The business cycle ought to be thought of as a series of discrete phases, each one quite distinct from the other, rather than as a smooth and uninterrupted process through time. This is how Goldman Sachs describes what is a compelling view of the dynamics of macro acceleration-and-deceleration and expansion-and-contraction and how these separate phases of their so-called 'swirlogram' can be mapped into asset class performance. This means that unlike traditional business cycle momentum jockeys and the extrapolating 'rulers' of the world, trade positioning should depend not only on the current state of the cycle but also on the near-term phase transition. As the cycle turns, so do assets; economic acceleration serves as an early indicator of looming shifts. Hence, vigilance in monitoring the business cycle with an eye towards identifying cyclical turning points is instrumental to a disciplined investment process. These lessons are timely too. Back in March, the business cycle peaked. The GLI shifted from the Expansion phase to the Slowdown phase; growth remained positive but acceleration turned negative. More ominously, April GLI growth was quite modest, with downward revisions to the last few months of data too. If the current downbeat data trajectory is extended, current GLI readings may prove to be overly optimistic. And should acceleration remains negative (which today's Philly Fed will drive), there is not much of a growth buffer to prevent the cycle from slipping into the Contraction phase, where the message for asset markets is clear and sobering.
The 4 quadrants of the new business cycle vision...
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and how assets perform under these quadrants...
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Visualizing the business cycle
We use the GS Global Leading Indicator (GLI), its growth (positive and negative) and acceleration (positive and negative) to define the business cycle and its four phases (see Charts 1 and 2). Peaks and troughs are clearly identified by the interaction of these two key characteristics. Cycle peaks occur when growth is positive, but no longer sequentially better, as acceleration shifts from positive (continuously rising growth) to negative (declining growth). And cycle troughs occur when growth is negative but no longer increasingly so, as acceleration shifts from negative (continuously declining growth) to positive (improving growth).
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Recasting the GLI as a function of its own growth and acceleration yields a different visualization of the business cycle that amplifies the prominence of the four phases. Each monthly data point is identified by two characteristics: GLI growth (the month-on-month percentage change) on the x-axis and GLI acceleration (the month-on-month change in growth) on the y-axis. Formally, this is a phase-space representation of the GLI; informally, we call it the GLI Swirlogram, as illustrated in Chart 3. In this representation, each phase is associated with a specific quadrant.
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As the GLI moves through time it traces out (by construction) a clockwise curve (see Chart 4), with some phase transitions more likely than others.
Just the facts: Phases of the cycle and asset returns
Moving clockwise through the Swirlogram, starting from the top right, the four phases of the cycle and some of key characteristics are:
1. Expansion (positive growth and positive acceleration):
- Asset returns are strongly positive – be it global equity indices, sectors, US treasuries (in yield terms) oil, metals, and some currencies too.
- This phase occurs about 40% of the time and lasts about seven months on average.
- From here, the cycle always peaks and moves “forward” (clockwise) to Slowdown. Acceleration turns negative even as growth remains positive. (Technically, owing to the smoothness of the GLI, this transition is deterministic, as we detail in our paper.)
- Economic data are relatively highly correlated with each other and fairly persistent.
- Returns dispersion across assets (within an asset class) is most modest in this phase, as a rising tide lifts all boats.
2. Slowdown (positive growth and negative acceleration):
- Returns are more muted, though for the S&P 500, still positive. Volatility is higher and so effective returns (which are expected returns scaled for uncertainty) are lower too.
- Realized skew is most negative in this phase.
- This phase also occurs about 40% of the time and lasts about seven months on average.
- Following a cycle peak, acceleration is almost as likely to turn positive again, as growth is to turn negative. Slowdown could either be a mid-cycle pause or a precursor to negative growth.
- Correlations across key macro data is, on average, weakest in this phase of the cycle.
3. Contraction (negative growth and negative acceleration):
- Returns are strongly negative in this phase. On an effective return basis, the Wavefront Growth Basket has the most concentrated negative returns across the assets we consider.
- This phase occurs only about 10% of the time and is short lived, lasting about 3 months on average.
- From here, the cycle has (nearly) always found a trough and moved on to the Recovery phase.
- Macro data tell a fairly clear and correlated story in this phase.
4. Recovery (negative growth and positive acceleration):
- Returns shift from strongly negative to very close to zero, on average.
- Returns dispersion across assets (within an asset class) is highest in this phase, signaling that differences in relative performance (adjusted for volatility) are greatest in this phase.
- This phase also occurs only about 10% of the time and is short lived, lasting about three months on average.
- Although worries about “double dips” often abound, and transitions in theory could be either forward to Expansion or back to Contraction, in the 25-year history of the GLI, the cycle has always moved forward to Expansion from the Recovery phase.
- Macro data are most correlated and persistent in this phase than any other.
Watching the data for tactical positioning
Should the data push through to this more negative state of the world and if history is any guide, asset markets are likely to respond fairly aggressively. It is interesting to note, that several assets that are typically harmed quite a bit in the Contraction phase have, in advance, already posted some significantly negative returns during the current Slowdown phase. Looking at assets from March 1st (when the February GLI was released) to current, the GS Wavefront US Growth Basket, the Materials sector, EM equities, and the Aussie dollar have posted returns more consistent with the Contraction phase rather than the Slowdown phase that has been observed. By contrast, the S&P 500, the Consumer Discretionary sector, and even the DAX, though not stellar, have performed much more in line with typical Slowdown patterns and have not yet suffered from Contraction pains, which may still turn out to be false.
Over the last week or so, markets have been buffeted by several factors: renewed uncertainly about the near-term outlook in Europe, weak Chinese data, and US financial sector issues too. None of these have motivated us, from a tactical perspective, to get off the sidelines.
we do not yet have enough information to feel comfortable with one interpretation over the other. As always, and as our recent work amplifies, the upcoming data and their direction will be crucial. Thursday’s Philly Fed release of May data will feed into the Advance May GLI reading. We will be watching closely to see if the GLI remains in the Slowdown phase or if it nears or even crosses into the Contraction phase.