Business Cycle Outlook - November 2020

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.
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