Understanding economic, market and super cycles

Last weekend, we visited Brighton Pier. My husband and I enjoyed the view and the sound of the waves. My children, full of excitement, tried out the different rides – including Air Race, which flipped them upside down and round-about, and Crazy Mouse – a roller-coaster.

Investing can sometimes be a bit like a roller-coaster ride, with our emotions peaking and troughing a bit like our hearts plunging from our throats to the pits of stomachs. It can be a thrill, but it can also be somewhat terrifying, especially if our life savings are involved.

And that’s exactly what it’s been like over the past couple of years. First the pandemic sent markets crashing, before we experienced the fastest recovery in history.

To understand this better and what it means for our investments, we first need to understand the economic cycle.

The economic cycle

The term economic cycle (or business cycle) refers to the fluctuations of the economy as it goes through four stages of a cyclical pattern: expansion, peak, contraction/recession, and trough.

Factors such as gross domestic product (GDP), interest rates, employment numbers, and consumer spending, can help to determine the current stage of the economic cycle.

Understanding the economic cycle can then help investors and businesses understand when to make investments and when to pull their money out, as it has a direct impact on everything from stocks and bonds, as well as profits and corporate earnings.

The market cycle

The market cycle follows a similar pattern to the economic cycle and is again divided into four distinct phases. Expansion occurs when investors are feeling confident and are looking to buy assets. It peaks when investors think prices have gone high enough and then contracts as people start selling instead of buying. The market cycle troughs when confidence and asset prices are at a low point.

Sometimes, a market cycle can be relatively gentle, like waves lapping gently on a shore. At other times, it may be more like the ocean during a ferocious storm, with investors first scrambling to buy specific assets, then panicking and selling in large quantities.

The chart below shows the psychology of the market cycle in more detail and is perhaps something we can all relate to.

There are several reasons for the natural cycles in the financial markets. Chief among them are macroeconomic factors including inflation, interest rates, economic growth rates and unemployment levels – the economic cycle we mentioned earlier.

A drop in interest rates and improving employment figures, will commonly send markets higher as they are perceived to indicate economic growth. On the other hand, a rise in inflation is often an indicator of an impending rise in interest rates, causing contraction of the market and slowdown of economic growth – which in turn can cause unemployment to increase and therefore dampen consumer spending further.

How the market cycle can anticipate the economic cycle

“Economies tend to move between ‘boom’ and ‘bust’,” explained James Yardley, senior research analyst at FundCalibre. “Our animal spirits lead us to become both overly exuberant in good times and overly pessimistic in bad times.

The tricky thing is that markets are generally clever, and they will usually see a recession a long time before it hits. Therefore the ‘market cycle’ tends to lead the ‘economic cycle’.

“Take the current fall in markets this year. At the start of the year, every economist was expecting growth. There was no mention of recession – even after Russia invaded Ukraine – but the markets were already pricing in worse times. We’ve seen a steep fall in many global markets from their peak and a recession in Europe and the US has now become the consensus view.

“Paradoxically, investing in a recession, like in March 2009 or April 2020 for example, can often be the time when you can make the best returns as an investor.

“But it is hard to be positive when everything around us is negative – and vice versa. It’s human nature to find it hard to go against the crowd. And unfortunately, investors will often divest in a recession and buy when everyone feels good at the top. It’s why we always tell investor not to panic when markets fall and urge caution when markets are very high.

“A very long-term investing-through-the-cycle approach is often the best way rather than trying to time the market cycle.

Super cycles

There are also cycles within industries. We see this all the time in various commodity markets. It feels like only yesterday, for example, that we were stunned by negative oil prices. Now, suddenly, everyone loves oil companies and investments again.

A ‘super cycle’ is a prolonged cycle where a particular industry or commodity experiences sustained growth. A famous one was the commodities super cycle, which followed the rise of China between 2000-2014. We also see cycles in many other industries like shipping or semi-conductors.

These industries all tend to follow the same pattern. High profits mean companies expand thinking the good times will last forever. The expansion causes a big increase in supply – be it a commodity, ships, chips etc. Demand then weakens and the industry is suddenly heavily oversupplied causing a crash in prices. Low prices mean people don’t invest in new supply causing a supply shortage. And the whole cycle repeats.

Marcus Phayre-Mudge, manager of TR Property Trust, recently talked about a green building super cycle – as offices and other buildings look to go to net zero (you can listen/read more here).

The managers of BlackRock World Mining trust also talked about a multi-decade period of strong demand for commodities on this podcast interview.

“Trying to time cycles can be very dangerous but also extremely profitable,” concluded James.

Thinking about where we are in the economic and market cycle today, smaller companies have historically done better as markets anticipate improving economic fortunes as we come out of recession – so in the near future, people could consider this area with funds such as IFSL Marlborough UK Micro Cap Growth, Jupiter European Smaller Companies, Artemis US Smaller Companies, Baillie Gifford Shin Nippon or The Global Smaller Companies Trust.