Investing through the cycle
Updated: Nov 15, 2019
Every economic or business cycle is different in its own way, but certain patterns within the cycle tend to repeat themselves. While unforeseen macroeconomic events or shocks can sometimes disrupt a trend, changes in these key indicators historically have provided a relatively reliable way of recognising the different phases of an economic cycle, providing a guideline for investing through the cycle.
At Acinox, we use leading indicators and market research to identify these changes in business cycles to find the best investment opportunities the global markets have to offer. Specifically, we split a business cycle into 4 distinct phases (see chart):
Early-cycle phase: Coming from a recession, the early phase shows a sharp recovery marking a distinctive negative to positive growth in economic activity (e.g., gross domestic product, industrial production), which then continues to accelerate quarter-over-quarter. Easy monetary policy provide stimulus for credit growth, creating a healthy environment for rapid margin expansion and profit growth. Most businesses see low inventories, while sales growth improves significantly.
Mid-cycle phase: The mid-cycle is typically the longest part of the cycle which represents a moderate rate of positive growth compared to early cycle. Economic activity and credit growth remain strong. Healthy profitability is seen across business against a relatively easing to neutral monetary policy backdrop. Inventories and sales grow, reaching equilibrium relative to each other.
Late-cycle phase: Normally seen to show the peak economic activity while also coinciding with slowdown in growth, albeit positive. A typical late-cycle phase showcases capacity becoming constrained for businesses, which leads to rising inflationary pressures. This does not always indicative of higher inflation rate, as rising inflationary pressures and a tight labor market tend to strain profit margins and lead to central banks moving towards tighter monetary policy. This is exactly what we are seeing across businesses in the US right now and have witnessed in 2019.
Recession phase: Features a contraction in economic activity. Corporate profits decline and credit is scarce for all economic actors. Monetary policy becomes more accommodative and inventories gradually fall despite low sales levels, setting up for the next recovery, marking the end of an economic or business cycle.
The performance of economically sensitive assets such as stocks tends to be the strongest during the early phase of the business cycle, when growth is strong, then moderates through the other phases until returns generally decline during the recession. In contrast, more defensive assets such as Treasury bonds typically experience the opposite pattern, enjoying their highest returns relative to stocks during a recession, and their worst performance during the early cycle.
Analysis of historical economic cycles also tends to prove that the relative performance of equity market sectors rotates as the overall economy shifts from one stage of the business cycle to the next, with different sectors offering varying returns depending on the phase.Although it is worth noting that technological developments, varying central bank monetary policy measures, and other global events factors have impacted this uniformity of sector performance across every business cycle. The below chart summarises sector performance through the different parts of a business cycle.
Early-cyle phase: On a relative basis, sectors that typically benefit most from a backdrop of low interest rates and the first signs of economic improvement are consumer discretionary, financials, and real estate. These conditions help industries within the sectors that typically benefit from increased borrowing, including diversified financials and consumer-linked industries such as autos and household durables in consumer discretionary.
After that you see the economically sensitive sectors follow the trend; as industrials see some of its industries such as transportation and capital goods see its stocks prices rise in anticipation of economic recovery. Similarly, Information technology and materials stocks rally based on renewed expectations for consumer and corporate spending strength.
The main losers of the early-cycle phase include communication services and utilities, which generally are more defensive in nature due to fairly persistent demand across all stages of the cycle. Energy sector stocks also tend to underperform during this phase, as inflationary pressures correlating with energy prices tend to be lower during a recovery from recession.
From a historical performance perspective, consumer discretionary stocks have beaten the broader market in every early-cycle phase since 1962, with industrials being second most impressive, followed by financials and information technology sectors which have also returned decently; while the communication services sector has historically underperformed in the early-cycle phase, but sectors evolution provides us less confidence in this pattern going forward.
Mid-cycle phase: As the economy moves into second gear with growth rates moderating after the early acceleration, the interest-rate-sensitive sectors start to taper off in terms of market performance as well. Generally, this is the longest phase of an economic cycle where most economically sensitive sector continue to do well (albeit worse than early phase), but this phase is also when most stock market corrections have taken place. For this reason, leading sectors in terms of performance continue to rotate frequently, resulting in the smallest sector-performance differentiation of any business cycle phase. Historical performance patterns suggest that no sector has outperformed or underperformed the broader market more than 75% of the time, and the magnitude of the relative performance has been modest compared with the other 3 phases.
However, Information technology has been the best performer of all the sectors during this phase, with certain industries such as semiconductors and hardware have done well than the others on the back of increasing confidence in the stability of an economic recovery. However, another sector that might outperform in this phase going forward can be the communication services sector due to the strength of the media industry at this point in the cycle.
From an underperformance perspective, the materials and utilities sectors have been seen to lag the most in this phase. However, this underperformance is not very distinctive; as investors don't make as many sector bets and employ other approaches to generate additional returns.
Late-cycle phase: This phase normally lasts a year and half, representing the time when the economic recovery matures. The energy and materials sectors again tend to do well in this phase as their fate is closely tied to the prices of raw materials which are now helped by building inflationary pressures, while the late-cycle economic expansion helps maintain solid demand.
Elsewhere, investors begin to see the signs of an economic slowdown and take a position in defensive-oriented sectors such as health care, consumer staples and utilities where revenues are tied more to basic needs and are less economically sensitive.
The energy sector has seen the most convincing patterns of outperformance in the late cycle, while Information technology and consumer discretionary stocks have suffered the most during this phase, as inflationary pressures cut down profit margins and investors move away from the most economically sensitive areas.
Recession phase: This phase has historically been the shortest, lasting slightly less than a year on average where economic growth stalls and contracts, sectors that are more economically sensitive fall out of favor, and those that are defensively oriented move to the front of the performance line.
The less economically sensitive sectors, including consumer staples, utilities, and health care, are dominated by industries that produce items such as toothpaste, electricity, and prescription drugs, which consumers are less likely to cut back on during a recession. These sectors’ profits are likely to be more stable than those in other sectors in a contracting economy. The consumer staples sector has a perfect track record of outperforming the broader market throughout the entire recession phase, while utilities and health care are frequent outperformers. High-dividend yields provided by utility and telecom companies also have helped these sectors hold up relatively well during recessions.
On the downside, economically and interest-rate-sensitive sectors— such as industrials, information technology, and real estate—typically have underperformed the broader market during this phase.
While identifying the key phases of an economic cycle and the right sectors to invest in can lead to higher portfolio returns; we believe that incorporating analysis and execution at the industry level may provide investors with greater returns over an economic cycle. Industries within each sector can have significantly different fundamental performance drivers that may be masked by sector-level results, leading to significantly different industry-level price performance.
Head of Investment Research