom line – this results in a scenario where the economy can be accelerating at the same time unemployment is increasing. In this sense, decreasing unemployment is lagging confirmation of an expansion trend and an indicator of general business confidence.

Short-term interest rates

Since short-term interest rates are subject to reactions to large movements in capital markets, they can operate as lagging indicators for economic sentiment. Short-term interest rates are also an effective lagging indicator because they can show (in certain circumstances) the stance of Central Banks to current fluctuations in the business cycle; for example the RBA anchoring short-term interest rates out till 2024.

With capital markets being so driven by sentiment at the moment, understanding leading and lagging indicators can be invaluable to understanding market movements – or to interpret and translate the market’s elation or panic to some given part of the business cycle.

Demystifying Money Supply

Let’s link two of the most topical indicators together: the leading indicator of money supply, with the lagging indicator of inflation.

There are several different measures of money supply, let’s define the two most commonly referenced;

M1 Money Supply: M1 is the supply of money composed of; physical currency and coins, checkable deposits and “demand deposits” (which are most commonly made up of checking or savings accounts). M1 captures the most liquid portions of overall money supply.

M2 Money Supply: M2 captures all portions of M1 supply plus what is termed “near money”, which includes; savings deposits, money market securities, mutual funds and short-term deposits. Whilst not as liquid as M1, it still captures what is considered ‘easily convertible near money’.

As a side note, when you see references to “M2 money supply increasing by 25% in 2021”, this does not mean that inflation is increasing at 25% – although this claim has been made by some market participants. What this more accurately reflects is an increase in cash flowing into near money assets such as savings accounts or checking accounts.

Source: Federal Reserve Economic Database

Traditionally, increased money supply eventually led to increased inflation. This relationship held strongly until around the 1990s, after which time it seems to have broken down – but why did it break down after that?

There are two concise answers we will touch on for the sake of brevity, plus an entire world of economic literature for those fond of extra reading.

Firstly, let’s discuss inflation targeting.

Most central banks now employ a form of monetary policy which sets a target inflation rate per annum, using short-term interest rates to try to maintain ‘price stability’ (i.e. control inflation). Prior to this, to use the Reserve Bank of Australia (RBA) as an example, central banks would employ ‘money targeting’ policies, which focused on the growth rate of money supply instead.

New Zealand was the first country to employ inflation targeting in 1990, followed shortly by Canada in 1991 and Australia in 1993. The US Federal Reserve only officially set an inflation target in 2012, but instead had a shifting target range which was still based around 1.7-2% per annum.

This means that prior to the 1990s the focus was entirely on controlling money supply without much consideration for the level of inflation it brought.  After the heightened levels of inflation (and associated economic costs) seen in the 1980s, inflation became the focus and therefore its level became controlled independently of the money supply.

Secondly, let’s discuss the velocity of money.

This is the rate at which money is exchanged between economic agents (consumers or firms), identifying how much one single unit of currency is used within a certain period of time.

The reason why this factor is important to inflation and to the business cycle is that velocity of money can show us the rate that consumers/firms are collectively spending their money.

Money can exist and not be spent – and if money is not spent, it does not contribute towards inflating prices because it is not creating demand within the real economy.

The price of bread doesn’t rise because the baker anticipates all the money hidden under your mattress will one day be spent on bread.

Source: Bloomberg

Velocity of M2 money in the US peaked in the late 1990s and has been collapsing ever since, very much in line with the breakdown of relationship between the overall M2 supply and level of inflation.

Given the breakdown in relationship, what can we expect from the drastic increase in money supply (particularly M1) in 2020-21? Will this new money prompt a new expansion in aggregate economic activity and therefore the business cycle? Will inflation once again follow money supply?

There is unending uncertainty around these topics, with vast disagreements from different market observants or schools of thinking.

Something that should underpin these questions is the notion that money supply and inflation do not hold a linear relationship; if a household increases their savings by 25% (i.e. increases the M2 money supply), they do not generally turn around three months later to spend every dollar they have saved.

Inflation is more likely to increase proportionally to increased money supply than be a direct conversion from one to the other.

To demonstrate the uncertainty surrounding these questions, I leave you with the former supply chart, but now showing data up to 2021 – we are seeing a leading indicator enter uncharted territory, with nothing to do but wonder if the business cycle will follow.

Source: Federal Reserve Economic Database
The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.

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