To build wealth over time, it’s essential to maximize the opportunity for positive compound returns across an entire economic cycle. Within a cycle一which could stretch from a year to a decade or more一there will be up and down markets. Achieving positive compound returns is relatively straightforward in a bull market, in which “a rising tide lifts all boats.” However, avoiding the inverse effect and related losses is more challenging in down or choppy markets.
Knowing when and how to pivot or reposition a portfolio to optimize the opportunity for positive returns across the economic cycle requires a disciplined strategy centered on three areas:
- Understanding the Economic or Market Cycle & Its Constituent Phases
- Knowing What Data Might Signal a Change in Phase
- Deploying Flexible Active Management To Achieve Portfolio Readjustment
The Economic or Market Cycle & Its Constituent Phases
Over time the economic cycle unfolds in phases, characterized by varying levels of economic expansion or contraction. And while no two economic cycles are the same, many characteristics of a given phase are analogous from cycle to cycle. A summary of phases is provided below:
The five phases of the economic cycle are Recovery, Expansion, Peak, Growth, and Decline.
In any given phase, market returns will broadly reflect underlying strengths and weaknesses across industry sectors, tempered by the day’s unique combination of influences from central bank policy, government spending, global events, and other macroeconomic factors.
A successful investment approach requires a firm grasp of which phase is underway, other singular impacts, and how to allocate capital within these conditions to optimize the opportunity for return and minimize losses.
In the words of Hilton Capital Management’s Co-Chief Investment Officer Bill Garvey, “Over time, achieving better investment results comes almost as much from avoiding losses as making gains. A disciplined approach to deploying capital within the context of the economic cycle is central to this process.”
What Data Might Signal a Change in Phase
According to Jay Samit, former Independent Vice Chairman of the multinational firm Deloitte, “Data may disappoint, but it never lies.”
The same may be said for anticipating a phase change drawing near. Timing can be a key consideration when making changes to any investment portfolio. Recognizing the oncoming shift is critical to maximizing return opportunities in the next phase. This requires a data-driven process grounded in ongoing analysis and identification of trends, inflection points, and other potential change-markers. For example:
The Transition from Peak to Growth Phase. Last year’s (2021) surge in consumer spending boosted corporate profits and real gross domestic product (GDP) growth to historic levels. However, the overhang from unprecedented expansionary fiscal policy, pent-up demand, and supply chain kinks emerged in Q4 2021 data.
The data hinted at potentially more challenging times ahead, such as:
- Despite a rapid, robust GDP recovery in 2020 and 2021, the Federal Reserve Open Market Committee’s (FOMC or the Fed) Longer Run FOMC Real GDP Projection remained at modest growth levels for 2022.
Longer Run FOMC Real GDP Projection
Central Tendency, Midpoint as of March 16, 2022
Source: Federal Reserve Bank of St. Louis and US. Federal Open Market Committee, Longer Run FOMC Summary of Economic Projections for the Growth Rate of Real Gross Domestic Product, Central Tendency, Midpoint [GDPC1CTMLR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org GDP = Gross Domestic Product is the amount of goods and services produced within a given country.
- The Consensus & Alternate Views of Real GDP Year-on-Year also projected declines in real GDP growth.
- The health of the manufacturing sector, while still expansionary, was starting to decline, as indicated in the ISM Manufacturing and Services (Purchase Managers Index) PMI.
- The U.S. Job Openings vs. Actual Hiring illustrated a surging labor market with the potential to provide cover for future Fed tightening and rate increases.
Job Openings vs Actual Hiring : High level of job openings:
December 31, 2000 to April 6, 2022
Source: Bloomberg/Hilton Capital Management/Bureau of Labor Statistics HIREPRIV – Hires Level From The Jolts Report Private SA JOLTTOTL- US Jobs Openings By Industry Total Seasonally Adjusted
- Higher oil prices continued to drive up inflation expectations.
- Compression in the U.S. 10 Year Treasury Note Yield minus the 2 Year Treasury Note Yield signaled expectation of future Fed rate hikes and slower growth.
U.S. 10 Year minus 2 Year Spread
July 1991 through April 6, 2022
Source: Bloomberg/Hilton Capital Management Index = Market Matrix US Sell 2 Year & Buy 10 Year Bond Yield Spread (USYC2Y10 Index)
These are only a handful of data points among many others that, when read in concert and consistently, illuminate changes ahead.
“We review 40 to 50 data points every month,” says Alex Oxenham, Co-Chief Investment Officer at Hilton Capital Management. “The data tells the story confirming where we are and where we’ll need to be. This enables us to pivot on the early side and optimize opportunity going forward.”
Flexible Active Management to Achieve Portfolio Readjustment
Once it’s clear a phase change is near, experienced active management enables the portfolio manager (PM) to position the portfolio accordingly一ahead or on the earlier side of the transition. Dynamic management across asset classes, styles, credit, and sectors further enhances opportunities for positive returns.
For example, in a pivot from the Growth to Decline phase, a reallocation away from risk-on assets (equity) toward risk-off assets (Treasuries) would be considered. More defensive sectors such as utilities, consumer staples, and health care would likely be favored over growth and momentum industries such as technology and luxury goods.
Of course, each phase has its unique circumstances. For example, influences such as the coronavirus pandemic, supply chain disruption, inflation, Fed action, and political unrest also help shape portfolio positions.
Finally, current economic conditions suggest we are in a slower growth phase. Achieving return and limiting losses will likely be more challenging than in the recent past. However, relying on a framework throughout the economic cycle enables experienced PMs to make data-driven decisions that may provide for better investment outcomes.
