Optimising Investment Returns Across the Business Cycle

The significant contribution of asset allocation to portfolio performance is a widely recognised principle among investment professionals. The intricate relationship between asset prices and economic conditions necessitates a macroeconomic investment approach to guide investors in optimising asset allocations across the business cycle. Put differently, investors stand to enhance portfolio returns by adjusting the exposure to different asset classes as the economy moves through the business cycle.

Dissecting the Business Cycle: Navigating Through the Phases

Business cycles are recurrent fluctuations in economic growth around the long-term trend. Typically characterised by peaks and throughs, each cycle comprises four distinct phases. To illustrate this framework and its application to active asset allocation, I will briefly outline each phase and how asset prices typically behave throughout the cycle.

Recovery Stage

The early stage of the cycle, often called the recovery stage, occurs when the economy has bottomed out, with growth still below potential but accelerating and moving towards trend. During this phase, policy remains accommodative, inflation is subdued, and corporations experience improved access to credit and start to experience a rapid upturn in business profits. In this environment, risky assets tend to perform well, with equities generally outperforming bonds, and cyclical sectors outperforming defensive stocks. In the bond market, credit spreads typically tighten, leading high-yield (lower-quality) bonds to perform better than high-quality debt.

Expansion Stage

As the recovery gathers momentum, the economy transitions into the expansion stage. Here, economic growth rises above trend, moderates, and eventually peaks. Policy remains accommodative but begins to tighten to counteract overheating risks and emerging inflationary pressures. As economic confidence abounds, risky assets continue to outperform, albeit less decisively when compared to the recovery stage.

Late Cycle Phase

As the expansion matures, the economy enters the next stage known as the late cycle phase. Economic activity slows down post-peak but remains above potential. Typically, consumption activity remains healthy, but businesses apply caution in their hiring practices. In this environment, inflation becomes a significant concern and monetary policy is tightened, restricting the access to credit. Assets that are highly sensitive to interest rate and inflation risks typically underperform, with long-dated bonds and certain cyclical equity sectors bearing the brunt, while defensive stocks and inflation-hedging assets provide better returns. This phase is followed by a recession.


During a recession, economic activity contracts, leading to declining business profits, increased unemployment, and reduced capital spending. In this phase inflation subsides and monetary policy becomes accommodative. Safe-haven assets like high-quality government bonds provide the best returns in recessions, whereas riskier corporate bonds underperform as credit spreads blow out. Equity markets generally struggle, as sectors that are characterised by relative safe income streams such as health care, outperform cyclical stocks.

Applying the Business Cycle Framework in Practice

The business cycle approach to asset allocation can be applied to both multi-asset portfolios and pure play asset class strategies. However, in practice each cycle is unique, and different economies may vary in their position within the cycle at any given time. Moreover, investment returns are optimised when asset allocations are adjusted pre-emptively in anticipation of impending changes in the business cycle.

For instance, a year ago, many investors anticipated an imminent recession in the U.S. based on tight monetary policy and credit conditions, a cooling labour market, high inflation, and soft forward looking economic indicators. However, in hindsight, these expectations proved incorrect, and a tactical strategy of preferring government bonds over equities delivered inferior returns over the course of the year.

Presently, many developed economies, including the U.S., are in the late stage of the cycle. While investors are now expecting central banks to ease policy through interest rate cuts, uncertainties remain regarding the timing and pace of such measures. Again, taking the U.S. as an example, the labour market is still tight by some measures, inflation is not falling as quickly as anticipated, and high frequency data suggests that the economy has stopped decelerating. Despite that the economy is in its late cycle stage, there is little evidence of an imminent recession. At the same time, equity market valuations are elevated, credit spreads are tight by historical standards, and bond yields are close to the highest levels since the global financial crisis. This underscores the complexity of asset allocation decisions.

In conclusion, while stylised facts about investment returns and the business cycle serve as valuable guides, successfully navigating financial markets demands discipline, skill and experience. Asset allocation decisions are seldom straightforward in practice, and a nuanced understanding of macroeconomic dynamics coupled with proactive adjustments to portfolios is imperative in optimising investment performance in a dynamic market environment.

Written by

David Lanzon, CFA

Senior Portfolio Manager, ReAPS Asset Management Ltd

The information contained in this article represents the opinion of the contributor and is solely provided for information purposes. It is not to be interpreted as investment advice, or to be used or considered as an offer, or a solicitation to sell / buy or subscribe for any financial instruments nor to constitute any advice or recommendation with respect to such financial instruments. This article was issued by ReAPS Asset Management Limited, a subsidiary of APS Bank plc. ReAPS Asset Management Limited (C77747) with registered address at APS Centre, Tower Street, Birkirkara BKR 4012 is regulated by the Malta Financial Services Authority as a UCITS Management Company and to carry out Investment Services activities under the Investment Services Act 1994 and is registered as an Investment Manager under the Retirement Pensions Act.

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