Economic Cycles and Their Impact on Investments: Do You Know How to Use Them to Your Advantage?

When investing, we should be interested not only in what and how much to invest, but also when to do it – whether our investments will be profitable depends to a large extent on economic cycles. Luminor bank’s senior portfolio manager Mantas Skardžius talks about their patterns and how to use them to your advantage.

Economic cycles are fluctuations in economic activity – a natural part of the economy, which, after getting used to, we can better guess where and when to invest our money, says M. Skardžius.

“Economic cycles shape economic performance and dynamics, influencing populations, businesses and governments. What phase a country’s economic cycle is in can be judged from its GDP, consumer spending, interest rates and inflation. Economic cycles typically last 4-10 years. For example, since 1950, the average US economic cycle has been about 5.5 years. When and in what you invest will depend on whether the investments will bring a profit,” says the bank’s representative.

According to the expert, diversification of asset classes and periodic portfolio rebalancing are key strategies to manage risk at various stages of economic cycles. In addition, you can always get individual recommendations tailored to your situation by contacting financial professionals.

What does the economic cycle depend on?

There are various theories that examine what causes economic cycles to change.

Theory of economy monetarism states that economic activity is determined by changes in interest rates as it becomes either more expensive or cheaper for households, firms and the government to borrow.

“On the other hand, Keynesian (Economist JM Keynes’s) view says that cycles are caused by changes in aggregate demand, which is determined by the fickle demand for investment. In other words, the root cause of economic instability is uncertainty, which causes people to not invest and hoard cash, then stop saving and invest heavily. As a result, economic changes are cyclical, and financial markets are inherently volatile,” says the expert.

The first phase of the cycle is development

In the development stage, economic activity grows, the main indicators of the economic cycle increase. This is often attributed to low unemployment, rising wages and growing consumer confidence in businesses. Businesses are expanding production, the general economic mood is positive.

“Companies’ income increases during growth, so it is best to have stocks in your portfolio at this time. Corporate bonds with higher yields can also provide attractive returns during periods of economic growth. For example, investors often find opportunities in the technology and energy sectors. Finally, real estate values ​​tend to rise during economic growth as well. This happens due to the increased demand for residential and commercial premises,” says the expert.

The next phase is the peak

During the peak period, growth rates begin to slow, but economic indicators remain positive, making it the best time to reallocate assets to avoid losing the gains made during the previous boom.

“As consumer demand increases, there comes a time when companies are no longer able to increase production to meet the growing demand. Companies may start increasing production costs, and some of them pass these costs on to consumers, as a result of which prices start to rise,” explains M. Skardžius.

According to the expert, at the peak stage, defensive stocks will bring the highest investment returns, ie, utilities, health care, and consumer goods sectors. In addition, short-term bonds can also provide stability and protection against a possible increase in interest rates.

The final phase is decline

The recession stage is characterized by a decline in economic activity. As the economy declines, GDP falls, businesses cut production, unemployment rises, and consumer spending falls. Confidence in the economy weakens, leading to lower investment and lower demand. According to M. Skardius, at such a time, governments and central banks can start implementing stimulus measures, such as lowering interest rates or increasing government spending, in order to stimulate economic activity.

“During a recession, it is safest to hold defensive stocks in the portfolio, which are characterized by the fact that the effects of the recession do not limit the products they offer. In fact, the demand for goods and products sold by these companies may even increase. As a result, it is likely that if you invest in them, you will not only lose money during the recession, but maybe even make money,” says the expert.

According to M. Skardžius, government bonds are considered one of the safest investments during a recession, as they ensure stability in interest payments. Dividend-yielding stocks can play the same role, maintaining the returns provided by the investment portfolio until the market recovers.

“However, it is important to remember that these stages replace each other, and the decline sooner or later turns into an upswing.” In other words, what goes down must come up, and vice versa. It is also important to know that in many cases, instead of trying to determine the stage of the market and make decisions based on it, the safest and often no less profitable strategy can be to maintain a diversified investment profile. This way, you will be better prepared to withstand all the ups and downs of economic cycles,” says the Luminor bank expert.

About Luminor:

Luminor is the leading independent bank in the Baltic States and the third largest provider of financial services in the region. We serve the financial needs of individuals, families and businesses. Like our home markets – Estonia, Latvia and Lithuania – we are young, dynamic and forward-looking.