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Business cycles

Business cycles are one of the defining characteristics of realistic market behaviour (“stylized facts”) in asset prices, volatilities, level and slope of yield curves, as well as in the broader macro-economic environment. Therefore, it is important to take business cycles into account when making investment decisions. Burns and Mitchell (1946) define business cycles as “a type of fluctuations found in the aggregate economic activity of nations that organize their work mainly in business enterprise”. Gyomai and Guidetti (2012) of the OECD describe business cycles as “recurrent sequences of alternating phases of expansion and contraction in economic activity”.

Ortec Finance Business Cycle Indicator

Similar to other business cycle indicators, the Ortec Finance Business Cycle Indicator (OF BCI) measures the global state of the business cycle on a monthly basis. In the graph, the resulting information is represented by the “History” and “Realization” lines. The values of the OF BCI are normalized to a standard deviation of 1. Values above 0 mean that economic activity (annual growth, annual equity returns, etc.) are above their underlying trend. Values below 0 mean that economic activity is below trend. So a value of 1 (-1) of the OF BCI can be interpreted as that the global economy is doing one standard deviation better (worse) than trend. However, on top of the measurement information, the OF BCI also provides up to date outlooks of how the business cycle is expected to evolve in the future, together with the associated uncertainty. In the graph, this outlook information is represented by the “Expectation” lines and the “Confidence” intervals around the expectation lines.

Construction

The OF BCI is constructed by compressing business cycle information from more than 300 global economic and financial market variables (growth, inflation, unemployment, exchange rates, equities, interest rates, real estate, volatilities etc.), according to the frequency domain methodology described in Lee and Steehouwer (2012). The outlook is obtained from a carefully constructed and thoroughly back-tested Dynamic Factor Model (DFM). The OF BCI has been found to be a strong driver of annual growth, annual equity returns, credit spreads, etc. on medium term horizons on a global scale. As such, the OF BCI is used as an important driver of the medium term outlook described by the Ortec Finance Scenarioset (OFS). For more information please refer to Steehouwer (2016) and the references stated there.

Three perspectives

The central buttons below the graph can be used for navigating between three perspectives on the OF BCI.
(1) “Latest outlook” focusses on the outlook for the next three years, starting from the most recent month for which the OF BCI is available. The text boxes positioned at the latest realization and within the confidence bands provide more in depth information.
(2) “Recent performance” focusses on what the outlook looked like during recent years and how this compares to how the OF BCI has developed in reality (“Realization” line).
(3) “Historical perspective” focusses on information that allows one to learn about historical business cycle developments going back to 2000, covering important episodes as the bust of the dot com bubble, the financial crisis and the Euro crisis.

References

  • Burns, A.F. and W.C. Mitchell (1946), “Measuring business cycles”, New York: National Bureau of Economic Research, Ch. 11.
  • Gyomai, G. and E. Guidetti (2012), “OECD System of Composite Leading Indicators”, Paris.
  • Lee, K. and H. Steehouwer (2012), “A Zero Phase Shift Band Pass Filter”, Paper presented at EEA-ESEM conference, 27-31 August 2012.
  • Steehouwer, H. (2016), “Ortec Finance scenario approach”, Ortec Finance scenario department paper.

Business cycles and investment decisions

It is important to take business cycles into account when making investment decisions. Business cycles are a defining characteristic of the movements on medium-term horizons in asset prices, volatilities and yield curves, as well as in the broader macro-economic environment. For example Gyomai and Guidetti (2012) describe business cycles as “recurrent sequences of alternating phases of expansion and contraction in economic activity”.

Business cycle scenarios

An unrivalled feature of the Ortec Finance stochastic economic and asset return scenarios is that they are powered by the Ortec Finance Business Cycle Indicator. This indicator is a key driver of scenarios of economic growth, equity markets and credit risk on medium-term horizons. The indicator not only estimates the state the global economy is in, but goes beyond that by also providing expectations, uncertainties and scenarios for the future state of the economy.

Methodology

The indicator is constructed by compressing business cycle information from more than 300 global economic and financial market variables (growth, inflation, unemployment, exchange rates, equities, interest rates, real estate, volatilities etc.), according to the frequency domain methodology described in Lee and Steehouwer (2012). The stochastic scenarios of the business cycle are obtained from a carefully constructed and thoroughly back-tested Dynamic Factor Model (DFM) as described in Steehouwer (2016).

The values of the indicator are normalized to a mean of zero and a standard deviation of 1. It moves through four consecutive phases, where the course of events during one phase sooner or later lead it into the next phase: (1) the “expansion phase” with economic activity (growth, equity returns, etc.) above trend and increasing, (2) the “slowdown phase” with activity above trend and decreasing, (3) the “contraction phase” with activity below trend and decreasing, and finally (4) the “recovery phase” with activity below trend and increasing.

  • Gyomai, G. and E. Guidetti (2012), “OECD System of Composite Leading Indicators”, Paris.
  • Lee, K. and H. Steehouwer (2012), “A Zero Phase Shift Band Pass Filter”, Paper presented at EEA-ESEM conference, 27-31 August 2012.
  • Steehouwer, H. (2016), “Ortec Finance scenario approach”, Ortec Finance scenario department paper.