Late Cycle Investing: Time to Get Active

By LCK Wealth Management on October 24, 2018

US economic growth remains robust and corporate profits are impressive, but upcoming conditions will likely impact corporate fortunes far more unevenly than we have seen during the cyclical expansion of the past ten years. Late-cycle conditions, such as rising inflation and tighter monetary policy, will combine with changing trade agreements and a shifting political landscape to create increasing differences in performance among sectors and securities. These wider performance differences are starting to unfold, and this new environment suggests that equity portfolio performance over the next year will be driven less by broad-market exposure and more by effective sector and security selection; thus, this point in the economic cycle may be an opportune time to rely more on experienced active managers and less on passive management vehicles like broad-market exchange-traded funds (ETFs). Active managers can take advantage of performance disparities, while passive strategies – which performed so well when all stocks were generally rising – are not structured to capture the performance differences that may be more characteristic of the anticipated environment.

Late Cycle Developments
Importantly, “late-cycle economics” taking shape does not mean we are on the brink of a recession, as tax cuts and capital investment incentives should continue to bolster the US economy into 2019; however, developments that unfold at this point in the economic cycle, such as higher inflation and tighter monetary policy, tend to affect companies differently. Both factors tend to push interest rates higher, and, as a result, interest-rate-sensitive companies and high-dividend stocks will be impacted much more than other equity issues. Recent increases in wage inflation (e.g., a rise of 2.9 percent in August – the highest since 2009, according to the Bureau of Labor Statistics) suggest profitability of labor-dependent industries could be compromised, especially as wage pressures respond to continued economic growth paired with unemployment at historically low levels. At the same time, companies with recent investments in labor-saving technology and robotics could be relative beneficiaries.

Good quality research at active-management firms should distinguish those companies poised to benefit from a changed environment from those who will struggle. In addition to the above-mentioned rising interest rates, wage increases could combine with strong economic growth and trade tariffs to push overall inflation higher. In such an environment, companies with greater pricing power – such as those in food, mining, and energy – could emerge as substantial outperformers; in contrast, those companies offering non-essential services, including airlines, retail, autos, and other consumer discretionary items will likely offer less favorable returns. During these times, active managers (especially those with broader mandates) can emphasize/avoid specific sectors, as well as identify relative value within underperforming and outperforming sectors.

Changing Trade Agreements
In addition to classic late-cycle developments like rising inflation and tighter Fed policy, active management opportunities have the potential to be increased by changing trade agreements. New trade pacts with Mexico, Canada, the European Union, and, eventually, China will inherently shift economic fortunes among companies. Again, analysts familiar with companies involved will have an advantage in selecting those credits likely to outperform, as compared to a passive strategy or an index that includes companies without regard to an evolving environment.

Election Effects
Finally, midterm elections can impact corporate profits, particularly if infrastructure spending gains support from Democrats along with the president. The election may also increase the likelihood of new regulation that is currently under review for technology companies. A shift toward Democratic leadership at the state level will also influence local priorities, funding, and regulations, creating a different environment in which companies compete; such changes create opportunities on which active managers can capitalize.

Evidence of Opportunity: Correlation and Dispersion
Evidence of a new investment environment that offers greater opportunity for active managers to outperform indices is starting to unfold. Correlation and dispersion of returns amongst companies are two data points that can characterize the potential for active managers to outperform the market or passive investments. For example, environments where returns are highly correlated suggest returns within an index moving similarly, giving active managers little opportunity to outperform; in such instances, passive management can be more compelling. Conversely, low correlation of returns suggests a market that presents active managers with greater opportunity to distinguish among securities and sectors to find those that may respond more favorably to expected changes in the environment, while avoiding those that respond poorly. The chart below suggests that recent correlations have reached extremely low levels, implying greater opportunity for active managers. As of August, correlation within the S&P 500 was in the 25th percentile of monthly values since January 2007, while the S&P MidCap 400 and the S&P SmallCap 600 correlations were in the 5^th percentile of observations. Please refer to the graphics below provided by S&P Dow Jones Indices:

An even more relevant metric to characterize the potential opportunity for active managers to outperform their index is dispersion. While correlation measures the extent to which two stocks or sectors move in the same direction, dispersion captures the difference in magnitude of their movement, or how much their return differs from the average. As such, periods of low dispersion favor passive management, while periods of higher return-dispersion suggest greater opportunity for active management. The chart below indicates that, in August, dispersion levels in the S&P 500 and the S&P MidCap 400 moved below the median level for the period since January 2007, while the S&P small-cap 600 was in the 95^th percentile.

Changing Strategy
Anticipated late-cycle conditions, combined with new trade dynamics and potential shifts driven by November elections, suggest correlation and dispersion will continue to provide active managers with opportunities to outperform indexes in the coming year. Investors wanting to shift from passive management to an active approach can pursue a more active strategy in several ways, without affecting the capitalization structure of their portfolio.