Business cycles
Business cycles are one of the defining characteristics of realistic market behaviour (“stylized facts”) in asset prices, volatilities, level and slope of yield curves, as well as in the broader
macro-economic environment. Therefore, it is important to take business cycles into account when making investment decisions. Burns and Mitchell (1946) define business cycles as “a type of fluctuations found in the aggregate economic
activity of nations that organize their work mainly in business enterprise”. Gyomai and Guidetti (2012) of the OECD describe business cycles as “recurrent sequences of alternating phases of expansion and contraction in economic
activity”.
Ortec Finance Business Cycle Indicator
Similar to other business cycle indicators, the Ortec Finance Business Cycle Indicator (OF BCI) measures the global state of the business cycle on a monthly basis. In the graph, the resulting information
is represented by the “History” and “Realization” lines. The values of the OF BCI are normalized to a standard deviation of 1. Values above 0 mean that economic activity (annual growth, annual equity returns, etc.) are above their
underlying trend. Values below 0 mean that economic activity is below trend. So a value of 1 (-1) of the OF BCI can be interpreted as that the global economy is doing one standard deviation better (worse) than trend. However, on top of
the measurement information, the OF BCI also provides up to date outlooks of how the business cycle is expected to evolve in the future, together with the associated uncertainty. In the graph, this outlook information is represented by
the “Expectation” lines and the “Confidence” intervals around the expectation lines.
Construction
The OF BCI 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 outlook is obtained from a carefully constructed and thoroughly back-tested Dynamic Factor Model (DFM).
The OF BCI has been found to be a strong driver of annual growth, annual equity returns, credit spreads, etc. on medium term horizons on a global scale. As such, the OF BCI is used as an important driver of the medium term outlook
described by the Ortec Finance Scenarioset (OFS). For more information please refer to Steehouwer (2016) and the references stated there.
Three perspectives
The central buttons below the graph can be used for navigating between three perspectives on the OF BCI.
(1) “Latest outlook” focusses on the outlook for the next three years, starting from the most
recent month for which the OF BCI is available. The text boxes positioned at the latest realization and within the confidence bands provide more in depth information.
(2) “Recent performance” focusses on what the outlook looked like
during recent years and how this compares to how the OF BCI has developed in reality (“Realization” line).
(3) “Historical perspective” focusses on information that allows one to learn about historical business cycle developments
going back to 2000, covering important episodes as the bust of the dot com bubble, the financial crisis and the Euro crisis.
References
- Burns, A.F. and W.C. Mitchell (1946), “Measuring business cycles”, New York: National Bureau of Economic Research, Ch. 11.
- 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.