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Understanding Risk Cycles

. Understanding how business and risk cycles interact can play a valuable role in setting appropriate asset allocation for multi-asset portfolios, says Nick Samouilhan, multi-asset manager at Aviva Investors

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Many people are familiar with the business cycle – the evolving behaviour of the economy over time between recession, recovery, trend growth, overheating/booms and then recession. These cycles vary in length, usually lasting anywhere from a few years to a decade. Their turning points are also unpredictable, although not their process. A recession, for example, is always followed by recovery; it's just the timing that is unknown.  

In investing, the business cycle finds its counter in the ‘risk cycle’, the fluctuating evolution of markets over time. This is where equities and other risk assets go through up and down cycles just like economic growth. The typical cycle would be: market sell-off, undervaluation, recovery, overvaluation and market sell-off again.

Linked Cycles

While both the above cycles are related, the risk cycle is not directly (or at least wholly) dependent on the business cycle. Valuations, for instance, also matter. When related to the business cycle, risk cycles tend to lead the business cycle rather than follow or be simultaneous with it. This is due to either markets pricing in economic expectations (such as market falls leading into recessions) or acting as the cause of the recovery and/or recession. For example, large falls in equity market valuations leading consumers to cut spending, causing recession.

The other main relationship occurs through business and risk cycles being unpredictable in timing, but not in general process. Just as recessions follow booms, so large losses on risk assets always follow excessive valuations when markets enter ‘bubble’ territory, it is just the timing that is unpredictable.

Asset Allocation Implications

For investing, understanding and appreciating the risk cycle assists asset-allocation decisions. For instance, even a broad understanding of where you are in the risk cycle helps decide whether to add, keep or decrease your allocations to risk assets.

This point is often forgotten when making investment decisions based on some historical measure of value, such as long-term credit spreads or price/earnings multiples. Markets are not stock environments, they are flow environments. This means momentum matters. Just like an economy tends to go from trend growth to recession, market valuations can go well into bubble territory before correcting. Getting out of the market too early ahead of a correction, means you miss some of the returns on offer.

Conclusion

The key is to understand where the risk cycle is going. Even if risk assets are at their long-term average valuations, they can still go much further if you are still in the appropriate part of the risk cycle. Our view to this is to understand where, given the risk cycle, these valuations could ultimately go and then fade out of the investment as the asset class approaches this optimal level.

Finally, remember that just like business cycles, all risk cycles are different in timing and nature. Today's exceptionally low cash returns and government bond valuations, for example, mean valuing equities on the basis of long-term averages could flag the need to exit the asset class too early.

 

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