The EPB Secular & Cyclical Economic Framework
Watch or read the EPB Secular & Cyclical Economic Framework.
The economy has long-term (secular) trends and shorter-term (cyclical) trends.
Secular trends are slow-moving and are impacted most closely by demographics and debt.
Cyclical trends are the 6-18 month fluctuations that occur on top of the secular trends.
EPB Research monitors these critical trends and details the probable path forward
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EPB Research Framework
The two most important variables in any economy are real growth and inflation. The level of growth or inflation is not as important as the direction. Is the growth rate increasing, or is the growth rate decreasing? Is the rate of inflation rising or falling? These are the more critical questions.
Real growth + inflation = nominal growth.
Asset prices and company profits are highly correlated to these changes in the rate of growth and the rate of inflation or nominal growth.
The EPB Research process analyzes the probable path forward for growth and inflation so that you can prepare your portfolio or business for the coming economic environment. There are two time-frames or two types of trends that we consider.
Secular economic trends are the longer-term, slower-moving trends in the economy that are most impacted by demographics and debt. Secular trends are like gravity in the economy. When thinking about secular economic trends, we are thinking about the 3-5 year time frame and how changes in demographics and changes in debt levels will impact the direction of growth and inflation. Will the gravity in the economy be pulling the growth rate down or pushing the growth rate up? Cyclical economic trends are the shorter-term fluctuations in the rate of growth or the rate of inflation that happen around the secular trend.
Many investors and business managers only focus on the short-term and ignore the long-term, but this is a critical mistake. Secular trends set the bias and constantly impact the cyclical trends. If secular trends persistently move lower, pushing the long-term growth rate down, then the cyclical upturns in growth will be weaker and shorter-lasting on average, while the downturns in growth or inflation will be more frequent and last longer. When growth and inflation are expected to decline, that generally means it is a time to be cautious with your portfolio or your business. When a period of rising growth is on the horizon, that is the best time to take significant risks.
Armed with information about the 3-5 year view and the 6-18 month view, you can improve your decision-making process, play offense when the risk-reward is most favorable and play defensive when danger is likely approaching. In the sections below, I will briefly review how I analyze secular and cyclical trends in more detail and how you can use this process to prepare for the coming economic environment.
Secular Trends (The 3-5 Year View)
Secular economic trends are the very long-term trends in the economy that are mainly influenced by demographics and debt levels. How many people are working, and how productive are those people? This is the basis for the structural or long-term trends in any economy. If more people are working and those people are getting more productive, that is a recipe for a sustained trend of strong and increasing economic growth. If fewer people are working and those people are getting less productive, that is a recipe for a continuous decline in economic activity. Let’s start with demographics. There are two major things to consider when analyzing demographics—the rate of population growth and the population’s age structure.
If the population is growing very rapidly, that means the economy needs more houses, more cars, and a larger and more advanced infrastructure. This increased need for investment requires a lot of capital, natural resources, and labor. But if the population is shrinking, not only are there fewer people to consume goods and services but there is no need to build more houses or more structures. This massively reduces economic growth as there is less demand for natural resources and labor. Capital becomes less effective. So it’s quite clear that increasing levels of population growth are positive for future economic growth and decreasing levels of population growth are bad for economic growth. Also, it’s important to recognize that consumption patterns are very closely tied to age. You don’t consume a lot when you are young, and you don’t consume much when you are old. The 25-64-year-old bracket is the age demographic that consumes the most and, thus, is the most significant positive force for economic growth.
Essentially, if we wanted to look at one metric to give us a clear view of demographics in the future, we want to look at the projected growth rate of the 25-64-year-old demographic. More people aged 25-64 means much more economic growth, and fewer people aged 25-64 means less economic growth. Very simple.
In the United States, the growth rate of the population aged 25-64 is slightly positive, which is a good thing, but directionally it’s falling. As a result, US demographics suggest that growth will be positive but slower than it has been over the last several decades when prime-age population growth was robust. So we know that population growth in our 25-64-year-old bracket tells us how many people will be working and how many people will be contributing positively to overall consumption, but how about the productivity of those workers? This is where debt levels come in. Debt levels directly impact productivity.
Higher debt levels drain an economy of productivity if the debt is not being used to generate a future income stream to repay both the principal and the interest. If the use of debt does not generate a lasting income stream, then future income must be diverted from a potentially productive use to repay the principal and the interest. The best way to measure whether the economy uses debt productively or unproductively is the debt to GDP ratio. We must consider both public or government debt and private debt, such as household debt, corporate debt, and banking sector debt. GDP is closely associated with national income. If the debt is used productively and increases overall national income, the debt to GDP ratio will decline. Suppose the debt is being used unproductively and not furthering the income-producing capacity of the nation. In that case, the debt to GDP ratio will rise, and future productivity growth will fall. To summarize, secular trends are the slower-moving forces that impact economic growth on a 3-5+ year basis. Demographics and debt most influence secular trends. Slower population growth is a negative force for growth, and older demographics reduce economic growth. Higher levels of debt to GDP reduce productivity and result in slower rates of growth.
Cyclical Trends (The 6-18 Month View)
Cyclical trends are the shorter-term, 6-18 month fluctuations in the direction of growth and inflation. On average, the direction of growth and inflation changes every 6-18 months, but it’s possible for a growth rate cycle to last a few years. Cyclical trends are defined by the “four corners” of the economy. Every single economy has four major segments: income, consumption, production, and employment
These four variables work together in a cyclical fashion – they feed on each other. More income leads to more consumption which requires increased production and more employment. This cycle can also work in reverse, where lower real income reduces consumption, lowering production, and reducing employment.
Economic data for income, consumption, production, and employment are called “coincident” indicators. These indicators do not provide any information about where the economy is heading. They simply define the trends as they stand today. If we take an average of the growth rate for these four corners, we can see that the direction of growth is highly cyclical and moves up and down every couple of years.
The chart below is an example from 2013 through 2019. Over these six years, the economy did not experience a recession, but there were several growth rate cycles or cyclical upturns and cyclical downturns.
When the growth rate is trending higher, that is called a cyclical upturn, and when the growth rate is trending lower, that is called a cyclical downturn. Asset prices and business profits respond very strongly to these changes in the direction of growth. The trending direction of coincident measures of growth and coincident measures of inflation are critical. However, these indicators do not tell us where we are heading, only the current trend. To understand where the economy is heading, we need to deeply study and track leading economic indicators, which is what we do inside the EPB Research community on a monthly basis
How To Use This Process
So now you know the overall framework at EPB Research. The economy has long-term, slow-moving secular trends that are influenced by demographics and debt, and the economy also has shorter-term growth rate cycles that are defined by a combination of income, consumption, production, and employment.
The secular trend is extremely important because it acts as gravity and exerts a persistent influence on the shorter-term cyclical trends. So how can you use this process to your benefit? From a very high level, when the growth rate in the economy is expected to trend higher, that is a great time to take risks with your portfolio or with your business. You want to play offense, buy risk assets, or expand your business operations. When the growth rate in the economy is expected to trend lower, that is the time to be highly cautious with your investments and prepare your business for a slowdown in profits.
Coincident data like income, consumption, production, and employment define the trend and tell you whether the economy is in a cyclical upturn or a cyclical downturn. Knowing where you are in the cycle is an advantage over most market participants and business managers. No one thinks in cyclical terms, and it’s often a fatal mistake. I hope this framework was valuable and deepened your understanding of how the economy moves. If you are interested in learning more about this process, or if you want regular updates on these longer-term and shorter-term trends, then consider joining the EPB Research Community.