Over the intermediate term, asset performance is often driven largely by cyclical factors tied to the state of the economy, such as corporate earnings, interest rates, and inflation. The business cycle, which encompasses the cyclical fluctuations in an economy over many months or a few years, can therefore be a critical determinant of equity market returns and the performance of equity sectors. This paper demonstrates Fidelity’s business cycle approach to sector investing, and how it potentially can generate positive, active returns over an intermediate time horizon.
Asset allocation framework
Fidelity’s Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to produce asset allocation recommendations for Fidelity’s portfolio managers and investment teams. Our framework begins with the premise that long-term historical averages provide a reasonable baseline for portfolio allocations. However, over shorter time horizons—30 years or less—asset price fluctuations are driven by a confluence of various short-, intermediate-, and long-term factors that may cause performance to deviate significantly from historical averages. For this reason, incorporating a framework that analyzes underlying factors and trends among the following three temporal segments can be an effective asset allocation approach: tactical (one to 12 months), business cycle (one to 10 years), and secular (10 to 30 years).
Understanding business cycle phases
Every business cycle is different in its own way, but certain patterns have tended to repeat themselves over time. Fluctuations in the business cycle are essentially distinct changes in the rate of growth in economic activity, particularly changes in three key cycles—the corporate profit cycle, the credit cycle, and the inventory cycle—as well as changes in the employment backdrop and monetary policy. While unforeseen macroeconomic events or shocks can sometimes disrupt a trend, changes in these key indicators historically have provided a relatively reliable guide to recognizing the different phases of an economic cycle. Our quantitatively backed, probabilistic approach helps in identifying, with a reasonable degree of confidence, the state of the business cycle at different points in time. Specifically, there are four distinct phases of a typical business cycle (see chart below).
- Early-cycle phase: Generally, a sharp recovery from recession, marked by an inflection from negative to positive growth in economic activity (e.g., gross domestic product, industrial production), then an accelerating growth rate. Credit conditions stop tightening amid easy monetary policy, creating a healthy environment for rapid margin expansion and profit growth. Business inventories are low, while sales growth improves significantly.
- Mid-cycle phase: Typically the longest phase of the business cycle. The mid-cycle is characterized by a positive but more moderate rate of growth than that experienced during the early-cycle phase. Economic activity gathers momentum, credit growth becomes strong, and profitability is healthy against an accommodative—though increasingly neutral—monetary policy backdrop. Inventories and sales grow, reaching equilibrium relative to each other.
- Late-cycle phase: Emblematic of an “overheated” economy poised to slip into recession and hindered by above-trend rates of inflation. Economic growth rates slow to “stall speed” against a backdrop of restrictive monetary policy, tightening credit availability, and deteriorating corporate profit margins. Inventories tend to build unexpectedly as sales growth declines.
- Recession phase: Features a contraction in economic activity. Corporate profits decline and credit is scarce for all economic actors. Monetary policy becomes more accommodative and inventories gradually fall despite low sales levels, setting up for the next recovery.
The performance of economically sensitive assets such as stocks tends to be the strongest during the early phase of the business cycle, when growth is rising at an accelerating rate, then moderates through the other phases until returns generally decline during the recession. In contrast, more defensive assets such as Treasury bonds typically experience the opposite pattern, enjoying their highest returns relative to stocks during a recession, and their worst performance during the early cycle.
Equity sector performance patterns
Historical analysis of the cycles since 1962 shows that the relative performance of equity market sectors has tended to rotate as the overall economy shifts from one stage of the business cycle to the next, with different sectors assuming performance leadership in different economic phases.1 Due to structural shifts in the economy, technological innovation, varying regulatory backdrops, and other factors, no one sector has behaved uniformly for every business cycle. While it is important to note outperformance, it is also helpful to recognize sectors with consistent underperformance. Knowing which sectors of the market to avoid can be just as useful as knowing which tend to have the most robust outperformance.
Historically the phase of the business cycle with the most robust performance, the early-cycle phase has tended to feature positive absolute performance. Since 1962, the broader stock market has produced an average total return of more than 20% per year during this phase, and its average length has been roughly one year. On a relative basis, sectors that typically benefit most from a backdrop of low interest rates and the first signs of economic improvement have tended to lead the broader market’s advance. Specifically, interest- rate-sensitive sectors—such as consumer discretionary and financials—historically have outperformed the broader market (see chart below). These sectors have performed well, due in part to industries within the sectors that typically benefit from increased borrowing, including diversified financials and consumer-linked industries such as autos and household durables in consumer discretionary.
Elsewhere, economically sensitive sectors—such as information technology, real estate, and industrials—have been boosted by shifts from recession to recovery. For example, the industrials sector has some industries—such as transportation—in which stock prices often have rallied in anticipation of economic recovery. Information technology and real estate stocks typically have been aided by renewed expectations for consumer and corporate spending strength.
Laggards of the early-cycle phase include telecommunication services and utilities, which generally are more defensive in nature due to fairly persistent demand across all stages of the cycle. Energy sector stocks also have lagged during the early phase, as inflationary pressures—and thus energy prices—tend to be lower during a recovery from recession. Each of these three sectors has failed to outperform the market in every early-cycle phase since 1962. From a performance consistency perspective, consumer discretionary stocks have beaten the broader market in every early-cycle phase since 1962, while industrials also have exhibited impressive cycle hit rates. The financials and information technology sectors both have had healthy average and median relative performance, though their low hit rates are due in part to the diversity of their underlying industries.
As the economy moves beyond its initial stage of recovery and as growth rates moderate, the leadership of interestrate- sensitive sectors typically has tapered. At this point in the cycle, economically sensitive sectors still have performed well, but a shift has often taken place toward some industries that see a peak in demand for their products or services only after the expansion has become more firmly entrenched. Average annual stock market performance has tended to be fairly strong (roughly 15%), though not to the same degree as in the early-cycle phase. In addition, the average mid-cycle phase of the business cycle tends to be significantly longer than any other stage (roughly three-and-a-half years), and this phase is also when most stock market corrections have taken place. For this reason, sector leadership has rotated frequently, resulting in the smallest sector-performance differentiation of any business cycle phase. No sector has outperformed or underperformed the broader market more than three-quarters of the time, and the magnitude of the relative performance has been modest compared with the other three phases.
Information technology has been the best performer of all the sectors during this phase, having certain industries— such as software and hardware—that typically pick up momentum once companies gain more confidence in the stability of an economic recovery and are more willing to make capital expenditures (see chart).
The industrials sector has lacked consistent outperformance, but contains industries that are well suited for a mid-cycle expansion. For example, capital-goods producers tend to benefit from the pickup in demand in an environment of sustained and more predictable economic growth. From an underperformance perspective, the utilities and materials sectors have lagged by the greatest magnitude. Due to the lack of clear sector leadership, the mid-cycle phase is a market environment in which investors may want to consider keeping their sector bets to a minimum while employing other approaches to generate additional active opportunities.
The late-cycle phase has had an average duration of roughly a year and a half, and overall stock market performance has averaged a little over 5% on an annualized basis. As the economic recovery matures, the energy and materials sectors, whose fate is closely tied to the prices of raw materials, previously have done well as inflationary pressures build and the late-cycle economic expansion helps maintain solid demand (see chart).
Elsewhere, as investors begin to glimpse signs of an economic slowdown, defensive-oriented sectors—those in which revenues are tied more to basic needs and are less economically sensitive, particularly health care, but also consumer staples and utilities—generally have performed well. Looking across all three analytical measures, the energy sector has seen the most convincing patterns of outperformance in the late cycle, with high average and median relative performance along with a high cycle hit rate.
Information technology and consumer discretionary stocks have lagged most often, tending to suffer the most during this phase, as inflationary pressures crimp profit margins and investors move away from the most economically sensitive areas.
The recession phase has historically been the shortest, lasting slightly less than a year on average—and the broader market has performed poorly during this phase (roughly –15% average annual return). As economic growth stalls and contracts, sectors that are more economically sensitive fall out of favor, and those that are defensively oriented move to the front of the performance line. These less economically sensitive sectors, including consumer staples, utilities, telecommunication services, and health care, are dominated by industries that produce items such as toothpaste, electricity, phone service, and prescription drugs, which consumers are less likely to cut back on during a recession (see Exhibit 6). These sectors’ profits are likely to be more stable than those in other sectors during a contracting economy. The consumer staples sector has a perfect track record of outperforming the broader market throughout the entire recession phase, while utilities, telecommunications services, and health care are frequent outperformers. High-dividend yields provided by utility and telecom companies also have helped these two sectors hold up relatively well during recessions. On the downside, economically and interest-rate-sensitive sectors— such as industrials, information technology, materials, real estate, and financials—typically have underperformed the broader market during this phase.
The merits of the business cycle approach
The business cycle approach offers considerable potential for taking advantage of relative sector-performance opportunities. As the probability of a shift in phase increases—for instance, from mid-cycle to late-cycle—such a strategy allows investors to adjust their exposure to sectors that have prominent performance patterns in the next phase of the cycle (see chart). Our views on these phase shifts are presented in recurring monthly updates on the business cycle.2 By its very nature, the business cycle focuses on an intermediate time horizon (i.e., cycle phases that rotate on average every few months to few years). This may make it more practical for some investors to execute than shorter-term approaches.
Additional considerations for capturing alpha in sectors
Incorporating analysis and execution at the industry level may provide investors with greater opportunities to generate relative outperformance (“alpha”) in a business cycle approach. Industries within each sector can have significantly different fundamental performance drivers that may be masked by sector-level results, leading to significantly different industry-level price performance (see chart). For example, during the early cycle—the phase with the most differentiated sector performance—the difference between the average relative returns of the best- and worst-performing sectors since 1981 was roughly 25 percentage points, whereas the relative performance differential at the industry level was roughly 75 percentage points.3
relative outperformance (“alpha”) in a business cycle approach. Industries within each sector can have significantly different fundamental performance drivers that may be masked by sector-level results, leading to significantly different industry-level price performance (see chart). For example, during the early cycle—the phase with the most differentiated sector performance—the difference between the average relative returns of the best- and worst-performing sectors since 1981 was roughly 25 percentage points, whereas the relative performance differential at the industry level was roughly 75 percentage points.3
In addition, there are other strategies that can be incorporated to complement the business cycle approach and potentially capture additional alpha in equity sectors. Consider the following:
- Macro-fundamental analysis: Macro-fundamental industry research can identify—independently of typical business cycle patterns—variables specific to the dynamics of each industry that may affect performance. For example, a significant change in the cost of key raw material inputs can drive a deviation in an industry’s performance—such as oil prices for airlines.
- Bottom-up analysis: Company-specific analysis— through individual security selection—can identify unique traits in individual companies that may outweigh the impact of the typical business cycle pattern on that company’s future performance.
- Global business-cycle analysis: The U.S. stock market has global exposure, which may warrant allocating toward or away from domestically focused sectors, depending on the phase of the U.S. business cycle relative to the rest of the world. When the U.S. business cycle is more favorable than the global cycle, sectors with more global exposure are likely to face greater headwinds to revenue growth, while more domestically linked sectors could fare relatively well. When the 11 equity market sectors are ranked by their exposure to foreign revenues, information technology comes out on top and telecommunication services lands at the bottom (see chart).
- Inflation overlay: The inflation backdrop can heavily influence some sectors’ profitability. Short-term inflation trends tend to ebb and flow with the movement of the business cycle, but longer-term inflation trends sometimes move independently of the business cycle. Of particular importance is whether producer prices are rising more quickly than consumer prices, and thus affecting profit margins negatively, or vice versa.
- Secular overlay: Long-term secular trends that are expected to unfold over multiple business cycles can warrant a permanently higher or lower allocation to a given sector than a pure business cycle approach would suggest.
- Tactical and quantitative strategies: Other short-term factors may include sector volatility, price momentum, or the implementation of new tax policies.
Every business cycle is different, and so are the relative performance patterns among equity sectors. However, using a disciplined business cycle approach, it is possible to identify key phases in the economy, and to use those signals in an effort to achieve active returns from sector allocation.
Analyzing relative sector performance
Certain metrics help evaluate the historical performance of each sector relative to the broader equity market (all data are annualized for comparison purposes):
- Full-phase average performance: Calculates the (geometric) average performance of a sector in a particular phase of the business cycle, and subtracts the performance of the broader equity market. This method better captures the impact of compounding and performance that is experienced across full market cycles (i.e., longer holding periods). However, performance outliers carry greater weight and can skew results.
- Median monthly difference: Calculates the difference in the monthly performance of a sector compared with the broader equity market, and then takes the midpoint of those observations. This measure is indifferent to when a return period begins during a phase, which makes it a good measure for investors who may miss significant portions of each business cycle phase. This method mutes the extreme performance differences of outliers, and also underemphasizes the impact of compounding returns.
- Cycle hit rate: Calculates the frequency of a sector’s outperforming the broader equity market over each business cycle phase since 1962. This measure represents the consistency of sector performance relative to the broader market over different cycles, removing the possibility that outsized gains during one period in history influence overall averages. This method suffers somewhat from small sample sizes, with only seven full cycles during the period, but persistent out- or underperformance still can be observed.
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