Whether or not the end of the cycle has started to emerge in the past few days, there are still a number of ways that investors can prepare for a more prolonged downturn in markets.
Moving from small-caps into large-cap stocks, adding to quality and value stocks and thinking carefully about fixed income are things that investors should already be considering, according to JP Morgan Asset Management’s Karen Ward.
Ward – JP Morgan’s chief market strategist for Europe, Middle East & Africa – said, although returns can be spectacular during the last part of the economic cycle, investors concerned the downturn may last longer should have already begun thinking about late-cycle strategies.
While another correction is currently taking hold of markets, it remains to be seen whether it will turn into something more serious or reverse course, as it did earlier this year.
The latest correction – stoked by concerns over the Federal Reserve’s rate-hiking cycle – have also begun to raise fears of a recession. Indeed, Ward said while no two recessions are exactly the same, there are some signs that one is due.
“The playbook often runs as follows: unemployment falls; emboldened workers ask for higher pay; central banks hike rates to stem inflationary pressure; higher wages and rising interest costs squeeze profits, which leads to job shedding,” she explained. “Fearful of losing work, consumers rein in spending, demand falls and the recession takes hold.”
However, while it looks simple on paper, she noted forecasting recessions is never easy, as economic relationships can change and the main protagonists influencing the economy can take unexpected turns.
“Workers may not ask for more pay, central banks may not slam on the brakes, and households and firms may keep spending despite higher interest rates if animal spirits are running high,” said the strategist.
“All of these can extend the economic cycle. And, of course, the playbook might change entirely in the event of a financial crisis or geopolitical shock.”
Unemployment rates in the US, Europe and the UK
Source: JPMorgan Asset Management
Indeed, the same playbook may not work across different economies as Ward noted that there were key differences between economic cycles in Europe and US.
Although knowing exactly what stage of the cycle the US finds itself is difficult, she said the country’s unemployment rate – currently at a 50-year low – suggests the expansion is coming to an end.
However, she said a rise in productivity indicates that firms are managing to squeeze more out of their existing staff. Subdued wage growth, meanwhile, means there hasn’t yet been a squeeze on corporate profits.
“Even stripping out the effect of the corporate tax reduction, earnings for S&P 500 companies rose at a solid double-digit rate in the second quarter,” she said.
But Ward (pictured) reminded investors that the Federal Reserve is continuing to slowly lift interest rates, which will be an increasing burden particularly for the companies that have leveraged up in recent years. 
“Higher interest rates may well start to bite just at the time when the almighty fiscal stimulus begins to fade,” she added.
In Europe however, where the economic cycle is not as advanced as in the US, the story is different.
“Having ‘double dipped’ with the sovereign crisis, unemployment is still relatively high in much of the region,” she said. “There is ample spare capacity, which is keeping core inflation low.
“As a result, the European Central Bank appears to have very little intention of lifting interest rates until at least the summer of 2019.
“In the UK, the recovery was more aligned to that of the US until the uncertainty surrounding the Brexit referendum slowed the pace of activity. Despite the fact that unemployment is at a multi-decade low, the Bank of England seems for now, more hesitant about raising rates.”
According to Ward, although these economic cycles aren’t aligned, it seems likely that a downturn in the US would filter through to a global slowdown, as, for example Europe is still a very export-dependent region and relies on demand from the US consumer.
As the past few days have shown however, it is prudent for investors to start making smaller shifts within their portfolios to increase their resilience in the event of a much more serious correction.
The first broad strategy investors should consider is moving towards a neutral allocation to equities, according to Ward. However, she noted they should avoid underweights due to the the tendency for equity markets to perform well at the tail-end of the cycle.
“We know that late-cycle returns can be spectacular, so, if you left the S&P 500 24 months before the last peak, you missed out 30 per cent,” she explained. “If you left 12 months too early you missed 15 per cent. Three years later that’s still a good decision but, in the meantime, people can be quite cross with you for missing out on those late cycle returns.”
End of cycle returns
Source: JPMorgan Asset Management
The next strategy consists on remaining regionally diversified in equities, as she said a shift in regional allocation rarely helps cushion performance in a market correction.
As Ward noted, large-cap stocks tend to perform better during downturns, a reason why rotating away from overweights in mid- and small-cap equities could also be a good move.
Ward’s next advice for those worried about a prolonged downturn is to reconsider overweights in growth stocks, adding to quality and value stocks.
“Quality stocks are the only investment style that have outperformed the index in every recent downturn. Value stocks usually outperform the index during bear markets,” said Ward.
“The exception was the global financial crisis, but this was because of the high weighting of financials in the value index during a crisis in the financial system.
“Value stocks have tended to strongly outperform growth when the period preceding the downturn has seen a significant rise in the relative valuation of growth stocks.”
When it comes to the fixed income part of the portfolio, Ward recommends considering bond strategies that can shift across regions, duration and risk as the cycle matures.
This is because an ability to shift across regions is critical to take advantage of markets where there is scope for central banks to cut rates.
She added: “Cash and short-dated liquidity instruments may play a greater role in providing ballast.
“Consider strategies with low correlation to risk assets such as macro funds and equity long/short funds, particularly those with the ability to take their net equity exposure to zero.”