Business Cycle, Economic Growth, Interest Rates, and Lending

Any businessperson, banker, and even consumer can tell you that the economy goes through cycles. At times, interest rates are through the roof and take home pay doesn't seem to stretch far enough. During other periods, the stock market is booming, there's a new car in every driveway, and businesses are expanding.

What we're describing in loose terms is an economy's business cycle. During various periods of this cycle, certain business sectors may perform better than others. We will also experience varying rates of economic growth and loan performance.


What is the Business Cycle?

A business cycle is an economy's natural fluctuation over time. In basic terms, it is defined in four phases - expansion, peak, contraction, and trough. These are not periods that occur regularly, nor are they easy to predict. In most cases, we measure business cycle periods in retrospect.

Expansion occurs between the trough and peak, when the economy is in a growth stage. Some of the figures that are measurements of healthy growth include having a GDP growth rate in the range of 2-3 percent, an inflation rate close to the 2 percent target, and a "natural" unemployment rate of 4.5 to 5 percent. The stock market rising consistently is another sign of the expansion phase.

Expansion nears its end when the economy begins to overheat. This happens when GDP growth exceeds 3 percent, inflation goes past its target and may even get out of control, and we begin to see various "market bubbles" due to speculation.

The second phase of the business cycle is the peak. This is the short period when the expansion phase transitions into a stage called the contraction.

The contraction phase could be a prolonged phase that includes an economic recession. This happens when there is weak economic growth that eventually becomes negative. The stock market tumbles and unemployment spikes, which are both signals that will continue until the economy hits a bottom.

The bottom is called the trough phase. This is the short period when the economy transitions between being in a recession and climbing back out into a growth cycle once again.

How the Business Cycle Impacts Different Sectors

Not all industries are equally sensitive to the economy's business cycles. According to the U.S. Bureau of Labor Statistics, there are some sectors that are relatively immune to business cycles. When a booming economy or downturn occurs, it is less likely to have an impact on industries or jobs concerned with education, communications, accounting, personal services, and healthcare.

In the financial services industry, there was once a separation between the performance of U.S. banks and those in other parts of the world. So, if the U.S. economy fell into a recession, foreign banks and economies might still prosper. Bloomberg reported on a discussion in Davos last month about the danger of overly synchronized work economies.

At the annual meeting of the World Economic Forum, it was pointed out that some developed countries may be coordinating economic policy too closely. This creates the danger of spreading financial hardships from one economy to another. As if this were a prophecy, world markets lost $8 trillion over eight days in the wake of instability in the U.S. stock market.


Where are We at Today in the Business Cycle?

Where we are in the current business cycle may be a subject up for debate after the stock market correction that we just experienced. On Feb. 5, we witnessed the largest single-day drop in the Dow in market history in intraday trading, with a tumble of nearly 1,600 points.

Even though this market correction of 10% was traumatic for many, there's a good chance that it was just that - a correction. In fact, this is the fifth correction that we've experienced in this bull market since 2011.

Every other economic signal indicates that we remain firmly in the expansion phase of the business cycle and not yet near a peak. There is no peak because we haven't experienced any inflation so to speak and GDP growth clocked in at 2.6 percent in the fourth quarter. Unemployment is at a 17-year low and wage growth is up.

The brief stock sell-off had a lot to do with the recent wage growth report and expectations about the Fed. In the past, the Federal Reserve has had a hand in nearly every U.S. recession by raising interest rates in the face of inflation growth. The recent wages report sent fear through Wall Street about the potential for rising inflation and soaring interest rates later this year.

While neither has happened yet, the possibilities are there.

Important point: The Fed has a new Chair this month in Jerome Powell, so it will be difficult to predict how the Fed will react with interest rates going forward.

How the Business Cycle Impacts Lending

Different phases of the business cycle will have an effect on lending. While it makes sense that banks would perform exceptionally well during periods of strong economic expansion, there is the potential for profits throughout the business cycle with the right loan portfolio mix. When the economy is expanding, there is a combination of a strong demand for banking services and loans and a ready supply of quality customers. Together, this helps to boost bank earnings.

Before leaving her position, outgoing Fed Chair Janet Yellen warned of the dangers of rising inflation. Most experts believe that her successor, Jerome Powell, intends to raise interest rates multiple times in 2018, which would put the base rate above 2.0 percent for the first time since the 2008 financial crisis. Unless wages rise in step with inflation, consumer spending will take a hit, and there will also be a credit squeeze. Payments on credit cards and other variable rate credit instruments will rise, which will impact default rates and bank profits.

When a downturn or contraction business cycle phase occurs, there is potential for disaster for banks who aren't prepared. Loan failure rates rise as consumers have depressed earnings, and deposits fall. According to a report from the St. Louis Federal Reserve, banks tend to tighten standards for both personal and business loans during periods of recession, which creates negative loan growth. It's the banks that tighten up their lending standards while also reviewing loan asset classes for risk that will best weather the storm of a market downturn as it heads towards expansion once again.

Partner With an Asset Management Company to Minimize Loan Risk and Maximize Returns

Lenders have faced record profits and share price performance in the wake of increased consumer spending and a boost in loan originations from lower interest rates. While the new tax law changes are good news for banks, there is a chance that we could be facing inflation and additional interest rate increases in the coming year, both of which could impact lending and bank profits.

The best way to minimize the risk of losses is to review the possibility of selling loans and buying loans in different asset classes. By partnering with a reputable asset management company, banks have the opportunity to connect with mortgage note buyers for loan portfolio optimization.