Three strategies to prepare portfolios for a late-cycle economy

Per the National Bureau of Economic Research, the current economic cycle started in May 2020 after the short COVID-19-driven recession. The early-cycle phase—during which economic data bottomed and then started to improve—lasted about a year. During this period, the U.S. Federal Reserve (Fed) was implementing its most supportive policies (low rates, heavy volumes of quantitative easing) and we saw strong upward price moves in stocks, particularly in speculative and highly cyclical areas.

In Q1 2021, we transitioned into the midcycle phase, which has been characterized by an improving economy, but at a rate more in line with historical norms. This phase is typically the longest of the cycle; this time, however, we have the Fed tightening much more aggressively than in recent midcycle periods, given today’s elevated levels of inflation. For this reason, we think it’s time to start positioning portfolios for a late-cycle economy. In late-cycle periods, the economy starts to decelerate, while inflationary pressures remain present. These periods tend to last about a year before a recession begins and are often accompanied by an inverted yield curve and an end of monetary tightening (our base case is that the Fed tightens throughout the summer before pausing).

A primary way we monitor the economic cycle in Market Intelligence is by studying the Conference Board’s Leading Economic Indicators (LEI). Regarding the current cycle, the LEI hit a low point in April 2020, peaked in April 2021, and has been decelerating since; the most current reading stands at less than 5%. We expect this trend to continue into 2023. As we move more fully into late cycle, we believe it’s important to emphasize strategies that can help investors weather what tends to be a more challenging period for markets. Here, we outline our top three late-cycle positions for portfolios today.

Emphasize quality with intermediate core and core-plus bonds

A common signpost of a late-cycle environment is an inversion of the U.S. Treasury yield curve. This develops as the Fed raises rates (or signals its intention to raise rates) and shorter-term Treasury yields rise above longer-term yields. A yield curve inversion is often a signal that investors believe the Fed is tightening too much given a deteriorating outlook for economic growth—an outlook that is priced into longer-term Treasury yields. On April 1, the 2-year Treasury yield surpassed the 10-year yield by five basis points, effectively starting the clock for a post yield curve inversion period.

Historically, during the period between a yield curve inversion and the subsequent recession, certain parts of the bond market have performed better than others. The areas that have historically underperformed—high-yield bonds and bank loans—by definition have lower credit quality and tend to suffer when liquidity conditions deteriorate in a recession. Conversely, core bonds—namely, Treasuries, mortgage-backed securities, and investment-grade corporate bonds—tend to hold up better given their higher credit quality. From a duration standpoint, intermediate-term bonds typically do better than shorter duration bonds. This is because rate hikes eventually turn to rate cuts as a recession approaches, and falling rates act as more of a tailwind to intermediate-term fixed-income positions.

To demonstrate this point, we looked at the performance of a range of bond market segments during the past three post-inversion to post-recession periods; intermediate-term core and core plus were at the top of the list. While these parts of the market have seen recent underperformance, we believe their yields now represent an attractive entry point and could be an appealing opportunity as we move into a late-cycle environment.

Tilt toward defensive equity sectors to lower portfolio beta

Another hallmark of late-cycle periods is elevated equity market volatility as investors begin to reassess their risk appetites. Beyond the Fed tightening and the inverted yield curve, fears of a global growth slowdown are adding to investor anxiety today. Surveys of manufacturers—reflected in the Purchasing Managers’ Index, or PMI—are holding up in the United States for now, but are falling in China and the eurozone after having peaked in the spring of 2021; in fact, the most recent data show that China’s economy is now contracting. Historically, as volatility picks up, risker (or high beta) assets tend to underperform. That’s why lowering the overall beta of a portfolio makes sense in late-cycle periods. More defensive U.S. equity sectors like utilities, consumer staples, REITs, and healthcare can help dampen volatility, since their lower beta profile means they’ll generally decline less than the overall market during periods of stress.

Consider adding alternatives for less correlated returns

Higher volatility in 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. While their returns may not keep up with those of riskier, higher-beta investments during strong bull markets, the risk/reward trade-off for alternatives can be attractive during late-cycle environments. Adding to alternative strategies during late-cycle periods may help dampen volatility while also offering a greater degree of downside protection.

In a rapidly progressing cycle, active portfolio adjustments are key

As Mark Twain famously said, “history never repeats itself, but it often rhymes.” While this economic cycle has progressed more rapidly than others in recent history, the signposts are the same: an inverted yield curve, tighter monetary policy, and slowing global growth. As the LEI decelerates and we move closer to late cycle, we think investors can benefit by emphasizing these three strategies in their portfolios. It still remains to be seen how this current cycle ends, but preparing for it today can make a big difference when it eventually does.