The Tellsons investment team aims to look across many years to generate stable returns from the combination of both bond and equity investments. The horizon we find useful is sometimes referred to as ‘the business cycle’ or economic cycle. Over the past century, modern economists have observed many different kinds of cycle in economic activity. Economic activity itself is characterised or measured in a variety of ways such as fluctuating investment and debt levels, employment and wage growth or consumption and inflation.
One of the main features of all these cycles is how hard they are to predict and measure – the economists are joined by sociologists and statisticians to study the patterns of data and there is little agreement between them. What is clear, however, is that periods of economic expansion are inevitably followed by periods when the rate of growth declines or even, for short periods, actually contracts, creating a recession.
Consider this chart of the UK’s real GDP from the Office for National Statistics. One full business cycle includes an expansion and contraction period. It starts at a trough (red point), goes through a period of expansion that ends at a peak (green point) and finishes with a period of slow-down or worse, a recession, at the next trough.
In theory, the business cycle is supposed to start with a shorter cycle of working capital and inventory accumulation; production then increases as capital investment in plant, machinery, product launches, factories and new offices comes on line, anticipating demand growth, driving employment and wage growth, fuelling consumption and driving higher corporate profits. Sooner or later inflation sets in, with rising interest rates required to slow demand and the corresponding declines in production growth, employment and wages, back towards the end of the cycle.
It is worth noting from the chart above that periods when decelerating growth actually dip into a contraction or actual negative growth – two quarters in succession technically defining a recession – are relatively few and short-lived.
These cycles seem, on average, to have taken around five years. When they move suddenly from peak to trough, commentators have tended to refer to them as cycles of ‘boom and bust’, with inflation destroying wealth, high interest rates destroying profits, squeezing businesses and household mortgages, constraining further borrowing and suppressing consumption.
At Tellsons, we look for bond and equity investments where we are likely to generate the best returns given the uncertainties about a company and the stage of the business cycle that we believe we are in. During the expansionary phase of the business cycle, the equity growth potential and dividend expectations will make the equity seem more attractive versus the bond. At the mature stage of the business cycle, when interest rates and yields are likely to have risen, we will be more likely to find bonds relatively more attractive as the company’s profitability may be declining at this point and returns from equities seem less compelling.
The shifting appetite investors have for equity risks and returns across these cycles is well illustrated by the chart below: it is the same as the previous chart but this time shown alongside the returns from the UK stock market:
Equity investors are rewarded with spectacular 20-50% type returns when the business cycle is expanding in its relatively narrow range of +2 to 6% but can experience losses of a similar magnitude as economic growth slows. Many investors find this second phase too painful to live with, sell their equity investments, realise significant losses and miss the rewards of the expansionary phase of the next cycle that invariably follows.
Tellsons believe the mix of lower but more predictable bond returns and higher but less predictable equity returns are a flexible, potentially more stable way of generating long-term returns and yet still ward off the debilitating effects of inflation. There are good and bad periods for investment returns in every business cycle but at Tellsons we believe that to stay the course across the whole journey is key to the long-term care and maintenance of wealth.
With thanks to Arthur F. Burns and Wesley C. Mitchell “Measuring Business Cycles,” National Bureau of Economic Research, U.S.A., 1946.