4 strategies for late-cycle investing

No one knows precisely when the 10-year-old bull market will breathe its last breath, or when the economy will fall into a recession. What’s clear from prior turns in the business cycle is that the strategies that have done the best on the way up often fare poorly on the way down. We examine four strategies that have the potential to help portfolios weather the turn.

Taking measures to lower risk across investor portfolios is warranted as monetary conditions continue to tighten. Nowhere will this be more important than in the fixed-income portion of portfolios. The exceptionally tight spreads for high-yield bonds in 2017 and most of 2018 suggested investors were pricing in very little credit risk. In past recessionary periods, these spreads widened significantly as default risks grew and liquidity became harder to find. This past December offered a preview of just that. Relative to high-yield bonds, investment-grade bonds have held up much better in periods of market stress and slowing economic growth and traditionally have provided important ballast that can help offset volatility in equities.¹

After reaching record lows in 2017, market volatility (measured by the Cboe Volatility Index) rose sharply in 2018, as investors reacted to signs that the cycle may be coming to an end. Beyond the U.S. Federal Reserve (Fed) tightening and flattening yield curve, talks of tariffs and signs of slowing global growth added to investor anxiety. Surveys of manufacturers—captured by the Purchasing Managers’ Index, or PMI—dropped sharply beginning early last year. All six of the largest developed markets outside the United States saw their PMIs drop. By the end of the year, PMIs in France and Italy had fallen below 50, indicating a contraction of economic activity.²

Historically, an inverse relationship has existed between rising volatility and the returns on risk assets, and this was certainly the case in 2018. A globally diversified portfolio of stocks and bonds returned -8.85% in 2018, the worst showing since 2008.³ A sustained rise in volatility is also notable in that higher volatility regimes have preceded each of the past three recessions. Investors should consider emphasizing sectors less tied to the economic cycle, along with strategies that balance return potential with risk management. All-weather equity strategies—whether actively managed or strategic beta—typically also feature a focus on valuation that can help provide a buffer against market declines.

Higher volatility among traditional risk assets like stocks and high-yield bonds may result in lower risk-adjusted returns in the year ahead. Beyond choosing less cyclically sensitive equity sectors, another way to seek higher risk-adjusted returns is to add alternative strategies that are less correlated with the business cycle. Real assets can be a good example. These strategies focus on physical assets—such as power generation, pipelines, and transportation infrastructure—whose economic lives are measured in decades. While their returns may not keep up with those of riskier, higher-beta holdings during strong bull markets, the risk/reward trade-off for real assets can strike a favorable balance during late-cycle environments. One key reason is that for many stocks in this universe, the companies’ returns on investment are set by government regulators or long-term contracts. Moreover, the industries they typically operate in are considered public services, beneficial and necessary for society. That status, along with the durable characteristics of the underlying assets (the actual roads, power plants, grids, etc.), means that underlying revenue streams are more likely to persist. Finally, in many cases returns on real assets are often indexed, or linked, to inflation, creating a potential inflation hedge. Although we have yet to see inflation break out in this economic cycle, inflation did finally climb to the Fed’s 2.0% target in 2018.⁴

"While their returns may not keep up with those of riskier, higher-beta holdings during strong bull markets, the risk/reward trade-off for real assets can strike a favorable balance during late-cycle environments."

Strategies that combine selectively shorting some areas of the market while maintaining long exposure to others have tended to gain a performance edge in late-cycle market environments. There are several reasons for this. First, earnings tend to have a greater effect on performance as business cycles progress, so it becomes more important to identify which companies can generate strong free cash flow. Second, as market volatility rises, so does return dispersion, creating fertile ground for a long/short approach. In fact, a growing body of research shows that the late-cycle backdrop has historically been favorable for long/short equity approaches, delivering both greater returns and a greater degree of downside protection.⁵

Financial advisors: Check out our resources to learn more about what strategies have historically provided value in late-cycle environments, and how other advisors are positioning their clients' portfolios today.

1 FactSet, as of 12/31/18. 2 Markit, World Bank, FactSet, as of 12/31/18. The Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment. It is not possible to invest directly in an index. 3 Based on a hypothetical portfolio—rebalanced annually—that represents a 60% stock/40% bond mix and tracks the MSCI World Index and the FTSE World Government Bond Index. Data is as of 12/31/18. 4 U.S. Federal Reserve, as of 12/31/18. 5 J.P. Morgan, Hedge Fund Research, Credit Suisse, MSCI, Wellington Management, 2018.