Economies and investment markets move in cycles

Provided by Mercer. The information in this article does not necessarily reflect the views of the Trustee.

The first three quarters of the 2009-10 financial year saw the global economy recover from the worst ravages of the Global Financial Crisis (GFC).* However, an upset in the final quarter has taken back some of the gains made, leaving a weak outlook for global growth for the rest of 2010 and into early next year.

Unfortunately, the end of one financial year does not neatly close the book on negative developments and the outlook for global growth for the rest of 2010 remains relatively weak compared to the outlook six months ago.

However, the good news is that historically, markets have tended to operate in cycles where periods of financial downturn have typically been followed by periods of growth.  The question is when will the markets recover enough to make up the losses incurred during the GFC and the more recent Sovereign Debt Crisis?

It’s useful to take a look at how markets and economies move through this cycle because it highlights the importance of taking a long-term view, particularly when it comes to investing your super.

There are four main stages in the economic cycle – 1. slow down, 2. recession, 3. recovery and 4. boom.  Let’s take a look at the key features of each stage, keeping in mind that share markets tend to move first, with economies falling into step after them.

1. Slowdown

The slowdown stage sees the start of a continuous period of decline during which share markets show significant drops in value. At the same time, inflation starts to fall and central banks tend to take action to reduce interest rates. Governments will also tend to act to stimulate the economy in an attempt to cushion the effect of a recession. In this environment investors may have a propensity to take defensive action and seek safer investments such as cash – taking a defensive approach may have an overall affect of  placing further downward pressure on share markets.

2. Recession

A recession tends to follow an economic slowdown and, as a rule of thumb, is measured as two or more consecutive quarters where a country’s Gross Domestic Product (GDP) declines in value. Features of a recession are similar to those of the slowdown stage, including share market volatility, government stimulus intervention and ongoing economic uncertainty. Unemployment tends to rise and a decline in trade (imports and exports) may occur. Remember, economies and share markets move out of synch, so at this stage, when the economy is in a recession, markets may start to show some initial small signs of positive movement. As with the slowdown stage, investors may often seek safe investments and bonds tend to provide this in the recession stage of the cycle.

It’s really important to keep in mind that with share markets starting to recover, switching investments into more defensive asset classes may mean missing out on sudden and unpredictable market improvements.

3. Recovery

Recovery is the stage that follows a recession. A key feature of this stage is that economic indicators and measures start to show a reverse in the negative trends of the previous two stages of the investment cycle. GDP and inflation start to show increases, as do employment rates. Share market recoveries will have already commenced in the previous recession stage and gain momentum during this part of the cycle. This positive market movement – which can be hard to time – highlights the importance of staying the course with your investments.

4. Boom

In this part of the cycle, the recovery is firmly entrenched, and global economies stabilise and enter a period of significant and sustained growth. Inflation will tend to rise as will trade, employment and GDP growth. Over a long period of time (usually years), this growth continues until it reaches a point where it is unsustainable. At this point, share markets and then economies reach the tipping point into the next market down turn and subsequent economic slowdown.

What does this mean for investors?

As an investor, it’s important to keep in mind that any significant long-term investment, such as your superannuation investment, will be subject to this cycle. Unfortunately, forecasting the point at which one stage of the cycle ends and another begins can never be precise.  If only it were!

As we saw over May and June 2010, a recovery can stall and revert to a slowdown for a period of time.  But a boom might be just around the corner and suddenly take off before you know it.  If you’ve responded to a negative period by seeking a safe haven in a more defensive asset class such as cash, your money may not be in the right place at the right time to capitalise on valuable growth opportunities that the initial boom stage brings.  So, by taking defensive action at the wrong time relative to the investment cycle and your own life cycle, you may risk locking in your losses and missing out on boom-time gains.

This is why taking a longer-term strategy with your investments is so important.  Adopting such a strategy means your investment will rise and fall in line with markets, but it should also significantly reduce the risk that you’ll miss out on valuable growth opportunities.

A financial adviser can help you look at your investments in the context of both the investment cycle and your own personal life cycle.  Such advice will help you avoid making reactive (and potentially counter-productive) decisions in the short term in favour of strategic (and potentially more opportunistic) investment decisions for the long term.

It is however important for investors to note that past performance data is not a reliable indicator of future market performance and serves only as an illustration of past trends.

*Mercer Investment Consulting


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