Just as farmers consider the seasons when deciding on what crops to plant, sensible investors factor in economic cycles when making investment decisions.
Capitalist economies are known for going through boom-and-bust cycles. Investors tend to pay a lot of attention to these cycles because, theoretically, it is easier to make money if you buy assets when prices are low (during the ‘bust’ part of the cycle) and sell them when prices are high (during the ‘boom’ part of the cycle).
According to ‘short-term debt cycle’ theory, when a central bank – the Reserve Bank of Australia in this country – lowers interest rates it makes it cheaper for people to borrow money to do things such as buy a home or start a business.
When more homes start getting built and businesses launched, businesspeople, investors and consumers begin feeling upbeat about the future. Property and share prices increase. Investors wanting to take advantage of the strong economy borrow money, which is still available at low interest rates, to do things such as buy investment properties and build share portfolios. With the economy now booming, businesses hire more workers and unemployment falls.
This process played out in more or less a textbook fashion in Australia and many other nations following the GFC. Central banks lowered interest rates to very low levels, people took advantage of ‘cheap money’ to buy assets and property markets – and share markets performed strongly while the price of gold shot up. Something similar now appears to be occurring with historically low interest rates encouraging first-home buyers to enter the property market mere months after restrictions related to COVID-19 shut down some of Australia’s biggest industries.
When the economic tide goes out
Unfortunately, people in general and investors in particular tend to start believing the party will go on forever and start bidding up the price of assets such as houses and shares, which is commonly known as a ‘bubble’. Booming asset prices causes inflation to rise, which can cause the central bank to increase interest rates.
All of a sudden, investors have to find extra money to pay more interest on the debts they racked up buying assets. To pay their debts, some investors have to sell their assets, which means asset prices start to fall. This can cause other investors to panic, and they too might decide to sell their assets before prices fall further.
Consumers notice asset prices, especially the price of their home, are falling. They stop spending money on non-essential items such as holidays, clothes and meals out. Hotels, clothing retailers and restaurants start laying off staff. This makes people even more worried about their jobs and less inclined to spend or invest money. This results in businesses making even more staff redundant. If this pattern continues long enough for the economy to shrink for two consecutive quarters, it’s notionally a recession.
When a country goes into recession, the central bank lowers interest rates, people start borrowing money to buy homes and launch businesses, and the cycle starts again.
At least that’s how it works according to Credit Cycle Theory.
Coronavirus and Australia’s miracle economy
The short-term economic debt cycle takes, on average, 5-10 years to play out and is widely believed to be an inescapable feature of free-market economies. Australia’s economy used to go through regular boom-bust cycles. Lots of economies in Asia, Europe and North America have continued to experience regular boom-and-bust cycles up to the present day.
That noted, it’s important for any Australians planning on investing in 2021 to understand how economic theory and real-world events diverge in the case of Australia.
Inflation was near non-existent and interest rates were at historic lows when Australia started to slip into recession in early 2020. In contrast to late 1990, the Australian economy wasn’t sent into recession by the Reserve Bank of Australia raising interest rates to eye-watering levels to keep inflation under control. The Australian economy was performing solidly, if unspectacularly, in early 2020. Like many economies, it was sent into recession by the shutdowns necessitated by the COVID-19 response.
Given Australia’s economy wasn’t functioning in line with short-term economic debt cycle theory before it went into recession, it’s dangerous to assume it will do so coming out of recession.
In the early days of the pandemic, many pundits predicted that Australia was set for a punishing recession that would see anywhere from 10-30% declines in property prices and double-digit unemployment. Given this bleak outlook, there was a lot of interest in early to mid-2020 in ‘safe haven’ – aka defensive – assets such as cash, gold, bonds and non-cyclical shares. (Safe haven assets are less exciting than growth assets, such as cyclical shares and real estate. But they provide reliable, if modest, returns even during the bust stage of economic cycles.)
But by late 2020 many of the same forecasters who were initially forecasting a devastating downturn began predicting a ‘V-shaped recovery’. At the time of writing, many newly optimistic economic experts have been pointing to booming stock markets and predicting property prices will grow strongly throughout 2021. There’s also cautious optimism that unemployment will peak around 7% and soon return to average levels. With things looking up, many investors are now wondering if growth assets will perform strongly throughout 2021 and beyond.
Think long term
Understandably, the fast-moving events of 2020 have left investors confused as to where the Australia economy is placed in the boom-and-bust cycle and whether they should be rebalancing their investment portfolio towards growth or safe haven investments.
Long-time ANZ Financial Adviser Rebecca Hurford believes that – after having endured a short, artificially induced bust – the Australian economy is now in the boom part of the cycle. But she argues that it’s always foolish to attempt to ‘time the market’ by investing in growth assets right after a bust with the hope of selling them shortly before the next bust.
“There are two things I always tell new clients,” Hurford says. “First, is the adage that it’s a matter of time in the market, not timing the market. Second, that they need to listen to their head not their heart.”
Hurford’s first point is that while the price of an asset will fluctuate in the short term, it will usually increase over the longer term.
“Imagine a young couple who buy a house,” Hurford says. “The price they can ask for that house will be tied to the health of the Australian economy and will go up and down from year to year. But the long-term trend will be for the house to appreciate in value. If the couple sell the house within a few years of buying it, they will probably make a small profit or loss. But if they sell it after owning it for three decades, they’ll usually be able to sell it for 4-5 times what they paid for it.”
The assets people commonly invest in – share portfolios, real estate, precious metals – usually do grow in value over the long term. However, human nature being what it is, greed and fear often motivate investors to make short-term ‘heart’ decisions rather than long-term ‘head’ ones.
“Let’s say someone invests $200,000 in shares, or an investment property, or gold,” Hurford says. “The economy booms and one year later their asset is worth $250,000. The investor is going to be tempted to sell and take the quick $50,000 profit. Now imagine the same scenario except that, due to an economic downturn, the asset is only worth $150,000 a year later. The investor is going to be tempted to sell the asset so they can avoid taking a loss any bigger than $50,000.”
However, if the investor has committed to holding the asset for at least a decade, the risk is much lower that they will end up selling at the bottom of a trough or near the top of the first peak. “The benefits of taking a calm and patient approach to investing are obvious to impartial observers, but it’s a lot harder to remain rational when it’s your money on the line,” Hurford says. “That’s why it can be helpful to talk to a financial adviser. They can explain how to manage your emotions and structure your investment portfolio to generate returns over the long term, regardless of the ups and downs of the economy.”