The Late-Cycle Playbook
The investment environment has shifted, and the era of easy money is over.
We have already positioned our portfolios to be able to help withstand volatility and minimize risk yet continue to participate in gains.
Age typically has little to do with why a bull market ends.
Investors should be wary of making a premature exit from equities, as that could be detrimental to long-term returns and personal financial objectives.
Investors today are challenged by powerful crosscurrents.
We prefer equities in the U.S., where, based on our proprietary 4Ps framework, we find more companies with attractive growth prospects.
We have carefully and methodically lowered our risk exposure.
We believe select areas of credit and alternative investments can help counter potential equity volatility and supplement core fixed income.
Alternative investments offer the ability to increase returns and manage risk.
These are tricky days for investors. As economic growth downshifts and corporate earnings slow, mounting evidence suggests we are now heading into the last phase of what has been a long period of expansion. After more than 10 very rewarding years investing in the financial markets, we do not think the global business cycle is finished just yet. But as it matures, late-cycle conditions of lower returns, higher volatility and greater policy risk will require those who wish continued success to change their investment approaches and become more selective in their portfolios.
Complacency is the enemy of investors. For most of the past decade, asset prices have risen with limited interruption. But the investment environment has shifted, and the era of easy money is over. Portfolios that served investors well during the steady ascent of risk assets could now be exposed and will have to work harder to generate returns than they have in previous years.
Faced with growing uncertainty, it may be tempting to take risk off the table altogether. However, doing so could harm purchasing power over time and jeopardize long-term financial goals. Indeed, although the late cycle often has featured more limited overall upside for a diversified portfolio, returns for most asset classes have been positive. Still, we believe investors should not be taking excessive risks for lower returns.
With an active approach, it is possible to remain invested while limiting your portfolio’s exposure in a decline. The fundamental challenge of a maturing cycle is to maintain exposure to risk assets without losing control of overall portfolio risk. In a late-cycle period, active investing is not just a defense against an anticipated deterioration in the economic outlook; it also provides the opportunity to be proactive during periods of higher volatility and correlations in asset classes.
The good news? There are concrete actions investors can take now to get their portfolios ready. City National Rochdale’s Late-Cycle Playbook involves taking deliberate and measured steps to improve the quality, yield and sources of diversification in portfolios we manage. By focusing on high-quality U.S. stocks, selected areas of the credit markets and niche alternative investments, we have already positioned our portfolios to be able to help withstand volatility and minimize risk yet continue to participate in gains.
A late-cycle environment like this one is undoubtedly more challenging, and investors should brace themselves for lower market returns, more volatility and bigger tail risks. Should conditions deteriorate more than expected, City National Rochdale stands ready to further reduce risk to protect client portfolios. But, in our view, it is not yet time to step away. Though the current cycle may be entering its twilight, there are still potential rewards ahead for investors who can proactively respond to changing investment conditions.
Equities: Focusing on Quality and Dividend Payers
As the ongoing bull market continues to set records in terms of length, questions naturally arise as to its sustainability. Yet age typically has little to do with why a bull market ends. We believe U.S. fundamentals continue to support the case for modest economic expansion and corporate profit growth. As long as they do, the market should provide modest gains, and while corrections are inevitable, bear markets outside of recessions are rare.
Identifying the end of a bull market isn’t easy, because it typically reaches its peak before the business cycle does. Indeed, late-cycle periods can last for an extended period of time, and investors should be wary of making a premature exit from equities, as that could be detrimental to long-term returns and personal financial objectives. Stocks typically perform relatively well in the latter stages of the economic cycle, and we see potential for this cycle to stretch further, with central banks’ continued willingness to underwrite the expansion. The challenge for investors is to remain watchful about risks that accompany the later stages of a bull market while also taking advantage of the potential for further gains.
If there is one lesson to be learned from past cycles, it’s that successfully navigating financial markets will require more thought and selectivity from here on. As the end of a cycle nears, investors have rarely been rewarded for just taking beta risk — that is, for passively holding a portfolio with broad market exposure. Historically, it’s been active managers who have benefited the most toward the end of the cycle, when market participants start to differentiate between companies that are sustaining earnings growth and those that have just come along for the bull market ride.
That may be especially true this time around. After years of central banks providing abundant liquidity and more investors invested in riskier assets than usual, the difference in the performance among sectors and stocks this cycle has been lower than the norm. As the investment environment shifts, valuations become stretched and price dispersion increases, active strategies that focus on factors that underpin the sustainability of investments and minimize the risk of sharp downturns in markets will have an increasingly important role to play.
For example, volatility tends to flare up late-cycle as financial markets increasingly reassess the risks of a recession. This suggests investing with a quality bias, selecting companies that can better withstand volatile episodes. Another strategy is to focus on companies exposed to secular growth (such as healthcare and consumer staples), as opposed to more cyclical sectors of the market (such as autos and semiconductors) that are at greater risk from deterioration in the overall economic outlook.
Investors today are challenged by powerful crosscurrents. On the one hand, monetary policy has pivoted toward easing, U.S. economic fundamentals remain generally healthy and valuations, while high from a historical perspective, still look reasonable compared to fixed income. On the other, the expansion is showing signs of aging, global conditions have weakened and policy uncertainty is rising; all of which argue for a conservative and deffensive approach. This is why we prefer equities in the U.S., where, based on our proprietary 4Ps framework, we find more companies with attractive growth prospects than in other developed economies, such as those in Europe, which face systematic constraints. Valuations also aren’t much richer than other major markets when viewed on a sector-adjusted basis.
At the same time, we continue to like Emerging Asia equities. While EM Asia has not been immune to trade tensions and slowing global demand, policy across the region is turning more supportive this year. The region’s strong long-term growth outlook remains robust, supported by rising income growth, healthy demographic trends, and high investment rates. Our focus is on domestic sectors and companies in EM Asian economies that should benefit from these structural tailwinds and have greater resilience to weakness abroad.
In our U.S. equity portfolios, we have carefully and methodically lowered our risk exposure. Our focus is on higher-quality companies with lower price-to-earnings ratios and strong balance sheets and earnings visibility. We have recently lowered exposure to MidSmall Cap equities, which tend to perform best at the beginnings of economic expansions and are more vulnerable in a market downturn. At the same time, we have reduced exposure to cyclical and export-oriented sectors most vulnerable to the effects of a maturing business cycle and global headwinds, with notable underweights in commodities, machinery, tech hardware and semiconductors.
In our equity income strategy, we are focusing on companies that can consistently and predictably grow their dividends, which provide income and can help bolster returns in times of market stress. Our research has found that dividend stocks can do well in a slower growth environment and can be less impacted than companies with more growth-oriented business. In past late-cycle periods, this has resulted in reduced volatility versus broader equity indexes.
Fixed Income and Alternative Investments
Traditional fixed income may continue to offer safe harbor in a recessionary environment, but with low interest rates and a potentially dovish Fed, it may be tempting for investors to increase equity exposure. However, we believe select areas of credit and alternative investments can help counter potential equity volatility and supplement core fixed income by adding additional streams of income and sources of price appreciation.
While this recovery has been longer than most, the excesses typically seen at the tops of previous credit cycles have yet to materialize. Broadly speaking, credit fundamentals remain healthy and default rates are low. With this in mind, we think opportunistic income continues to offer pockets of value. At the same time, we are nudging quality higher across our various strategies in response to late-cycle indicators and prefer asset classes with seniority in the capital structure at current market valuations.
In the context of risk-adjusted returns, both leveraged loans and high yield bonds are historically less volatile and experience less dramatic drawdowns than equities. Positions in these asset classes are likely to exceed returns from traditional investment grade fixed income in an expansionary environment, while limiting the downside if growth slows. We also believe that credit alternatives with lower correlations to U.S. markets, such as emerging market high yield and local currency investments, not only offer a yield advantage, but also provide reduced interest rate exposure and higher covenant quality compared to the U.S. domestic market.
In the late stages of the business cycle, investors struggling to source diversified sources of return can also benefit from careful consideration of alternative investments. A common concern among investors today is that, with the combination of low interest rates and high valuations, fixed income asset classes may not provide the same level of income and diversification from equities as in the past. Alternative investments offer the ability to increase returns and manage risk. However, not all alternatives are positioned to thrive in the current environment and investors should be highly selective.
We believe that alternative investments offer a source of stable income that is less prone to bouts of volatility during times of market stress. Beyond liquid alternatives, investors in search of non-correlated diversification have options in less-liquid areas of the market, which can provide high yields, strong fundamental quality and price stability. For instance, returns in the reinsurance market do not rely on economic cycles and business fundamentals. Similarly, capital leasing investments, such as railcar and aircraft, are historically stable across environments and offer tax-advantaged returns with low correlations to public asset classes.
Although late-cycle volatility can be viewed negatively, it may also provide buying opportunities. For investors with liquid assets looking for strong returns over long periods of time, investments in CLO equity tranches can benefit from volatile credit markets, allowing the purchase of loans at substantial discounts to par while providing leveraged exposure upon economic recovery. These discounts can significantly improve long-term performance and shield investors against increased default rates that can occur during recessionary periods. For instance, equity investments in CLO vintages just prior to the great recession had stronger performances versus other vintage years pre and post the 2008 downturn.
While we believe these niches are compelling, investors should be wary of “traditional” alternatives, such as many private equity and hedge funds, understanding that not all alternatives are positioned to thrive in the current environment. These investments often charge excessive fees and, in many cases, offer returns highly correlated with core asset classes, thereby presenting the same risks based on elevated valuations presently seen in debt and equity markets. Investing in these strategies may also carry negative tax consequences, especially with the high turnover found in many hedge funds.