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Investment strategy insights

Navigating the business cycle

Chief Investment Office GWM | 15 February 2019 9:16 pm GMT Michael Ryan, CFA, Chief Investment Officer Americas, mike.ryan@; Vinay Pande, Head of Trading Strategies, vinay.pande@; Justin Waring, Investment Strategist Americas, justin.waring@

? As the economy moves into its later stages, and as the market cycles becomes more mature, risk and return characteristics change.

? Short-term selloffs are common in every stage of the market cycle, but volatility characteristics change as each bull market ages.

? Early in a given cycle--as markets are coming out of a recession--investors are willing to overpay for liquidity and protection.

? By mid-cycle, investors are more comfortable in taking risk, and the liquidity and volatility premia become less expensive.

? Investors should be careful not to sell volatility too cheaply during late-cycle environments, since tail risks and spikes in volatility become more threatening to such a strategy.

Market participants were understandably shaken by the sharp spike in volatility experienced during the fourth quarter of 2018 ? especially the steep sell-off in risk assets for the month of December. Not only did global equity markets post one of their worst quarters since the global financial crisis, but December also marked the worst final month of the year for the S&P 500 since the Great Depression (Figure 1). It's therefore not surprisingly that many came to question both the durability of the economic expansion and the sustainability of the current bull market.

Fig. 1: At -9.2%, 2018 saw the worst December for the S&P 500 since 1931 December S&P 500 price returns

But while the flaring of volatility during the last quarter of 2018 was unnerving, it wasn't all that unusual. Bull markets are routinely subject to periodic selloffs and episodic surges in volatility. What made this most recent decline in risk assets so unsettling was not just the severity of the selloff itself, but the fact that it occurred so deep into the business cycle and at such an advanced stage of the bull market.

Source: UBS, Bloomberg, as of 11 February 2019

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document.

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Keep in mind that this expansion is already the second longest in the post war era while the bull market recently eclipsed the 1990-2000 market run as the longest on record (Figure 2), and that the economic expansion is on pace to become the longest in history in the coming months (Figure 3). Fig. 2: The post-financial crisis bull market is the longest since World War II Post-WWII bull market lengths, in total months

Source: UBS, Bloomberg, as of 11 February 2019

Fig. 3: This economic expansion is on pace to be the longest (and slowest) in modern history Cumulative real GDP growth and months of expansion

Source: UBS, Bloomberg, as of 11 February 2019

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Not uncommon

But as unsettling as the recent selloff may have been, this correction also serves a useful purpose by reminding investors that swings in volatility are common. In fact, they often become more frequent as the economy progresses through the later stages of the business cycle.

Fig. 4: The business cycle: Where are we? The cycle compass

In this report, we will build upon the excellent work done recently by our colleagues across CIO on business and investment cycles to provide some context to the recent bout of volatility. What's more, we will offer additional guidance on how best to position portfolios in order to best navigate through this next more challenging stage of the business cycle as volatility remains elevated.

There are countless models that seek to segregate the business cycle into discrete segments. Within CIO, we have developed a framework that segregates the business cycle into four distinct stages (Figure 4): ? 1) Early cycle: recovery; ? 2) Mid cycle: expansion; ? 3) Late cycle: overheating; and ? 4) End of cycle: recession

We evaluate the current cycle dynamics on an ongoing basis in our Bull market monitor. Rather than rehash all of the excellent work done by our colleagues here, we'll instead provide a summary of the principal characteristics of the business cycle model and the key insights with regard to performance across different asset classes.

Economic cycles vs. business cycles

At this point I believe it's important to make a distinction between what we mean by the terms "economic cycles" and "business cycles." The two terms are often used interchangeably, but for our purposes we need to make a distinction between the two in order to better delineate the differences that occur both across and within various cycles.

When we speak in this report of different "economic cycles" we are referring to the distinctions that exist between different historical periods. On the other hand, when we refer to differences in the "business cycle" we mean the distinctions between the stages within a single cycle.

For example, when we want to compare the current cycle to say a cycle that occurred during the 1980s we would make this distinction by referring to the "different economic cycles."

On the other hand, when we want to discuss the shifting dynamics within the current cycle we would do this by referring to the "different stages of the current business cycle." We choose this protocol in order to make it less confusing for the reader when we are discussing the differences within and across cycles.

Source: Bloomberg, Congressional Budget Office, OECD, UBS, as of 11 February 2019.

Note: Approximate total returns on asset classes by business cycle stage, annualized, based on historical observations over the past 30 years and CIO expert assessment.

For further reading: ? Global financial markets: The business

cycle: An investment framework, 19 December 2018 ? Global financial markets: The business cycle: Where are we?, 19 December 2018 ? Investment strategy insights: Bull Market Monitor: Getting later in the cycle, 25 January 2019

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Investment strategy insights

Two key drivers As Figure 5 illustrates, the two key drivers for differentiating between the four stages of the business cycle are economic activity and interest rates. Keep in mind of course, that every economic cycle is different. The overall pace of growth, rate of inflation, policy approach and shifting geopolitical events will all impact the depth, breadth and duration of each phase of the cycle. This means that there is a fairly high degree of variability across different historical periods as well.

That said, the relative growth and rate dynamics across economic cycles tend to follow a relatively consistent and mostly reliable pattern through each stage: ? The early stage of the business cycle (recovery) is typically distin-

guished by a resumption of economic activity and a bottoming out of interest rates;

? Mid-cycle is marked by accelerating growth and a stable-tomoderately rising interest rate environment;

? Late cycle witnesses a leveling off of growth and a peaking of interest rates; and

? End of cycle includes a sharp decline in economic activity and falling interest rates.

Returns diverge... Not surprisingly, investment performance also deviates across the business cycle: ? Equities tend to do relatively well across all of the different

stages of the cycle except recessions;

? Credit (especially high yield) performs best at the early stage of the cycle and deteriorates sequentially as the cycle matures;

? Treasuries fair best during the latter two stages of the business cycle when interest rates peak and then decline sharply; and

? Commodities exhibit some of the broadest dispersion of returns, with the best returns registered during the late stage when the economy is typically running above trend, only to be follow by the worst performance during the end of cycle as the economy contracts and inflation falls.

While much of the focus rightly centers upon how asset class returns diverge across the four stages of the business cycle (Figure 6), consideration must also be given to how volatility itself changes as well. Not surprisingly, volatility is highest when the economy is experiencing the greatest period of flux ? this tends to be during both the earliest and latest stages of the cycle.

...and volatility shifts During the recovery phase asset prices are typically depressed, growth prospects are still modest but accelerating, and monetary policy is often in transition. This is an environment ripe for sharp swings in asset prices. In contrast, as we enter a recession economic activity contracts sharply, risk asset prices begin to de-rate and monetary policy shifts once again.

Fig. 5: Historical study of US business cycles Measures of economic activity and interest rates, normalized against long-term trends, %

Source: Bloomberg, Congressional Budget Office, OECD, UBS, as of December 2018. * US real output gap, as measured by the US Congressional Budget Office. ** Official projection of the US real output gap by the US Congressional Budget Office. *** US Treasury 3-month yield, normalized by subtracting an estimate of US potential nominal growth; US potential nominal GDP growth is approximated using an arithmetic average of the US Treasury 30-year yield and a 12-month-ahead projection of US potential nominal output as estimated by the OECD.

Fig. 6: Average asset class returns by market cycle Annualized total returns, in %

Source: UBS, Bloomberg, as of 11 February 2019

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Investment strategy insights

This also suggests a more volatile backdrop for financial assets. As Figure 7 illustrates, volatility for both equity and credit are indeed highest during recoveries and recessions.

? Note: For large moves equity volatility almost always rises and falls in the opposite direction as equity markets themselves, but there have been notable exceptions. For example, equity volatility rose (from depressed levels) during the strong equity rally of the late 1990s. And volatility fell from very elevated levels in the beginning of 2009, even though the equity market kept declining sharply.

There is one more element of asset class return volatility which must also be understood, and it has to do with the level of *skewness of returns. Skewness is a measure of the "asymmetry" in the return distribution for different asset classes. A normal distribution is perfectly symmetrical with 95% of observations lying within 2 standard deviations on either side of the mean. We know from experience that asset class returns rarely fall within a standard normal distribution, but instead exhibit differences in measures such as skewness (other differences include the level of kurtosis, but we won't explore that topic in this discussion).

Fig. 7: Average volatility by market cycle

Source: UBS, Bloomberg, as of 11 February 2019 Fig. 8: S&P 500 return distribution statistics 3- and 6-month rolling returns (non-annualized)

A distribution that tails to the right would be said have positive skewness, while a distribution with a leftward tail would have negative skewness. As Figure 8 also illustrates, markets tend to exhibit the highest level of skewness during both recoveries and recessions, but the direction of that skewness differs greatly. During recoveries, risk assets' return distributions tend to exhibit a more pronounced right tail or "positive skewness," while during recessions those asset classes' returns tend towards negative skewness and a more pronounced left tail. This distinction will be an important one in terms of how we choose to manage volatility across the business cycle.

Another important concept is the "choppiness" of markets during different environments. Figure 9 displays one interpretation of this concept, looking at violent "whipsaw" movements (swings between greater-than-5% monthly S&P 500 moves). Many of the largest S&P 500 moves (in both directions) occur during recessions or in the early cycle market phase.

However, we also see many tail risk clusters (large back-and-forth moves from month to month) occurring during other parts of the cycle. These tail risk clusters are even more difficult to predict than recessions, and they can be particularly damaging to any strategies with significant "path dependency." Path-dependent strategies are those whose returns depend on the sequence of returns, so that a sharp whipsaw movement can result in losses.

Managing through the cycle

Understanding how both return and volatility measures differ across the different stages of the business cycle is an important first step in effectively positioning portfolios for each transition.

Source: UBS, Bloomberg, as of 11 February 2019

Fig. 9: Markets are choppiest around recessions Greater-than-5% S&P 500 monthly returns, with tail risk clusters* and recessions shaded

*This statistical measure of skewness is not the same as the term "skew" used in implied volatility markets, where it refers to the difference between the implied volatility of out-of-the-money put and call options relative to at-the-moneyoptions.

Source: UBS, Bloomberg, as of 11 February 2019. *Tail risk clusters are events where markets "whipsaw" between a greater-than-5% gain in one month and greater-than-5% loss in the next month (or vice versa)

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