Industry long ago learned to ride the peaks and troughs of the economy but with the 1990-92 recession, the rules appear to have changed.
Karl Marx described the business cycle as part of 'the fundamental contradiction of capitalism'. For 30 years after the second world war, under the influence of Lord Keynes, governments tried to smooth out the economy's fluctuations by deliberate counter-cyclical policies. Lord (Nigel) Lawson, no Keynesian, claimed, only half-jokingly, to have eliminated the business cycle in the 1980s.
Events were to prove him wrong, with a speedy dose of reality in the form of the cyclical downturn that culminated in the 1990-92 recession. It was not the worst recession in the postwar period, but it was the longest. And, coming after the consumer and investment boom of the late '80s, and the mood of optimism of that period, which had encouraged a wide-spread belief that Britain had embarked on an era of permanently faster growth, it was perhaps the most shocking.
The cycle, then, is something that businesses have to learn to live with. Indeed Lawson, in a recent speech to the Social Market Foundation, derided suggestions by the present Chancellor, Kenneth Clarke, that the present framework of economic policy would ensure there were no more boom-bust cycles. But what are the rules of the cycle? Which businesses are first to hit the downturn, and can those same businesses expect to emerge earliest at the other end? Is every business cyclical to a degree, or are some companies immune from the ups and downs brought about by regular movements in the wider economy?
To answer this question, it is necessary first to define some terms. The business cycle is taken to refer to the economy's regular pattern, whereby recovery leads to a peak in activity, followed by a downturn and a new cyclical trough. Each peak (and each trough) is, on average, four to five years apart. The short business cycle is distinct from the 10-year Juglar cycle (after the economist who identified it), which has been less easy to define in modern times. Still more controversial is the 50-year Kondratieff cycle, with 25-year upswings and downswings, named after the Russian economist who spotted it in the 1920s.
To return to the more familiar four to five-year business cycle, its existence suggests that corporate planning should be an easy task. Recoveries last for two or three years followed by a couple of years of easier conditions where the economy turns down. There are, however, important real-world complications. The first is that the peaks and troughs are never exactly four or five years apart. This is what caught out both government ministers and many businessmen in the early 1990s, when the downturn lasted far longer than they had expected.
The second complication is that not all countries follow the same cycle. Thus the US economy was first into the most recent recession and has now been out of it for longest. Britain, two years into the recovery phase of the cycle, followed the US out of recession, but the economies of Continental Europe did not emerge from their difficulties until around a year later. Japan was yet further down the cyclical track.
Third, each cycle will be characterised by special factors which affect the timing of upswings and downturns. In the case of Europe, Germany's post-unification boom had the effect of maintaining strong growth in the core economies of the EC (but not in Britain) for longer than would otherwise have been the case. By contrast, the response of the German Bundesbank to that boom, in the form of a prolonged period of high interest rates, meant that Europe was slow to recover.
These complications mean, according to Richard Kersley, a strategist at stockbrokers BZW, that predicting the precise cyclical performance of individual industries is 'much more of an art than a science'. He cites certain industries, such as pharmaceuticals and food manufacturing and retailing, which are relatively immune from the cycle. But outside these sectors, anyone who tries to base decisions on when particular sectors are likely to kick in to recovery or suffer from a downturn, is likely to become unstuck. In the nature of these things, though, analysts are required to operate according to some cyclical model of the way the economy operates. Sushil Wadhwani of Goldman Sachs has devised a list of sectors which are particularly cyclical in nature. They are banks, building materials producers, the chemicals industry, contracting and construction firms, electricals (manufacturers rather than the power companies and regional electricity distributors), hotels and leisure, metals, motors, property, stores and textiles. Together, they account for about a quarter of quoted companies in Britain. And, so far, Wadhwani has been encouraged by the performance of the model. 'In terms of stock-market performance, these sectors have, if anything, outperformed the rest of the market by more than we would have expected,' he says.
Among specific companies, some clearly have businesses that are more cyclical than others. According to a list compiled by Salomon Brothers, the investment bank, ICI is the most cyclical of leading quoted companies, as defined by the variation in its earnings during the business cycle. ICI is followed, perhaps surprisingly, by two insurance companies, Guardian Royal Insurance and the Royal, and then the TSB, BOC, Standard Chartered Bank, Rolls-Royce, Commercial Union Assurance, General Accident, British Steel, Royal Bank of Scotland, De La Rue, British Aerospace and Lloyds Bank. The surprise is the relatively small number of mainstream manufacturing firms on that list.
ICI's position at the head of the table is particularly interesting. Traditionally thought of as the bellwether of the UK economy, its international diversification should have rendered that title redundant. Well under half of ICI's business is in Britain. Its cycle should be that of the industrialised world as a whole, because more than 80% of its sales are in the 25 member countries of the Organisation for Economic Co-operation and Development. Such diversification, and the fact that cycles in different industrialised economies are out of synchronisation, should mean that ICI's earnings are less cyclical than in the past. The facts suggest otherwise.
The ground rules of business cycles are straightforward enough. Consider a situation, familiar a couple of years ago, when the economy is 'bumping along the bottom'. Companies are the first to make a move, increasing investment in response to an expected increase in demand from consumers. Thus, the first industries to experience an upturn are capital goods manufacturers. Firms also increase their demand for finance, and begin to put in place advertising and promotion programmes. Construction activity, both for commercial and residential property, and for other schemes, also rises ahead of the general upturn. So, when the anticipated increase in consumer demand comes through they are ready for it. Nor is the process an accidental one. Firms, by virtue of their actions in boosting investment, will increase incomes and employment among capital goods manufacturers and others, which itself will lead to an increase in consumer demand. This, in the jargon, is the Keynesian accelerator at work. Near the top of the cycle the opposite occurs: firms cut back on their capital spending ahead of an expected slowdown in final demand. Their cutbacks help lead to the very downturn their actions were intended to anticipate. And so it goes on.
How do the ground rules fit the experience of the most recent cycle? At the onset of recession, the theory fitted the facts reasonably well. Manufacturing output effectively stopped growing in the summer of 1989, after a particularly sharp rise. Industry's growth reached a plateau at a time when retail sales were growing at more than 2% a year, and a year before the sharp, mid-1990 dive into recession. Capital spending by private-sector firms reached a peak early in l989, before embarking on its decline. There is evidence then of anticipatory behaviour by businesses, probably in direct response to the high interest rate regime of that time.
Not all sectors saw it coming. The construction industry was still growing strongly in the first half of 1990, with output growth of 3%, before hitting the buffers in mid-year. And some industries had reason to believe that the recession would leave them relatively unscathed. Motor manufacturers saw demand dive in the home market but this was compensated for, initially, by strong export demand. Thus, car output was still rising strongly in first-half 1991, until disappointing August registrations finally hit production.
In summary, the onset of recession fitted the theory of business cycles quite well. Companies anticipated a downturn in activity by cutting back investment. Many were still left holding the baby in the form of excessive debt during a period of very high interest rates, but few optimistically carried on raising output in the face of a downturn in domestic demand.
The other side of the cycle, recovery, has however been rather different. Consumers were the first to respond to lower interest rates. Retail sales began recovering in the spring of 1992. Until August this year, it appeared that the only segment of consumer spending not fully participating in the upturn was the housing market. But disappointing new car registrations in August, with sales to private buyers down some 4% on a year earlier, suggested that a reluctance to spend on big-ticket items was more general.
If, however, the consumer was relatively quick to perk up, the company sector was not. There are two possible explanations for this. Industry went into recession on the back of a substantial investment boom, and apparently decided that capacity was adequate, at least for a time, to meet demand upturn that was expected to be relatively weak. In addition, firms have given a greater priority to repaying debt than boosting investment, a factor explained by high levels of corporate debt during the recession. 'We have seen a different response by industry in this recovery,' says BZW's Kersley. 'The first move has been to cut costs, followed by an attempt to get some price increases on top of those cost cuts. Only then have firms tried to generate some increases in volume.' Slowest of all to emerge, again in contrast to the normal cyclical pattern, has been construction, which could only genuinely be said to be experiencing an upturn this year, two years after the overall economy's emergence from recession. Excess capacity is one explanation for this but construction has also been hit by cutbacks in infrastructure spending by the Treasury, and a lacuna until new projects under the private finance initiative begin to come on stream. 'We've had to rewrite received wisdom,' says Mark Franklin, industrial economist at Oxford Economic Forecasting. 'It was always thought the construction industry was very much a leading sector of the economy. One would really have expected building to have led the rest of the economy out of recession.' The recovery pattern, therefore, turns the theoretical model on its head. Consumers have been relatively quick on their feet while companies have lumbered only slowly into action, with one eye firmly on the next downturn.
Within the company sector, performance has differed markedly according to industry. The cyclical low-point for chemicals and man-made fibres was as long ago as the fourth quarter of 1990, only a short way into the general recession. By the third quarter of 1994, output had risen by 15.6%. Contrast that with engineering, which continued to decline until mid-1992, and had only recovered 7.6% by the third quarter of 1994. The textiles, leather and clothing sector troughed at the end of 1991 but its recovery has been particularly muted, with output up by only 5% over the following three years (in contrast to a sharp, 18% output drop during the recession from its cyclical peak in the late 1980s). The metals sector has barely had a recovery at all. Its output in the first three months of 1994 was only fractionally above the cyclical low-point at the end of 1992. Recovery has come through to a degree during 1994, but only to take metals' output to a level 1.5% above the trough. And for a sector protected against the pain of the cycle, look at food, drink and tobacco. The cyclical low-point, at the end of 1991, was only 1% below the mid-l990 peak. The subsequent general economic recovery has added 4% to output over three years.
There are other surprises. One is the performance of the banks. Banking was one of the go-go sectors of the 1980s. In the depths of the 1980-81 recession, the banks were stung with a one-off £400 million windfall profits tax, because it was felt they were profiting unduly from the high-interest regime that was hurting the rest of the economy so much. No such tax could have been levied in the 1990-92 recession. While high interest rates were the cause, they had the effect of pushing up bad debts among bank customers to an unprecedented level and, in some cases, forcing the clearing banks into overall losses.
Oddest of all, perhaps, has been the performance of the advertising sector, arguably the glamour sector of the pre-recession period. Advertising spending grew comfortably faster than the overall economy. It had its own protection against cyclical downturns, on the argument that how-ever much companies were spending during the good times, they would have to increase their advertising spend when demand conditions grew tougher. Even allowing for some cyclical variations, advertising could be expected to lead the economy out of recession, as firms teased out demand from reluctant buyers - but not in this cycle. It is only now emerging - late - from its worst recession since the war. Nor is this purely a British phenomenon. The US advertising industry has, if anything, fared even worse.
All of which suggests, either that the old rules have been replaced by new ones, or that each cycle is intrinsically different. 'I think we have learned that the yardsticks by which we used to judge how industries perform during the cycle no longer apply,' says Ian Harnett, economist and strategist at SGST Securities. 'So much depends on the nature of the cycle itself. We may pretend to understand how these things operate, but basically it is a fudge.' For businesses, the message is clear. Either seek the haven of activities which are non-cyclical, although outside public utilities, food and healthcare, these are relatively few. Or accept that, when riding the business cycle, from time to time you are bound to fall off.
.jpg)
