In PIMCO’s recent Cyclical Outlook, our colleagues Joachim Fels and Andrew Balls outlined a “growing but slowing” backdrop, with the global economy in the final stages of an economic cycle. This late-cycle phase poses significant challenges to asset allocators. We think the keys to dealing with them are to stay flexible and to focus on quality when structuring a portfolio.

Returns disperse as the business cycle ages

It might not have seemed like it at the time, but in retrospect, in 2009 one just needed to stay invested to generate generally attractive performance over the decade since: Most asset classes did well, particularly on a risk-adjusted basis as market volatility was so low. Yet this year – with its sharp volatility spikes in February and again this past week – has already proven more difficult.

If history is any guide, we expect this volatility to continue. Since World War II, there has been higher dispersion in returns across asset classes as the business cycle has aged (see chart).

While there is no complete consensus that the world economy is in the late cycle – and no way to be certain until the peak is well behind us – markets this year are sending strong signals that we are in the second half of the expansion. Typically, equities tend to benefit later in the economic cycle as earnings growth continues and so far, 2018 has been no exception. Global earnings growth of nearly 20% year-over-year (according to the MSCI All Country World Index/Bloomberg) has supported equity markets even as other asset classes have been down.

The challenge for asset allocators

Yet the aging cycle complicates the asset allocation decision. Although equities have historically been the best-performing asset in the second half of an expansion, they tend to suffer as the cycle turns and an inevitable recession follows. While the current U.S. expansion is the second-longest since World War II, acute signs of the end are few, and it is notoriously difficult to predict the turn.

So how are investors to cope? We suggest three steps:

• Health-check your portfolio. Review the composition of your portfolio to understand not only the current risk distribution but also how it might behave in an adverse environment when asset class volatilities and correlations shift. Not only do these tend to be periods where risks in existing investments change, they also tend be ones where investors need to make portfolio shifts because of cash or rebalancing requirements. It’s healthy to understand how much risk you currently have and begin to plan for the eventual cyclical turn.
• Increase flexibility. As dispersion grows both across and within asset classes, the importance of having a more liquid, more flexible portfolio increases. Look to simplify and avoid less liquid positions unless you’re getting adequately compensated for the illiquidity risk.
• Focus on quality. Finally, seek to increase the overall quality of your portfolio. This means focusing on countries, industries and companies that are more robust and have better maneuverability to manage a more adverse environment. While we think this is very relevant across asset classes, it’s particularly so within equity markets. The graphic below illustrates how companies with higher quality factors, such as earnings-to-asset ratios and profit margins, have tended to outperform late in the cycle. It also shows how those with higher value factors tend to underperform, and instead do well in the period immediately following a recession.

In conclusion, as the cycle advances, preparing portfolios now can go a long way to not only withstanding adverse environments but also taking advantage of likely market divergence.

Learn more about flexible investing with the PIMCO GIS Dynamic Multi-Asset Fund.