Economic cycle - a barometer of equity performance?

Wednesday, 11th November 2015 09:42 - by David Harbage

Recent survey evidence from the Organisation for Economic Co-operation and Development 'think tank' suggests that global economic growth is slowing.

The OECD have lowered forecasts for global growth from 3.0% this year to 2.9%, and a sharper downgrade in 2016 from 3.6% to 3.3%. Some might consider that a downturn in economic activity would lead to corresponding weakness in the equity market and, by contrast, strength in the government bond market. (The latter reflecting an anticipation that interest rates would remain low or be cut, aided by the prospect of inflation falling). Such intuitive expectations might be misplaced, however, if history is any precedent.

The economic cycle can be likened to a clock, with 12 o'clock representing the top, or peak of activity or output (as measured by gross domestic product or GDP). With 6 o'clock representing the bottom, or low spot in the economic cycle (perhaps exhibiting negative GDP in periods of recession), 3 o'clock a downward point and 9 o'clock an improving trend. If the same clock is divided into four equal quadrants, featuring the top quartile of GDP output (between 7.5 minutes to the hour and 7.5 minutes past), the bottom (22.5 minutes past the hour through to 22.5 minutes to the hour) and the other two periods representing the mid-way pace of economic activity.

Considering domestic economic cycles since 1945, and the performance of the UK equity market through each part of those cycles, the results might come as a surprise. Domestic stocks and shares performed best when the UK economic cycle was in its bottom quartile, typically delivering double-digit returns four times higher than the weakest quartile of stock market performance which, strange though it may seem, was when GDP was close to its peak. On balance, the mid or halfway periods within the cycle showed annualised returns of 5% when the economy was slowing and 7% when on an improving tack. Incidentally, the worst quartile of equity returns (occurring when economic activity was most robust) still delivered - on average - a positive return of 3% during that period.

Such an illustration can be helpful but, in reality of course, economic cycles will not be as straightforward as a clock: an economic cycle can vary in terms of timescale (from a period of months to a number of years), magnitude (measuring the 'wave' from its depths, or bottom, to the top) and indeed can move anti-clockwise (when the normal trending direction of the economy is temporarily reversed). If one wishes to place any credence on this indication of correlation between economic and equity performance, in order to determine how stock markets are likely to perform, one has to decide where we are currently positioned in the economic cycle.

The consensus of economists and market commentators anticipate growth in the UK's GDP to be 2.4% this year and the same pace in 2016. Co-incidentally, this represents the trend (or average) pace of domestic economic growth over the past forty years. More pertinently perhaps, it would seem that the pace of growth at home is quickening and GDP has yet to peak - although, it should be acknowledged, one cannot know that (or appreciate where the economy is in the cycle) until after the event. However, forecasts for global economic growth (and for China, and the emerging economies, in particular) have been retreating; this must inevitably have an impact on domestic activity and the UK stock market.

Sophisticated investors will not be surprised by the above findings: that stock market returns do not replicate or coincide with the health of the economy and, on balance might be encouraged by signs of weakness. Essentially, believing that the current cycle is likely to remain in a flat spot (almost certainly in a 'bath', rather than a 'V' shape), before pushing on again later, the peak is being put off. However, other economists will consider that the top has already been reached and that the recent easing in forward-looking revisions signals a downward trend. That the UK and the US economies are pushing forward, while those of many emerging economies are weakening, just helps to heighten debate (or confuse the picture, according to perspective). As they say in the industry, “It takes two to make a market".

Written by David Harbage for lse.co.uk on the 10th Novemeber 2015

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.