- The business cycle drives markets.
- The business cycle is at a turning point.
- The decline of the business cycle drives earnings, yields, and commodities lower.
- The business cycle will rise again when inflation and home prices decline.
The decision to increase production to replenish inventories due to increasing demand involves several steps. There is the need to hire more people, to increase the purchase of raw materials, and to increase borrowing to finance operations and to improve and increase capacity.
These decisions have a positive impact on employment and income. Commodities find a bottom following the prolonged slide during Phase 3 and Phase 4. Yields also stabilize as the demand for credit increases.
The positive feedback is caused by rising employment, rising income, and rising sales. Business needs to increase production to replenish inventories to meet expanding demand.
There is a point, however, when capacity constraints begin to appear, and the economy is overheating. The business cycle is now in Phase 2. In this phase commodities rise first, followed by rising yields. Wages grow faster and inflation moves higher.
This is where we are now. Inflation is beginning to erode the purchasing power of the consumers. Home prices have been rising fast, impacting consumers’ optimism. The outcome is a slowdown in retail sales.
This is a critical phase for business. Cutting production to adjust inventories due to the prospect of slower sales is not an easy decision. The costs involved in reducing capacity are high. However, industrial production eventually must be cut to adjust inventories to waning demand.
This is the time when the business cycle enters in Phase 3. The slowdown in production shows at first in lower growth in average workweek, lower commodities and lower yields.
The negative feedback of lower employment, lower demand, lower inventories, lower production, lower income will eventually stop in Phase 4. The end of this phase will be flagged by the decline of the main factor that has caused consumers to reduce their purchases.
As soon as inflation declines, purchasing power improves, demand rises, and the positive feedback causes the business cycle to enter in Phase 1.
Where do we stand now?
Inflation is rising with consumer prices up more than 6% y/y (see above chart). Inflation has been steadily rising since 2016, an event clearly noticed by consumers.
Consumer sentiment rose more slowly beginning in 2016 as inflation started to rise. The sharp rise of inflation since 2020 has been accompanied by steeply lower consumer optimism. Overall inflation is hurting the purchasing power.
Source: St. Louis Fed, The Peter Dag Portfolio Strategy and ManagementInflation at the gas pump, groceries, and retail stores is not the only enemy of consumers’ optimism. The increase in home prices of more than 15% y/y is creating a negative environment for spending (see above chart). One more reason why consumer confidence has declined sharply in the past several months.
It should come as no surprise, therefore, that retail sales have been growing more slowly, declining in three of the past six months (see above chart). It seems reasonable to expect consumer confidence to improve only after inflation and home prices start slowing down, thus increasing the purchasing power of consumers.
Source: St. Louis Fed, The Peter Dag Portfolio Strategy and ManagementThe job of business is to produce and stock the products consumers want to buy. This is what has happened since 2020 (see above chart). Inventories have been growing rapidly since April and the rate of change is still rising. Business will have to cut inventories considering declining consumer confidence and slower sales.
This is exactly the inflection point pushing the business cycle from Phase 2 to Phase 3. Like many times in the past, business will eventually be forced to slow down production as consumers’ demand keeps slowing down. This is where we are now in the business cycle.
The business cycle indicator in the above chart shows the business cycle is declining, reflecting a slowdown in business activity. The slowdown is meaningful enough to be accompanied by lower copper (and commodities in general) and yields.
This is what investors should expect when the business cycle is in Phase 3. The business cycle indicator is updated in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary subscription is available to the readers of this article on www.peterdag.com.
- The business cycle is in Phase 3 and will eventually transition to Phase 4.
- Inflation will decline toward the end of Phase 4.
- Cyclical stocks are unattractive in Phase 3 and Phase 4.
- Defensive stocks and bonds outperform the market in Phase 3 and Phase 4 as discussed in a previous article (see here).
- Inflation is rising with consumer prices up more than 6%
- The decline in both inflation and the growth of home prices will trigger the end of the weakness in cyclical stocks. Defensive stocks and bonds will start underperforming at that time.