How To Measure The Economic Cycle Part II
Three weeks ago, we started a multi-part series at EPB Macro Research on how to measure the five phases of the economic cycle as well as how to profit in each distinct phase by shifting your portfolio into the best performing asset classes at the right time.
The goal of this multi-part series is to properly identify and define the stages of the economic cycle, understand what investments perform the best/worst in each stage of the economic cycle, know what indicators to look for when the economy is shifting to a new stage of the economic cycle, and learn how the asset allocation model at EPB Macro Research ties into the long-run economic cycle.
At the end of this series, my hope is that members have a firm understanding of how we think about the economic cycle at EPB Macro Research, gain confidence in knowing where we are in the economic cycle and have more conviction in what we are trying to do with the asset allocation model.
Sign up for a two-week free trial to read the first two parts of this series (preview below).
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Preview Of The Economic Cycle Series
Below is an excerpt from Part II of this series inside EPB Macro Research. There will be one or two new parts released per week, only to members of EPB Macro Research until completion of this series.
Broad Look At GDP & Its Components
GDP, in its broadest sense, is defined as personal consumption + government spending + private investment (including residential and business) + net exports. The formula is commonly seen in the form (GDP = C+G+I+NX).
Personal consumption and government spending are the largest components to GDP, making up roughly 70% and 17% respectively. Despite comprising the largest share of GDP, these two variables are the least volatile and do not necessarily drive the large cyclical swings in the economic cycle.
Private investment (16%) and net exports (-3%) are highly volatile and are the primary drivers behind the large swings in GDP. One subcomponent of consumption (durable goods), is also quite volatile which will be covered in more detail below.
The following chart maps the four main GDP components in year over year terms for a volatility comparison. Net exports and private investment can swing as much as +/- 30% in year over year terms, drastically changing the growth rate of the economy in GDP terms while personal consumption trends, the largest share of the economy, can get overlooked.
Source: BEA, EPB Macro Research
Before moving on to what indicators we will use to define the economic cycle, a brief look at the breakdown of the largest component, personal spending, is important as one subcategory will be very important in defining the cycle.
Personal spending (70% of GDP) is broken down into three main categories, two of which are not very volatile, are fairly consistent and do not provide much information regarding the economic cycle. One category, is highly volatile, while the smallest share of personal consumption, but its trends are very reliable in assessing the direction of the economy.
Personal spending is comprised of services, non-durable goods, and durable goods.
Services spending is about 65% of total spending and consists of medical care, home maintenance, personal grooming etc. This is the largest category of spending and not volatile.
Nondurable goods spending, 22%, is made up primarily of food, clothing and nondiscretionary, smaller ticket items.
Durable goods spending, 13%, is the category we care about as this consists of auto-related spending, home appliances, and heavy-duty, big-ticket items and the type of spending that gets pulled back first during a slowdown and accelerates sharply in an expansion. Durables goods spending is a great leading indicator of consumption and growth.
In summary, the economic volatility comes from business spending on inventory and plant & equipment (lagging), net exports, and housing (leading) and durable goods consumption (leading).
What Indicators Are Best To Use
There are hundreds of economic data points that get released with varying degrees of frequency. Some indicators are better than others while some are outright misleading.
The best economic indicators are released on a monthly basis (sometimes weekly) as opposed to quarterly, have relatively small backward revisions month to month and consistently monitor specific trends. Not all indicators lead the economic cycle and some economic data points are very important in confirming trends and outlining lagging variables such as business spending. Leading indicators are different than reliable indicators.
If you'd like to read Part II in full, sign up for a free trial of EPB Macro Research. As I wrote above, there is no risk in trying a two-week free trial. You can read the first two parts of this series, along with the other content at EPB Macro Research and decide if the service is right for you. You will never be charged if you cancel within the first two weeks but I am confident that you will find massive value.
I look forward to hearing from you in the member chat room with your thoughts on the first and second part of this series!