What Is Expansion?
Expansion is the phase of the business cycle where real gross domestic product (GDP) grows for two or more consecutive quarters, moving from a trough to a peak. Expansion is typically accompanied by a rise in employment, consumer confidence, and equity markets and is also referred to as an economic recovery.
- Expansion is the phase of the business cycle when the economy moves from a trough to a peak.
- Expansions last on average about four to five years but have been known to go on anywhere from 10 months to more than a decade.
- Focusing on interest rates and capital expenditure can help investors to determine where we are in the business cycle.
The rise and fall of economic growth is not a completely random, unexplainable phenomenon. Like the weather, the economy is believed to follow a cyclical path that continues to repeat itself over time. This process is called the business cycle and is broken down into four distinct, identifiable phases:
- Expansion: The economy is moving out of recession. Money is cheap to borrow, businesses build up inventories again and consumers start spending. GDP rises, per capita income grows, unemployment declines, and equity markets generally perform well.
- Peak: The expansion phase eventually peaks. Sharp demand leads the cost of goods to soar and suddenly economic indicators stop growing.
- Contraction: Economic growth begins to weaken. Companies stop hiring as demand tapers off and then begin laying off staff to reduce expenses.
- Trough: The economy transitions from the contraction phase to the expansion phase. The economy hits rock bottom, paving the way for a recovery.
Economists, policymakers, and investors closely study business cycles. Learning about economic expansion and contraction patterns of the past can assist in forecasting potential future trends and identifying investment opportunities.
Expansions last on average about four to five years but have been known to go on anywhere from 10 months to more than 10 years. The National Bureau of Economic Research (NBER) determines the dates for business cycles in the United States.
The longest U.S. expansion on record lasted 128 months, or just over 10 and a half years, according to the NBER, ending in February 2020.
Leading indicators such as average weekly hours worked by manufacturing employees, unemployment claims, new orders for consumer goods, and building permits all give clues as to whether an expansion or contraction is occurring in the near future.
However, economists and analysts generally agree that there are two main forces that best determine corporate profits and the state of the general economy: capital expenditure (CapEx), the money companies spend on maintaining, improving, and buying new assets; and interest rates.
The Credit Cycle
When the economy needs a lift, policymakers try to lower borrowing costs, encouraging businesses and consumers to spend more. When the Federal Reserve (Fed) cuts interest rates, saving is no longer favorable and the expansion phase begins. Money flows freely through the economy, companies take on loans to fund expansion, job prospects improve, and consumer spending rockets.
Eventually, the cheap flow of money and subsequent increase in spending will cause inflation to rise, leading central banks to hike interest rates. Suddenly the onus is on encouraging people to rein in on spending and moderating economic growth. Company revenues fall, share prices decline, and the economy contracts again.
The CapEx Cycle
Several economists, including Irving Fisher, note that cycles move in tandem with company attempts to match ever-changing consumer demand. When the economy is growing, customers are buying and borrowing costs are cheap, management teams regularly seek to capitalize by ramping up production.
At first, this leads to higher sales and decent returns on invested capital (ROIC). Later, the competition gets fiercer and greed takes its toll. Eventually, supply outstrips demand, prices fall, early debt binges become more difficult to service, and companies are left with no choice but to lay off staff.