Secular market cycles: What’s your strategy for your portfolio?

Global financial markets have revelled in somewhat of a sweet spot over the last eight years. Most striking are the significant positive returns across major asset classes that historically exhibit strong negative correlation. The Standard & Poor’s 500 Index (SPTR500N), a broad measure of U.S. equity markets, returned 176 percent cumulatively to the end of February 2018, even as the bull market run in bonds defied investors’ expectations and entered its eighth consecutive year. Ten-year U.S. Treasuries during the same period returned almost 30.3 percent. With the U.S. economy now well into its ninth year of expansion, how long can this sweet spot last?

As expected, markets experienced several bouts of heightened volatility during the period. The TED spread, the difference between three-month U.S. Treasury bill rate and three-month London Interbank Offered Rate (LIBOR) and is indicative of perceived risks in the global banking system, recently ballooned to levels not seen since October 2016. These latest readings are baffling investors as to whether the spike is related to technical factors or a sign of the usual culprits: looming monetary illiquidity, global economic risk or deteriorating credit conditions. The question now remains, is this recent volatility indicative of an end to the current expansion? Exactly where are we in the expansion phase?

Admittedly the phases of a business cycle are not always linear. It is possible to have cycles where an economy skips a phase or even reverts to a previous one. There is also no fixed time frame for a phase to last, making the length of the current expansion which began in 2009 anyone’s guess. Irrespective of the answers to the questions above, one thing is certain, business cycles are extremely difficult, if not impossible, to predict. Consequently, the key to achieving optimal portfolio performance is to be cognizant of the characteristics inherent in each phase and maintain the flexibility to adjust your portfolio when key pivot points occur.

It is quite evident when an economy is in the expansion phase. Gross Domestic Product (GDP) typically grows 2 to 3 percent per annum, with stocks entering a bull market run. Developed markets stocks and fixed income instruments historically do well, with smaller companies providing some of the greatest growth potential given their flexibility to take advantage of changing market dynamics. Emerging markets (EM) also tend to grow at a faster pace during the early phase of an economic upturn. While developing countries’ equity and debt are generally considered riskier investment options versus developed markets, the risk/reward ratio can be very attractive at this phase. Furthermore, emerging markets have proven to be an attractive complement to developed market exposures as they provide an effective hedge against a falling U.S. dollar. Mid and large capitalisation developed market stocks, however, tend to perform better in the later stages of an expansion.

During the peak phase of the business cycle, the economy forges full steam ahead to operate at its maximum capacity. Investors often achieve and exceed lofty returns expectations late in this cycle. As euphoria sweeps across asset classes, GDP growth exceeds 3 percent, asset bubbles begin to form and inflationary pressure rears its ugly head. As markets climb to new highs, the consensus view of a ‘new normal’ becomes commonplace with returns expectations appearing absolute or almost guaranteed. At the end of this phase, cash and fixed income assets tend to outperform the general market, while stocks, commodities and junk bonds underperform. Cash market instruments such as money market funds, short-term assets and corporate bonds tend to make great investments at the end of an economic peak. Incorporating some gold exposure can also provide a good hedge against inflation including strong downside protection in the event of a market crash.

When fundamentals finally return to markets, investors are typically caught off guard. With bated breath, they anxiously anticipate every market action overreacting to any news that falls short of their lofty expectations. Anxiety swiftly manifests as fear, panic sets in and selling pressure begins to mount. As the economy contracts to a halt, equities enter a bear market (characterized by a reduction in prices of 20 percent or more) and panic selling becomes prevalent. During this phase, far too many investors sell into the downturn after it’s too late. In an economic contraction, fixed income instruments and the cash market tend to outperform the general market. Paradoxically, because markets are forward looking, a moderate exposure to equity is recommended in this phase.

With markets experiencing a free fall, consumers and business confidence sink to a low. After the economy contracts (negative GDP readings), recessionary indicators become more prevalent with experts predicting years of economic distress. During an economic trough stocks, real estate and commodities including gold and oil tend to be the more attractive investments.

Empirical evidence suggests that financial markets are indeed cyclical in nature. Consequently, addressing the ebbs and flows inherent in a business cycle should be a crucial tenet of any investment policy. Awareness of secular and cyclical market cycles, committing to a diversified risk/reward strategy and taking the emotions out of steep market movements are fail-safe ways to optimize your portfolio in any phase of the business cycle.

Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.

Statistics and Data Source: Bloomberg LP, Bureau of Economic Analysis, The Canadian Encyclopaedia