Editorial

Managing the late cycle

A series of disappointing economic data over the last couple of weeks, in particular from the euro area, has sparked recession concerns. While for financial markets the worst seems over, with equity markets having pared the December losses during January and February, we are interested in which stage of the economic cycle we are currently in – and what this means for the economy. In a nutshell, we find that the US economy has entered the late stage of the economic cycle – not because of the age of the cycle, but because of recent developments in economic figures. The euro area also shares many features of a late-cycle economy. We suggest three ways to benefit from typical late-cycle behaviour: first, slowly add to volatility long positions; second, exploit rising cross-asset return correlations by preferring equities and sovereigns over credit; and third, prefer defensive sectors over cyclicals.

What is 'late cycle'?

The classical business cycle model sees economic output oscillating around a growth trend. Hence, actual growth moves from a trough into an expansion to finally peak and then enter a period of contracting growth ending in a trough – and the whole thing starts all over again. We need only look to the US to see that periods of expansion are significantly longer than periods of contraction. Therefore, an alternative description of the business cycle is used among practitioners delineating expansion into three distinct periods – early cycle, mid cycle, and late cycle. The period of contracting growth is usually called recession. The shift from mid to late cycle becomes visible via:

  • Growth moderating following a peak in growth during the mid cycle

  • Tightening credit growth 

  • Increasing pressure on earnings 

  • A monetary policy which is becoming contractionary/restrictive

  • Growing inventories while sales growth declines 

  • Rising inflationary pressure the later the late cycle


Clearly, in reality none of these indicators behave according to textbook. Rather, there are intermittent periods where growth moderates, inventories build and credit conditions tighten. In particular, during the current cycle we observed a period of tightening credit and peaking growth in the US when the strong decline in oil prices triggered a recession in the oil sector. Back then, monetary policy was still highly accommodative, which has changed today. In conclusion, this means:

  • While growth was still strong in 2018, current data suggest that this might have been the peak. Quarterly growth rates have been declining following a strong second quarter. This points to a growth moderation in the US in 2019 (Chart 1)

  • Credit conditions have started to tighten recently (Chart 1)

  • Earnings estimates have recently been revised lower (Chart 2)

  • Monetary policy is neutral to restrictive when comparing the natural rate of interest in the US (based on the Laubach-Williams estimate) with the real Fed funds rate (Fed funds effective rate less Personal Consumption Expenditure (PCE) core inflation year-over-year; Chart 3)

  • Inventories are on the rise both for wholesale and retail, while retail sales growth has recently slumped (Chart 4)

  • Inflationary pressure indeed is not evident for the overall economy – the US core Consumer Price Index (CPI) recently dropped from 2.4% mid-2018 to 2.2% in January. Recent increases in average hourly earnings and in producer prices could potentially lead to higher prices in the future. Nevertheless, strong inflationary pressure would signal that the economy is reaching the late stage of the late-cycle period

Chart 1: Real GDP growth could have peaked, while credit conditions are tightening
Chart 1: Real GDP growth could have peaked, while credit conditions are tightening
Source: Bloomberg, Federal Reserve's Senior Loan Officer Survey (SLOS)
Chart 2: Earnings estimates are increasingly downgraded for the S&P 500
Chart 2: Earnings estimates are increasingly downgraded for the S&P 500
Source: Bloomberg, Commerzbank Research
Chart 3: Monetary policy has turned from expansionary to at least neutral over the past months
Chart 3: Monetary policy has turned from expansionary to at least neutral over the past months
Source: Bloomberg, Commerzbank Research
Chart 4: US retail sales growth has recently collapsed while inventories are rising quite strongly for both retail and wholesale
Chart 4: US retail sales growth has recently collapsed while inventories are rising quite strongly for both retail and wholesale
Source: Bloomberg, Commerzbank Research

Bottom line: evidence is strong enough to suggest the US economy has entered the late cycle. But what about other important regions like the euro area? Monetary policy is still fairly accommodative, when looking at the difference between the natural rate of interest and the real European Central Bank’s rate. However, earnings seem to have peaked, GDP is also on a downward trajectory with year-over-year growth rates having reached their highs in mid-2017. Loans to non-financial corporates are also growing at a much slower pace than in mid-2018. And finally, retail sales are declining and inventories are growing (Chart 5). This means: bar a very expansionary monetary policy, the euro area currently shares the features of a late-cycle economy.

Chart 5: For the euro area, the high degree of monetary accommodation does not fit the picture of the economy being in late cycle
Chart 5: For the euro area, the high degree of monetary accommodation does not fit the picture of the economy being in late cycle
Source: Bloomberg, Commerzbank Research
The extraordinary tool: Slowly increasing exposure to long volatility


As the economic cycle matures, volatility tends to pick up. One reason for this is a more restrictive monetary policy – riskier investments suddenly need to compete with higher coupons on fixed-income instruments. Investors may even start to demand a higher risk premium on top of that. This generally increases uncertainty. An additional factor during this cycle is the liquidity flood provided by central banks. This has reduced competition for capital across the asset classes. However, the period of easy money seems over; markets have balanced the liquidity flood. For as long as we are not seeing additional liquidity supply, any change to this vulnerable steady state is likely to see volatility rise – if history is any guidance, we have only seen the beginning of the late-cycle pick-up in volatility. This suggests that adding a small volatility long position to the portfolio makes sense if the volatility futures curve is flattish.

The multi-asset way: Prefer equities and bonds over credit

Another feature of the late cycle is an increasing return differentiation between the different asset classes. Chart 6 shows that we have been seeing a rise in the cross-asset return differentiation since early 2018. This implies that major market themes are gradually taking over as a driver of asset-class performance again, resulting in a more pronounced return differentiation across the asset classes. This increases the importance of asset allocation again. A very simplistic approach to optimise a multi-asset portfolio in the late cycle is to replace investment grade credit by a mixture of equities and bonds – during the late cycle, equities still tend to perform, while the rate hike cycle is gradually coming to an end, meaning that there is less of a burden from rising rates. At the same time, credit investors usually start to demand a higher compensation for the risk of a looming downturn of the economy, resulting in slowly but steadily rising spreads.

Chart 6: As the cycle matures, return differentiation increases again across the asset classes
Chart 6: As the cycle matures, return differentiation increases again across the asset classes
Source: Bloomberg, Commerzbank Research
The classic: Replace cyclicals with defensives

Chart 7 shows the performance of a basket of cyclical sectors (materials, industrials, consumer discretionary) versus defensive sectors (healthcare, telecommunications, utilities) both in the credit and the equity space over the past two decades. For equities in particular we observe an underperformance of cyclical versus defensive sectors as the cycle matures. It hence makes sense to add to more defensive sectors in a late-cycle environment.

Chart 7: Defensives tend to outperform cyclicals as the cycle matures
Chart 7: Defensives tend to outperform cyclicals as the cycle matures
Source: Bloomberg, Markit, Commerzbank Research

Last word

It is possible to benefit from an economy entering the late stage of the cycle – the list of options given here is not meant to be exhaustive. The message is clear: one needs to manage risks and benefits more closely. Just reducing risk could cost a decent share of performance as equity markets tend to perform well during the early late-cycle stages. If removing risk from equities means adding to credit, this could even be very costly as credit tends to underperform in the early late cycle. It is only about a year before the economy enters a recession that the performance of equity markets becomes more muted before collapsing. In our view, it seems prudent to enter the late cycle with a preference for defensive equities and sovereign bonds over credit.