With recession indicators flashing amber rather than red, now might be a good time for investors to start thinking about how their portfolios are positioned for the late-cycle environment, according to Walker Crips Investment Management’s Andrew Morgan.
The overwhelming majority of asset allocators now believe that the global economy has moved into the late-cycle stage, according to the latest Bank of America Merrill Lynch Global Fund Manager Survey.
“We have witnessed one of the longest periods of economic expansion – and one of the longest bull markets – on record,” explained Morgan
“Meanwhile, unemployment rates in the US and UK are now at half-century lows below 4 per cent, a classic characteristic of the late cycle.”
Source: BofA Merril Lynch Global Fund Manager Survey
Morgan believes the business cycle got a new lease of life from fiscal largesse across the Atlantic.
“It can be argued that the maturity of the global economic cycle was delayed by Donald Trump’s tax cuts 18 months ago,” he said. “However, that massive fiscal stimulus is beginning to fade, and the Federal Reserve is bringing interest rates higher.”
While near full employment has been welcomed by some, comes with two downsides, said Morgan.
The first is increased demand, which manufacturers normally struggle to keep up with, and which therefore leads to rising prices and inflation.
The second is higher wages, which reduce companies’ profitability, and which in turn make companies’ share prices look expensive or cause them to fall.
Indeed, investors need to be careful not to be caught out by rising inflation at this stage of the cycle, cautioned Morgan.
“Given the pressures on prices that come from high numbers of people in work, a major risk at this stage is a sudden uptick in inflation,” he said.
The Walker Crips portfolio manager also warned about the risk of increasingly correlated assets in the late-cycle environment.
“Correlation between shares and bonds tends to increase at this time, as both traditional asset classes tend to respond negatively to inflation surprises,” he said. “So, what might have seemed like a well-diversified portfolio during the bull market, can quickly look like a one-way bet on benign inflation.”
To this end, Morgan’s team would aim for a greater bias towards investments which have low (or negative) correlations to equities and bonds.
They also aim to reduce portfolio volatility and raise liquidity in portfolios, both through higher cash balances and through the avoidance of illiquid or unlisted holdings.
“Given that demand tends to outstrip supply at this stage of the cycle, energy and materials shares tend to perform well. Quality also tends to outperform late in the cycle, whilst momentum underperforms,” he said.
Performance of style indices over 10yrs
Source: FE Analytics
A focus on corporate governance can also help steer investors towards quality stocks.
“Our portfolio’s environmental, social & governance screening pays particular attention to governance; we believe the quality bias within our portfolios will serve them well during this late-cycle period,” he added.
The team’s preference for quality stocks at this stage of the business cycle means that the Walker Crips team are more overweight large-caps than small-caps, which also provides greater liquidity if they need to react to market events quickly.
Morgan said he is also wary of sectors where labour costs are high, such as consumer discretionary, noting that as wage growth climbs, these companies find profitability is hit.
“As part of our strategy of countering the risk that shares and bonds will perform similarly, we aim to buy genuinely uncorrelated assets, many of which can be found within the alternatives sector,” he added.
“Within absolute return funds, we like the Natixis H20 MultiReturns fund, as it demonstrates low correlation with traditional asset classes.”
The £427.3m H20 MultiReturns fund was launched in 2013 and is managed by Jeremy Touboul and Vincent Chailley. It aims to outperform the LIBOR GBP 1m index by 4 per cent over a time horizon of three years. Since launch, it has made a total return of 72.53 per cent.
Performance of fund vs sector & benchmark since launch
Source: FE Analytics
The Walker Crips manager also likes gold, which he said tends to outperform during risk-off episodes.
“We have been increasing our exposure to the commodity since the autumn of last year,” the portfolio manager explained. “We would expect gold to outperform during periods of rising inflation expectations, along with rising recession risk.”
Morgan said investing in bonds during the late-cycle usually delivers fewer diversification benefits to portfolios, as the correlations between the traditional asset classes tend to increase.
“We have long been underweight fixed income,” he explained. “A period when central banks are raising interest rates and pursuing quantitative tightening is obviously not conducive to fixed income investing.”
He said the ending of austerity in many major economies is also likely to increase the supply of government bonds at precisely the moment that buyers of these bonds (i.e. central banks pursuing quantitative easing) are disappearing.
“So, we seek low-volatility returns elsewhere, such as alternatives,” he added. “Within the allocation that we do have for fixed income, we are biased towards high-quality, investment-grade bonds, and for shorter maturities, which are less sensitive to interest rate and inflation shocks.