With the recent inversion of the U.S. two-year and 10-year treasury yield curve (shown in the chart below), concern has grown over an impending recession.
Central banks are tightening liquidity amidst slowing economies while inflation erodes real incomes and purchasing power. The Russia-Ukraine conflict and Covid lockdowns in China have exacerbated the situation.
A recession in the next year to two should not be a surprise. But recessions need not be feared. Investors can safeguard their portfolios during such times in several ways, and a recessionary bear market often provides the best buying opportunities.
What is a recession and how to identify it?
The technical definition of a recession is when real GDP declines for two consecutive quarters.
However, the National Bureau of Economic Research, an American private nonprofit research organization, does not necessarily wait for quarterly declines in GDP to declare a recession, but relies on more frequent monthly data.
According to the Bureau, more than 30 recessions have occurred in the U.S. since 1854. The most serious ones were the 1929 Great Depression, the 2008 Global Financial Crisis, and the 2020 Covid-19 recession.
Recessions cannot be predicted, but economists follow leading indicators such as industrial production, unemployment, real income and wholesale retail trade.
Industrial production is an important indicator of the strength of an economy. The health of industrial production in one country is assessed by comparing trade deficits with other countries.
Real disposable income (adjusted for inflation and social security measures) is another significant indicator, particularly in consumer-oriented economies such as the U.S. and Japan.
The inversion of the U.S. Treasury yield curve is another leading indicator of a recession. This occurs when short-term yields are below longer-term yields. The last seven recessions in the U.S. occurred within 18 months of a yield curve inversion. But not all yield curve inversions were followed by a recession. Asset prices and risk sentiments are other meaningful indicators.
Where are we today?
At the beginning of 2022, the global economy was expected to recover to pre-pandemic levels.
However, sustained inflation and the Ukraine-Russia conflict have slowed global economic growth from an estimated 6.1% in 2021 to 3.6% in 2022 and 2023 (see chart below). These forecasts are 0.8% and 0.2% below the January projections for 2022 and 2023, respectively.
Source: IMF, The World Bank
Advanced economies are likely to see a greater slowdown in the coming years. But the picture seems less gloomy for emerging and developing economies, with growth expected to resume 2023.
How should investors safeguard their portfolios?
An investor can take several approaches to build a more resilient portfolio in a recessionary environment.
Firstly, recessions and market downturns are unpredictable. Surviving this uncertainty requires effective diversification to reduce unsystematic and systematic risks.
Unsystematic risks refer to idiosyncratic risks of specific investments. To reduce such risks, each investment should be sized appropriately. More investments mean lower systematic risk.
Systematic risk is market risk, which cannot be eliminated. However, it can be reduced by investing in uncorrelated asset classes or asset classes that share a negative or a low correlation. These asset classes react differently to different market events. Some assets may go down, and some may go up, which reduces the overall volatility of the portfolio. Examples of asset classes include equities, bonds, commodities, currencies and real estate in the public and private markets.
Secondly, market downturns can be hedged with put options. The buyer of a put option pays a premium for the right, but not the obligation, to sell a stock or an index at a future date at a predetermined price (the “strike” price). It is a form of insurance that if the price of the stock drops, it can be still be sold for at least the strike price. And if the price rises, the holder of the put option still benefits from the upside.
Thirdly, the portfolio allocation can be increased to safe-haven assets, such as precious metals or counter-cyclical equities such as utilities or consumer staples, while decreasing allocation to cyclical or highly leveraged companies. In a recessionary or stagflationary environment, the best performers will be companies with healthy balance sheets and strong pricing and costing power.
Fourthly, invest in dividend-paying stocks. Historically, dividends have accounted for a significant portion of the total return of the stock. Stable companies that pay dividends tend to deliver above-average returns over the long run and tend to have more stable earnings growth.
Finally, short-term investments are more susceptible to market fluctuations. Reinvesting earnings over the long term will compound the returns exponentially.The chart above shows that the value of a $10 million investment compounded at 8% annually would double in nine years. The investment grows faster when the time horizon is longer so that the highest returns are made in the later years of the investment.
Investing in uncertain times
Since 2004, The Family Office has helped over 200 clients preserve and grow their wealth over multiple economic cycles.
We do not have a crystal ball that foresees the future. But our time-tested approach to wealth management will continue to serve investors well. Call us today to begin preserving and compounding your wealth over the long term in these uncertain times.