Systematically observing and measuring the different [[Cycles|cycles]] in the economy and financial markets gives us a consistent framework for understanding their inherent [[Complexity|complexity]]. Most market participants focus on predicting these cycles which often leads to the mis-pricing of market risk and opportunities for those who have a deeper understanding of how these cycles work. We look at the past before we look at the future. 1. **Expansion:** in the early phases of an expansion incomes and spending increase without increasing prices because production and supply are still ample to meet demand. As the expansion progresses inventories are drawn down and businesses increase production to replenish depleted inventories which increases consumer incomes and supports spending. As companies recognize strong demand they invest and borrow to take advantage of new opportunities and consumers increase consumption by borrowing to make new purchases. This increased demand for credit has two effects: 1) it increases the cost of longer-term credit, raising longer-term interest rates and steepening the yield curve and 2) it pulls consumption forward through the use of credit. 2. **Peak:** As the cycle moves into later innings spending starts to drive prices higher as companies increase not only production but prices to increase profits and demand can outstrip the productive capacity of the economy as consumers borrow to buy more goods and services. As prices rise, inflation rises and this is when the central bank typically steps in to increase interest rates in an attempt to reduce inflation by increasing the cost of short-term credit. If the central bank is able to raise interest rates enough to slow spending and reduce prices, lower inflation and less demand for long-term credit will lower the interest rate on long-term credit which will cause the yield curve to flatten. This is often referred to as a soft-landing. 3. **Contraction:** If the central bank raises short-term interest rates enough to meaningfully reduce spending and companies begin to reduce costs by laying off workers and reducing incomes which further reduces spending and can lead to a contraction in the economy. Prices fall as companies produced too much and supply is higher than demand. As unemployment increases and spending decreases the central bank will stop raising interest rates and begin to lower interest rates. If the central bank is able to lower interest rates enough to stimulate spending and companies begin to borrow and hire workers the demand for long-term credit will increase and steepen the yield curve once again. 4. **Trough:** As the central bank lowers interest rates and prices fall eventually consumers and businesses will begin to spend again as the opportunity of lower prices increases demand and borrowing will increase as the cost of capital has fallen. ![[Pasted image 20231206102207.png]] ## Cross Asset Correlations Through the Cycle **Expansion Phase** In the early phases of an expansion income, spending, and profit rise together in a virtuous cycle. Interest remains are typically low coming out of a recession and as the demand for credit increases interest rates begin to rise. Prices remain stable in the early parts of an expansion as leftover supply from the previous contraction is absorbed and new production is brought online to meet increased demand which also increases incomes. Aggregate incomes increase as companies hire more workers and wages increase which supports consumer spending. Profit margins increase as production increases with the increase in employment. 1. Stocks find an excess low and begin a new uptrend. 2. Stable interest rates. Credit markets re-open. Bonds find an excess high and begin a new downtrend. The correlation between stocks and bonds is negative. 3. Real Estate does well as the economy grows. 4. Commodities rise with economic growth. **Peak** As the expansion ages spending and investment is increasingly speculative as the good times are expected to continue forever and this spending is increasingly financed by debt which pressures interest rates higher. Companies begin to raise prices in a response to strong demand and demand can outstrip supply which also puts pressure on prices. The pool of available labor shrinks as employment increases and wages increase which puts pressure on profit margins which increasingly makes companies raise prices. Higher prices lead to higher inflation and because the central bank cares about inflation it may begin to raise interest rates. 1. Interest rates increase reflecting higher growth and inflation. Credit markets begin to tighten. 2. Stocks accelerate 3. Real Estate suffers from higher interest rates and tighter credit 4. Commodities accelerate exacerbating inflation **Recession** The expansion is typically cut short by an increase in interest rates related to inflation. This is the point where aggregate debt levels and the credit markets determine if the downturn is a cyclical recession or a larger deleveraging cycle. In the run up to the peak speculative activity increases into a frenzy until it stops all of the sudden. The central bank has historically managed the business cycle by raising interest rates as inflation increases in the later stages of an economic expansion. Explore Further: [[Growth-Inflation Tradeoff]] | [How The Economic Machine Works by Ray Dalio](https://youtu.be/PHe0bXAIuk0?si=Ryc3DW4h0JA7An1F) | [Principles For Navigating Big Debt Crises](https://www.principles.com/big-debt-crises) Tags: #portfolio-management Your support for Cedars Hill Group is greatly appreciated <form action="https://www.paypal.com/donate" method="post" target="_top"> <input type="hidden" name="hosted_button_id" value="74PGN8ZXHQVHS" /> <input type="image" src="https://www.paypalobjects.com/en_US/i/btn/btn_donate_LG.gif" border="0" name="submit" title="PayPal - The safer, easier way to pay online!" alt="Donate with PayPal button" /> <img alt="" border="0" src="https://www.paypal.com/en_US/i/scr/pixel.gif" width="1" height="1" /> </form>