Why MF investor needs to study different economic cycles

Mehrab IraniTata Investment Corporation

Risks and returns are two sides of the investment coin. During boom period, investors just look at return forgetting that there is risk also while during recession, investors are so worried about risk that they forget that investments will give returns also. Just now I want to bring out one more aspect of investing. I have seen different experts arguing that during bear market we have to invest in the so perceived defensive sectors like say FMCG, pharmaceuticals etc. I have seen that if a Fund Manager looses 5% while the market looses 10% than no doubt that particular Fund manager has done an excellent job but does it serve the purpose of the investor. I believe, the investor is putting in his / her money for getting positive returns and not for getting lesser negative returns! There are different broad asset classes (without going into their individual subsets or sectors) like equities, fixed income (bonds), commodities, real estate and ofcourse cash. Different asset classes perform in a different manner during different phases of the economic cycle. As a general rule, first interest rates come down (bond prices go up), then equities enter a bull market and finally commodities blossom. There are some periods in the interim when none perform well and at that point of time we have to look at cash for “preserving our capital”. There are also periods when all or some of the asset classes move in the same positive or negative direction.

For example, in India the credit risk free 10-year Government of India (GSec) bond had given a return of around 36% between July 2008 to Jan 2009 while during the same period the equity markets as represented by the BSE Sensex have fallen by around 32%. Hence, while one has given positive 36% return the other one has given negative 32% return and thus eroding the capital. Let us take the example of another cycle. Between the years 2000 to 2003, equity markets as represented by the BSE Sensex fell by a massive 53% or eroding more than half of the capital while bonds as represented by the 10-year benchmark bond gave absolute return of more than 30% (coupon interest was extra for all the years which when added will give total return of more than 50%). Even if we study the US Dow Jones Industrial Average (DJIA) for the past 117 years from its inception in 1896, it has given mediocre or negative returns for extended period of times ranging from 10 to 30 years which might be a full investment cycle for an individual. For example, the DJIA in the period of 36 years from its inception i.e. 1896 to 1932 gave no returns (except dividends), it started at 41 in 1896 and was back at 41 at the bottom of the great depression in 1932. A period of 36 years might be the full life cycle for an individual who might have earned nothing (except dividends) if he / she would have just bought at 1896 and sold at 1932! I am not saying which one is good or bad and over the long term equities outperform debt etc (very long term investment in any asset class is a farce put forward by the brokers and investment advisors to “fool” common people to commit money) but just stating that different asset classes perform differently during different time periods.

Let us now study the economic or business cycle to drive home this point. Around the equilibrium line, the economic cycle moves from extreme contraction to over expansion. This is the same way in which an equity market moves from extreme under valuation to over valuation. The economy and equities markets are all like pendulum – they swing from one extreme to another. That point justifies why different commodities like steel, cement etc also move in cycles. That also explains why even agricultural commodities like say sugar move in cycles (although the sugar demand might just vary marginally and not in big cycles).

Study of economic cycles is of paramount importance to a mutual fund investor as it would allow him to gauge as to which is the best mutual fund category to invest his / her hard earned money into. Therefore, let us now venture into studying the different economic cycles so as to understand how different asset classes perform at different points of time and understand which should be the preferred mutual fund category to invest in each phase of the economic cycle. The preferred mutual fund category is mentioned in bracket.

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Mehrab Irani

GM|Tata Investment Corporation

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Interest rates peak and Bond prices bottom (Medium Term Gilt Funds): An economic cycle begins as bond prices bottom out and conversely interest rates peak. This generally occurs after the economy has entered an over heated or high growth phase. The preferred asset class at this stage should be GSecs and hence the investor would get superior risk return in a medium term Gilt Fund which would add duration to his coupon.

Demand for credit declines (Long Term Gilt Funds): The prevailing recessionary conditions reduces the demand for credit, as businesses and consumers retrench. Companies find themselves in some kind of cash squeeze at this stage of the cycle. Sales start dipping sharply, inventories pile up, companies respond by cutting production and not ordering further since they are stuck with inventory. A cash-flow deficit results because of falling / dwindling sales which results in short term borrowings at high costs. This is one reason why interest rates witness a parabolic rise at the end of the cycle. This is like a forced corporate borrowing and that is the reason interest rates generally peak with such kind of a spike. The investor would be best positioned in a long term Gilt Fund which would offer him higher risk adjusted return in a steep and elevated yield curve scenario.

Central Bank comes into action (Long Term Gilt Funds / Income Funds/ Short Term Plans): The Central Bank then increases money supply, cuts interest rates as well as frames new easy rules for borrowing and lending. This results in lower interest rates at the shorter end and a steeper yield curve. If the market feels that inflation will return soon than the yield curve will remain steep and investors will forego higher but risky long term yields in favour of lesser but safer short-term yields. This period is all about the expectations of the recovery and inflation. The spread (difference between equivalent credit risk free GSecs and Bonds) is generally high at this point of time. In light of the above, it would be prudent to keep money in long term gilt funds and also start allocating money to Income funds as well as short term plans. The overall southward movement in the yield curve will benefit both Gilt and Income funds while the steepness of the yield curve at the shorter end would help short term plans.

Equities Bottom Out (Equities): Once interest rates have peaked (bond prices bottomed out) its only a matter of time before equities will bottom i.e. end of the bear market and not necessarily beginning of a new bull market because that may be some time away. Once the market believes that interest rates have indeed topped out then stocks will be accumulated in anticipation of a recovery. During recession companies are generally more aggressive in cutting costs and lowering their break even levels. Therefore the recovery in equities is much greater and the initial rally from lows might be very explosive. One clue of whether the initial recovery rally will be above or below average might be the time lag between the low in bond yields and the recovery in stocks. Generally speaking, the longer the lag, the greater is the implied severity and duration of the recession. For example, in the US, in 1877, the lag was 4 years and it was followed by doubling of stock prices. In 1920 and 1982, the bottom in bonds and stocks was separated by about one year, and both the periods were associated by longer than average bull market in equities. The 1920 period was followed by the “roaring twenties” which led to the great depression in 1929 while the 1982 (kindly note that this year marked the end of the near 50 years long “primary” bear market in US bonds during which period long term US Treasuries had moved up from 2.03% in April 1946 to 15.1% in October 1981) the bull market lasted almost 18 years upto 2000. One thing we have to remember is that the spreads between GSecs and corporates have to narrow i.e. the borrowing costs for businesses have to come down to lay down the roots of a new bull market in equities; just reduction in GSecs is not enough although that is the beginning.

Equities would be the best asset class during this market phase. Initially start allocation to index and large cap equity funds, then as the bull market progresses and more investor confidence ascends then put your money in diversified funds and when the bull market is in full flow spice up your investments with mid cap / sector / theme based funds.

Commodities bottom out (Cyclical and Commodity Stocks / Commodities): Now bonds have risen and stocks are rising in the economic cycle but commodities, particularly industrial commodities, might still be in a bear market. Mostly, the price low occurs during the terminal phase of the recession, but even so, commodities usually remain in wide trading range and only embark on a sustainable advance once the recovery is underway. The final peak in commodity prices develops under a cloud of speculative froth as both individuals and companies try to cash in on the boom. That lays down the roots of the next economic downturn, increase in interest rates and so forth. We can turn our clock back to the year 2007 and see how different commodity prices were rising and how companies were announcing expansion plans in various sectors including cement, steel, construction, real estate, land values etc. The roots of the current economic recession were getting laid down perhaps at that point of time. An investor should continue with the equity fund investments and along with it ought now add commodity based funds also to the portfolio for maximizing returns.

Conclusion: To conclude, it’s wise as an investor to position in the right asset class so as to make the maximum of the economic cycle – remember when one asset class is in a bear market most probably there is some other asset class which is in a bull market. Hence, we don’t have to be obsessed with a single asset class and try to always stay with it even when that particular asset class is in a bear market in order to make “lower losses”. Look around yourself, there will be a separate asset class which might be in a bull market and shift your funds to that until your preferred asset class enters its bull market. Position yourself in the fund which is best suited to capture this emerging opportunity.