Where we are in the economic cycle and perfectly timing that call are two of the key challenges currently facing investors when it comes to portfolio construction, according to Legal and General Investment Management (LGIM). 
“This [question] cuts through Brexit, trade wars and all of those things,” according to Tim Drayson (pictured), head of economics at LGIM. “Getting this call right, it’s actually critical to the performance of asset allocation.”
While a precise answer is difficult to give, said the economist, the data suggests that markets are now in a late-stage environment.
This assumption is based on economic indicators in the US market, which Drayson said while noting “that the US is not the whole world economy” it still has the most steep and sophisticated financial markets, and “typically leads to growth elsewhere”
“So, we find that if you can call the downturn in the US economy then generally you can call the big swings in global asset prices,” said Drayson.
One of the key indicators suggesting the late-cycle stage, concerns the health of the US corporate sector and corporate profit margins in particular.
The recent squeeze on earnings, which Drayson said could be due to the US/China trade war, it has forced many companies to cut back on investments and hiring, which could potential lead to “crack” in the labour market.
With the stage of the cycle identified, what should multi-asset managers be doing with their portfolios?
Christopher Jeffrey, fixed income strategist at LGIM, said that it – confusingly –does and doesn’t matter that we’re in a late cycle environment.
“From an investment perspective what we care about is does this have any kind of predictable and repeatable impact on asset prices,” he explained.
Looking back at previous economic cycles, typically when it gets to the late cycle stage “things get a bit choppier,” according to Jeffrey, but that doesn’t mean that you should move away from equities entirely.
“It’s not the case that you should throw out the equity baby with the life cycle bathwater,” he said.
According to Jeffrey, there is no market evidence, historically, that as markets have approached the late point that the global economy downturns and asset returns peter out.
Despite major headwinds to growth such as the US/China trade war and the impact of an impeachment inquiry on Donald Trump’s presidency and re-election, equity markets remain at all-time highs, said Jeffrey.
“That is not historically abnormal during these kinds of environments,” the strategist said. “What is historically abnormal, is what we’ve seen in the fixed income market.
“If we were playing a game of Cluedo and were asking who was responsible for killing of the economic expansion and the asset cycle the typical culprits in the library with the lead pipe would be the Federal Reserve raising rates in response to inflationary pressure, choking off real income growers, and putting up debt servicing ratios.
“The impact has been pretty pathetic returns on fixed income assets.”
As such, what they need to call correctly at the moment, said the strategist, is the equity risk premium and the volatility associated with that. 
During periods of expansion the equity risk premium can be up to 10 per cent, and in a contraction, it can go down to -15 per cent.
“Getting that pivot right, is crucial,” Jeffrey said. “The kind of implications of this has when thinking about where you allocate assets.
“We’re under the impression that this late-cycle environment will continue and [we’ll] see growth assets do well. But as we progress, the risk of this tipping point is growing week-by-week, quarter-by-quarter, year-by-year.”
Looking for those opportunities and compiling this late-cycle analysis Justin Onuekwusi, LGIM’s head of retail multi-asset funds, and currency strategist Willem Klijnstra have paid close attention to the volatility impact, particularly in the US market.
“Late-cycle doesn’t necessarily mean greater volatility,” Onuekwusi (pictured) said. “But given the recent low volatility and benign environment between 2009 and 2017, you could argue that the normalisation of volatility is going to feel like an increase in volatility. And that’s typically what our clients are saying.”
On the retail side of multi-asset management, Onuekwusi said they have seen a lot of clients moving towards US index funds who are using them as “building blocks to try and be more cost-effective”.
However, they could be unknowingly opening themselves to much higher levels of risk.
Top-10 constituents of the MSCI USA index (as of 30 August 2019)
Source: MSCI
Looking at the MSCI USA index, the sum of the top five stocks – Microsoft, Apple, Amazon, Alphabet, and Facebook – have a greater than the total market capitalisation than the London Stock Exchange, which suggests a lot of stock concentration in the US.
“If you look at the top 100 stocks in the US, five stocks drove 90 per cent of that total return,” Onuekwusi said. “And then the downside in Q4, those same five stocks drove 25 per cent of the losses.
“And you may say ‘well, 95 per cent upside and 25 per cent downside, that’s a pretty good payoff,’ but that’s not really the point,” he argued. “The point is that a lot of clients don’t understand this stock concentration risk they’re taking on.”
As such, strategist Klijnstra said that they tend to look elsewhere for diversification.
“When we think about protecting our portfolios against a spike in volatility, we don’t look at the US – we look at Europe,” he said. “That’s where we go low on volatility. And this is an example of a trade that we think makes sense when you are entering at the late cycle."