Anticipation, economic cycles and financial markets.

Historically, over long periods, there have been recurrent fluctuations on the charts of changes in the prices of financial assets that have the same type of profile but are not regular over time. These fluctuations evolve through the same pattern known as the economic cycle. There is also a financial cycle that is based on economic cycles, with a time lag linked to the expectations of financial market participants.

economic cycles

There are several types of economic cycles in the economic literature, we will confine ourselves here to a synthesis applied on the basis of the observation of the CAC40 index since 1998. These are repeated in history in an irremediable way. Economic cycles are linked to economic fundamentals as well as asset price developments in financial markets, which in turn are linked to monetary policies pursued by central banks.

Let us start the scheme with a “hollow” period at the end of the previous cycle; central banks have at that time so-called accommodating monetary policies (low interest rates, possibly unconventional policies), assets have valuations considered attractive by investors.

The markets are showing an increase, the decrease in the cost of credit allows companies to start increasing their investments, supported in theory by the capital provided through the financial markets.

This is followed by a period of economic expansion with a decline in business inventories, production growing faster than consumption, and firms hiring to meet the rising self-sustaining demand resulting from falling unemployment. At that time, business and household confidence is at its highest.

Then a peak (or period of overheating) is reached: inflation or inflation-related fears emerge and central banks adopt restrictive monetary policies. Markets adjust downwards at that time, which has a negative impact on the economy.

We are then entering a period of recession. As interest rates are still high (restrictive policies of central banks are used to try not to allow inflation to erode the purchasing power of economic agents), the strengthening of the reference currency (due to high interest rates) causes a decline in the competitiveness of companies and a decrease in their investments, which in turn lead to poaching, which reduces consumption.

Corporate inventories are increasing and investors’ expectations about economic health are negative, they are selling financial assets, which further overwhelms the fall in prices on the financial markets.

Then, we return to the period of troughs described at the beginning, when rates are at their lowest and the authorities massively support the economy (accommodative policies of central banks, government investments, etc.), which provides abundant liquidity to the markets, stimulates the economy, financial asset prices are considered undervalued, investors reposition themselves at the time of purchase, then we observe the expansion period and so on.

When we examine the graph of the evolution of the CAC40 since 1998 we can thus deduce the following financial cycles (the deduction of economic cycles is more delicate).

Cycle 1998-2003
September 1998: Hollow.
October 1998 – August 2000: Expansion.
August 2000: Summit.
September 2000 – December 2002: Recession.
March 2003: Digging.

Cycle 2003-2009
March 2003: Hollow (indeed, the trough of the previous cycle is shared with the next cycle).
April 2003-April 2007: Expansion.
June 2007: Summit.
July 2007-January 2009: Recession.
February 2009: Hollow.

The gap between economic and financial cycles is due to investors’ expectations of the health of an economy, the medium/long term investor seeks to identify the position of the economy in relation to its cycle in order to try to speculate on a reversal of the trend on the financial markets before others.

They generally proceed by analysing macroeconomic indicators. This is one of the reasons why markets recover faster than the economy as it begins to expand and falls before the economy is in recession. It should therefore be noted that this amplifies or deteriorates the economy depending on the position in the cycle.

In an attempt to anticipate changes in the direction of the economy and thus anticipate the global trend of markets, rational investors analyse the evolution of the main indicators whose impact on GDP is only effective between 6 months and 1 year after their publication: orders for current consumer goods and durable goods, surveys linked to consumer and business morale, as well as the money supply (likely to change the type of policies conducted by the central bank).

They use complementary indicators that reflect within about 1 month the current state of the economy: the employment rate, industrial production and household disposable income, to corroborate their first idea (obtained by the main indicators).

Composite indicators are used to identify turning points. Investors with quantitative economic skills also use time series and DSGE models, tools also used by experts from international monetary institutions who wish to forecast GDP over a given time horizon.

Quantitative trading room managers will prefer sophisticated customized algorithms with integration of as many variables as possible. The transcription into lines of code in the algorithm to be executed as completely as possible in order to introduce the different correlations and cause-and-effect links between the variables.

Enio DARIU

BONDS & SHARES

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