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Economy

Introduction to Economic Cycles

INTRODUCTION

This week, let’s focus on getting the basics of an Economic Cycle right. When you’re through with this article, you’d no longer feel lost when the wizards on Financial Times say stuff like “Expect a serious economic contraction in Q2 of year 2034″. Alright, let’s jump right into it!

What is a Cycle?

A cycle is a set of regularly repeating events, be it signifying the ups and downs of economical growth, the consumer spending patterns in an E-Commerce site or even our constant “planning to gym but sleeping an extra hour instead” cycle!

What is a Trend?

If the entity of interest is developing or changing in a particular direction consistently then we call that a trend! For example, when a vaccine is finally discovered for COVID-19 and the cases for the same decline over time, we say it’s a negative trend (that’s the kind of negativity we actually need, right?)

Connection between a Trend and an Economic Cycle

Well this part’s a little tricky because well, in the short run a cycle can contain alternating positive and negative trends. But in the long run, a trend can consist of multiple cycles. Ray Dalio explains this concept beautifully in his 30min video “How the Economic Machine Works”. Below is an image from the same, to help visualise this relationship between a trend and a cycle in your mind for now.

Image credits: “How the Economic Machine Works” – Ray Dalio

Ten Second Definitions:

  1. Bullish Market: When the market prices are rising consistently (prices are charging ahead like the bulls!).
  2. Bearish Market: When the market prices are declining consistently (prices are retreating to their den like a bear).
  3. Illiquidity: When the money and credit supply in an economy is low (constrained liquid (i.e cash or credit) in the economy hence illiquid)
  4. Black-Swan: How often do you see a black swan? Um, next to never right? That’s the term used to categorise those VERY rare and unpredictable events whose impact on the order of life is massive.

DIGGING DEEPER INTO ECONOMIC CYCLES

There are phases when unemployment rates are low, inflation is positive but tolerable, average wages are growing, markets are bullish, asset values are high, consumer spending is high and LIFE IS GREAT. That’s a sign of an Economic Expansion.

Now, there are also times when the opposite is taking place. So we’re looking at an economy where, markets are bearish, consumer sentiments are low, unemployment rises, illiquidity in the system increases and the economy in general is experiencing a GLOOMY time. That’s a sign of an Economic Contraction.

An Economic Cycle refers to the fluctuations between periods of economic expansions and contractions.

Why do we need to know what an Economic Cycle is?

From an investors point of view, there are certain asset classes which perform well in economic downturns and there those which prosper in periods of expansion. Analyzing the relationship between asset returns and economic cycles would positively help an investor remain cognizant while developing/maintaining her portfolio.

Additionally, from a business owner’s perspective, especially if they are dealing with cyclical products (For example, clothes, luxury handbags, new cars, refrigerators, etc.), understanding the phase of a business cycle would help them plan their production and resources ideally. For example, when the entire economy is in a slowdown there usually is a drop in air-travel, this way companies catering to the aviation industry would plan a reduction in their production in advance if they foresee a drop in demand.

NOTE: Economic cycles often fluctuate in size and intensity and don’t ALWAYS stick to an exact framework, this is because of the decisions made by the players (individuals, corporations and governments) and exogenous factors (like natural disasters and black-swan type events, hello COVID-19). However, the generic cyclical pattern of the economic activity still holds good, because that’s just how the world works, there are good times and there are bad times as a consequence of our decisions and interactions.

With that, we come to an end on the mini Knowledge-Session on “Introduction to Economic Cycles”. In the next post, I’d be going over the phases of an Economic Cycle and Shapes of Economic Recovery.

Stay tuned for new articles every week, simplifying Finance for Gen A to Z.

Happy Learning,

Prarthana Shetty

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