What is Cyclical Risk
Cyclical risk is the risk of business cycles or other economic cycles adversely affecting the returns of an investment, an asset class or an individual company's profits. Cyclical risks exist because the broad economy has been shown to move in cycles — periods of peak performance followed by a downturn, then a trough of low activity. Between the peak and trough of a business or economic cycle, investments may fall in value, reflecting lower profits and the uncertainty surrounding future returns.
BREAKING DOWN Cyclical Risk
Cyclical risk does not typically have a tangible measure, but instead is reflected in the prices or valuations of assets that are deemed to have higher or lower cyclical risks than the market. Inflation is also a factor that can influence market cycles and present its own cyclical risks.
Inflation represents the incremental price increase of goods and services in an economy. It can be influenced by many factors. It is closely followed and monitored through policy interventions by the Federal Reserve. Inflation tends to be higher in expanding economies and lower in slowing economies. In the U.S., annual inflation typically ranges from 0% to 2%.
Inflation is highly cyclical and can pose its own risk to investors while also causing cyclical risks in the economy. To manage inflation risks, investors typically turn to inflation trades that provide protection and possible upside potential in times of rising prices. Treasury inflation protected securities are a popular inflation trade that can protect investors. High growth sectors of the economy are also leading areas of investment when inflation is rising.
Cyclical Risk Factors
Generally cyclical risks are systemic risks that broadly affect market economies. The 2008 financial crisis caused the beginning of a recessionary cycle that affected numerous areas of the market, specifically financial services. Innovations in technology and new political agendas are other factors that can influence economic market cycles. Gross domestic product and corporate earnings growth are two metrics that typically provide indications for market cycles.
Individual businesses and sectors can also experience market cycles caused by idiosyncratic risks. Idiosyncratic factors can cause recessions, troughs and expansions for companies and specific areas of the market.
Investment Sectors and Rotation Strategies
A few prevalent investing strategies exist to provide for risk mitigation and return opportunities during various market cycles. Macro hedging and sector rotation are two strategies investors can use to manage and profit from cyclical risks.
Generally certain sectors of the market are more prone to cyclical risks than others. Defensive stock sectors will see less correlation with economic volatility. These sectors can include consumer staples stocks focused on food, power, water and gas. Inversely, cyclical stocks generally benefit from a growing economy. These sectors can include consumer discretionary stocks focused on luxury items, entertainment and leisure. Certain sectors such as technology may also be the driving force behind an economic expansion.
Since stocks and sectors are affected differently through different economic cycles, they provide opportunities for sector rotation and macro hedging. Sector rotation and macro hedging strategies are actively managed investment strategies that help investors navigate through market cycles, mitigating losses and capturing opportunities for gains.