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Date: November 5, 2018
Category: Alternative Investments

Late Cycle Investing: Prepare Now!

It’s true that every business cycle is different, but many economists suggest that history tends to repeat itself, and there is a clear pattern of cyclical fluctuations in the economy.1 And when they economy fluctuates, so do your investments.

On average, economic cycles in the U.S. last around 34 months, but current economic expansion is now more than three times that length, 114 months to be exact. Couple this extended expansion with rapidly rising interest rates, increased consumer confidence, and a tightening labor market, and it’s clear that we are approaching the latter stage of this current business cycle – if we’re not already there.2

A late-cycle phase is typically defined by a slowdown in growth, low levels of unemployment, rising inflation, high cash rates, and a flattening yield curve. Additionally, you may see earnings growth slow and profit margins shrink, however, we’ve yet to see this in part due to the recent tax cuts implemented by the Trump administration.3 Still, inflation-adjusted wages remain flat, the share of federal revenue paid by corporations has fallen substantially, and the federal deficit is growing at exponential rates – all things that you would typically expect to see during a recession, not an expansion.4

So, with an economic contraction looming and consumer expectations declining, there are numerous investment decisions to consider.

Asset selection is vital

It’s important to understand how different assets classes perform during the different stages of the business cycle. Studies conducted over a 60-year period have shown that shifts between business cycle phases have resulted in varying performance between asset classes. Generally, assets considered to be economically sensitive, like stocks, perform best during earlier phases in the cycle, when the economy is growing, and then decline when a recession hits. Conversely, defensive assets, such as bonds and cash-like short-term debt experience growth in latter stages of the cycle. But as you’ll see, these options may present additional challenges for you in today’s investment environment.1

Considerations when investing late in the cycle

While portfolio diversification is always an important factor to consider, it’s particularly important as we move later into the cycle. To help combat potential challenges, you may want to implement a business cycle approach to asset allocation. Overweighting asset classes that tend to outperform during the latter stage of the cycle and underweighting economically-sensitive assets like stocks may help you enhance your portfolio’s overall performance.1

Additionally, it’s important to consider adding assets that are not correlated to the broader equity markets. As discussed, stocks are economically sensitive assets, but there are several asset classes that are generally unaffected by market movement and may help manage risk and return.

Public real estate exhibits low correlation with public markets and is not typically impacted by changes in the economy as quickly as equities. However, sector choice is important. You’ll want to focus on sectors that are naturally more insulated against a downturn. For example, needs-based sectors like multifamily and healthcare may outperform a sector like retail.5

Corporate credit also has the potential to perform well late in the cycle. As you know, when we enter a late business cycle, interest rates begin to rise exponentially. While traditional bonds may perform well in the latter stages of the cycle, traditional bonds are still paying historically low yields as interest rates rise. An allocation to corporate credit, specifically floating-rate assets and senior secured loans may offer protection in the rising rate and inflationary environments that come late in these cycles.

It’s not about if, but when

It’s not yet clear if we are entering a late cycle, but it’s important to remember that for every expansion there is a recession. Economic contraction, quicker interest rate increases that don’t match economic expansion, or investor overconfidence are all possibilities that should be taken into consideration.

The best thing you can do is prepare and understand how different investments react to each stage of the cycle.

The Lesson Here:

No matter what comes next, it’s important to consider diversifying your portfolio in an effort to balance out any potential falls in the equity markets that come with time.

1 Fidelity. How to Invest Using the Business Cycle. 6/25/18.

2 New York Life. The Late Innings of the Business Cycle. 3/16/18.

3 Forbes. Take The Long-Term View In A Late-Cycle Market. 6/18/18.

4 Press Herald. Our View: Federal Tax Cuts Not Worth the Temporary Bump in Growth. 7/31/18.

5 U.S. News. Real Estate May Be a Safe Haven in a Bear Market. 6/19/18.
 
Resource Securities LLC, Member FINRA/SIPC.
 
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