Have you ever wondered why your investments perform well one year and struggle the next? The answer often lies in economic cycles—natural phases of growth and slowdown in the economy. These cycles affect practically everything including share values, real estate, commodities, etc.
Having a good knowledge of these ups and downs is key to making smarter investment decisions. With such knowledge, you can turn economic shifts into opportunities for long-term financial success.
This article discusses the concept of economic cycles and their effect on investments, as well as the practical approach to reorganising your portfolio at every phase.
Understanding the Economic Cycles
An economic cycle, or business cycle, is the natural rise and fall of the economy between growth and slowdown. It is tracked using factors like GDP, interest rates, employment levels, and consumer spending to identify which stage the economy is in.
Knowing the stage of the cycle helps investors and businesses decide the best times to invest or withdraw funds. Each stage affects stocks, bonds, profits, and company earnings differently.
The economic cycle, or business cycle goes through four stages:
● Expansion: During this phase stock, bonds and other securities are likely to yield high returns alongside increased earnings of the corporations.
● Peak: Growth slows, and markets may become overvalued.
● Contraction: Investments may decline in value as profits decrease.
● Trough: The economy stabilises, setting the stage for recovery.
As the cycle repeats, recovery indicators like rising job creation, increasing consumer confidence, and better corporate earnings signal the return to expansion.
Recognizing these phases and their signals helps investors prepare for market changes and make smart decisions.
How to Different Asset Classes React to Market Cycles
Economic cycles impact how different investments perform. Knowing these patterns can help investors make smart decisions and boost their returns. Here’s how major asset types typically behave during different phases of the market:
1. Equity
Investing in stocks requires understanding how different types of stocks react to market cycles. Broadly, stocks can be categorised as cyclical or defensive.
● Cyclical Stocks: These belong to industries like automobiles, banking, and construction, which do well when the economy is growing. However, they tend to drop during downturns as consumer demand slows.
● Defensive Stocks: These include sectors like healthcare, utilities, and FMCG (fast-moving consumer goods).
These stocks are less affected by economic changes because people continue to buy essential goods and services, even in tough times. Knowing when to switch between cyclical and defensive stocks is crucial for better returns. This is where sector rotation strategies come into play. These strategies involve shifting investments to industries that are likely to perform well in the current market phase.
For example, during expansion, focus on cyclical sectors like banking and technology, while during slowdowns, shift to defensive sectors like healthcare and FMCG. The Sensex reflects these trends—rising sharply in growth phases as cyclical stocks gain and fall during recessions, where defensive stocks help limit losses. Therefore, having a good understanding of these patterns helps in strategic portfolio adjustments.
2. Fixed-Income
Fixed-income investments, like bonds, react differently to market cycles depending on their type and the state of the economy. So, if we take government and corporate bonds as an example, they react differently.
So, government bonds are considered low-risk and tend to perform well during economic slowdowns or recessions. This is because investors seek safer options when the stock market is volatile or the economy is uncertain.
During these times, central banks often lower interest rates to boost economic activity, which increases the price of existing bonds and makes them more attractive.
On the other hand, corporate bonds offer higher returns but come with greater risk, as they depend on the financial health of companies. These bonds perform better during expansion phases when businesses are thriving and default risks are low. However, in a downturn, companies may struggle to meet their debt obligations, making corporate bonds riskier.
On top of that, bond yields tend to fall during recessions (as interest rates drop) and rise during periods of growth, affecting both government and corporate bond returns. Therefore, balancing these options based on the economic cycle can help optimise a fixed-income portfolio.
3. Real Estate
Real estate prices in India are closely tied to the economy. During times of growth, when jobs are increasing, incomes are rising, and people are spending more, real estate demand goes up. This leads to higher property prices, especially in major cities like Mumbai, Bengaluru, and Delhi NCR.
Both residential and commercial properties tend to do well during these phases as businesses expand and people look to upgrade their homes.
However, during a recession or slowdown, the opposite happens. Fewer people can afford to buy property, and businesses delay expansion plans. This causes real estate prices to stagnate or even fall.
Cities like Bengaluru, which have strong job markets, may hold up better. Whereas cities with weaker economic activity might see sharper declines.
How to Invest During Different Market Cycles?
Knowing how to adapt your investment strategy in line with the market cycle can increase the efficiency of your portfolio’s advancement.
1. Asset Allocation Shifts
When the economy is booming, it is a good time to invest more in the stock market since companies generally do well and the return is stable. On the contrary, in times of economic recession or uncertainty, it is good to invest in bonds and other fixed-income securities as these are stable and provide reasonable returns.
2. Sector-Specific Strategies
Different sectors perform well in different phases of the economy. During growth, industries like technology, consumer goods, and industrials often do well. In tough times, defensive sectors like healthcare, utilities, and basic consumer products remain strong because people always need these essentials.
3. International Diversification
Different countries experience economic growth and slowdowns at different times. Investing in global markets allows you to take advantage of these differences. When one country's economy struggles, another might be growing, offering better opportunities. Spreading your investments across various countries reduces risk and helps you find growth opportunities even in challenging times.
4. Hedging Techniques
Hedging helps protect your investments during uncertain times. You can consider Gold as it often keeps or grows its value when the economy struggles. These strategies act as a safety net, giving your portfolio extra protection.
5. Regular Portfolio Rebalancing
As the economy changes, it's important to adjust your investments to stay on track. Regularly reviewing and updating your portfolio ensures you have the right mix of assets, like stocks and bonds, to match your financial goals and comfort with risk.
This practice helps keep your investments balanced and responsive to market shifts.
Conclusion
Economic cycles are always changing, but as an investor, you can be prepared. Each stage of the cycle affects investments in a different way. That is why knowing what happens in these stages helps you make better choices. You need to adjust your portfolio often and stay informed. With the right steps, you can keep your investments strong and steady, no matter the economy’s changes.
