Kondratieff Cycle

The public attention focuses on the business cycle. It's quite understandable given its importance. However, economists distinguished also other cycles, such as Kitchin inventory cycles, the Kuznets cycles and the Kondratieff cycles (a.k.a. Kondratiev cycles).

The latter were described in 1925 by Russian economist Nikolai Kondratieff who originally identified three phases of the cycles and believed that their key drivers are social shifts (changes in inequity, opportunity). However, the theory has been refined over the years and it is currently divided into four ‘seasons’: spring (economic upswing), summer (economic slowdown), autumn (the plateau phase characterized by speculative fever), winter (deflation and depression). The two most important drivers behind the Kondratieff cycles are technological innovations and the debt cycles.

Technological Revolutions

According to Joseph Schumpeter, the accumulation of innovations leads to technological revolutions, which transform societies and launch Kondratieff waves.

There have been five such revolutions in the modern capitalist economies: the Industrial Revolution (started about 1771), the Age of Steam and Railways (1829), the Age of Steel and Heavy Engineering (1875), the Age of Oil, Electricity, the Automobile and Mass Production (1908), the Age of Information and Telecommunications (1971).

The chart below displays the last three waves, which are approximated by cycles in the rolling 10-year earnings yield (inverted P/E ratio) on the S&P 500 Index. When the new technology enters the scene, the average return starts to increase, while when technology approaches its limits, the average return on equities declines.

Chart 1: Rolling 10-year earnings yield on the S&P 500 Index from 1881 to February 2018.

We currently live in the fifth age, but the sixth technological revolution is coming. When it arrives, productivity should rise, while gold may struggle. However, although technological revolution will bring prosperity, it will be born in pain. During the transition period, gold may shine.

Debt Cycles

Debt cycles are also a key to understand Kondratieff waves. They are comprised of alternate leveraging and deleveraging of debt. The former occurs when people incur debt, increasing the debt-to-income ratio, or the debt-to-assets ratio. The latter is the opposite, so it means paying back the debts, which leads to the decrease in the amount of debt relative to wages or assets.

Thanks to leveraging, economic units can increase their spending and magnify profits when the returns from the asset more than offset the costs of borrowing. This is why increasing debt load may temporarily boost economic growth. However, at some point debt servicing costs become too relative to income. When the debt level reaches a saturation point, the deleveraging begins, and GDP growth slows down (think about the Great Recession).

Kondratieff Cycle and Gold

Gold performs the best during summers (due to high inflation – remember the 1970s?) and winters (due to the economic crisis – remember the 2000s?) and the worst during autumns, when there is disinflation, like in the 1980s and the 1990s.

Kondratieff waves are a controversial concept, not accepted by all economists. But if they are true, investors may hedge against them by buying gold. In particular, it should glitter during summer phase, which may come in the 2020s, as the debts are rising and the inflationary pressure is growing.