Understanding the Business Cycle: A Framework for Economic Forecasting

Introduction

Forecasting economic trends and asset prices is notoriously difficult. Many economists and analysts rely on theoretical models that often fail to predict major turning points or recessions. However, there is a more practical approach based on understanding and analyzing business cycles.

This article will explore a framework for economic forecasting that combines long-term secular trends with shorter-term business cycle indicators. By looking at how these cycles interact, we can make probabilistic forecasts about economic growth, inflation, and asset prices.

The Importance of Cycles

Economies and markets do not move in straight lines. They ebb and flow over time in cycles of expansion and contraction. These cycles occur on different timescales:

• Long-term secular cycles that play out over decades
• Business cycles lasting several years
• Short-term fluctuations over months

By understanding where we are in these various cycles, we can get a sense of the overall trajectory and make informed predictions.

Long-Term Secular Cycles

The first step is to look at the big picture secular trends that shape economies over many years or decades. Some key long-term cycles to consider:

Demographics

Demographic trends have a major impact on economic growth, inflation, and asset prices over time. For example:

• Aging populations in developed countries tend to lead to slower growth and deflationary pressures as spending declines
• Young, growing populations in emerging markets can drive rapid economic expansion

Understanding demographic shifts provides important context for long-term economic forecasts.

Debt Supercycle

Economies go through long-term cycles of debt accumulation and deleveraging. Currently, many developed economies are in the late stages of a debt supercycle:

• Total debt-to-GDP ratios are at record highs in many countries
• The rate of debt growth is slowing, indicating we may be near the peak
• A period of deleveraging often follows, which can weigh on growth

The stage of the debt cycle impacts monetary policy, growth potential, and financial stability.

Equity Market Cycle

Stock markets also exhibit long-term secular cycles in valuations and returns:

• Extended periods of above-average returns are typically followed by below-average returns
• Current high valuations may indicate lower future returns ahead

These long-term market cycles influence investment returns over 10-20 year periods.

Commodity Supercycle

Commodity prices tend to move in multi-decade cycles of boom and bust. Understanding where we are in the commodity supercycle provides context for inflation trends and certain asset classes.

The Business Cycle

Within the context of these long-term trends, economies move through shorter business cycles of expansion and contraction. Analyzing the business cycle is crucial for making nearer-term economic and market forecasts.

The ISM Manufacturing Index

One of the best indicators of the business cycle is the ISM Manufacturing Index. This survey of purchasing managers has an excellent track record of signaling economic turning points:

• Readings above 50 indicate expansion
• Readings below 50 indicate contraction
• Crossing below 46 has historically signaled recession with high probability

The ISM index correlates closely with GDP growth, both in the US and globally. By forecasting the direction of the ISM, we can make informed predictions about economic growth.

Asset Prices and the Business Cycle

Many asset prices are closely tied to the business cycle as measured by the ISM:

• Stock market returns correlate strongly with the ISM on a year-over-year basis
• Commodity prices like copper and oil tend to follow the cycle
• Credit spreads widen as the ISM declines, signaling increased default risk
• Even bond yields have historically followed the cycle, though this relationship has broken down recently due to central bank intervention

By understanding where we are in the business cycle, we can make probabilistic forecasts for various asset classes.

Short-Term Economic Cycles

Within the broader business cycle, there are shorter-term fluctuations in economic data. The Citi Economic Surprise Index (CESI) is useful for tracking these:

• The CESI measures whether economic data is coming in above or below consensus expectations
• It tends to move in 2-3 month cycles
• The direction of the CESI can signal whether the ISM is likely to rise or fall in the near-term

Tracking these short-term cycles provides additional context for forecasting turning points in the broader business cycle.

Putting It All Together

By combining analysis of long-term secular trends, the business cycle, and short-term economic fluctuations, we can build a comprehensive framework for economic and market forecasting.

The process looks like this:

1. Assess the big picture secular backdrop (demographics, debt cycle, etc.)
2. Determine where we are in the business cycle using the ISM
3. Use the CESI to forecast near-term moves in the ISM
4. Make probabilistic forecasts for growth, inflation, and asset prices based on cycle analysis
5. Continually reassess as new data comes in

This framework doesn't guarantee perfect foresight, but it provides a structured way to make informed predictions. It forces us to think probabilistically and helps avoid the pitfalls of linear extrapolation.

Key Takeaways

• Economies and markets move in cycles on different timescales
• Combining long-term secular analysis with business cycle indicators improves forecasting
• The ISM Manufacturing Index is an excellent gauge of the business cycle
• Many asset prices correlate closely with the business cycle
• Short-term economic surprise data helps forecast turns in the cycle
• This framework allows for probabilistic forecasting of economic trends and markets

Conclusion

While economic forecasting will always involve uncertainty, understanding cycles provides a major advantage. This framework of combining secular trends, business cycle analysis, and short-term indicators allows for more nuanced and accurate predictions.

By moving beyond simplistic models and thinking in terms of probabilities, we can develop a more realistic view of economies and markets. This approach may not be perfect, but it offers a significant improvement over conventional economic forecasting methods.

Ultimately, the goal is to make better-informed investment and business decisions. A cycle-based framework gives us the tools to navigate the complexities of the global economy and financial markets.

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