Corporate earnings, interest rates, inflation, and other factors that change as economies expand and contract can affect the performance of investments. Understanding how various types of stocks, bonds, and other assets have historically performed at various points in the business cycle may help investors identify opportunities as well as risks.
Knowing the cycle may also help investors evaluate and adjust their exposure to different types of investments, as the likelihood of a shift from one phase of the cycle to the next increases. This business-cycle investing approach differs from both short- and long-term approaches because shifts from one phase of the business cycle to the next have historically taken place every few months or years on average.
Fidelity's Asset Allocation Research Team believes long-term historical average returns provide reasonable guidance for allocating assets in portfolios. However, over periods of 30 years or less, short-, intermediate-, and long-term factors may cause performance to deviate significantly from those averages, so analyzing factors and trends over shorter time periods can also be an effective approach to asset allocation.
Investment performance is driven by short-, intermediate-, and long-term factors
Understanding business cycle phases
Every business cycle is different, but certain patterns have tended to repeat over time. Changes in the cycle reflect changes in corporate profits, credit availability, inventories of unsold goods, employment, and monetary policy. While unforeseen macroeconomic, political, or environmental events can sometimes disrupt a trend, these key indicators have historically provided a relatively reliable guide to recognizing the phases of the cycle. Bear in mind, though, that the length of each phase has varied widely.
A typical business cycle contains 4 distinct phases.
- Early cycle: Generally, a sharp recovery from recession, as economic indicators such as gross domestic product and industrial production move from negative to positive and growth accelerates. More credit and low interest rates aid profit growth. Business inventories are low, and sales grow significantly.
- Mid-cycle: Typically the longest phase with moderate growth. Economic activity gathers momentum, credit growth is strong, and profitability is healthy as monetary policy turns increasingly neutral.
- Late cycle: Economic activity often reaches its peak, implying that growth remains positive but slowing. Rising inflation and a tight labor market may crimp profits and lead to higher interest rates.
- Recession: Economic activity contracts, profits decline, and credit is scarce for businesses and consumers. Rates and business inventories gradually fall, setting the stage for recovery.
How investments have performed during each phase
Historically, different investments have taken turns delivering the highest returns as the economy has moved from one stage of the cycle to the next.* Due to structural shifts in the economy, technological innovation, regulatory changes, and other factors, no investment has behaved uniformly during every cycle. However, some types of stocks or bonds have consistently outperformed while others have underperformed, and knowing which is which can help investors set realistic expectations for returns. Recently, of course, COVID-19 has had a significant impact on investment performance.
Historically, performance of stocks and bonds has been heavily influenced by the business cycle
Investments in the early cycle
Since 1962, stocks have delivered their highest performance during the early cycle, returning an average of more than 20% per year during this phase, which has lasted roughly one year on average. Stocks have typically benefited more than bonds and cash from the typical early cycle combination of low interest rates, the first signs of economic improvement, and the rebound in corporate earnings. Stocks that typically benefit most from low interest rates—such as those of companies in the consumer discretionary, financials, and real estate industries—have outperformed. Consumer discretionary stocks have beaten the broader market in every early cycle since 1962.
Other industries that typically benefit from increased borrowing—including diversified financials, autos, and household durables—have also been strong early cycle performers. High-yield corporate bonds have also averaged strong annual gains during the early cycle.
Investments in the mid-cycle
As growth moderates, stocks that are sensitive to interest rates and economic activity have historically still performed well, but stocks of companies whose products are only in demand once the expansion has become more firmly entrenched have also delivered strong returns. Annual stock market performance has averaged roughly 14% during the mid-cycle. Bonds and cash have typically posted lower returns than stocks but the difference in returns among the 3 has historically not been as great as during the early cycle.
Information technology stocks have been the best performers during this phase, with semiconductor and hardware stocks typically picking up momentum once companies gain confidence in the recovery and begin to spend capital.
At nearly 3 years on average, the mid-cycle tends to be longer than any other phase and is also when most market corrections have taken place. No single category of investments has outperformed the broader market more than half of the time during the mid-cycle.
Investments in the late cycle
The late cycle has historically lasted an average of a year and a half, with the overall stock market averaging an annualized 5% return. As the recovery matures, inflation and interest rates typically rise, and investors shift away from economically sensitive assets. Higher inflation typically weighs on the performance of longer duration bonds. Energy and utility stocks have done well as inflation rises and demand continues. Cash has also tended to outperform bonds, but investors should be cautious about making changes to their asset allocation in pursuit of opportunities during the late cycle.
Investments in recession
Recession has historically been the shortest phase of the cycle, lasting slightly less than a year on average and stocks have performed poorly with a −15% average annual return. Interest rates typically fall during recessions, providing a tailwind for investment-grade corporate and government bonds, which have outperformed stocks in most recessions. As growth contracts, stocks that are sensitive to the health of the economy lose favor, and defensive ones perform better. These include stocks of companies that produce items such as toothpaste, electricity, and prescription drugs, which consumers are less likely to cut back on during a recession. In a contracting economy, these companies’ profits are likely to be more stable than those of others.
High dividends paid by utility and health care companies have helped their stocks during recessions. Interest-rate-sensitive stocks including those of financial, industrial, information technology, and real estate companies typically have underperformed the broader market during this phase.
While every business cycle is different, an approach to investment analysis that identifies key phases in the economy and looks at how investments have performed in those phases in the past may offer investors guidance as they set expectations for their portfolios.