Seeking investment opportunities in business cycles

Key Takeaways:

• The business cycle reflects the collective fluctuations in economic activity, which can be a determinant of sector performance and provide investment opportunity over the intermediate-term.
• This approach aims to identify stages in the economy that provide a framework for rebalancing and asset allocation aimed at reducing exposure to assets that typically underperform to assets that typically outperform.
• Asset allocation according to the business cycle can add value as part of an intermediate-term investment strategy.

The Business Cycle:

It is important to note that every business cycle differs in its own way; however, certain patterns have historically repeated themselves over time which can present opportunities in the markets. In its simplest form, the business cycle can be thought of as the fluctuations in growth in the economy over time.

There are four stages of the business cycle:

Early - Follows a recession and is typically associated with a sharp recovery in economic activity. 

Mid - The longest phase of the business cycle and displays positive but more moderate growth than the early stage.

Late - Coincides with peak economic activity. The rate of growth remains positive but is slowing.

Recession - Contraction in economic activity and growth.

Characteristics of The Business Cycle’s Stages:

Assessing where we currently are in the business cycle?

Our view is that the US economy is in a recession however, one that will be short lived and will see a rapid shift to the early stage of the business cycle.

In the beginning of 2020, the stock markets were raging through an unprecedented 11-year bull market. A bull market is defined as an increase in asset prices that is not disrupted by a 20% decline in prices (a bear market). Suddenly, the COVID-19 outbreak derailed the bull market in record time. The S&P 500 posted its quickest 30% drop ever recorded, in just 22 days.

The rapid spread of COVID-19 has forced governments across the globe to shut down their economies to combat the spread of the virus. These actions have sent the economy into a forced recession. Businesses have been mandated to close their doors as social distancing protocols have been implemented worldwide.

It is extremely important to note that the recession we are currently in is strikingly different from previous recessions - especially the 2008/2009 recession. There was nothing fundamentally wrong with global economies and the US economy was performing at record numbers before the virus spread. Banks have strong cash reserves and balance sheets, the consumer was the strongest ever, unemployment was at multi-decade lows, and corporate earnings were resilient. This all of course came to a screeching halt when quarantine and work from home mandates were implemented.

The recession that we are currently seeing is likely to be short lived. It is likely to last a few months rather than a year plus. Even during the economic slowdown, many sectors and businesses are thriving and showing unprecedented growth. Consumer staples and household goods are booming as individuals are stocking up their houses with essentials as they are forced to stay indoors. Technology companies are seeing record demand as their users increase due to the work from home culture; however, airlines, cruises, restaurants, and other hospitality companies are at serious risk of default as their businesses have been forced to virtually stop their revenue streams.

We are likely to see a rapid and sharp bounce in economic activity once the spread of the virus peaks and the economy reopens for business. While individuals are chomping at the bit being stuck in their homes for extended periods of times, they will likely be cautious when it comes to spending on big ticket items, restaurants, technology, and consumer staples/discretionary. These will likely be the main benefactors of this rebound in activity. As the economy gets its footing back, housing, travel, and hospitality will likely see growth restored as interest rates remain at record lows. 

In our opinion, we are currently in a recession; however as the data starts to improve and President Trump looks to reopen low risk parts of the economy, we will quickly enter into the early stage of the business cycle and we recommend to begin rebalancing portfolios to take advantage of lower equity prices.

‍

‍Seeking opportunity in equity markets and rebalancing portfolios.

While all of our clients are in diversified portfolios across equity, bonds, cash, and gold assets, we believe the current business cycle and market environment raises a strong opportunity in equity markets. Risk averse assets have achieved what their purpose is in a diversified portfolio - hold their value or gain in value as equity markets decline. Interest rates have been lowered across the globe by central banks and the Fed has lowered US rates to 0%. Short-term Treasury yields have even gone negative in the secondary market as investors have scrambled for cash.

Looking at the performance of US stocks, bonds, and cash from 1950 to 2018, we can see that shifts between business cycle stages create clear differentiation in asset price performance in the chart below. Generally, the performance of economically sensitive assets, such as stocks, tend to be the strongest when growth is rising at an accelerating rate during the early stage, then moderates through the other stages until returns generally decline during recessions. In contrast, defensive assets, such as investment-grade corporate bonds and cash-like short-term debt, have experienced the opposite pattern with their highest returns during a recession and the weakest relative performance during the early cycle. However, in the current environment and economic impact on corporate debt/smaller corporations, our view is underweight corporate bonds and small-cap equities.

Outlook and rebalancing portfolios:‍

As cases may peak in the coming 4-8 weeks, low risk parts of the economy will begin to reopen and eventually cities like New York and San Francisco will reopen. The rebound in equity markets will likely be quick and investors must be positioned to take advantage of these opportunities before these changes in the economy happen as markets tend to react before the news has hit. While it is impossible to perfectly time the bottom in the market, we believe the markets are in the process of bottoming, as cases in China have been contained, production is coming back, and research for antiviral medications is advancing. 

The US Government has also passed a $2 trillion fiscal stimulus bill aimed at easing the debt/reduced revenue strain on industries impacted the most by COVID-19 and to assist individuals in their monetary obligations through these tough times. This is a historic bill and will have a major impact on the recovery of the US economy.

Our view is to rebalance a portion of assets from cash, gold, and bond holdings into equity holdings, and more specifically the Nasdaq 100 index. The reasoning for this is the sectors within the Nasdaq 100 are poised to benefit the most and more than the overall S&P 500 index, as the Nasdaq 100 index is more heavily weighted in technology, consumer discretionary, consumer staples, and healthcare sectors versus the S&P 500 having exposure to riskier sectors like energy and travel/hospitality.

Of course, these viewpoints may not be suitable for all investors, especially ones that are in or retiring shortly. One should always seek personalized financial advice for their particular circumstances.

If you have not done so already, please schedule a call to discuss the rebalancing of your portfolio by clicking here.

iShares Nasdaq 100 UCITS ETF USD (Accum)

iShares S&P 500 UCITS ETF USD (Accum)