The concept of Economic Cycles, which are sometimes referred to as Business Cycles, is a theory that attempts to explain changes in economic activity that vary from a long term growth trend as observed in a developed market economy. Factors considered in defining an economic cycle include growth of GDP, household income, employment rates, etc. Economic Cycles are divided into two main categories: booms and recessions. Booms are associated with a strong economy, while recessions are characterized by below-trend economic growth. The National Bureau of Economic Research (NBER) is considered the authoritative source in the US that reports the dates of the peaks and troughs that quantify Economic Cycles. NBER defines economic cycles a bit differently than Economic Cycle Theory.
Rather than booms and recessions, it classifies the economy as being in expansion or contraction. Expansion is when several pieces of economic data are improving, and contraction is a decline in the same data. These definitions focus more on the movement of data, whereas the boom/recession definition only refers to the data’s position relative to historical averages.
The basic idea behind economic cycles is that they’re more than just mere fluctuations in economic activity and are significant enough to be “widely diffused over the economy.” . A short term decline in economic activity has historically been observed to be followed by a short term gain in economic activity. Observed over longer periods, the highs and lows average out to form the trend, or average, economic growth rate. The Economic Cycles Theory holds that although this trend growth rate is subject to change, it has remained relatively steady in the past, thus theoretically indicating the general rate of economic growth that we can expect to see in the mid-term future. No attempt is made by Economic Cycles Theory to describe economic activity during extended periods of decline, only growth.
Key features of an economic boom:
- Above-trend GDP growth
- Higher disposable incomes
- Less unemployment
- Increased consumer spending
Key features of a recession:
- Below-average GDP growth. The historical definition of a recession is when the economy has two consecutive quarters of negative growth. Usually by the time the official reports come available to identify a recession the market has already priced in the recession. Most recessions have a time span of 18-24 months.
- Lower disposable incomes
- Higher unemployment rates
- Decreased consumer spending is caused by the above mentioned conditions, lower disposable income from inflationary pressures, higher commodity prices such as oil, or food sources. The less spending can lead to higher unemployment. Many times this first shows in the retail sector. The three items mentioned, basically, will manifest itself on the other and snowball into a recessionary period.
While the economy as a whole is negatively impacted by economic cycles, certain companies and industries are particularly sensitive to changes in the overall state of the economy. Manufacturers of durable goods like cars, appliances, and electronics are among the most impacted. When times are bad, people tend to cut back on the purchase of durables, as the ones they already have can generally last through the recession. At the same time, durables usually benefit the most from booms. As disposable income increases, consumers are likely to go out and buy that new car they’ve been holding out on. In addition to manufacturers, financial institutions are susceptible to declining demand for financial services and an overall decrease in the amount of money flowing through the economy.
- General Motors (GM), Ford Motor Company (F), DAIMLERCHRYSLER AG (DCX), and other car companies can be significantly impacted by recessions. During economic downturns, people often put off buying new cars until later, or buy less expensive models.
- United Airlines (UAUA), Air France ADS (AKH), and British Airways plc (LON:BAY) are three leading airlines, which tend to suffer during recessions.
- FedEx (FDX) and United Parcel Service (UPS) are the two leading package carriers. The volume of packages mailed is highly correlated with macroeconomic conditions, subjecting FedEx and UPS to cyclical swings in revenues and profits.
- Whirlpool (WHR), and Sears Holdings (SHLD) are all leading manufacturers of home appliances, which are subject to declining demand for durable goods. In addition to people’s tendency to avoid larger purchases during recessions, the demand for appliances is tightly linked to new home sales, which also tend to slow during recessions.
- Alcoa (AA) and US Steel (X) produce aluminum and steel, respectively. These two materials are used in a wide range of construction and manufacturing capacities, subjecting them to the performance of their end markets.
- Caterpillar (CAT) and Tractor Supply Company (TSCO) both manufacture farming equipment. As farmers feel the effects of economic fluctuations, they tend to adjust their large equipment purchases accordingly.
- D.R. Horton (DHI), Lennar (LEN), Toll Brothers (TOL), and Pulte Homes (PHM) are large companies in the residential construction industry. With the declining demand for durable goods, new home sales are likely to decrease as well.
- Foster Wheeler (FWLT) and CRH (CRH) are both involved in construction. FWLT provides construction services to various industrial customers, and CRH manufactures and distributes building materials, like cement and premixed concrete.
- The performance of Home Depot (HD), Lowe’s Companies (LOW), and other home improvement retailers is largely correlated to the housing market. Any declines in new home construction or renovations would likely harm retailers such as these.
- Bear Stearns Companies (BSC), Merrill Lynch (MER), Morgan Stanley (MS), Goldman Sachs Group (GS), Credit Suisse Group (CS), Lehman Brothers Fin SA (LEH), UBS AG (UBS), J P Morgan Chase (JPM), Lazard (LAZ), Jefferies Group (JEF), and other providers of investment services can be negatively impacted by recessions. On the other hand, these firms are likely to benefit from economic booms as customers’ demand for financial services increases.
- Real Estate Investment Trusts (REITs) such as Vornado Realty Trust (VNO) also tend to be particularly affected, as demand for lease space and properties varies with the economic cycle.
Commercial Real Estate Service Firms
- Firms that earn revenues from Commercial Real Estate transactions such as Jones Lang LaSalle (JLL) and CB Richard Ellis Group (CBG) are also negatively affected by recessions, and benefit from economic booms.
- Choice Hotels International (CHH) and other hotel/lodging companies serving middle income customers can be negatively impacted by recessions.
Other Areas of Discretionary Spending
- Brink’s Company (BCO) and other home security service providers which primarily serve single family residential consumers
- Zale (ZLC) and other luxury commodity sellers
- Omnicom Group (OMC), Interpublic Group of Companies (IPG) and other advertising firms suffer during recessions since advertising budgets are viewed as discretionary spending by many of their clients and are often one of the first areas where firms cut costs during a slowdown.
- Apollo Group (APOL), Career Education (CECO), ITT Educational Services (ESI) and other education providers typically see enrollment increase during economic downturns as poorer job prospects cause prospective students to view continuing eduction more favorably. During the 2001 recession, enrollment growth at four-year for-profit education institutions doubled, and during the first years of recessions over the last four decades, enrollment growth in two-year education programs has increased by an average of 12%.
On the other hand, certain goods are relatively insulated from the impact of economic cycles. Goods that have a relatively inelastic demand with respect to income are generally shielded. For example, food has a very inelastic demand. No matter how bad the economy gets, people have to eat and will continue to purchase food. This is particular true for staple foods and goods like insulin and bread. In addition, when the economy improves, people rarely eat more or buy more necessities.
Food manufacturers and retailers
- Safeway (SWY), Wal-Mart Stores (WMT), Sysco (SYY), and other food retailers are somewhat protected from recessions. For health reasons, the demand for food is unlikely to decrease below a certain level, giving food retailers some degree of insulation from poor economic conditions. However, foods which are considered more luxurious or expensive will fluctuate during economic cycles.
- Pepsico (PEP), Kraft Foods (KFT), and H.J. Heinz Company (HNZ), as well as other food manufacturers, generally see a smaller decline in sales resulting from a recession.
- Altria Group (MO), Lorillard (LO), and REYNOLDS AMERICAN (RAI) and other large tobacco companies in the U.S are protected from recession. Though cigarettes are not generally considered necessities, they still have steeply inelastic demand. In addition, other illegal addictive drugs like heroin and cocaine are almost totally protected from cycles. Because of the inherent nature of addictive substances, consumption becomes a necessity to the user regardless of cost.
Required Medicine and Medical Equipment
- Many required medicines like insulin and key equipment are not impacted by economic cycles. This is because patients must buy or use medicine and equipment that is necessary for their survival regardless of the prevailing economic condition. Thus, suppliers of such goods are also insulated since hospitals and patients must buy as necessary.
- Exelon (EXC), Entergy (ETR), and other providers of key utilities are unlikely to suffer greatly during a recession. Commercial and residential buildings must be powered and have access to sewage and water. These necessities are somewhat protect from shifts in the general economy.
Milton Friedman has said that economic cycles aren’t really “cycles” that there is no clear beginning and end unlike the seasonal cycle for, among other economic activity, retail sales and seasonal credit cycle which peak before summer and trough after.
The Chicago School, which is often seen as neo-classical or monetarists, emphasizes the correlation between the “credit cycle” and the business cycle. These economists argue that interest rates act as the general price level for money and that the monetary causes the shifts in the business cycle. This school of thought believes that correct manipulation of monetary policy, mostly through the Federal Reserve can eliminate the business cycles. The thinking goes that by correctly increasing and decreasing the supply of money at the right time, the toughs and bubbles can be avoided.
Keynesian Theory argues that because price levels and wages (price of labor) are relatively rigid in the short run, expansion in spending will alter real output. This is in contrast to classical economic theory which states that changes in government spending will not alter economic conditions since such spending must be offset by equally large, albeit future, taxes. However, Keynes argued that all actions do occur in the short run, where prices are rigid and so government spending can effectively stimulate the economy. Thus, Keynesian Theory advocates for extensive deficit spending which, aided by a “money multiplier” can reverse economic downturns which have occurred due to a fall in consumer consumption. In this way, Keynes saw the government as temporarily stimulating the economy by replacing the drop in spending from consumers. According to this theory, the government spending must be deficit and not balanced by equivalent taxing.
This school of thought disagrees with traditional economics in that there is no linear equilibrium that the economy trends towards. Instead, society is filled with a series of individuals who use rule of thumb judgments based on incomplete information sets. The result is a dynamic, chaotic system with no clear distinction between micro and macro economics. Eric Beinhocker views economic cycles from a network and game theory perspective. This view re-frames cycles in terms of evolutionary growth rather than having a discrete beginning and end.
The exponential growth of an economic bubble is unsustainable and results in synchronized wealth destruction when the bubble collapses. On a global scale this reinforces the periodicity of the cycle because the entire world economy must go through the recovery at the same time. Individual savings and investment behaviors become synchronized.