What is an economic cycle?

The term ‘economic cycle’ often appears in economic and investment commentaries, but few of us fully understand what it means or how it can influence company performance.

‘Economic cycle’, also known as the business cycle, refers to the circular journey of an economy from expansion to contraction and then back again. Along the way, the cycle is punctuated by four key stages: expansion, peak, contraction and trough.

Expansion refers to a period of strong economic growth, typically fuelled by low interest rates. Low interest rates can enable businesses and consumers to borrow cheaply. This can help fund business growth and consumer spending. During this period, we can expect to see growth in wages and employment, as well as a general trend of sustained demand for products and services.

Economic growth peaks when the economy reaches its maximum productive output and is no longer able to meet consumer demand. This can lead to higher prices as demand increases for goods and services but businesses are unable to increase supply accordingly. Some businesses may decide to invest more to increase their production capabilities, but this can make the provision of goods or services more expensive. Against this kind of backdrop economic growth becomes unsustainable, inflation may go up, central banks may increase interest rates to counter inflation, and the economy could begin to contract.

The contraction phase of the economic cycle typically involves a decline in consumer spending and business profitability. Employment and income levels may fall as companies reduce their workforces. The economic contraction may even lead to a recession.

The bottom of the market cycle is referred to as the trough, the point at which economic growth hits its lowest point and consumer spending and income are typically at their weakest. After this point, the economy may begin to grow again, starting a new cycle.

US economic cycles have an estimated average length of around five-and-a-half years. But there can be wide variations. For example, two cyclical peaks were recorded between 2019 and 2020 (1).

Cyclical, non-cyclical and structural companies

Different types of companies can respond differently to economic cycles. Companies that specialise in non-essential goods and services are typically considered ‘cyclical’ companies, as they are more sensitive to the economic cycle and move largely in lockstep with it. So consumers are typically less willing to spend money on travel, luxury goods and hospitality in tougher economic times. This can hinder the performance of companies in these industries during a cyclical downturn.

Non-cyclical industries typically include healthcare, essential consumer goods (such as food) and utilities (such as electricity and water suppliers). These are less influenced by the economic cycle due to their necessity to consumers. The demand for these services is evergreen and can be maintained, even if at a reduced level, regardless of where we are in the economic cycle.

Finally some companies or industries are more subject to ‘structural’ than cyclical trends. Structural trends refer to dramatic shifts in how industries or markets function. Examples can include ageing populations, such as in Japan, or artificial intelligence. Both of these structural trends have developed over time, with little option for reversal. Industries supported by structural trends are generally less exposed to cyclical factors.

Cyclical and structural trends can impact the long-term performance of investment portfolios. At Schroders Personal Wealth one of our key principles is to take an active approach to investment management. In this regard we use our own investment skills, and that of our investment partner Schroder Investment Management, to aim to ensure our funds and portfolios are positioned to benefit from these trends.

Source:

(1) Investopedia (www.investopedia.com), ‘Economic cycle: definition and four stages of the business cycle’, 19 December 2023.