Late-Cycle Investing: Survive and Thrive
When the market starts to anticipate the next downturn, in our view it does not necessarily pay to beat the rush by adopting an underweight in risk assets. While the late stage of the cycle is a time of corporate balance-sheet deterioration, that buildup of leverage can propel a final burst of earnings expansion. Mature cycles have often been characterized by a late surge in equity and credit markets, and missing out can compromise long-term performance
At the same time these market dynamics not only tend to generate a great deal of volatility, but also cause bouts of strong correlation between equity and bond performance, making it increasingly difficult to manage overall portfolio risk. Alternative investments such as hedge funds or alternative risk premia strategies can help with this—but that merely reinforces the message that the direction for traditional assets is radically uncertain and the need for nimbleness, tactical trading and flexibility is paramount.
The fundamental late-cycle investing challenge is, therefore, to maintain exposure to growth without losing control of overall portfolio risk.
The dynamics of a typical cycle. Every cycle is different and it is not a given that all of the described conditions will prevail at the same time. In our view, we are currently transitioning between the mid- and late-stages of this cycle, with different conditions prevailing in different markets and regions.
Source: Neuberger Berman. Overweight and underweight positioning views reflect sample positioning ideas 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.
We think this challenge could be especially acute in the mature stage of the current cycle. One reason is that, whereas government bond yields have tended to be high during the late stages of past cycles, a decade of central bank intervention and concerns about long-term growth and inflation have left them low or even negative. The more cautious investor therefore has no obvious place to go when they underweight their equity allocation.
But there is more to it than that, and to understand why, it helps to think about how the turn in this cycle is likely to play out, and why it may look different to previous recessions. In short, we believe it is likely to be longer but shallower: the slowdown may be less severe but the recovery may be much slower and weaker. That has important implications for market dynamics in the lead-up to that downturn.
Two things happened during past recessions. First, the economy endured a severe shock from one of four sources: inflation, energy supply, manufacturing-sector inventory imbalances or financial imbalances. Second, the economy recovered thanks to meaningful fiscal and monetary-policy interventions from government and the central bank underpinning a restoration of consumer and business sentiment.
Next time around, there may be two contradictory forces at work: on the one hand, during the past two recessions central banks have shown increasing willingness and capacity to intervene to curtail meaningful economic downturns; on the other, the capacity for a fiscal, monetary or mortgage-finance stimulus may be limited.
We think the next downturn could be longer-lasting, therefore, because it’s not obvious that we have the tools to fight it.
Source: Bank of America Merrill Lynch. Data as of Dec. 31, 2018.
While we anticipate a longer downturn than usual, we also think it could be shallower. In fact, rather than asking when the next recession is likely to arrive, it might be better to ask whether it will arrive at all. That is partly because of the willingness of central banks and government to intervene much earlier and more strongly in response to signs of stress than in the past, perhaps due to the realization that they have weaker tools with which to address a more severe downturn. Witness the actions of the Federal Reserve and the European Central Bank in response to minor market volatility during the first quarter of 2019, and the fact that the U.S. has been expanding its deficit at a stage when it would have been tightening it in previous cycles.
But our anticipation of a shallower downturn also owes a lot to structural changes in developed economies. We think the causes of the last dozen or so recessions in the U.S. economy can be grouped into four categories. To find out why we think the first three have become much less likely over recent years, but why the longer business cycles that have resulted make the fourth one more impactful, explore the chart below.
Source: Bureau of Economic Analysis, Neuberger Berman. Annualized growth rate. Annual data for 1930 – 1946, quarterly data for 1947 – 2018.
We argue that the fundamental late-cycle investing challenge is to maintain exposure to growth without losing control of overall portfolio risk. In our view, as this cycle matures and turns it may never be advantageous to adopt all-out “late-cycle defensiveness”, but markets will still be characterized by high volatility, potentially deep sell-offs and a growing risk of financial shock—and that makes the challenge especially acute.
Given our starting point that business cycles are structurally longer, with shallower but extended downturns, it is perhaps no surprise that our late-cycle investing principles should be so “evergreen.” While each cycle is different and each stage of a cycle is different, we think these principles of thoughtful asset allocation, true diversification, risk awareness and robust governance take investors back to basics.
Part of our argument is that cyclical dynamics have become less distinct due to structural changes in the way the economy works. The other part of our argument is that a genuinely strategic approach to investing should be applicable anywhere in the cycle, and should enable one to look through the cycle.
When we write about our principles for late-cycle investing, therefore, we do so not to delineate the “right” allocations to make or even the “right” sort of portfolio to adopt. Instead, we are trying to delineate the right sort of questions to ask of your governance structures, your flexibility and your adaptability as an investor, at the point when they are likely to face their most stringent test. To put it another way, making portfolios robust against the volatility of the cycle (“surviving”) is also about maintaining the ability to pick up value opportunities that look through the cycle (“thriving”). If you are able to pursue your portfolio strategy during this period, you are more likely to be on surer ground whatever stage of the cycle we are in.