How Asset Classes Perform During the Business Cycle
Using historical data, we determine what phase of the business cycle, or macro regime, we’re in based on the most recent level and change in our leading indicator, relying only on information that’s available at the time.
Historical analysis of the last 45 years shows that asset returns vary significantly between regimes, with major implications for asset allocation decisions. Here’s a summary of our findings.
Risky assets perform remarkably well and investors are compensated for taking on additional risk in this macro regime. Both equities and credit outperform government bonds. High yield credit outperforms investment grade and delivers the best total returns as an asset class, often outperforming equities. Government bonds provide attractive returns over cash, since inflation is still falling and monetary policy is in its final easing stage.
Equities are the best-performing asset class in this phase, often benefitting from the sustained acceleration in economic momentum that translates into rapid earnings growth and an expansion in profit margins. Credit markets are now mainly an income proposition. High yield still outperforms investment grade, while due to rising inflation and tightening monetary policy, government bonds are the worst-performing asset class.
This phase is the most uncertain for asset allocation decisions. Equity, credit and government bond markets all deliver similar performance that’s broadly in line with cash yields, which at this stage have risen due to cumulative policy tightening. Once volatility is factored in, this macro regime offers unattractive risk-adjust returns, which points to a neutral asset allocation stance.
Government bonds are the best-performing asset class, supported by severe risk aversion, falling inflation and aggressive monetary policy easing. In this environment, the most appropriate asset allocation strategy is to reduce risk by underweighting exposures to equities and credit, and overweighting high quality government bonds.
It is also important to note that while our macro regimes framework is a very significant and powerful input to our investment process, we do not rely on it on a standalone basis. We combine macro analysis with market indicators to assess valuation and momentum, and use risk measures to assess volatility and the credit cycle.
To learn more, download our full paper on dynamic asset allocation.
*Sources: OppenheimerFunds’ proprietary research of the U.S. Business Cycle Leading Indicator, 12/31/14. Bloomberg. Annualized monthly returns of the defined risk premia from January 1970 — December 2013. Risk Premia are defined as follows: U.S. Equity Premium = MSCI U.S. Total Return Index — U.S. Treasuries 10-YR. High Yield Premium = U.S. High Yield — U.S. Investment Grade Credit. Credit Premium = U.S. Investment Grade — U.S. Treasuries. Duration Premium = U.S. Treasuries 10-YR — U.S. T-bills 3-Month. See definitions page for index definitions. Past performance does not guarantee future results.
The S&P 500 Index is a market capitalization weighted index of the 500 largest domestic U.S. stocks.
The Bloomberg Barclays Aggregate Bond Index is an index of U.S. Government and corporate bonds that includes reinvestment of dividends.
The Bloomberg Barclays U.S. Aggregate Credit Index includes both corporate and non-corporate sectors. The corporate sectors are Industrial, Utility and Finance, which include both U.S. and non-U.S. corporations. The non-corporate sectors are Sovereign, Supranational, Foreign Agency and Foreign Local Government. The index is calculated monthly on a price-only and total-return basis. All returns are market value-weighted inclusive of accrued interest.
The Bloomberg Barclays Pan-European High-Yield (Euro) Index measures the market of non-investment-grade, fixed rate corporate bonds denominated in Euro.
The Bloomberg Barclays Euro Corporate Bond Index is a broad-based benchmark that measures the investment-grade, euro-denominated, fixed rate corporate bond market.
Credit Suisse U.S. High Yield Index tracks the performance of domestic non-investment-grade corporate bonds.
Citigroup 3-Month Treasury Bill Index is an unmanaged index that tracks short-term U.S. Government debt instruments.
Citigroup 10-Year Treasury Benchmark On-the-Run Index is an unmanaged index that tracks the performance of on-the-run U.S. Government debt instruments with approximately 10 years to maturity.
The MSCI Total Return Index measure the price performance of markets with the income from constituent dividend payments.
The MSCI Europe Index is a free-float weighted equity index designed to measure the equity market performance of the developed markets in Europe.
U.S. Duration Premium: U.S. Treasuries 10-Yr — U.S. T-Bills 3-Month. For the 10-Yr Treasuries, Citigroup 10-Year Treasury Benchmark On-the-Run Total Return Index is used from 1980 onward. Prior to 1980, history is backfilled with estimated total returns using 10-Yr yields from Bloomberg between 1970 and 1980.
U.S. High Yield Premium: U.S. High Yield — U.S. Investment Grade Credit, using the Credit Suisse U.S. High Yield Index and the Bloomberg Barclays U.S. Aggregate Credit Index.
U.S. Credit Premium: U.S. Investment Grade — U.S. Treasuries, using the Bloomberg Barclays U.S. Aggregate Credit Excess Return Index from 1988 onward. Prior to 1988, we backfill the excess returns using the Bloomberg Barclays U.S. Aggregate Credit Total Return Index minus estimated duration-equivalent U.S. Treasury total returns.
U.S. Equity Premium: MSCI Total Return Index — U.S. Treasuries 10-Yr.
The indices are unmanaged and cannot be purchased directly by investors.