7 months ago • 2 mins
The economy’s twists and turns might feel completely unpredictable at times. After all, bond and stock prices are driven by different factors with varying lags. But there’s actually a clear, reliable cycle underlying the whole system: let’s break it down so you can start expecting the unexpected.
Liquidity – that’s the accessibility and affordability of credit – has a lot to do with pushing us through the cycle. See, when credit is easily accessible and cheap, households can splash out and businesses can fuel their operations well. Plus, low interest rates increase what a firm's future cash flows are worth today and buoy up asset prices. Lower rates also push investors seeking higher returns toward riskier assets like stocks. And when economic growth is strong, companies – and their profit – benefit. As a result, stocks outshine bonds – which suffer from investors' preference for riskier assets – to reach new highs, often hitting their peak for the cycle.
But if there’s too much economic growth, it often leads to inflation. That forces central banks to raise interest rates, a bid to curb the amount of credit available and slow down growth in order to tamp down rising prices. Both stocks and bonds struggle in that environment, which looks something like the top of the chart – and is where we probably are right now.
Now, the beauty of this cycle is that it helps us predict what’s next. We’re arguably sitting on the top-right-hand side of the chart at the moment, just before central banks take their feet off the rate-hiking pedal and before economic growth slows down. And while bonds could benefit from what follows, stocks won’t necessarily reap the same rewards. Instead, as those rate hikes start to bite the economy more seriously, companies’ profit will likely take a hit and investor sentiment will grow sour. Investors, then, won’t want to buy stocks until their expected returns go up, which would probably only happen when prices and valuations fall. Bonds, on the other hand, should get a leg up from interest rate cuts and investors seeking safe-haven assets. That’s not to say they’ll shoot the lights out or stay stable by any means, but they sure look better than stocks at this stage of the cycle.
So if you’re hovering over the stock market trigger, maybe exercise some patience. It might be better to wait until it’s easier for folks and firms to access credit and economic growth has stabilized. Sure, stocks are forward-looking and tend to bottom before the recession ends – but they rarely bottom before it starts. So unless you think the economic slowdown is already over, it might pay off to remain cautious in that last stage of the cycle.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.
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