Recent History as a Guide to the Business Cycle
In order to determine which stage of the business cycle the economy is in, economists lean on indicators like GDP, industrial production and the unemployment rate. However, by the time this data is released, it’s explaining the past and isn’t an indicator of future returns.
As an alternative, we construct a leading indicator of the U.S. business cycle by analyzing more timely economic data culled from business and consumer surveys, the manufacturing and housing sectors, and monetary policy.
The period in between the recessions of 2000 and 2008 is an example that bolsters our theory on business cycle dynamics.
- Recovery, April 2001 – July 2003
This business cycle began with a recovery phase that lasted from April 2001 to June 2003. Our leading indicator began to rebound, driven by improving business surveys, construction activity and aggressive monetary easing by the Fed. Stocks underperformed due to the tech sector, but risky assets such as credit outperformed.
- Expansion, July 2003 – Jan. 2006
The markets moved into the expansion regime when the U.S. economy began to grow above trend beginning in the third quarter of 2003. Our indicator registered broad improvements in housing activity, consumer sentiment and strong labor market conditions. Stocks were the best performing asset class, while credit offered stable income with low volatility.
- Slowdown, Q1 2006 – Q3 2007
The slowdown was led by a substantial deceleration in housing activity, followed by manufacturing and falling consumer confidence. In spite of the slowdown, labor markets showed strength for another year, with rising wages and falling unemployment, which caused the Fed to remain on hold. Stocks continued to outperform, but credit markets showed signs of stress.
- Contraction, Q4 2007 – Q2 2009
Our indicator showed the economy entered the contraction phase at the end of 2007, when the U.S. began growing below trend, driven by deterioration in all its components. The economy then plunged into a dramatic recession lasting two years. Risky assets underperformed, while government bonds were the only asset class able to provide protection and diversification.
In the next section, read about how different asset classes perform through the business cycle, or download our full paper on dynamic asset allocation through the business cycle.