Late Cycle Investing – when and where?

By: Bryn Hatty, Chief Investment Officer, Stonehage Fleming South Africa

Often some of the best equity returns can be achieved in the last few years and months before a recession. Of course, staying invested late in the cycle is not without risks – the biggest being overstaying your welcome.

Where should you invest late in the economic cycle?

After the strong global equity market rally early this year valuations, though not excessive, are no longer cheap. However, with ongoing monetary easing there are potentially still reasonable returns available.

The risk is that monetary easing may over-stimulate the US economy, already at full employment, resulting in a sharp tightening in financial conditions leading to a recession.

Investors should consider gradually reducing exposure to global equity markets and within the equity category consider moving exposure away from high growth investments towards more quality and value-based investments or managers.

Some cash on hand will likely reduce the volatility of your portfolio, while providing the opportunity to buy cheap assets in the event of a market sell off.  In the absence of the protection historically provided by bonds, investing with good hedge fund managers is likely to pay off as the increased market dispersion should be beneficial to these managers.

In the late part of the economic cycle, inflation often starts coming through as the economy starts to overheat and there aren’t enough resources available for the increased demand – be that commodities or labour. As a result, in addition to equities, real assets that can offer protection against inflation tend to do well in this environment.

As inflation rises however, interest rates are also likely to rise as lenders need compensation for the decline in purchasing power of future interest and principal repayments. Therefore bonds, notably fixed rate bonds, are negatively impacted by inflation as yields rise and therefore prices decrease.

The longer-dated the income stream, the more negatively the asset will be impacted as the income stream is being discounted for a longer period. For example, a 1% interest rate rise will have a much larger impact on a 100-year bond than a two-year bond.

Similarly, if you’re invested in companies where you’re paying a high price for future earnings growth in 10- or 15-years’ time, those earnings will be discounted more aggressively.

So, as interest rates rise and the economic outlook becomes more uncertain, the valuations of high growth companies will tend to be more negatively affected than, for example, well run companies with a strong asset underpin. This is the part of the cycle where value and quality stocks generally outperform high growth stocks.

As the economy turns down there is generally increased dispersion in returns both between and within asset classes. Since the global financial crisis, momentum has been the order of the day – assets have risen and fallen together largely driven by monetary conditions.

As a result, investors haven’t been as discerning about their assets. A momentum driven environment is difficult for active managers, which is why there has been such a big move towards indexation, or passive investing.

This changes as the economy slows and poorer quality assets start to show their true colours. For example, if a business has been largely using debt fueled acquisitions to grow earnings, and its earnings start to disappoint, the company’s high debt levels will start to concern investors.

Globally, because of the low interest rate environment prevailing for some time, particularly in the US, companies have materially increased borrowings, often to buy back their own shares. This has had the impact of artificially increasing company earnings while also increasing corporate leverage.  This raises red flags for future earnings growth as well as the corporate debt market, especially in a rising interest rate environment.

Another important consideration late in the cycle is to reduce leverage. Increasing your portfolio’s cash holdings has a similar impact to ensuring that the companies you’ve invested in have a strong balance sheet with low debt levels – this provides flexibility when there is a market sell off and the opportunity to buy assets or other businesses cheaply.

For a long period now, bonds have been a great diversifier for equities, providing protection during equity selloffs. However, that’s because the global economy has been in a very low inflation environment. If an era of high inflation returns, bonds won’t provide protection. In addition, interest rates are coming off a very low base so there is limited room for interest rates to fall from current levels.

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