Understanding the Next Phase of the Market Cycle

Market cycles rarely unfold in a straight line, and identifying the current phase of the cycle can help investors calibrate expectations and risk exposure. We explore the framework for thinking about cyclical positioning.

Executive Summary

Investment markets move in cycles, shaped by the interplay of economic growth, monetary policy, corporate profitability and investor sentiment. While no two cycles are identical, understanding the general framework through which market cycles are analysed can help investors set realistic expectations and think more clearly about portfolio positioning. This article provides a general, educational overview of the market cycle framework and its potential relevance to current conditions.

It is important to stress at the outset that cycle analysis is inherently imprecise, and that attempting to time markets based on perceived cycle position carries significant risk. Rather, our purpose is to help investors understand the broad forces at play, and to encourage a disciplined, long-term approach to portfolio construction that is resilient across different phases of the cycle.

Market Context

The traditional framework for describing economic and market cycles divides the cycle into several broad phases: an early expansion phase characterised by accelerating growth and easing financial conditions, a mid-to-late expansion phase in which growth remains positive but begins to moderate, a peak phase in which growth and corporate profitability reach a high point, and a contraction phase in which economic activity slows or declines, often accompanied by tighter financial conditions and rising credit stress.

Following an extended period of unusual conditions, spanning a global pandemic, an inflation surge and an aggressive monetary tightening cycle, many observers have debated where the current cycle sits within this traditional framework. Some indicators, such as resilient labour markets and consumer spending, have pointed to continued expansion, while others, including slowing manufacturing activity and tighter lending standards, have suggested a more mature or transitional phase of the cycle.

No two cycles are identical, but the underlying forces that drive them, credit, sentiment and profitability, tend to rhyme across time.

Key Investment Considerations

Different asset classes and sectors have historically exhibited differing sensitivities to various phases of the market cycle. Cyclical sectors, such as industrials and consumer discretionary businesses, have tended to perform relatively well during periods of accelerating growth, while more defensive sectors, such as utilities and consumer staples, have often demonstrated greater relative resilience during periods of slowing growth or contraction. Fixed income assets, too, have exhibited differing behaviour across cycle phases, with credit spreads typically widening during periods of economic stress and narrowing during periods of expansion.

It is important to note, however, that historical patterns are not a reliable guide to future performance, and that each cycle has unique characteristics driven by the specific circumstances of the time. Structural changes in the economy, including the growing weight of technology and services relative to traditional manufacturing, may also alter the way cyclical dynamics play out relative to prior cycles.

Opportunities

Understanding the broad cycle framework can help investors think about the balance of their portfolio across cyclical and defensive exposures, without necessarily attempting to make precise tactical calls on cycle timing. For investors with a longer time horizon, periods of heightened uncertainty regarding cycle position can present opportunities to acquire quality assets at more attractive valuations, particularly where market sentiment has become excessively pessimistic relative to underlying fundamentals.

Additionally, active management approaches that incorporate a view on the broader macroeconomic and cyclical environment may be able to add value through tactical adjustments to sector and asset class weightings, though this requires disciplined risk management and a clear-eyed acknowledgement of the difficulty inherent in such calls.

Risks

The principal risk associated with cycle-based investing is the difficulty of accurately identifying the current phase of the cycle in real time, let alone predicting the timing of transitions between phases. Investors who make significant portfolio changes based on a mistaken view of cycle position may find themselves poorly positioned when conditions do not evolve as expected. There is also a risk of over-reliance on historical patterns that may not repeat in the current cycle, given the unique structural and policy circumstances of the present environment.

Behavioural biases, including the tendency to extrapolate recent trends indefinitely into the future, can also lead investors astray when assessing cycle position, particularly during periods of unusually strong or weak market performance.

Outlook

Looking ahead, we expect continued debate among market participants regarding the precise phase of the current cycle, given the unusual combination of factors that have characterised the post-pandemic environment. Rather than attempting to resolve this debate definitively, we believe investors are better served by focusing on portfolio resilience across a range of plausible cycle outcomes, incorporating a mix of cyclical and defensive exposures appropriate to their individual risk tolerance and time horizon.

We would also note that structural themes, such as the ongoing investment in digital infrastructure and energy transition, may exhibit dynamics somewhat independent of the traditional economic cycle, given the multi-year investment horizons involved. This suggests that a purely cycle-based approach to portfolio construction may need to be supplemented with consideration of these longer-term structural trends.

Conclusion

Understanding the market cycle framework provides investors with a useful lens through which to consider portfolio positioning, without offering precise predictive power regarding future market movements. A disciplined, diversified approach that acknowledges the inherent uncertainty of cycle timing, while remaining attentive to the broad forces shaping the economic environment, is likely to serve investors better over the long term than attempts at precise cycle timing. This article is general information only and does not constitute personal financial advice.

Information contained within these insights is provided for general information purposes only and does not constitute personal financial advice, an offer or recommendation to acquire or dispose of any financial product. Investors should consider their individual circumstances and obtain appropriate professional advice before making investment decisions.