We invest for many reasons, but however that may be, the end goal is to earn significant returns after considering the various risks faced.
A portfolio-based approach to investing is preferable over simply investing in individual securities; as the adage goes, “Don’t put all your eggs in one basket.”.
Our economy goes through different stages of the economic cycles, where asset classes will perform better or worse comparatively.
In this article, we will examine how the four cycles of the economy affect each asset class and its performance. We will also focus on adapting our portfolio according to the changing economic scenario to maximize our investment returns.
Before diving further, here is a brief explanation of what a portfolio is, the portfolio approach to investing, and economic cycle for the uninitiated:
- A portfolio is a collection of assets – stocks, bonds, real estate, cryptocurrencies, etc. – owned by an individual or entity. It varies from person to person as it is based on a person’s risk tolerance, investment goal, and time horizon.
- Portfolio-based Investing involves investment in different asset categories in varying proportions instead of a single asset. This may include stocks, bonds, money market instruments, cash and cash equivalents, commodities, cryptocurrencies, etc.
Investors aim for significant returns by diversifying their investments in a way that reflects their financial goals and risk appetite.
Every investor/saver wants to utilize their savings/surplus capital to create more wealth and ROI. to do this, capital is invested in a way that the investment pool(portfolio) is divided into smaller sub-pools so that the risk of losing money can be minimized. This is called portfolio allocation.
- Economic Cycle refers to the economy’s fluctuations between periods of growth (expansion) and recession (contraction).
Economic/Market cycles are phases of growth/contraction when society/countries/financial markets/economies can be in a state of growth or contraction.
Growth is when everything is positive – more jobs, more revenue, more profits, more businesses, more taxes for the government. And contraction is the reverse – job losses, falling revenue for companies, falling profits, higher costs, economic pressures on governments such as rising food prices or high fuel costs etc.
Understanding and examining factors like Gross Domestic Product (GDP), interest rate, total employment, and consumer spending are necessary to determine the stage of the economic cycle.
The economic cycle is characterized by four stages, which are also referred to as the business cycle. These four stages are Early, Mid, Late, and Recession.
Historical returns of Different Asset Classes, 1981 – 2019
As mentioned earlier, the various asset classes performed differently during each economic phase. Below we will understand how to identify each stage of the economic cycle and invest accordingly.
THE FOUR PHASES OF ECONOMIC CYCLE:
- Early-cycle (Expansion) Phase:
Lasting an average of about one year.
This phase is generally a sharp recovery from recession, marked by a change from negative to positive growth in economic activity (e.g., gross domestic product, industrial production, employment, etc.).
Credit conditions improve and begin to grow as monetary policy eases up. Money and liquidity in the economy arise, as a result, creating a healthy environment for rapid margin expansion and profit growth.
Inventories decline as sales grow significantly and production increases correspondingly.
Historically, this cycle has produced the most robust stock performance on an absolute basis. Stocks typically generate more returns than bonds and cash from the backdrop of low-interest rates.
Since stocks are generally valued on their future earnings potential, this environment of easy readily available, low-interest rates benefits them the most.
Within the equity markets, more economically sensitive stocks have tended to do well in the early cycle. These three sectors have historically outperformed consistently: Real Estate, Consumer Discretionary, and Industrials. While in bond markets, credit-sensitive fixed income sectors such as high-yield corporate bonds tended to do better during this period.
It is recommended to overweight riskier assets and underweight more defensive assets classes during this expansion phase.
- Mid-cycle (Peak) Phase:
This phase tends to be the longest of the cycle, averaging nearly four years. Following the expansion phase, the economic growth in this cycle is positive with moderate growth.
The monetary policy is accommodative, changing to neutral increasingly. With the interest rates at their lowest, corporate earnings are at their highest. Inventories and sales grow, reaching an equilibrium relative to each other.
As the economy transitioned from its initial stage of recovery and as growth rates moderated, the performance of the economically sensitive assets tapered off.
Stock markets tend to perform fairly strongly, though not as robust as in the early cycle phase. This is the phase when most stock market corrections tend to occur.
These three sectors tend to perform well during this period: Industrials, Information technology, and Basic Materials. Bonds and cash continued to generate lower returns than equities in the mid-cycle.
Since the performance of equity asset classes tends to weaken as more equity drawdowns occur in this cycle, portfolio tilt should be more moderate than during the early cycle phase. Reduction in riskier assets holding is prudent.
- Late-cycle (Contraction) Phase:
The third phase is the contraction with an average duration of approximately a year and a half. During this phase, growth slows down and shrinks as the economic recovery matures and begins to overheat.
Inflationary pressures build-up, resulting in a tighter monetary policy. Businesses lay off employees as profit margins decline, resulting in the unemployment rate rising above normal levels.
The average stock performance, in this phase, is roughly in line with cash. Defensive and inflation-protected sectors, such as Basic Materials, Health Care, Consumer Staples, Utilities, and Energy, outperform their peers.
The growing inflation that typically accompanies this cycle tends to weigh on the performance of the longer-duration bonds, although they still lag behind the absolute returns of shorter-duration cash.
In general, equity exhibited mixed performance during the late-cycle, and cash tends to outperform bonds. Therefore, neutral portfolio allocation without heavy emphasis on any of the asset classes is warranted.
- Recession Phase:
This is the fourth phase and historically has been the shortest cycle, lasting around nine months on average. The economic growth stalls, resulting in the contraction of economic activity.
Corporate profit declines and credit becomes scarce. Monetary policy tends to become more accommodative to propel economic growth.
Typically, no sectors tend to do very well during this stage and the stock markets may have entered a major correction by this point.
Assets that are more economically sensitive tend to fall out of favor, and those that are defensively oriented rise to the top of the performance line. The sectors to invest in this phase are those that provide stability and are more defensive.
These include Consumer Staples and Health Care as these sectors provide goods and services to the people regardless of the economic situation. Cash, here, tends to perform better than the late cycle, while the falling interest rates act as a major tailwind for bonds.
Investment-grade bonds that are interest-rate sensitive exhibit solid positive returns. This phase favors a portfolio that exceedingly allocates to defensive assets.
Academic research has shown that asset allocation decisions can be responsible for anywhere between 40% and 90% of returns variability among portfolios.
However, there is still debate over the best way to incorporate economic factors into the asset allocation process.
Every economic cycle is different, and each asset classes perform in different ways depending on the economic conditions. However, by using a disciplined approach, it is possible to identify key phases in the economy’s natural ebb and flow.
These signals can provide the potential to generate incremental returns over the intermediate term, and they can be incorporated into an asset allocation framework that analyzes underlying factors and trends across various time horizons.