Latest / How Canadian Markets Work / Episode 22: The Business Cycle (Visible Only in Hindsight)

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Episode 22: The Business Cycle (Visible Only in Hindsight) · How Canadian Markets Work

0:00
Imagine you are driving down a highway at night
0:02
and your windshield is completely blacked out.
0:07
Oh, that sounds absolutely terrifying. Right,
0:09
it really is. The only way you can steer, like
0:12
the only way you know where you are on the road
0:14
is by staring intently into the rear view mirror.
0:17
Wow. OK, I can picture that. You can see exactly
0:20
where you were 10 miles ago. And you can sort
0:22
of guess where you were a mile ago. But you have
0:25
absolutely no idea what is directly in front
0:28
of your bumper. Which is just a recipe for disaster.
0:30
Exactly. So welcome to another deep dive. Today
0:33
we are looking at why navigating the global economy
0:36
feels exactly like that blind highway. It is
0:40
such a perfect analogy for what we're talking
0:42
about today. Thanks. We are going to unpack the
0:44
business cycle today. We'll be exploring how
0:46
economies organically ebb and flow, why we only
0:50
ever know we are in a recession after it is already
0:52
over, and why trying to time your investments
0:55
based on the evening news is, well, essentially
0:57
a mathematical trap. Yeah, a trap that a lot
0:59
of people fall into, unfortunately. Yeah, definitely.
1:02
And we have a really robust stack of source material
1:04
today. It breaks down these economic phases,
1:07
the hidden timelines of market indicators, and
1:11
the unique, highly vulnerable realities of the
1:14
Canadian economy specifically. There is a lot
1:16
to get through, but it's all incredibly relevant
1:19
to anyone listening right now. It really is.
1:21
So to set the stage for you, let me pose a seemingly
1:25
simple question. Are we in a recession right
1:28
now? Well, the funny thing is, nobody can actually
1:31
answer that for you in this exact moment. Wait,
1:34
really? Nobody? Nobody. I mean, not even the
1:37
world's most resourced central bankers can give
1:39
you a definitive answer in real time. That is
1:41
just wild to think about. It is, right. The economic
1:44
data we all consume daily creates this really
1:48
powerful illusion of the present. Yes, the illusion
1:50
of the present. I love how our sources describe
1:52
that. Because when you read a headline, it feels
1:55
like you're reading about today. But we are always...
1:59
invariably looking in that rear view mirror you
2:01
mentioned. Right, staring out the back of the
2:02
car. Exactly. The data required to describe this
2:06
current week, it will not be fully compiled for
2:09
months. And even when it is released, it is subject
2:12
to heavy revisions down the road. So that time
2:15
delay is totally fascinating. But before we can
2:19
understand why real -time measurement is literally
2:21
impossible, I feel like we need to understand
2:23
what we are actually trying to measure. I agree.
2:26
We have to start with the basics of the cycle
2:28
itself. Right. Because economies do not just
2:30
grow in a straight, smooth, upward trajectory
2:33
forever. They breathe, they expand, they stall,
2:36
they contract, and they recover. Yeah. So let
2:40
us start with the baseline condition. Economists
2:42
call this the expansion phase. And that's where
2:45
things feel pretty good, right? Very good. This
2:47
is where an economy spends the vast majority
2:49
of its time, actually. During an expansion, businesses
2:52
are seeing steady demand, so they hire more workers.
2:54
Which means more people have paychecks. Right.
2:57
And because businesses are competing for those
2:59
workers, wages slowly rise. Consumers feeling
3:03
secure in their jobs go out and spend those wages.
3:06
Which then just creates even more demand for
3:08
the businesses. Exactly. It is a virtuous, self
3:12
-reinforcing loop of rising output and improving
3:15
confidence. But I hear people say all the time,
3:18
particularly after a long expansion, that, you
3:21
know, we are due for a recession. Oh, I hear
3:23
that constantly. Right. It's almost as if the
3:26
economy has a biological clock ticking down.
3:28
Why wouldn't a 10 -year expansion just, I don't
3:31
know, naturally run out of steam and die of old
3:33
age? Well, because an economy is not a battery
3:36
that just drains over a set period. It is a really
3:40
complex network of human decisions and productivity.
3:43
So it doesn't just get tired? No, expansions
3:45
do not die of voltage. They usually die of overheating.
3:48
Oh, overheating, like an engine. Yes, precisely.
3:51
As long as productivity keeps matching demand,
3:54
an expansion can theoretically continue for a
3:56
very long time. But eventually, that virtuous
3:59
loop we just talked about starts to reach its
4:01
physical limits. The engine just starts running
4:03
too hot. Precisely the right way to think about
4:06
it. When the economy is stretched to its maximum
4:09
capacity, we enter the peak phase. OK, so what
4:11
does the peak actually look like on the ground?
4:13
Well, growth is still happening, but it is decelerating.
4:17
The labor market becomes incredibly tight. Meaning?
4:21
Basically, everyone who wants a job already has
4:24
one. Right. So companies simply cannot find enough
4:27
people to expand their operations. Because they
4:30
cannot produce more goods to meet the high demand,
4:33
they do the only thing they can do. They raise
4:35
their prices. Exactly. They raise prices. And
4:38
this is the mechanism that triggers heavy inflationary
4:40
pressure. Which means the peak is less like the
4:43
thrilling top of a roller coaster. more like
4:47
a car engine running completely out of oil. That
4:50
is a great visual. The demand is so hot that
4:53
supply chains and labor forces just lock up entirely.
4:56
And that friction forces the economy into the
4:58
next phase, which is the contraction. Right.
5:01
Output begins to fall. Businesses look at the
5:03
rising costs and the shifting landscape, and
5:05
they, well, they decide to defer building that
5:07
new factory. They freeze hiring. Exactly. And
5:10
if that contraction is dope enough and sustained
5:12
enough, we bring out the dreaded R word. We call
5:15
it recession. We do. And, you know, the word
5:18
recession carries so much emotional weight. Oh,
5:20
definitely. People panic when they hear it. But
5:22
if you ask the average person to define it, they
5:24
will usually give you a very specific, confident
5:27
rule of thumb. Yes, the famous two consecutive
5:30
quarters of negative real GDP growth. Right.
5:33
Let me just clarify that jargon for you really
5:35
quickly. Real GDP, it just means the total output
5:40
of the economy, but adjusted for inflation. Right,
5:42
to keep things accurate. Exactly. It strips out
5:45
the illusion of rising prices so you can see
5:47
if the actual volume of goods and services is
5:49
shrinking. And yeah, two negative quarters is
5:52
the definition I hear literally everywhere. It
5:55
is an incredibly popular shorthand. But it is
5:58
actually a myth. Wait, really? A myth? Yeah.
6:01
It is not the formal definition used by the institutions
6:04
that actually bait these cycles. The two -quarter
6:07
rule is highly misleading. How so? Well, you
6:10
could theoretically have two mildly negative
6:12
quarters where employment holds up perfectly
6:14
fine, wages are stable, and nobody feels like
6:18
they're in a recession. OK, that makes sense.
6:20
And conversely, you can have a violent, severe
6:23
economic crash that does not fit that two -quarter
6:25
pattern at all. Our sources actually point to
6:28
the year 2020 as the ultimate proof of this,
6:30
right? Yes. 2020 is the perfect example. The
6:33
economic shutdown in 2020 was just incredibly
6:35
deep. Output collapsed more in a matter of weeks
6:38
than it usually does in an entire decade. It
6:40
was staggering. But the contraction was very
6:43
brief. It did not neatly fit a six -month, two
6:46
-quarter timeline. Yet, I mean... Nobody in their
6:49
right mind would argue that 2020 was not a recession.
6:52
Exactly. Which brings us to how recessions are
6:55
actually defined and declared. Right. So who
6:57
actually makes the call? Well, in Canada, formal
7:00
recession dating is determined by a specialized
7:03
committee at a think tank called the C .D. Howe
7:05
Institute. OK, so they are the official referees.
7:08
Basically, yes. And they ignore that rigid two
7:11
quarter rule. Instead, they look at three specific
7:13
dimensions. Depth. duration, and breadth. Okay,
7:17
let's break those down. Depth is obviously how
7:19
far output fell. Right. Duration asks how long
7:21
the pain lasted, and breadth asks how widely
7:25
the contraction spread. Like, was it just the
7:27
manufacturing sector that suffered, or did the
7:29
pain ripple across retail services and construction
7:32
alike? Exactly. And because they need all of
7:35
that granular data to evaluate the depth, duration,
7:38
and breadth, they can only make their judgment
7:41
retroactively. Right so they act as historians
7:43
essentially not forecasters. Exactly. They will
7:46
often declare that a recession began six or even
7:49
nine months ago. Wow. So by the time they officially
7:52
announced the contraction, the economy has usually
7:54
already hit the trough, like the absolute bottom
7:58
of the cycle. Yes. And it has usually already
8:00
begun to recover by the time they announce it.
8:02
That is wild. So if we have to wait for a committee
8:05
to tell us we were in a recession six months
8:07
ago, how do we track this ourselves today? That
8:09
is the million dollar question. Right. How do
8:12
you know what is happening to the economy right
8:14
now without waiting for the official referees?
8:17
Well, the answer lies in understanding that economic
8:20
data does not all travel on the same timeline.
8:23
We have indicators that act almost like time
8:26
travelers. Oh, time travelers. I love that. Our
8:30
sources categorize these into three distinct
8:32
buckets, right? Yes. Leading, coincident, and
8:35
lagging indicators. OK, let's start with the
8:38
leading indicators. These are the really fascinating
8:40
ones. They are the signals that physically turn
8:44
before the broader economy does. They give us
8:46
a glimpse through that blacked out windshield.
8:49
Right. They show us what's coming. A perfect
8:51
example of a leading indicator is new building
8:55
permits. Yeah. Think about the mechanism there.
8:58
A real estate developer has to apply for a municipal
9:01
permit months. sometimes years, before they hire
9:04
a construction crew. Right, before they pour
9:06
a single concrete foundation or buy any lumber.
9:09
Exactly. So if the number of permit applications
9:12
suddenly falls off a cliff today, it tells you
9:14
with high certainty that construction activity
9:17
will slow down significantly six to nine months
9:19
from now. That makes total sense. And the stock
9:22
market is also a massive leading indicator, which
9:25
we will dig into shortly. But then we have...
9:27
Coincident indicators. Right. These move roughly
9:30
at the exact same time as the broader economy.
9:33
So this is your gross domestic product, your
9:35
retail sales, your daily manufacturing output.
9:38
Exactly. They tell you what the engine is doing
9:40
right this second. OK. And finally, we have the
9:44
lagging indicators. Yes. These data points only
9:48
turn after the economy has already shifted into
9:50
a new phase. Corporate profits are a classic
9:53
lagging indicator, right? They are. And this
9:55
makes sense mechanically because corporate earnings
9:57
reports are, well, they're literally historical
10:00
accounting documents. Right. A company cannot
10:02
tell you how much profit it made in the first
10:04
quarter until the second quarter has already
10:07
begun. Exactly. But the most emotionally charged
10:09
lagging indicator by far is the unemployment
10:12
rate. And this creates a wild paradox that I
10:15
really want to unpack here. Go for it. Why is
10:17
it that the general public feels the absolute
10:20
worst about the economy and governments get blamed
10:24
the most at the exact moment the macroeconomic
10:28
data says things are improving? It's a great
10:30
question. And it comes down to the deep psychology
10:32
of business owners. OK. Walk us through that.
10:35
Well, why does unemployment lag behind the rest
10:37
of the economy? Because firing people is incredibly
10:40
painful and hiring people is very expensive.
10:42
Right. Business owners are human beings. Exactly.
10:45
When an economy starts to dip into a contraction,
10:48
a business owner does not instantly lay off their
10:51
staff. They delay. They absorb lower profits
10:54
for a bit. Right. Hoping the dip is just a temporary
10:56
blip. They only let people go when the financial
10:59
reality absolutely forces their hand. And then
11:02
on the flip side, when the economy hits the trough
11:05
and demand finally starts to recover, That same
11:08
business owner has just survived a really traumatic
11:10
period. They have been completely burned. Right.
11:13
So if they get a surge of new orders, they do
11:15
not immediately hire back 50 people. No way.
11:19
They will push their skeleton crew to work overtime,
11:21
waiting to see if the recovery is actually sustainable.
11:24
Because taking on a new employee's salary and
11:26
benefits is a massive multi -year financial commitment.
11:30
Exactly. Because they delay hiring until they
11:33
feel absolutely confident, the unemployment rate
11:35
continues to rise even after the overall economic
11:38
output has hit bottom and started climbing. Wow.
11:41
So when the economy is slowly climbing out of
11:44
the trough, it feels like the darkest days of
11:46
the cycle to the average person. Yes. The lagging
11:50
indicator, which is human unemployment, is at
11:53
its absolute peak, while the coincident indicators
11:55
are quietly improving. That perfectly explains
11:59
the cognitive dissonance we feel watching the
12:01
evening news. Doesn't it? You know, the anchors
12:03
are cheerfully announcing that GDP is up and
12:06
the recovery is underway, but you are looking
12:08
around your neighborhood seeing Fralisa signs
12:11
and out of work friends. And you think the media
12:13
is completely delusional. Exactly. But they aren't
12:16
delusional. They are just looking at a coincident
12:19
indicator while you are experiencing the painful
12:21
reality of a lagging one. It is a profound disconnect.
12:25
But you know, if unemployment stays high, Even
12:27
when the economy is technically recovering, how
12:30
do different businesses survive that gap? Right.
12:32
A luxury car dealership is going to feel that
12:35
lingering pain a lot longer than a grocery store.
12:37
Yes. This cycle does not impact all industries
12:40
equally, which directly dictates what happens
12:43
to your own paycheck and your own investment
12:45
portfolio. OK, let's get into that. We can roughly
12:48
divide the economy into cyclical sectors and
12:51
defensive sectors. Right. Cyclical sectors are
12:55
exactly what they sound like. They ride the wave
12:57
of the cycle. They absolutely thrive during the
13:00
expansion and peak. And they crash hard during
13:02
a contraction. So think about the psychology
13:04
of a booming expansion. Employment is strong.
13:07
Wages are up. People feel wealthy. So they buy
13:10
big ticket items. Exactly. They finance new vehicles.
13:14
They renovate their kitchens. They book international
13:18
travel. Right. And because of this, the auto
13:21
industry, construction, luxury goods, and resource
13:24
extraction, like mining for the copper that goes
13:28
into all those new houses. Those are all deeply
13:30
cyclical. Yes, very sensitive to the cycle. But
13:33
the moment that friction hits and we slide into
13:36
a contraction, consumer behavior flips overnight.
13:39
People cancel the kitchen renovation. Yep. They
13:42
decide their current car can easily run for another
13:44
three years. Those cyclical revenues just collapse.
13:47
But what don't they stop buying? Groceries. They
13:50
do not stop buying food. Right. they still pay
13:52
to keep the lights on and the water running.
13:54
and they absolutely still buy their prescription
13:57
medications. So these are the defensive sectors.
13:59
Consumer staples, utilities, and healthcare.
14:02
Because the demand for these goods and services
14:04
is highly inelastic. And inelastic demand simply
14:08
means that a change in price or a drop in a consumer's
14:11
income barely changes how much of the product
14:14
they buy. Right. You don't skip your heart medication
14:16
just because the country's GDP contracted by
14:19
2%. Exactly. Because of that inelasticity, defensive
14:23
sectors provide a cushion. They do not fall nearly
14:26
as far during a recession. The trade -off, of
14:28
course, is that a utility company also doesn't
14:31
see its profits triple during a booming expansion.
14:34
Right. They are steady but slow. Now, applying
14:37
this dynamic to Canada reveals a highly specific
14:40
structural vulnerability that our sources heavily
14:42
emphasized. This is such a crucial point for
14:44
Canadian listeners. Yes. If you look at the broad
14:47
Canadian stock market index, it is not a perfectly
14:50
balanced miniature reflection of the global economy.
14:53
Not at all. It is heavily, heavily concentrated
14:55
in just three sectors. Financials, energy, and
14:58
materials. We are talking about massive banks,
15:01
oil extraction, and mining operations. And if
15:05
you apply our previous framework to those three
15:07
sectors, you realize they are all deeply cyclical.
15:11
Totally. Oil and mining literally power global
15:14
industrial expansion. And banks fund the loans
15:16
for all those new cars and new factories. Therefore,
15:19
the Canadian stock market as a whole is structurally
15:22
cyclical. Which means it is inherently prone
15:25
to falling much further during a global economic
15:28
downturn than a highly diversified market. Right.
15:32
Like the United States, which has a massive Christian
15:34
of defensive health care and technology sectors.
15:36
So let me bring this directly home to you, the
15:38
listener. This dynamic creates a compounding
15:42
risk in how you structure your financial life.
15:44
It really does. Let's say you work a highly cyclical
15:47
job. Maybe you are a project manager in commercial
15:49
real estate, or you work in forestry. OK. Yep.
15:53
If you also hold a retirement portfolio that
15:55
is exclusively invested in the Canadian index,
15:58
you have essentially doubled down on cyclical
16:00
risk. It is a dangerous alignment, frankly. When
16:03
the contraction phase hits, your primary income
16:06
is suddenly threatened because your industry
16:08
halts. simultaneously, your net worth crashes
16:12
because your heavily Canadian portfolio is dragged
16:16
down by the banking and energy sectors. That
16:18
is a brutal double whammy. Conversely, if you
16:21
are a registered nurse, your job is highly defensive.
16:25
Yes, your income is relatively secure regardless
16:28
of where we are in the business cycle. So your
16:30
portfolio strategy should ideally counterbalance
16:32
the realities of your paycheck. Absolutely. Now,
16:35
there's one more layer to Canada's cyclical vulnerability,
16:39
which our sources refer to as the imported cycle.
16:42
Right. Canada is a relatively small, highly open
16:44
economy. But more importantly, we send the overwhelming
16:47
majority of our exports to one dominant neighbor,
16:51
the United States. Mechanically, this means the
16:53
Canadian business cycle is rarely fully our own.
16:56
Consider how it cascades. If the United States
16:59
enters a recession, their housing market slows
17:02
down. And they immediately stop buying Canadian
17:04
lumber. Exactly. So Canadian lumber mills lay
17:06
off workers. Those workers stop spending money
17:09
in their local Canadian towns, dragging local
17:11
businesses down with them. So a U .S. contraction
17:14
will actively pull Canada down into a recession,
17:18
regardless of how fundamentally healthy our domestic
17:20
economy appeared to be beforehand. Which brings
17:23
up a very logical, very tempting hypothesis.
17:26
Oh, I know where you're going with this. If the
17:28
business cycle moves in these defined phases,
17:31
and if the Canadian market is this structurally
17:34
vulnerable, why not just actively trade around
17:37
it? It sounds so easy in theory. Right. If I
17:40
see leading indicators like building permits
17:42
dropping, why shouldn't I just sell all my cyclical
17:44
Canadian stocks, hide in defensive utility companies,
17:48
and then buy my cyclical stocks back once the
17:51
recession is officially announced? It is the
17:53
most natural, logical thought a human being can
17:56
have when faced with economic risk. Right. But
17:58
it is an absolute mathematical trial. Wow. OK,
18:01
why? The reason it fails ties entirely back to
18:04
our time traveling indicators. Remember earlier
18:06
when we noted that the stock market itself is
18:08
a leading indicator? Yes, the stock market doesn't
18:10
wait for the C .D. Howe Institute. It doesn't
18:12
wait for anyone. The stock market is essentially
18:15
a collective anticipation engine. Anticipation
18:18
engine. I like that. Investors do not buy a stock
18:22
based on the profits a company is making today.
18:24
They buy the stock based on the profits they
18:27
expect the company to make six to 12 months from
18:29
now. Ah, I see. Because of this forward -looking
18:32
psychology, stock prices generally turn down
18:35
and begin dropping months before recession is
18:38
visible in the everyday economy. Let's walk through
18:41
exactly how this traps a smart, well -intentioned
18:44
investor. OK. Let's say you decide to wait for
18:47
confirmation. You watch the news and the official
18:49
economic referees finally declare, we have experienced
18:52
a severe contraction. We are officially in a
18:55
recession. So you feel the panic. Exactly. You
18:57
log into your brokerage account and you sell
19:00
your cyclical Canadian funds to protect yourself
19:02
from further losses. But the stock market already
19:05
saw that recession coming six months ago and
19:07
priced in the damage. Oh, wow. So you are way
19:10
too late. Way too late. By the time the lagging
19:12
data confirms the recession to the public. the
19:14
evening news the stock market has already moved
19:17
on it is now looking forward to the recovery
19:19
phase exactly yeah it is already pricing in the
19:22
upcoming expansion so by selling on the bad news
19:25
you are almost certainly selling at the absolute
19:27
bottom you lock in your losses and worse you
19:30
will miss the upward swing of the new expansion
19:32
because you will be too scared to buy back in
19:35
until the lagging indicators like the unemployment
19:38
rate look healthy again and by the time employment
19:41
looks healthy the stock market has already surged
19:43
upward for an entire year. So you miss the recovery
19:46
completely. Exactly. You might wonder why we
19:49
can't just listen to the brilliant economists
19:51
who forecast these turning points so we can sell
19:54
before the market drops. Right. Why not just
19:57
trust the experts? Because the historical track
19:59
record of economic forecasting is notoriously
20:02
terrible. Is it really that bad? It really is.
20:05
And economists do not miss recessions because
20:07
they lack intelligence. They miss them because
20:10
turning points in the business cycle are freemally
20:12
driven by sudden Unpredictable shocks like a
20:16
global health crisis exactly or a certain geopolitical
20:19
conflict or an overnight banking panic right
20:22
things that cannot be Mathematically extrapolated
20:24
from current data exactly you cannot put a sudden
20:27
collapse in human confidence into a spreadsheet
20:30
Therefore, understanding the business cycle is
20:33
not a tool for market timing. No, not at all.
20:35
It is a framework for knowing what you own rather
20:38
than predicting what will happen. That is the
20:41
perfect way to phrase it. If you know your portfolio
20:43
is heavily Canadian, you simply accept that it
20:46
is highly cyclical. When it drops sharply during
20:50
a contraction, you don't panic because you understood
20:53
the mechanical nature of the asset before you
20:55
ever bought it. Knowing rather than predicting.
20:58
It shifts the burden from trying to be a psychic
21:01
to simply being prepared. Well, let's briefly
21:04
retrace our steps today. We unpacked the four
21:06
phases of the business cycle, the expansion,
21:09
the overheating peak, the contraction, and the
21:11
trough. We explored how these phases do not run
21:13
on a set calendar. Right, and we dismantled the
21:16
myth of the two -quarter rule. We learned how
21:18
to categorize our economic indicators, discovering
21:21
the deep psychology behind why human unemployment
21:24
lags so painfully behind the actual recovery.
21:27
We also analyzed the specific cyclical vulnerabilities
21:30
of the Canadian economy, which is heavily tethered
21:33
to resource extraction, banks, and the health
21:36
of the United States. And finally, we expose
21:39
the ultimate trap of market timing, proving that
21:42
waiting for the news basically guarantees you
21:44
are acting too late. As we wrap up, I want to
21:47
leave you with one final slightly provocative
21:49
thought. Oh, I love these. Let's hear it. Throughout
21:52
this deep dive, we have discussed the business
21:54
cycle almost as if it were a natural phenomenon.
21:57
like the changing of the seasons or a storm system
21:59
rolling in. But there's a massive complication
22:02
to this narrative. Modern policy actively responds
22:06
to the cycle. The government and the central
22:08
banks do not just sit back and watch it rain.
22:11
No, they intervene constantly. When a contraction
22:13
hits, central banks dramatically lower interest
22:16
rates. Governments print money, issue stimulus
22:19
checks, and alter tax policies to artificially
22:22
stimulate demand. Therefore, the historical record
22:25
of the business cycles that economists study
22:27
so intently is not a record of a natural free
22:30
market economy at all. Wait, really? Yeah. It
22:33
is a record of economies that have already been
22:35
heavily altered by human intervention. Wow. It
22:39
leaves us with a profound question to ponder.
22:42
Are we actually studying a natural economic cycle
22:45
anymore? Or are we just studying the historical
22:48
echoes of our own interventions? If you continuously
22:51
alter the inputs while the experiment is running,
22:54
you can never truly know what the natural outcome
22:56
would have been. Exactly. That is a brilliant
22:59
thought to end on. Thank you so much for joining
23:02
us and exploring these concepts today. We warmly
23:05
invite you to look at your own financial life,
23:07
consider whether your paycheck and your portfolio
23:09
are dangerously aligned, and remember to spend
23:12
a little more time looking through the windshield
23:14
rather than staring at the mirror. Beautifully
23:16
said. Until next time.