Using the economy to find investments

The business cycle can be a key driver of stock market returns and sector performance.

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The business cycle pushes and pulls the stock market like the moon influences the tides. Even if you can’t see it, the business cycle is always at work as the economy expands, peaks, contracts, and recovers—taking the earnings and stocks of businesses up and down with it.

It isn’t always predictable, but understanding the business cycle may give you some insight into the types of businesses that are poised to do well in the next phase of the cycle and those that may fall out of favor with investors for a period of time.

First, what is the business cycle?

Economists call the waxing and waning fluctuations in economic growth the business cycle. There are usually four distinct phases. In theory, the phases logically follow each other. In reality, things don’t always happen that way. Sometimes one phase may be skipped, for instance, or the cycle may go backwards to a previous phase.

In the early-cycle phase, economic growth picks up after the previous cycle—a recession. Economic indicators like gross domestic product (GDP), industrial production, and employment begin to show signs of positive growth. Monetary policy, controlled by the Federal Reserve, is typically still loose or accommodative. That generally means interest rates are relatively low. During this phase, businesses and consumers find that borrowing becomes easier than it was in the previous cycle. Inventories may be low but sales are usually picking up.

In the mid-cycle phase, economic growth is still positive, but not accelerating like it was in the early- cycle phase. Monetary policy is typically accommodative at the beginning of the phase and becomes more neutral as the cycle progresses. In response to growing sales, inventories have usually grown, reaching a balance with consumer demand.

In the late-cycle phase, inflation may start to show signs of life. Monetary policy becomes tighter as the Federal Reserve attempts to cool the economy by raising interest rates to slow down the amount of money being lent and borrowed. Businesses find that borrowing may be harder and consumers may have trouble borrowing, too. Economic growth slows, as do sales. Inventories start to pile up.

In the recession phase, economic activity stalls. Corporate profits fall, and it gets harder for businesses and consumers to borrow money. The Fed moves to a more accommodative stance, lowering interest rates to make borrowing and lending easier. Eventually, supply falls as stores reduce inventories and manufacturers produce less stuff. In time, lower supply may spark some demand and push the cycle back toward the early phase.

How can I use this information?

Some investors use sectors as a way of investing with the business cycle. Sectors are big chunks of the stock market. There are 11 sectors, and each is made up of a few different industries that share common characteristics. For instance, the energy sector includes companies that drill for oil, companies that make equipment for oil drilling, and companies that go out and look for the oil. All the companies associated with natural gas and coal are also included in the energy sector.

The economy is broadly divided into 11 sectors.
Consumer discretionary Consumer staples
Energy Financials
Health care Industrials
Information technology Materials
Telecommunication services Utilities
Real estate
Source: Global Industry Classification Standard

Historically, some sectors have performed better than others at various points in the business cycle.

Where are we now?

In recent business cycle updates published on Fidelity Viewpoints®, Fidelity analysts and researchers have highlighted evidence of late-cycle activity that they believe puts the economy near the end of the mid-cycle phase and closer to the late-cycle phase.

“The U.S. and global economies have continued to gain momentum despite post-Brexit headwinds. The U.S. continues to experience a mix of mid- and late-cycle dynamics with low odds of recession, while the global economic expansion continues at a slow but steady pace,” Fidelity experts report in the Viewpoints story, “September business cycle: improved cyclical trends.”

Slowing earnings and strengthening inflation were cited as factors pointing to the mid- to late-stage of the business cycle.

Knowing where the economy stands in the business cycle may spark some investment ideas or give you some perspective on what’s happening in the stock market now—or in the near future.

Learn more

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Past performance is no guarantee of future results.

Investing involves risk, including risk of loss.
The Business Cycle Framework depicts the general pattern of economic cycles throughout history, though each cycle is different; specific commentary on the current stage is provided in the main body of the text. In general, the typical business cycle demonstrates the following:
During the typical early-cycle phase, the economy bottoms out and picks up steam until it exits recession then begins the recovery as activity accelerates. Inflationary pressures are typically low, monetary policy is accommodative, and the yield curve is steep. Economically sensitive asset classes such as stocks tend to experience their best performance of the cycle.
During the typical mid-cycle phase, the economy exits recovery and enters into expansion, characterized by broader and more self-sustaining economic momentum but a more moderate pace of growth. Inflationary pressures typically begin to rise, monetary policy becomes tighter, and the yield curve experiences some flattening. Economically sensitive asset classes tend to continue benefiting from a growing economy, but their relative advantage narrows.
During the typical late-cycle phase, the economic expansion matures, inflationary pressures continue to rise, and the yield curve may eventually become flat or inverted. Eventually, the economy contracts and enters recession, with monetary policy shifting from tightening to easing. Less economically sensitive asset categories tend to hold up better, particularly right before and upon entering recession.
Because of their narrow focus, sector funds tend to be more volatile than funds that diversify across many sectors and companies.
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