Why the business cycle matters to investors

To construct a well-diversified global portfolio that adapts to changes in the economic environment, investment managers consider the connections between the real economy and the financial markets. Importantly, managers need to understand how these connections change when viewed on a regional rather than a global scale.

LGT's quantitative and economic analysts recently examined how closely a key macroeconomic metric - the output gap - correlates with asset class performance during business cycles. By focusing on regional data on the output gap, LGT analysts showed that stock markets in developed countries track the US business cycle closely. This information is particularly useful for the creation of strategic, long-term investment strategies.

LGT also found that for tactical or shorter-term asset allocation decisions, US business cycle data can be supplemented by regional business cycle indicators, which can help to diversify portfolios, particularly when considering emerging Asian stock, bond, and commodity investments. Emerging Asia in this context generally refers to all Asian economies except Japan.

Identifying potential output 

In economic theory, potential output represents the theoretical, true production capacity of an economy. In the real world, actual gross domestic product (GDP) differs from this theoretical figure, often quite substantially. This is because an economy rarely operates in an equilibrium state. Rather it moves through a series of stages, often referred to as a business cycle.

The business cycle most familiar to investors is the investment cycle of seven to 11 years, known as the Juglar cycle. This cycle has four distinct phases: expansion, slowdown, recession and recovery, which represent the waxing and waning of the business cycle around theoretical equilibrium GDP.

Economists use a range of indicators to estimate actual GDP, or where an economy is within this cycle. "Macroeconomic variables like inflation and employment rates will behave differently during an expansion phase versus say, slowdown or recovery," explains Philipp Zhang, Quantitative Researcher with LGT Private Banking EMEA. "Equally, macroeconomic shocks like the Covid crisis also affect how much actual GDP deviates from the theoretical equilibrium."

Tracking the output gap

These differences between potential and actual GDP are called 'output gaps', and they can be positive or negative. The expansion phase (a positive output gap) implies that an economy is producing beyond its current potential GDP because of technological advances, or higher production capacity, or simply because more people are working overtime. In essence, this represents a level of GDP that cannot be sustained in the long term. In the slowdown phase, as the name implies, although there is still a positive output gap, it is narrowing, implying that the economy may soon fall below potential.

An economy persistently producing below capacity with no signs of improvement, and with a negative output gap, is classified as being in recession. A reversal of this downward trend, with production slowly returning to potential, but still in negative output territory, is said to be in recovery.

LGT's economists and quantitative analysts used the theoretical output gap framework and their own internal data to develop information on regional business cycles over the last 30 years. "What we found," reveals Zhang, "was that Western developed market output gaps move largely in parallel, especially during major economic shocks." The Japanese economy also mostly followed the same pattern.

Emerging Asia is special

But in the emerging Asian economies, the output gap is out of sync with the US output gap. "For instance, a slowdown in emerging Asia occurs at the same time as one in the US only five per cent of the time. In fact, emerging Asia is most likely to experience an expansionary phase in the event of a US slowdown with a 36 per cent probability," reports Zhang. In contrast, a UK expansion phase coincides with a US expansion 76 per cent of the time.

Unsurprisingly, major investment asset classes like stocks, bonds, and commodities perform differently during the four business cycle phases. So LGT analysts also looked at the correlations between asset classes and business cycle phases. Typically, riskier asset classes like stocks perform worst during economic slowdowns, exactly when their performance correlates most closely with the behaviour of the broader market. It is here that the steady performance of government bonds provides necessary diversification.

As bull markets are born in recessions, the typical performance of risky assets starts to be positive and really takes off in the recovery phase. In an expansion, risks and excesses build up. Higher inflation necessitates both higher interest rates and a negative inflation risk premium for risk-free bonds (the benchmark used by economists to describe theoretical bonds that always repay interest and principal).

Unexpected patterns - useful for decision-making

"In the larger Western economies and Japan, asset class performance largely moves in tandem or parallel with the US output gap or business cycle," states Zhang. "This isn't all that surprising given the size of the US economy. We do observe some small differences here and there, but what is important is that the shape of the graphs is very similar."

The pattern changes when certain regional business cycles are plotted against the performance of major asset classes. When looking at the output gap in emerging Asia, LGT analysts found, contrary to the expectation that emerging market stocks would perform worst during a slowdown in Asian regional economies, they in fact perform worst during the expansion phase.

Further LGT analysis looked at whether these observations could be helpful when developing predictive models used in the bank’s investment strategy process. "We concluded that the emerging Asia output gap adds useful nuance when considering investments in Asian and emerging market equities," said Zhang.