Cyclical Risk

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.

Understanding Cyclical Risk

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.

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. Some companies are more volatile than others, struggling during an economic slowdown and excelling when a recovery is underway. To reflect the risks associated with their volatile share prices, these firms often trade on lower valuations.

Defensive stock sectors, such as consumer staples focused on food, power, water, and gas, are less vulnerable to economic volatility because their products are deemed to be essential purchases even during a recession. In contrast, discretionary expenses tend to decline during a downturn, impacting, for example, consumer discretionary stocks that specialize in luxury items, leisure, and entertainment.

A few prevalent investing strategies exist to provide 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. These fall under the umbrella of hedging strategies and are actively managed investment strategies that help investors navigate through market cycles, mitigating losses and capturing opportunities for gains.

Types of Cyclical Risk

The economic or business cycle is influenced by a number of factors, including company investment, consumer spending, and banks lending money at affordable rates. To get a better handle on cyclical risks, investors are advised to keep tabs on the following indicators, each of which can help us to identify where we are in the cycle.

Inflation

The incremental price increase of goods and services in an economy is highly cyclical and can pose its own risk to investors, while also causing cyclical risks in the economy. That is why commonly used inflation indexes, such as the Consumer Price Index (CPI) and the Wholesale Price Index (WPI), are closely monitored.

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 (TIPS) 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.

Interest Rates

When inflation surges, central banks seek to encourage people to spend less by hiking interest rates. Eventually, this leads demand to taper off and company revenues and share prices to fall.

Investors regularly focus on the yield curve to determine whether interest rates are likely to rise in the future. Signs that higher borrowing costs are forthcoming often lead cyclical stocks to fall out of favor and defensive, cash-rich firms to soar in popularity.

Capital Expenditure

Companies often become greedy when times are good. Capacity is ramped up and competition intensifies until supply outstrips demand and profits vanish.

Investors can look at capital expenditure (CapEx) to depreciation ratios to identify signs of excessive investment. Capital spending efficiency across entire nations can also be tracked by checking out capacity utilization rates. Historically, a rate of 82% or higher hints that a recession could be forthcoming.