Cyclical Analysis

Economic growth = Trend component + Cyclical Component

Inventory cycle: 2-4 years, inventory to sales ratio

When business is confident in the economic outlook, this will keep increasing and economy will growth and employment improved.

However, at the peak, orders will reduce and economy will be in the downturn.

Business cycle: 9-11 years: initial recovery => early expansion => late expansion => slow down=> recession

Real GDP, output gap = trend – current GDP

Recession: -ve GDP growth over 2 consecutive quarters

Inflation rises in the later stages of expansion and flows in the recession and initial recovery. (think of the trend component and cyclical component)

Consumer spending is much larger than business spending in GDP, gauged by new non-farm payroll and unemployment data. Consumer confidence increases when the recovery starts.

Business spending is more volatile than consumer spending.

Neutral rate = short term interest rate balances inflation and economic growth = real GDP growth + target inflation rate

Fiscal policy is only important when there is a direction change and changes directed by the government (i.e. not the result of a business cycle)

Assets with high returns during recession should have low risk premium

Assets with low returns during recession should have high risk premium

Low inflation is good for stock because no interference from government

High inflation rate is bad for stock because there will be restrictive policies to limit the economic activities and difficult to pass cost to customers

Deflation is also bad for stocks for reduced economic activities

Deflation is extremely bad for debt leveraged investment e.g. real estate

Real estate is a good hedge for inflation

Cash instrument is a good hedge for inflation also. But value can be zero in deflation.

Taylor’s rule

Short term interest rate target = neutral rate + 0.5*((expected GDP growth – long term trend in GDP growth) + (expected inflation – target inflation))

Expansionary Monetary + Expansionary Fiscal policies: steep upward yield curve

Expansionary Monetary + Restrictive Fiscal policies: Less steep yield curve

Restrictive Monetary + Expansionary Fiscal policies: Flat

Restrictive Monetary + Restrictive Fiscal policies: Inverted yield curve

Trend economic growth:

1. Changes in employment level (labor participation rate and population)
2. Changes in productivity (new capitals and total factor productivity growth)

New investment needs higher return than the growth in new investment to justify a high stock price

Milton Friedman’s permanent income hypothesis:

Consumer spending is stable and depends on the long term income

Long term trend can be affected by government structural policies and shocks.