Business cycles vary over time in strength, length and visibility. Some expansions (booms) end due to natural imbalances accrued over time, others do so as a direct result of an external shock. While the current expansion may have built up imbalances on the way to becoming the longest post-war boom, it was the emergence of the Covid-19 global pandemic which precipitated the US economy entering into a deep contraction (bust).
As the economy's trajectory suddenly shifted, so did the risk and return profiles of financial markets. Heightened volatility is now a prominent feature in equity and credit markets as risk premiums are recalibrated to reflect the new economic reality. In order to gauge the eventual path of risk assets beyond the short term, it may be instructive to handicap their typical behavior during prior periods of economic expansions and contractions.
In exhibit 1, monthly average excess returns over cash have been summarized for the previous four business cycles (November 1982 to March 2020) with the assumption that the US economy peaked in December 2019 (on a quarterly basis) and will show contraction from March 2020 in earnest. To better grasp performance over the cycles, expansion and contractions, as defined by NBER, have been tiered to reflect the onset, middle, and tail end of each phase. Additionally, to capture performance around turning points, peaks and troughs have been included. These are defined as the period comprising the three months before and after NBER's cyclical peak and trough markers (including the month of such markers). For monthly data, peaks coincide with the onset of a recession while troughs correspond with the end of one.
Exhibit 1: Average Monthly Excess Returns (%)
Source: Bloomberg, BofA, NBER, Aegon AM US. Notes: S&P 500 index; US 10yr Treasury Index; Bloomberg Barclays US Treasury Total Return Index, Bloomberg Barclays US Corporate Bond Total Return Index; Bloomberg Barclays US Corporate High Yield Total Return Index
Typically, a stronger demand for safe havens has lead to outperformance of treasury bonds at the onset of a contraction while equities fared the worst. As the contraction sunsets, high yield has typically enjoyed the highest excess returns, and equities have lead the pack for the remainder of the expansion once recovery is established. Performance around the peak in expansions and the trough in contractions has been consistent with these observations. Broadly speaking, treasuries lead as economic activity peaks and begins to turn, followed by investment grade. High yield outperformed as activity bottomed out and began to turn, followed by equities. Would forward looking indicators, which contain information about contemporaneous risk premiums and expected performance, confirm the observed ex-post excess returns?
Exhibit 2: Yields and spreads through cycles (%)
Sources: Bloomberg, BofA, NBER, Aegon AM US
Exhibit 2 suggests that the earnings yield for equities (the inverse of the forward PE ratio and a proxy for the cost of equity) may be highest at the onset of expansions and drastically fall through during the remaining stages of the boom, bottoming out in the latter stages, to reflect a lower risk premium for stocks. This is consistent with equity outperformance once recovery is established. Similarly, credit spreads may peak at the trough of economic activity before narrowing for the remainder of the expansion and bottoming out at the top of the expansion. As seen in exhibit 1's ex-post results, this is consistent with credit generally performing well at positive turning points for the economy (trough) and throughout the recovery as the yield curve flattens.
As the US economy has transitioned from an expansion to a contraction, past patterns of US asset classes suggests realized returns may favor Treasury bonds in the initial stages of the recession. Deeper into the contraction and as the economy reaches a turning point (trough) High Yield bonds may outperform, and pass the baton to Equities once the recovery has been established. Although past behavior is not indicative of future results, understanding these patterns may be crucial to broad portfolio positioning that may help mitigate risks and be accretive to risk-adjusted returns over time.
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