The smart investor’s guide to the Economic Cycle

What are the different phases in an economic cycle?

Think of the phases in an economic cycle like seasons, although we don’t experience them all in one year – the average economic cycle normally runs for five years.

How can you manage equity investment risk during economic fluctuations?

Different types of assets benefit during different phases in the cycle.

Equities perform well during the expansion phase, but poorly in the contraction phase - sometimes declining significantly. During the global financial crisis of 2008, the FTSE All World Index of global equities declined by 58%¹. Equities tend to take longer to fully recover compared to other asset classes but offer the most attractive return over a full cycle.

If you have a medium-term investment horizon, a typical equity market drop is intolerable. Therefore, spreading investments across equities, bonds, cash and alternatives such as gold and commodities (more on alternatives below) can help balance risk and reward within your portfolio based on how long you plan to invest. This strategy aims to keep drawdowns (the decline in the value of an investment from its highest point to its lowest point) within acceptable limits and align the average time it takes to recover from losses within your investment horizon.

For short-term goals, a conservative strategy that allocates more money to bonds, alternatives and cash helps to reduce risk. In contrast, for those clients with long-term goals, a riskier approach may be suitable with a larger portion invested in equities as you can tolerate more short-term volatility and aim for higher returns over the long term.

The longer you stay invested in equities, the less risky they become. As illustrated in the chart below (fig 1), over the past century negative US equity returns over 10 years (rolling 10-year data shown in purple) have been rare, although over shorter time frames, equity markets often show negative returns.

Fig 1 Rolling returns in US equity market over one, five and ten-year periods

How can active investment portfolio management help during different economic phases?

At Canaccord Wealth, we aim to deliver the best risk-reward balance throughout the economic cycle, catering to our various client investment risk appetites.

Each cycle is unique and will impact asset volatility and how each asset class performs in relation to one another (known as correlations). As active multi-asset investors, these elements guide our rigorous risk management approach, and we adjust our asset allocations accordingly. Our strict risk profiling framework is also designed to avoid human biases and unexpected outcomes.

Fig 2 Our strategic investment framework

What are the active portfolio management levers you can pull?

At Canaccord Wealth, we tend to focus on the following asset classes:

Lever 1: Equities

• We focus on high-quality companies, considering their strength, value and diversification benefits
• Historically, investing in quality companies has provided better returns with lower risk compared to the broader equity market
• Quality companies with steady earnings, strong balance sheets and a competitive edge tend to perform better during market downturns.

The graph below (fig 3) shows the historic return of quality equities against the broader market.

Fig 3 Quality equity returns vs FTSE All-World Index

Source: Bloomberg

Lever 2: Fixed income

Fixed income assets, or bonds, play an important role in a balanced portfolio, although the specific type of asset we choose to invest in can change during the economic cycle:

• Our goal when investing in fixed income assets is to deliver strong returns over a cycle while providing stability in a multi-asset context during the contraction phase.
• Understanding the interest rate cycle is key to fixed income investing: when interest rates rise (typically during the expansion phase), bond prices fall; we aim to reduce interest rate risk and focus on higher yielding areas of fixed income to enhance returns, often taking more credit risk (the risk of default). For more information on fixed interest investing and what we mean by credit risk visit our glossary of terms here.
• When economic activity slows, central banks tend to lower interest rates to stimulate growth; this stage in the economic cycle is usually best for traditional fixed income assets, such as government and high-quality corporate bonds.

The graph below (fig 4) illustrates how investing in US treasury bonds, since the 1987 stock market crash, has offset equity market drawdowns (as explained above) of 10% or more. We prioritise this diversification characteristic across our fixed income allocations when risk of recession is elevated. During the 2022 inflation surge bonds failed to diversify equity risk, as you can see below, resulting in the worst year on record for multi-asset investors.

Fig 4 US treasury bonds vs US equities