When it comes to economic cycles, there are four main stages, which are expansion, peak, contraction and trough.
The stage that an economy is in can have a significant impact on the performance of a particular type of investment as well as certain industries.
Therefore, picking investments that suit a particular stage of the economic cycle can help to improve the returns that an investor achieves. It can also help an investor to minimise risk.
The very top of the economic cycle is called the peak. It is the stage of the cycle where expansion ends, representing the last month before an economy enters recession.
The very bottom of the economic cycled is called the trough, which refers to the phase in the economic cycle that marks the end of the contraction phase. It is the stage that occurs just before the expansion phase and is the opposite of the peak phase.
Expansion is the phase of the business cycle where the GDP of a country grows for two or more consecutive quarters – Moving from a trough to a peak. On average, it lasts for between 4 and 5 years.
Expansion is characterised by a rise in employment and increased consumer spending. The stock market tends to rise dramatically during the expansion phase.
This happens because interest rates fall, making money cheap to borrow. This allows businesses to grow their operations very aggressively.
The expansion phase can be identified through low interest rates and a low level of unemployment.
The investment type that performs the best during expansion would be stocks. In particular basic industry stocks (i.e. chemicals, paper, steel) and cyclical consumer stocks (general retailers, airlines, leisure, automobiles) perform the best.
Contraction refers to the phase in the economic cycle where the economy as a whole starts to decline. It starts when GDP has declined for 2 or more quarters, resulting in an official recession.
The contraction phase is a symbol of financial hardship for many, with unemployment increasing as opportunities decline. It’s not always clear how long a contraction can last for, though it can last for years.
Although GDP is the primary measure of contraction, what the public experiences is more visible. There is a lack of productivity, which results in a lack of jobs and less money being spent by consumers.
Precious metals, like gold, tend to perform well in the contraction phase, as investors see gold as a defence against inflation.
Defensive stocks also perform well (food, retail, pharmaceuticals, and utilities), as they operate in fields that are always needed by people, regardless of whether the economy is strong or not. When things are not well with the economy, people also tend to stock up, which results in higher profits for defensive stocks.
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