Business cycle

An economy does not grow at a steady pace. It speeds up for a while, then slows down, then speeds up again. That repeating pattern is the business cycle.

Why does a retirement adviser care? Because different assets behave differently at different points in the cycle. Getting the cycle wrong does not just cost growth — it can hit a retiree's income when they can least afford it.

The workbook ties the business cycle directly to Gross Domestic Product (GDP): real GDP, measured to strip out inflation, moves through cycles of expansion and recession, and that movement creates the business cycle.

During a recession, growth in sales, production and employment slows. Company performance weakens, and so do equity investments.

During expansion, growth runs significantly above trend. If it overheats, the result is an inflationary situation: real estate prices and rentals boom, as do commodities. To cool an overheated economy, monetary actions such as raising interest rates are taken — and higher rates hurt both bond prices and equity markets, since bond prices move inversely to yields and higher borrowing costs weigh on company profits.

The practical rule the workbook draws out: commodities tend to do well in inflationary, overheated phases; equity tends to correct unless companies can pass rising costs on to customers without hurting demand.

An economy is growing at 9% a year, well above its long-run trend of around 6–7%. Real estate prices in metro cities rise sharply and commodity prices follow. The central bank, concerned about overheating, raises the policy rate.

Bond prices fall as yields rise — an investor holding a long-duration bond fund sees its NAV drop. Equity markets also fall, on expectation that higher borrowing costs will squeeze company profits and slow expansion plans. A retiree drawing income from a portfolio weighted toward long bonds and equity in this phase sees both legs of the portfolio under pressure at once — precisely the moment a bucket strategy with 3–5 years of safe assets set aside is meant to protect against.

Chapter 2, section 2.8 (Impact of Macro-Economic Factors on Asset Classes), introduces the business cycle as the mechanism behind GDP's effect on asset returns. Expect questions on which asset class does well in which phase of the cycle, and why a rate hike used to cool an overheating economy hurts both bonds and equities together.

• The business cycle is GDP's cycle of expansion and recession — not a fixed calendar length. It has no stated duration in the workbook; do not invent one.
• A rate hike to cool overheating hurts bonds and equities simultaneously. Candidates sometimes assume only one asset class is affected by a monetary tightening move.
• Commodities and real estate tend to do well in the overheating phase, which is the opposite of what happens to bonds at the same time — the workbook expects the contrast to be understood together, not as isolated facts.