Asset classes and the economic cycles

Different asset classes perform better in different environments.  Investors can optimize portfolio performance by identifying which assets perform the best at certain phases of the economic cycle. In this article, we will go through the different asset classes and outline which economic phase is best to purchase each one.

Cash

Cash is the lowest generating asset class. This asset class is also considered a safe haven so investors flock to cash when the economy is weak or in a recession. They want to ensure their capital is not eroded by volatile periods of the economy and therefore they invest in cash. Cash performs poorly in economically strong periods as there are other higher yielding asset classes. Investors rotate into equities or property when the economy picks up.

Bonds

Bonds are another asset class which is considered a safe haven. There are two types of bonds – government bonds and corporate bonds. When an investor purchases a government bond, they are essentially lending money to the government and in return they receive regular interest payments. The initial capital is returned to them at the end of the period. These asset classes are considered low risk as no Australian government has defaulted on their loan. In periods of recession, the popularity of bonds increases. However high yielding bonds are not as popular as a high investment grade bond as investors prefer security over yield. This demonstrates that investors see high yielding bonds as risky asset classes. In the recession phase, corporate profits decrease as consumers stop spending.  Credit is hard to obtain so it is difficult for companies to expand. Bonds usually outperform in these recessionary phases. However, they underperform in periods where the economy is stronger as investors rotate out of bonds and into higher performing asset classes.

Property

Property performs the best in the early phase of the economy when it is expanding. This is when interest rates are low and credit is easy to obtain. Unemployment is also low and economic growth is good. Rental prices are rising and property vacancy is low. During this period there is an increase in construction jobs as demand for property rises. Investor activity is high in this phase as the dominant emotion in the market is one of optimism and confidence. When investors can obtain credit easily and interest rates are low, then this can create an environment for strong house prices. Property does not perform well in recessionary periods as there is more real estate supply than demand. People are hesitant to purchase during this period as they do not have confidence in the economy. Unemployment may be high so there may also be foreclosures on properties which can drive down sentiment.

Shares

Shares perform the best in the early phase of the business cycle. This is a period of low interest rates and strong economic outlook. Consumers feel confident about the economy so there is an increase in spending activity. This creates higher sales volumes and lower inventory. Credit is easy to obtain so companies can expand and grow profits further. The stock market rallies when conditions are favourable such as when there is optimism in the market and interest rates are low. Shares also perform well in the mid-cycle phase of the economy but not as well as in the early phase. The mid-cycle phase occurs when economic growth has already peaked and credit is strong. Company profit growth is softer in this phase because it has already reached its peak. Cyclical stocks are stocks which move in line with the economy and these do the best in early phase. Such sectors include financials as loans become popular when interest rates are low. Real estate stocks also do well for the same reason of low interest rates. Industrial and resource stocks perform well as construction and manufacturing activity increases again in the early phase. Consumer discretionary stocks also do well as in the early phase as household spending increases. Shares tend to perform poorly in recessionary periods as investors move to safe haven such as bonds and cash. Defensive stocks will therefore perform better in recessionary periods.

Lauren Hua is a private client adviser at Fairmont Equities.

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