This post sets out the key features of the economic cycle that forms the basis of Ascendant Strategy’s rigorous economic framework and our ability to help investors and corporates make sound investment decisions.
Most economies within the modern economic and financial system (i.e. those characterised by a relatively free price mechanism, private land tenure, a well-developed banking system, etc.) display regular cyclical patterns of expansive followed by depressed economic activity. The research we have access to shows that the periodicity of such activity is a remarkably regular 18 years on average.
How the economic cycle unfolds
The cycle is driven by two major factors: speculation in real estate and the lending (credit creation) against the massive increase in real estate (in reality land) values that are generated by such speculation. Owing to the fact that land is absolutely fixed in supply and that its use tends to cluster in specific locations that are themselves unique, higher prices for real estate do not bring more supply into markets (as they would other commodities, goods and services). (Indeed, there is evidence that the opposite happens, whereby owners of land withhold land from the market in the expectation of future price increases, thus restricting supply and contributing to further increase). Competition for land and location occurs most when economic conditions are good, businesses invest, consumers feel wealthy and their purchasing power increases, resulting in higher levels of economic activity. Ultimately the gains of such activity manifest themselves as the higher rental value of land, as many have noted, which in stable private property systems is capitalised into a price. The cycle unfolds in four phases as follows:
- The first act of the 18 year cycle begins as the wreckage of the previous cycle is cleared away, where economies move from recession back to growth and business conditions pick up, unemployment comes down and consumer spending returns. This leads to the first expansion of an 18 year cycle.
- An increasingly confident economy may often experience a mid-cycle slow down. This slowdown is the traditional version of a business cycle downturn where supply may outrun demand or vice versa. Such contractions generally prove to be short-lived and tend not to be financial in their nature, i.e. implicate the financial system.
- The next act of the cycle is the second boom. Speculation plays as much of a role in this boom as does business expansion, though standard economic data may not be able to distinguish between the two. In this phase of the cycle, higher demand for real estate (land) is more obvious; and land is more expensive to acquire, mortgages comprise an increasing proportion of the loans made by the banking system, the quality of a bank’s loan book is increasingly predicated on high land values. A characteristic of this phase is easy credit and relaxed lending standards. The final part of this phase is frenetic real estate activity, called by some the Winner’s Curse phase.
- The final great act of the cycle is the crash. At some point the cycle can no longer continue to support ever increasing values. In speculative markets, if prices are not increasing they are falling. As speculation stalls, prices fall, dramatically. Unlike other contractions, the problem with such falling values is that the banking system faces the real possibility that loans outstanding exceed the collateral value of assets they were created against and that people are no longer able to meet their loan obligations. Such problems disrupt the normal operation of the banking system (e.g. inter-bank lending) and can lead to a full-blown economic crisis. They also result in the need for large scale intervention in the banking system by government; the cost of such bailouts is often huge additional borrowing which then results in reduced public spending in other areas, exacerbating or prolonging the recession.
The diagram above illustrates the cycle in a stylised way. Eventually the wreckage is cleared away and conditions are ripe for renewed activity and the economy turns back to the first phase noted above. In the UK, we have dated the prior cyclical peaks to 1972, 1989 and 2007). We are now of the view that the UK has now entered the first phase of expansion again that should last most of the rest of the decade. The final cyclical peak is due around 2026, with the trough of the downturn around 2028-30.
Why the cycle repeats
The cycle is repetitive because the structure of the economy does not change. Far from making use of a crisis to drive change, the policy response at the cyclical downturn is designed to preserve the current system. The standard bag of tricks consists of the following:
- Dramatic reduction in interest rates to prop up asset values, inflate away debt and encourage consumer spending
- Back stopping banks by providing emergency liquidity
- Significant state intervention in the financial sector, including ring-fencing toxic assets and, in many cases, taking them on to the public sector balance sheet
- Measures to stimulate house-building and construction, as major pro-cyclical sectors and large employers.
To find out more about why the 18 year cycle is important, please download our FREE E-Book 7 Reasons Why Investors Need to Understand the 18 Year Cycle by following the hyperlink and completing the form.
You can purchase a detailed, blow-by-blow account of the 18 year cycle in our report The 18 Year Cycle Unveiled from our Reports page.
How we use this information
We at Ascendant Strategy are experts in applying this information to practical business decisions. At each phase of the cycle there are opportunities and risks to work through. We specialise in interpreting economic data and information in light of our economic framework to give investors security in relation to the decisions they are making.
Timing is of critical importance and Ascendant Strategy has developed a suite of indicators to track each phase of the cycle to provide investors with added assurance on how things are unfolding.
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