Changes in the growth rate of the US economy have huge implications on financial markets. Since many investors’ financial well-being is tied to financial markets, through retirement savings and investment accounts, they are impacted by these changes as well. We look at how our Business Cycle Indicator (BCI) tracks the growth rate of the US economy, and how it can be a useful guide for helping investors navigate market cycles.
Financial markets and US economy move cycles. We experience prolonged periods of economic expansion, or “Booms”, and short but sharp contractions, or “Busts”. These cycles of booms and busts is what is known as the business cycle. And because financial markets react to changes in the economy, market cycles often follow business cycles.
Recession Risks for Retirees
BCI was designed to address the significant risk a recession poses for investors, especially those who are approaching retirement or have recently retired. The risks are greater for those near retirement because they have little time to allow financial markets to rebound after a steep decline; a common side-effect of a recession.
For example, someone retiring in the next two years has likely made some assumptions about how much income they will pull from their retirement savings. If their retirement savings suffers a large decline, it could jeopardize their plans for retirement. During the Great Recession, many near-retirees had to make some difficult decisions, often opting to delay retirement.
Historically, BCI has provided the same reading prior to every recession since 1968. A reading below -0.9 occurred prior to each of the seven recessions that occurred during that time period. We don’t know what will happen in the future, but every business cycle follows a similar pattern. BCI is a data-driven process for tracking those patterns.
Importantly for investors, BCI’s readings also correlate with stock market returns. Over the last 30 years, when BCI is signaling that the economy is expanding, the average return for the stock market is more than 16% per year. When it signals the economy is entering a recession, the average return is -8.4% per year.
Changes in GDP and Business Cycle Indicator
Gross Domestic Product is how we measure the size of the overall economy. Financial markets put a heavy emphasis on the quarterly report that measures the pace of economic growth. Because BCI has a strong track record of warning before a recession occurs, it should also provide some insight into quarterly GDP announcements.
Below is a chart that shows GDP (grey bars), with BCI (blue line), and recessions (grey shaded areas) going back to 1968. Over the entire time period, BCI has a descent correlation to changes in GDP growth at 0.57. A correlation above zero means the two typically move in the same direction. A reading of 1 would mean the two are identical.
Important GDP Release Next Week
Next week we get the preliminary GDP reading for the first quarter of 2019. Financial markets will be keenly watching this release because growth has been slowing at a rapid pace. In the second quarter of 2018, the economy grew at a 4.2% annualize rate. In the third quarter, that pace fell to 3.4%, followed by a reading of 2.2% in the fourth quarter. BCI bottomed in December of last year and has been recovering during the first four months of this year.
The stock market was down nearly 20% during the fourth quarter of 2018, as many investors feared the slowing economy might result in an outright recession. During the first four months of 2019, the stock market has rallied back as recession fears subsided. The market is near the all-time high it set in September of last year. Thus far, the stock market appears to be agreeing with BCI about the risk of a recession.
Next week’s GDP report will provide an important glimpse into the growth rate of the economy at a potentially pivotal point in the economic cycle. With BCI moving higher, we expect GDP growth to reaccelerate, and confirm that recession risks are falling. In the end, if we do not experience a recession, financial markets have rewarded those investors who are disciplined enough to remain invested.