The post-COVID business cycle has been fast. What can investors do to position their portfolios for late cycle?
No two business cycles are the same, but they certainly rhyme. Typically, we should expect economic activity to moderate during this late stage, with company profits challenged by higher input costs and restrictive monetary policy. Looking to history for investing clues, we can see that:
- Expected returns across asset classes tend to converge, which is where active management can help to identify similar returns with less risk.
- Equities have historically had positive returns in all phases of the business cycle, which forms the basis of our “stay invested” mantra.
- Expected returns from government bonds tend to increase, bringing value to portfolio diversification.
Figure 1
This chart shows the typical stages of a business cycle and the financial conditions that we expect to observe in each. The cycle starts with end cycle, where the economy tends to contract before rebounding during early cycle as easy policy support activity and higher profits. After this, activity and profit growth tend to peak in mid cycle as the economy is in expansion mode, before ending with a slowdown in late cycle.
Based on our read across a swathe of economic and market indicators, combined with increasingly tighter monetary policy ahead, we believe we’ll enter a late cycle environment before the end of the year.
This chart shows the business cycle index split out by components. The chart shows that we are in our eighth business cycle since 1960, and this one is on track to be the fastest move from early to late cycle. Low unemployment, high inflation, and high capital and residential investment as a percentage of GDP are all in late-cycle territory, while unit labour costs, consumer interest payments, consumer confidence, and the 3M/10Y Treasury yield curve are still early-stage indicators.
There are 4 key chapters of our late-cycle playbook: 1) Fixed income; 2) Equities; 3) Volatility; and 4) foreign exchange and commodities.
Chapter 1. Fixed income: play the yield curve
Late-cycle sets up time for a potentially bumpy ride in fixed income markets. While the yield curve (the spread between a longer-dated government bond and a shorter-dated government bond) tends to be flat, extending duration can provide more diversification value in a downturn. For instance, figure 2 shows how longer-duration U.S. Treasuries would perform if yields were to decline (as we would expect in a recession).The value of duration is at play, and longer-duration Treasuries outperform shorter-duration equivalents.
Figure 2
This chart shows the benefit of owning duration during an economic downturn, characterized by a 200bps fall in government bond yields in this case. For U.S. Treasuries, the 2-year would see a 4% return, the 5-year would derive a 9% return, and the longer duration 10-year would see its price return of 18%.
As we move through the cycle, higher quality assets have historically done well in the later stages of the cycle due to less sensitivity to spread widening and a higher sensitivity to declining risk-free rates. Investors should consider building allocations to core fixed income.
That said, credit fundamentals tend to fluctuate when the economy is expanding, with early-cycle deleveraging giving way to less creditor-friendly behaviours as the cycle matures (figure 3). The damage of these decisions is realised as revenue growth slows and margins compress heading into a downturn. Early in the credit cycle is the time to consider taking on risk and look for extended credit opportunities. Late-cycle is a time to think about dialling down risk.
Figure 3
This graphic shows the difficulty of timing the market as we can quickly shift from improving to deteriorating fundamentals. At the top of the cycle, we tend to have solid credit fundamentals, but a shift in focus from management teams from credit friendly actions to more aggressive actions that look to increase leverage or engage in M&A for example. The opposite is true at the bottom of the cycle, as companies have weak credit metrics and look to improve management trends as the operating environment improves.
However, the rapid pace of this cycle has one positive in that companies have generally not had time to dig into typical late-cycle patterns. Many are just exiting post-COVID deleveraging mode and while M&A and shareholder rewards have picked up, credit measures remain strong. This suggests credit may hold up better than history suggests.
Finally, the yield curve typically flattens during expansions as central banks draw closer to raising policy rates towards neutral. Yield curves can invert in late-cycle when the policy rate is at an elevated level, economic activity deteriorates and markets expect that the policy rate, in response, to decline in the future. On average, an inverted U.S. yield curve is followed by about 80bps of steepening over the next year, and the average difference between 10-year and 2-year Treasuries has been just over 90bps. With that said, core fixed income can offer elevated returns in such an environment.
Chapter 2. Equities: move up in quality
This year has already been a wild ride across markets, with equity volatility far higher than what we experienced in 2021, when we were firmly in mid cycle. We expect this to continue because volatility tends to gravitate higher as we move from mid- to late-cycle and closer to recession. In the context of ongoing uncertainty related to inflation, the Fed and geopolitics, higher volatility makes sense – all of these headwinds result in investors questioning the validity of future cash flows.
Equities have historically and on average had positive returns in all phases of the business cycle, but return expectations should be tempered given slower earnings growth, lower valuations (multiples) and higher volatility. To counter lower expected returns, we advocate for moving up in quality and away from cyclicality, and utilising active management (figure 4). Above all, investors have traditionally been rewarded for staying invested despite the bumps.
Figure 4
This chart shows the median performance of high versus low profitability stock. It shows that high profitability stocks underperform by -1.1% during a recession, outperform by 1.2% in early-cycle, outperform by 4.3% in mid-cycle, and see their greatest outperformance of 5.3% in late-cycle.
Understandably, the term quality can seem broad (and it is), but we generally expect such companies to have the following characteristics.
- High gross margins and profitability can indicate that a company has strong pricing power and may be able to maintain earnings growth in the face of rising expenses. In the past, large-cap firms have outperformed small caps late-cycle.
- Defensive revenue streams that can weather an economic deceleration. Low-dividend stocks, where durability tends to live, have historically outperformed higher-dividend stocks late-cycle.
- Secular demand drivers that allow revenues to be unaffected by higher rates. Growth, where secular ideas generally live, have outperformed cyclicals late-cycle.
Figure 5
This table shows the best performing investment styles at different stages of the cycle. During a recession and early cycle, small cap companies tend to perform better compared the mid- and late cycle. On quality, more profitable, higher quality names tend to perform better at each stage of the cycle except for a recession. Growth stocks only tend to outperform in late cycle, with value being preferred otherwise.
Chapter 3. Volatility: use it to your advantage
Market volatility refers to the measure of how much an asset’s price and returns move (relative to the average) for a given period of time. At a fundamental level, volatility is driven by the level of uncertainty of an asset’s future cash flows, price and value. Therefore, it is commonly used as a measure of risk. For example, bond prices are generally less volatile than those of equities because they have fixed cash flows.
Historically, volatility varies considerably depending on the stage of the business cycle. It tends to be highest during recession (due to uncertainty around the future of the economy) and lowest in mid-cycle when economic momentum is strong. Late-cycle, volatility generally rises as economic clarity wanes, alongside slowing growth and restrictive monetary policy.
During periods of high volatility like late-cycle and recessions, derivatives become most valuable to investors looking to protect their portfolios or profit from a particular view. Volatility is the most important variable in pricing structured notes and options strategies – higher volatility equals more favourable terms. Investors could consider options strategies as a replacement for cash equity exposure or as way to stay long risk with protection on the downside. Strategies like structured notes can also be used to take advantage of the high volatility environment and provide downside protection.
Figure 6
This chart shows the run on 1-year forward SPX returns as a representation of S&P 500 volatility at different stages of the business cycle. It shows that volatility rises throughout the cycle, peaking at 27% in a recession compared to just 10% in early-cycle. The volatility then comes in at 15% in mid-cycle and 17% in late-cycle
Chapter 4. Foreign exchange and commodities: a mixed bag for the dollar and strength for commodities
Late-cycle tends to be a mixed bag for the U.S. dollar. After broad-based strength in mid-cycle, the dollar tends to rally against developed market currencies and depreciate against emerging market ones in late-cycle. We suspect the key driver of the divergence is inflation-fighting credibility as emerging market central banks need to raise rates more to attract investment capital. Still, with recession risks elevated, we wouldn’t bet against the dollar here.
Historically the late stages of the business cycle often produce better returns for commodities, and we could argue that late-cycle is the only phase in which one should consider cyclically owning commodities – gold for its defensive characteristics and oil for its cyclical demand-led surge. Oil has the added benefit of supply restraints this cycle. The post-pandemic demand surge for oil has highlighted that many economies have over-invested in renewables for the future and underinvested in fossil fuels for today. This imbalance is likely to last beyond this cycle and, despite already elevated prices, makes us optimistic on commodities over the medium term. Higher fossil fuel costs are likely to translate into higher revenues, profits, cash flows and dividends for producers at a time when other companies suffer margin deterioration as their input costs accelerate.
All in all, investing isn’t easy in today’s volatile environment, and active management and thoughtful structuring are essential. Your J.P. Morgan team is here to help you determine the best course of action for your portfolio.
