When the economy goes into a tailspin, you can hear reports about the cessation of housing construction, an increase in applications for unemployment benefits and a reduction in production.
How does this affect us as investors? What to do with your portfolio?
As you will see, these indicators are part of a broader picture that determines the strength of the economy and whether we are going through a period of recession or expansion. (See also “Overview of Past Recessions.”)
To understand the state of the economy at a given time, we need to start with a business cycle.
Typically, a business cycle consists of four different periods of activity, each of which can last for months or years.
Peak. At its peak, the economy is operating at full capacity. Employment is at or near maximum levels, real gross domestic product (GDP) is growing at a healthy pace, and incomes are growing. Less encouraging, prices tend to rise due to inflation. Despite this, most enterprises, workers and investors enjoy a boom.
Recession. The old adage “that which goes up must come down” is perfectly applicable here. After great growth and success, income and employment begin to decline due to any number of reasons: an external event, such as an invasion or shock, a sudden correction of overheated asset prices or a decrease in consumer spending to inflation, which, in turn, can lead to that firms will lay off employees. (Since wage-paying companies pay workers, and the prices they charge consumers are “inelastic” or inherently resilient to changes, wage cuts are the general answer). Rising unemployment is pushing consumer spending even further, causing a vicious cycle of economic contraction. A recession is usually defined as two or more consecutive quarters of decline in real GDP. (See Also, «9 General Effects of Inflation.»)
This is a section of the business cycle when output and employment decline. At the moment, costs and investments have significantly weakened, lowering prices and wages. This rebalancing makes new purchases attractive to consumers, and new investments — in labor and assets — are attractive for firms.
Extension (recovery). During recovery — or “expansion,” if we do not discuss it in the context of the latest recession, the economy will begin to grow again. As consumers spend more, firms increase their output, which leads them to hire more workers. Competition for labor arises by pushing wages and investing more money in the pockets of workers (who are also consumers). This allows firms to charge more, sparking inflation, which, although mild, at the beginning, can ultimately stop growth and start the cycle again. However, in the long run, most countries tend to grow, with each peak reaching a higher maximum than the last .
Business cycle phases
This scheme is oversimplified, of course: economies sometimes experience a double-dip recession, for example, when a short recovery is followed by another recession. Not all economies have a positive long-term growth path. The relationships between costs, prices, wages, and production described above are also too simple: governments often have a big impact at all stages of the cycle. Excessive taxation, regulation or printing of money can trigger a recession; fiscal and monetary incentives can turn a shrinking economy around when the supposedly natural tendency toward rebalancing cannot be realized. (See also “Sectors that thrive in recession.”)