Episode 7 - Positioning bond and equity funds through different cycles

What are business cycles

• Financial markets, much like the broader economy, move in cycles. These cycles are shaped by shifts in economic activity, interest rates, inflation, corporate earnings, and investor sentiment.
• While the timing and duration of each cycle can vary, understanding the typical phases of a business cycle—and how to adapt your investment strategy accordingly—can help investors navigate uncertainty and make more informed, resilient decisions.
• In economics, a business cycle refers to the recurring pattern of economic upswing and softening that influences asset prices over time.
• These cycles are not always predictable in length or intensity, but they generally follow four key stages: recovery, expansion, slowdown, and contraction.

Business cycles and real GDP

• The graph of the US real GDP growth over time illustrates the cyclical nature of the economy, characterized by alternating periods of expansion and contraction. These fluctuations form the foundation of the business cycle.
• Understanding the relationship between GDP growth and asset class behavior helps investors align their portfolios with the prevailing economic environment, enhancing both resilience and return potential across market cycles.
• Specifically, portfolio managers may invest in certain sectors that have historically increased in price during a particular phase in the economic cycle and avoid those that have underperformed at that point.

Bond investing through business cycles

• Bond fund performance is closely tied to interest rate movements, which are influenced by the economic cycle.
• During recovery, central banks often raise rates to curb inflation, pressuring long-duration bonds—making short-duration or floating-rate funds more attractive, as they are less sensitive to rising interest rates. Meanwhile, investors may also start to cautiously rotate into higher-yielding segments like emerging market or high-yield bonds to enhance returns.
• During contraction, central banks tend to cut rates and investors typically seek safety in high-quality bonds, such as investment-grade corporate or government bonds.
• Between January 2007 and January 2009, the US economy entered a deep recession, with real GDP contracting by -2.6% in 2009—the sharpest decline since World War II.
• Equity markets reflected this downturn, with the S&P 500 Index falling nearly -49%. In contrast, as risk aversion surged, high-quality fixed income provided a safe haven: global investment grade bonds (as represented by Bloomberg Global Aggregate Bond Index) rose +8% during the same period.
• This divergence highlights the defensive role of investment-grade bonds during economic contractions.

Equity investing through business cycles

• During recovery and expansion, corporate earnings typically rebound, investor sentiment improves, and monetary policy is often supportive.
• These conditions create a favorable environment for equity outperformance, particularly among growth and cyclical stocks.

• From October 2020 to December 2021, the US economy rebounded strongly from the pandemic-induced recession. After a sharp contraction of -2.2% in 2020, real GDP surged by +6.1% in 2021, marking one of the fastest growth rates in decades.
• Equity markets responded with enthusiasm: the S&P 500 Index gained +65%, while the Bloomberg Global Aggregate Bond Index remained flat.
• This period illustrates how equities tend to outperform during economic recoveries and expansions, especially when supported by accommodative monetary policies, strong earnings growth, and investor optimism.

Final Thoughts

• By recognizing the characteristics of each phase and adapting your strategy accordingly, you can better manage risk, capture opportunities, and build a portfolio that is resilient across economic environments.
• Investors who are aware of their own risk tolerance and consider historical market trends may be better equipped to make thoughtful decisions about their long-term investment strategies.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.