Curmi & Partners

Navigating the business cycle

By Robert Ducker

Understanding where we are in the business cycle and anticipating inflection points may present the investor with a unique opportunity to generate alpha. The business cycle represents fluctuations in economic activity over a period of time. We hereby define it in four phases:

(1) Recovery – Economy starts its repair process after recession. Business confidence is rising but unemployment and consumer confidence is still low. Management of companies is focused on fixing their balance sheets. Generally, we see bond spreads tightening while equities underperform.

(2) Upswing – Economy grows at the fastest pace in what is considered to be the healthiest period in the cycle. This stage is characterised by high business and consumer confidence and low unemployment. Companies have completed their deleveraging process and corporate profits are rising. This is usually a risk-on phase with both equities and bonds generating healthy profits.

(3) Slowdown – This phase is usually characterised by anxious bond investors as corporate leverage is rising and economy is slowing down, confidence starts to waver and inflation starts ticking up. Typically, equities outperform bonds while also seeing an uptick in volatility.

(4) Recession – Business investment and consumer spending decline sharply as unemployment rises. Central Banks will usually adopt expansionary policies to stimulate the economy. Both equities and bonds will usually fall in this stage and corporate profits plunge.

The chart above depicts the different phases of the business cycle. The blue line marks the start of the recovery stage; the green line is the start of the upswing, followed by the orange line which marks the start of the slowdown stage and finally the red line which signals the start of the recession.

We have been in the upswing stage since mid 2012 with both equities and bonds rallying after European Central Bank (“ECB”) President Mario Draghi promised to do “whatever it takes” to save the Euro. The question is whether a move into the slowdown stage is imminent and how to position the portfolio if it does happen. Credit should provide a leading indicator for the equity market and we continue to monitor spread moves closely. Widening credit spreads would generally be a sign that we are heading into the slowdown phase of the business cycle unless Central Bank intervention delays this from happening. Credit spreads widened sharply in 2016 due to a number of specific factors including concerns over Emerging Market economies especially China, the sell-off in the commodity and energy markets and concerns on the banking sector’s ability to navigate through unconventional monetary policy adopted by Central Banks around the world. This move in credit spreads was mitigated mainly by the Federal Reserve adopting a more dovish stance on its monetary policy which was later supported by the ECB’s decision to buy corporate bonds.

At this stage, leverage levels in Europe are still manageable, but the situation in the United States is different. Leverage has increased substantially in the United States since the Global Financial Crisis but bond yields and spreads are yet to reflect this. Some analysts are warning that both credit and equity markets have become complacent, driven partly by the portfolio rebalancing as investors had to move outside of their comfort zone in the search for yield. If we do move into the slowdown phase equities generally outperform credit but with an uptick in volatility. Will less Central Bank intervention be the catalyst for this?

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business