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John Ficenec investigates the history of economic cycles and Investors Chronicle sector speciliasts provide some ideas so investors can get ready for whatever happens next.
April 25, 2013

Stock markets around the world are giving up their gains and a raft of earnings warnings in the US have spooked investors. But with the anaemic recovery seemingly running out of steam and inflation on the wane governments could hit the printing presses at any moment. So the Investors Chronicle takes a look at the history of economic cycles and how investors can position themselves for the next stage.

Fighting the cycle

When the father of business cycles, Clement Juglar, first identified them in 1862 he plotted a stately procession over a period of 7-11 years. Recently economic cycles have been more akin to a rollercoaster as they lurch from boom to bust at breakneck speed. It wasn’t always so, economist Simon Kuznets described an infrastructure driven cycle which lasted 15-25 years and Russian economist Nikolai Kondratiev developed a business super cycle over 45-60 years.

Austrian economist Joseph Schumpeter expanded on Juglar’s theory by dividing the cycle into four phases. Firstly expansion during which low interest rates drive increased production and prices, followed by crisis as stock exchanges crash and bankruptcies rise, then recession as production and prices fall hampered by high interest rates, and finally recovery as stocks bounce back as prices and incomes fall to match the economy. With the economic world so labelled it settled into its gentle perambulations, safe in the knowledge that while recession was painful, it was a necessary evil for recovery which was just around the corner.

This Austrian school of economic cycles was finessed by Nobel laureate Friedrich Hayek in the. Hayek surmised that fractional reserve banking will be allowed to run riot through ineffective central bank policies, which will in turn allow interest rates to remain too low for too long. He believed the glut of credit would lead inexorably to speculative bubbles and lowered savings, ultimately leading to a crash as the huge credit creation becomes unsustainable. Once the market crashes, credit dries up and the money supply contracts sharply. Markets only “clear” once prices adjust to the new conditions causing resources to be reallocated back towards more efficient uses. Sounds familiar doesn’t it, but apparently it doesn’t have to be this way, even more, this thinking is just plain wrong according to Keynes.

Keynes decided to do away with the business cycle completely, the problem was fluctuations in demand not a regularly identifiable business cycle. His thinking was taken a step further by Nobel laureate Milton Friedman who in the 1950’s decided it was all down to the supply of money. He identified economic ‘fluctuations’ caused by mistakes in monetary policy. “A shock comes along which knocks the economy down, and then it recovers. But the idea that there are regular intervals, regular size, I think that is not supported,” he argued. This monetarist school of thought spawned Reagonomics in the US and Thatcherism in the UK, even today his presence is felt. Friedman once quipped that price deflation can be solved by “dropping money from out of a helicopter”, it’s not difficult to see which hymn sheet Ben Bernanke is singing from.

So the battle lines are drawn between the “Austrian school” and the “Keynesians” yet they are still no closer to agreement. At times the debates take on a Swiftian air with confirmed Kenysian Paul Krugman using his New York Times blog to battle it out with supporters of Hayek. But given the "Dismal Science's" track record at foreseeing the last crash its probably best to focus on what is happening in the real world and how to position your investments accordingly. With this in mind iShares owner Blackrock issued a timely piece of research entitled “Record Profits – How Much Longer?”

The wheel turns

Up until now corporations have been riding the crest of a profits wave. After the 2008 crash they slashed cost bases and cut employees, and were then aided by low interest rates and low inflation combined with slow but steady sales growth. In this environment profits soared and the cash rolled in. But a raft of earnings warnings in the US has spooked the markets, and according to Thomson Reuters negative outlooks for the current quarter outnumber positive outlooks by 3.5 to one, the weakest ratio since the third quarter 2001. The nascent US recovery is also running out of steam, the Chigaco Fed National Activity Index three-month moving average (CFNAI) slumped to -0.34 in May, its third consecutive reading below zero, and dangerously close to a -0.7 reading which suggests a recession has begun.

Companies have had it good for three years now but Russ Koesterich, iShares chief investment strategist, warns: “Eventually this benevolent combination will come to an end.” He foresees two likely scenarios in which margins will get hit, and recommends two different strategies to protect your investments. The first scenario being a slowdown, or even declining economic growth, which will depress margins from the top down as sales slow, in which case he recommends turning defensive and holding consumer staples, healthcare, and utilities. The second scenario is if inflation takes off which will compress margins from the bottom up as costs rise, in which case natural resource companies like oil and gas, and metals and mining will be preferred. He goes on to say that the one place investors don’t want to be is financials, they are at risk from both a slowing economy and rising interest rates.

Investing full circle

The global economy is slowing but there is always the chance governments will hit the printing presses once again. With this in mind the Investors Chronicle sector specialists have provided their following top picks to deal with any market come rain or shine.

Defensives for a slowing economyShares to ride inflation
SectorConsumer StaplesHealthcareUtilitiesMetals&MiningOil&Gas
SpecilaistJohn HughmanJulian HofmannJohn FicenecMark RobinsonMatthew Allan
IdeasProctor & GambleGSKUnited UtilitiesAnglo PacificBG
UnileverSevern TrentBaobab ResourcesBP
DevroCentricaRio TintoShell