The best way to learn about the workings of an economic
cycle is to take a journey through a full cycle. We
will begin this journey with the recession.
The Recession
Historically, Australia has a recession every seven
to nine years. The start of the recession is often
characterised by high interest rates, growing unemployment,
lack of consumer confidence and the failure of many
businesses.
Fortunately, with gloom comes opportunity. Recessions
force business to minimise wastage and improve efficiency
and productivity.
Once the economy begins to improve (which it invariably
does) companies quickly translate their productivity
improvements into increased profits. Consequently,
the share market begins to rise in value in line
with improved company earnings.
This is the start of the share market cycle.
The Share Market Cycle
As a result of improved company performances, investors
begin to regain confidence in the share market. This
confidence accelerates the increase in the value
of shares.
As the share market continues to rise, investors’ confidence
in the market begins to outpace gains made due to
good company performances. This is because of a number
of factors, including increased investor savings,
a buoyant economy and an overly optimistic view of
the share market.
Eventually, the market reaches a point where the
price paid for shares cannot be justified by asset
backings or earnings. This forces a rapid reduction
in the value of shares. This reduction is often known
as a share market correction or, in extreme instances,
share market crash.
A share market correction signals the start of the
real estate cycle.
The Real Estate Cycle
As might be expected, share market corrections do
little for investor confidence.
As the share market pitches restlessly, investors
are quick to channel their savings into the security
of bricks and mortar. Of course, a rapid increase
in the demand for real estate results in a corresponding
increase in property values.
Historically, the value of property rises by at
least 25% per year throughout this period of the
economic cycle.
Because property purchases are funded primarily
by borrowings, a corresponding increase in demand
for real estate causes an increased demand in borrowings
(interest rates).
And because interest rates increase in line with
the demand for real estate (as well as other factors
such as inflation), the rapid growth of the real
estate market cannot be sustained once interest rates
make the cost of borrowing money too expensive.
However, unlike the share market, the property market
stabilises at the close of the real estate cycle – rather
than crashing.
This stabilisation in the value of real estate prices
marks the beginning of the fixed interest (or cash)
cycle.
The Fixed Interest Cycle
At this stage of the economic cycle, equity investment
is not an exciting prospect for investors. The share
market is doing little, and interest rates are too
high to make borrowing for a property an attractive
investment.
Investors have little choice but to hold on to their
current investments, or make most of high interest
rates and invest in debt (bonds, debentures and fixed
interest).
High interest rates slow the economy and lead us
towards another recession – the point where
our journey began.
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