Bonds are strongest in the reflation phase (when the economy is being stimulated by increasing the money supply or by reducing taxes) as interest rates are cut and inflation expectations plummet. Equities perform best in the recovery phase as economic growth and profits surge. Commodities take the lead in the overheating phase as breakneck growth and supply shortages push their prices ever higher.
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It takes knowledge to ride the market’s ups and downs
Economic cycles call for shifting portfolio assets
Trevor Greetham
22 March 2009
When the last equity bull market began in 1982, very few investors dared to invest in stocks. By the time the market peaked in 2000, it seemed illogical to hold anything else.
A similar change in sentiment can be traced over what might be called the “BRICs boom” from 2003 to 2007.
Each time the bulls run away with equities, investors tend to lose sight of risk and ignore all other asset classes. Stocks may go down in any given year, the mantra goes, but with the potential for double-digit returns, why dilute their performance with other assets?
The reason, of course, becomes obvious when the stock market tumbles and investors pay a stiff penalty for a heavy concentration in equities.
Many investors seem to overlook the fact that a well-diversified portfolio of stocks, bonds, property, commodities and cash would have performed very well over the past 30 years and with much less volatility.
Each time a bull run in one asset class comes to a halt, leadership passes to another. When equities peaked in 2007, commodities surged. When the commodity run ran out of steam in the middle of last year, government bonds started to post outsized returns. When the world economy recovers from its current difficulties, stocks will take up the running again.
With a multi-asset portfolio, investors can have access to growth-oriented investments likely to make them the most money over the long run, while damping down short-term volatility and reducing the risk of large losses in times of trouble.
Indeed, historically, many of these asset classes are almost completely uncorrelated, which means their performance on a month-by-month basis bears no relation to each other. The correlation between global government bonds and global stocks has been close to zero over the past five years, and they headed in starkly opposite directions after Lehman Brothers’ failure in September.
Bonds and commodities also exhibit little or no correlation.
Intuitively, we can see that placing these assets together in a portfolio can generate smoother returns over the long term than you would see from a pure equity investment.
In contrast, investors hoping to reduce volatility last year by combining Hong Kong stocks with global stocks would have seen little benefit. The five-year average correlation between the two investments is around 80 per cent.
To get the most out of multi-asset investing, however, investors need to be aware of the economic conditions best suited to each asset class so they can boost their returns by making a tactical tilt in that direction.
Economies do not grow in a straight line, as we are all too well aware today. Deviation around the long-term trend growth path creates the economic cycle.
There are four phases - reflation, recovery, overheating and stagflation - which are recognised by the strength of the economy and the direction of inflation.
An economy operating below its trend growth path, in reflation or recovery, will suffer from deflationary pressures. The opposite is true when economies are operating above their trend growth path during the overheating and stagflation phases.
The main asset classes deliver their best performances in different phases of this cycle.
Bonds are strongest in the reflation phase (when the economy is being stimulated by increasing the money supply or by reducing taxes) as interest rates are cut and inflation expectations plummet. Equities perform best in the recovery phase as economic growth and profits surge. Commodities take the lead in the overheating phase as breakneck growth and supply shortages push their prices ever higher.
Stagflation leads investors to be at their most defensive, making cash the most reliable asset class, although some commodities can also do well at such times.
Right now, the world economy is mired firmly in the reflation phase.
US consumer price inflation is close to zero in year-on-year terms, and global inflation indicators - which take into account spare capacity in the world economy, the price of oil, surveys of manufacturer pricing power and economists’ inflation forecasts - are at their most negative.
This phase of the economic cycle calls for a defensive investment strategy, which overweights bonds and underweights equities and commodities. With inflation falling fast and central banks slashing interest rates, government securities are performing well with low risk. Yields are low but they got a lot lower in Japan in the 1990s, in similar circumstances.
More adventurous investors may look to the corporate space, where yields are much higher, albeit accompanied by the spectre of corporate defaults to come.
While the economic momentum is still clearly on the downside, investors should keep in mind that we are likely to hit the low point sometime this year following an unprecedented array of stimulus measures from governments and central banks.
The new US administration is pushing through economic stimulus at a furious pace, beginning recently with a US$787 billion stimulus package designed to create or save 3.6 million jobs. The US Federal Reserve, under “depression buff” Ben Bernanke, is expanding the money supply, mirroring the policy that got America out of a tailspin in the 1930s.
These are encouraging signs for equities from the world’s largest economy and the epicentre of the global financial crisis.
Certainly, shares are beginning to look cheap against earnings and asset values, and dividend yields are high. Interest-rate-sensitive sectors of the stock market such as consumer cyclicals, and defensive industries - such as consumer staples and health care - are the most attractive areas for equity investors to start with.
At some point, financial and property stocks are likely to recover, and this will be the best sign that economic recovery is not far behind. However, investors who have had their fingers burned over the past year are not likely to rush back into stocks in a hurry. This is where multi-asset funds have a major part to play.
By continuing to invest regularly, investors can make equity purchases at trough valuations while reducing the risk of further losses through exposure to uncorrelated assets.
Trevor Greetham is asset allocation director of Fidelity International
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