Investors are beginning to think about when and how the current, exceptionally long, business cycle will end, and what it could mean for their portfolios. The expansion began in 2009, and despite some fits and starts has endured with the help of generous monetary stimulus and, in recent years, the support of tax cuts and deregulation in the U.S. But nothing lasts forever. And although our base case is for a “soft landing” and extension of global growth, there are near-term dangers including trade tensions, slowing globalization and the potential for monetary mistakes. As a result, we believe it’s prudent to think about positioning should we in fact be nearing a slowdown.
A Cycle to Remember
U.S. economic expansions since 1900, ranked by length in months
Source: National Bureau of Economic Research, OECD. Data as of June 2019.
Theoretically, the approach of an economic downturn implies the need to allocate less to “risk assets” like equities and lower-quality bonds, and more to “save-haven” assets like government bonds. But it’s a balance. Such a reduction in risk exposure may mean missing out on potential bursts of leverage-driven economic activity and earnings growth, and resulting market surges that sometimes happen late in a cycle. Meanwhile, volatility associated with an aging expansion may actually increase correlations between stocks and bonds, reducing the value of the diversification designed to help mitigate against market weakness.
The current environment only makes such a transition more difficult. Bond yields are much lower than in past cycles. As a result, the reduction in long-term return profile for rebalancing from equities to bonds (assuming we avoid a near-term market decline) could be substantial. Moreover, the economy has changed structurally—suggesting that we could be in for longer, less extreme ups and downs than in the past. This could mean a soft landing followed by an eventual economic downturn that is mild but relatively long in duration.
Recessions have typically started in a number of ways: with economic malaise or some kind of geopolitical event.1 However, factors that can make them worse appear less impactful today: Inflation shocks are less likely due to global supply chains and labor markets, aging populations and automation; energy shocks are less of a danger now that we rely less on OPEC countries for fuel; and a shift to services and just-in-time manufacturing supply chains have reduced the likelihood and impact of inventory imbalances. At the same time, something that might reduce the length and severity of downturns may not be as readily available: With the extensive monetary easing after the financial crisis, the Federal Reserve has less room to cut rates to help lift the economy out of recession (see “Unlocking Inflation”). For better or worse, the net result appears to be the potential for longer, less extreme market cycles.
How might investors adjust? Keep in mind that the foundation of an investment plan is a well-considered strategic asset allocation, matched to your personal goals and risk tolerance. In addition, you may choose to apply tactical portfolio tilts to capitalize on current market dynamics. Within that planning framework, here are three ideas that can help you navigate an evolving market.
Late-Cycle: Particularly Challenging for Investors
|Market Conditions||Portfolio Positioning Views|
|Equity Valuations||Full & Rising||Equities||Overweight
(but tilted to growth/quality)
(but look to earn illiquidity premia and high cash flows)
|Bond Curves||High & Flat||Bonds||Underweight
(as yields are lower than in past cycles)
|Volatility||High||Hedge Funds &
(but focus on genuinely uncorrelated strategies)
Source: Neuberger Berman. Overweight and underweight positioning views reflect portfolio positioning views and are for illustrative purposes only. See end disclosures for additional information regarding the Neuberger Berman Multi-Asset Class team and Asset Allocation Committee views expressed.
Idea 1: Distinguish Signals From Noise
When looking at the transition from late-cycle to end-cycle, investors often consider data from two places: the real economy and financial markets.
Financial markets are forward-looking. That is why, in the past, equity and credit markets have often sold off and government bond yield curves have often flattened and inverted well in advance of a downturn in GDP growth or corporate earnings. All three of these indicators were flashing red at the end of 2018, but we think they are compromised as economic forecasters. Markets are more liquid nowadays, so selling associated with de-risking can actually accentuate market declines without a real-world basis.
Back in 2016, many investors focused on volatile financial market conditions when, in order to see where the economy was actually going, they should have been paying more attention to robust-looking U.S. fundamental data, such as housing starts or consumer confidence.
Today, economic indicators paint a mixed picture. The table below shows data points that are often considered indicators of the potential for imminent downturns. Several suggest that the economy is still mid- or in some cases even early-cycle. Looking at conditions outside the U.S., the data trends suggest that the end of the cycle is even further away: Recoveries in European employment, wage growth, inflation and industrial activity still lag those in the U.S., for example, potentially leaving room for further improvement.
Signals From Real Economy Remain Largely Reassuring
Source: Citi Research, Institute for Supply Management, Conference Board, Federal Reserve Bank of St. Louis. Data as of June 30, 2019. For illustrative purposes only. Historical trends do not imply, forecast or guarantee future results. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed.
Eyes on Corporate Debt, China and Trade
There are some areas to watch. Investment-grade companies are carrying more debt, particularly in the lower-rated BBB bond sector. But much of this is in traditionally defensive, non-cyclical sectors to take advantage of very low, long-term interest rates, and many issuers are planning to reduce their debt levels. In high yield bonds and loans, the picture is mixed; a longer-but-shallower downturn would likely imply a higher default rate than in previous cycles, and lower recovery levels. That makes a strong case for a quality-focused, fundamentals-driven approach to credit. But we believe the workout of imbalances in the credit markets is likely to be a long process rather than a sudden shock that could spark an economic decline.
China also bears scrutiny, and not just because it is the world’s second-largest economy. It has been in a slowdown in recent years, exacerbated recently by its trade dispute with the U.S. The government has responded with stimulus, and we are anticipating signs of recovery as the year progresses. More broadly, investors should keep an eye on the overall impacts of trade conflict, as tariffs and a resulting chilling effect for global companies are offsetting many of the economic gains from tax relief two years ago.
A key, however, is to consider the underlying fundamental data as a more reliable window into economic health than more volatile financial markets.
Idea 2: Reassess Asset Allocation
The fundamental late-cycle investing challenge is to maintain exposure to growth potential without losing control of overall portfolio risk. Diversification is key, but as mentioned this is much more difficult amid low bond yields.
Inflation-related strategies. Of the risks facing bonds, a central one is inflation. For structural reasons, we think the probability of long periods of high inflation is low, but it is prudent to expect some increase during the mature part of a business cycle. That lends support to a case for inflation-protected bonds, as well as carefully selected floating-rate bank loans. Beyond bond markets, commodities have often performed well during inflation spikes and the later stages of the cycle, as have publicly traded real estate securities. Because inflation expectations are so muted, many of these markets remain attractively priced.
Different return sources. In seeking genuine diversification, we think it’s worth looking at hedge funds (whether as private vehicles or “liquid alternative” mutual funds). Many of the most popular strategies, such as long-short equity, can reduce one’s equity market exposure in a portfolio. And “uncorrelated strategies” derive substantially all their returns from market-agnostic trading approaches; these include equity market-neutral, trend-following, macro, volatility and arbitrage strategies.
Private markets also offer significant diversification benefits. Buyout strategies, although fully priced, can provide exposure to operational improvements in businesses and innovative products, as well as lower volatility and an illiquidity premium. Other areas of interest include venture and growth-capital funds, the less-expensive European buyout markets, and idiosyncratic opportunities via co-investment and secondaries, as well as cash-flow-generative niches such as private debt, trademarks and royalty streams.
Broader regional exposures. While we may speak of the late-cycle dynamics of the global economy, the fact is that different regions appear to be at different points in their cycles—and China and other emerging markets are navigating their own megacycles of economic development and fiscal reform. That may explain investment opportunities such as lower equity price-to-earnings ratios in Europe than in the U.S., or higher-rated emerging markets sovereign bonds trading with credit spreads similar to those of riskier U.S. and European high yield corporate bonds.
Equity Markets Appear Cheaper Outside the U.S.
Price/Earnings of U.S. Equities vs. Europe and Emerging Markets
Source: Bloomberg. Data as of June 30, 2019. S&P 500, MSCI Europe and MSCI Emerging Markets (EM) indices.
Within the U.S., where late-cycle characteristics are more evident, we would broadly favor a tilt toward larger, more-liquid stocks and higher-quality businesses. Investors may also want to consider regional cyclical differences when allocating domestically: If the rest of the world is lagging the U.S. in this cycle, it makes a case for U.S. companies with high non-U.S. dollar sales.
Idea 3: Identify ‘Through-Cycle’ Themes
One way of dealing with cyclical investment challenges is to look for investments whose performance is not primarily determined by the business cycle, or whose dynamics supersede or “look through” that cycle.
With emerging markets, on the one hand we are dealing with an asset class that appears highly sensitive to the business cycle because of its importance in global supply chains. On the other hand, emerging markets are also navigating their own megacycles: moving up the world’s value chain, becoming consumers as well as its producers, and adopting fiscal, monetary-policy, economic and financial reforms.
Should China’s stimulus measures fail to gain traction or the U.S. dollar continue to strengthen, neither would be positive for emerging markets. But they are now better able to absorb such stresses, as shown during the 2008 – 09 financial crisis, when many of their economies fared much better than those of developed market economies.
Similar long-term investment themes are available elsewhere. Some, such as mitigating the impact of climate change, represent both vast challenges to society and billions of dollars’ worth of growth-investment potential. Others, such as Big Data, artificial intelligence, 5G connectivity and autonomous vehicles, have the potential to drive change in many parts of our lives.
These themes could be sources of resilient earnings growth during a period of widespread earnings deterioration; volatility around companies within a theme is typically driven by news flow around the theme rather than, say, U.S. dollar strength or other economic data. Of course, investors who look through cycles too blithely can get sucked into bubbles—particularly during the later stages of a cycle. So, it’s important to have confidence that a given theme is real, and that pricing has a relationship to tangible fundamentals.
Bottom Line: Back to Basic Fundamentals
While economic cycles vary and each stage of a cycle is different, we think the notions of looking past market “noise” to fundamentals, allocating thoughtfully and seeking strategic opportunities are useful at any time. A keen understanding of risk will be important in the coming months and years, as will the ability to be nimble, to help minimize vulnerabilities and to capitalize on dislocations and value opportunities when they occur. More broadly, maintaining a steady approach, consistent with your particular circumstances and balancing risk and reward, can help keep your portfolio grounded regardless of whatever the point within the economic cycle.
For further details, read our white paper, Survive and Thrive: Robustness, Flexibility and Opportunism in Late-Cycle Investing.