How to recession proof a portfolio
26 August 2022
What is a recession?
Before we discuss how to recession proof a portfolio, let’s define what we mean by a recession. Technically, a recession is defined as two successive quarters of negative GDP growth (the total of all goods and services produced in a country). However, recessions are more broadly defined by a collection of characteristics; rising unemployment, falling real incomes and, at the corporate level, declining sales and production. The reason a slightly broader definition is required is, over the last six months, we have seen two consecutive quarters of negative GDP growth in the USA, but other economic readings are so strong policymakers have determined it not to be in recession.
The world economy has experienced five global recessions over the past seven decades: 1975, 1982, 1991, 2009, and 2020. During each of these episodes, global GDP contracted, and this contraction was accompanied by a weakening of other key indicators of global economic activity. These recessions were highly synchronized internationally, with severe economic and financial disruptions in many countries.
The 2009 global recession, caused by the global financial crisis, was by far the deepest and most disruptive of the five recessions. At the epicentre of the crisis was a hugely intertwined, and highly indebted, global financial sector. The resulting contraction in risk appetite, lending, and investment left the developed world taking the brunt of the recession.
Recessions are typically followed by a period of expansion. However, the expansion that followed the 2009 recession was the weakest in the post-war period in these economies, many of them struggled to overcome the legacies of the crisis.
We note, however, that drawdowns in equity markets are not just restricted to recessions. Market corrections (a decline of more than -10%) are much more common than recessions. There have been 24 market corrections over the last 50 years, five of which were larger than -20%, the threshold that constitutes a bear market.
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What has happened this year?
Year to date we have seen a significant repricing in risky assets. Central bank tightening around the world has systematically removed stimulus and liquidity, leaving investors worrying about the potential for future growth.
Reacting to Covid-19 back in 2020, policymakers injected unprecedented levels of liquidity into capital markets, to free up economies paralysed by the pandemic. As economies opened up, demand returned but there were huge supply issues, so inflation reared its head. The war in Ukraine worsened the supply issues and the resulting price increases have forced central banks all over the world to increase interest rates and reduce liquidity, in an attempt to control inflation.
So where has that left us? Equities in US entered into a bear market earlier in the year, underperforming even the European equity market which has had a war on its doorstep, before leading the rebound we have seen in the last six weeks. Many of the largest companies listed on the main market in the UK derive a significant amount of their revenue from commodities and from lending money. Higher commodity prices and rising interest rates have acted as a fillip for their earnings. For this reason, the FTSE 100 has held up much better than most financial markets. However, the small and mid-capitalisation parts of the UK stock market have sold off in line with the rest of the world. In Japan, the threat of inflation remains much more benign which, coupled with a heavy devaluation of the Yen, has offered some relative outperformance.
Ultimately, investors have struggled with conflicting data regarding the health of the global economy; for every double-digit inflation print there is a robust jobs report, consumer confidence might be at multi-decade lows, but corporate earnings remain largely unperturbed, for now at least. In the face of elevated recession risks, it seems a good time to discuss what would be the right steps to take in a portfolio to combat this threat.
What changes should you make?
So, what should you be doing inside your portfolio if you are worried about a recession? The first step, and the most important one, is making sure you are invested in the correct risk band (taking an appropriate level of investment risk for your long-term goals). This is the one that matches your emotional and financial ability to take risk, and your need to take risk to achieve your objectives. If you are unsure about how much risk, you should be taking then it’s best to seek advice. The reason is that the biggest losers, investment-wise, in a recession are forced sellers. If you are taking the correct level of investment risk to meet your long-term goals, then market drawdowns – recession or otherwise – shouldn’t impact your ability to stay invested, which is the most important aspect. With effective planning you should be able to avoid selling investments during recessions. As doing so could significantly reduce the sustainability of your savings – how long they could last for a given level of spending.
If history has taught us anything, consistently calling the top of a market is impossible. Or as legendary investor Peter Lynch said, “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” For this reason, any recommendation to sell down your portfolio to cash, or take significant amounts of risk off the table, must be taken with a huge pinch of salt.
It is very easy to say ‘the best thing to do with your portfolio in a recession is to take as little risk as possible’ but putting this into practice at exactly the right moment is far harder. Economists have been predicting a market crash as far back as mid-2017, in which time (up to the start of this year) global stocks (as measured by MSCI World) were up over 75%! Even with the most recent selloff, you are in a far better place than had you sold to cash back then. Now, not only is it very tough to successfully time taking risk off the table, but it is also equally hard to time putting it back on. Markets are forward-looking, and the trough in a selloff is usually far earlier than expected. It generally comes when bad news is entrenched, and the general feeling is particularly dire. What happens during this time is the selling becomes exhausted and, at the margin, money starts flowing back into some heavily oversold assets. There can be months of uneasy market rallies that, no doubt, feel wholly unsustainable before the news flow begins to turn positive and a more upbeat sentiment begins to permeate the market. By this point most investors will feel much more comfortable about re-entering, but not only will it be too late to pick up any bargains, the levels might already be higher than when you sold!
So, what can you do?
The most successful way to protect your portfolio from a recession is to diversify. The last five global recessions (and all the interim market drawdowns) had different causes. There has been a different cocktail of factors that contributed to each selloff. The factors that drive an economy into a recession have a direct impact on which asset classes provide the best protection during. On top of that, the entry point for each asset class plays an important role in its subsequent performance. There are ‘safe haven’ assets that have a strong track record of performing well during sharp risk-off events, however, there is no guarantee they do the same in each one, and the opportunity cost of holding these at the wrong time can be very expensive.
One of the easiest ways to protect against a potential recession is by increasing liquidity within your portfolio. As mentioned earlier, the biggest losers in a recession are those who are forced to sell (a phenomenon that is not restricted to just recessions). This is exacerbated by assets that are illiquid. The greater the liquidity of the underlying asset the more likely you are to receive a fair bid, even during periods of market stress. Assets that change hands infrequently can have a much greater haircut priced in during downturns, which, if you combine with being a forced seller (encashing investments to meet cash requirements elsewhere being a typical driver), can leave an investor significantly out of pocket. Maintaining a high level of liquidity and a diversified portfolio will help ensure a savvy investor has the opportunity to be on the other side of this trade, picking up heavily discounted assets when others have to sell.
The final change worth making in portfolios if you are concerned about a recession, is tilting your asset mix towards those that have the potential to do well during tough times. However, they don’t work every time, so maintaining high levels of diversification and liquidity is key. Assuming the cause of the recession is monetary tightening (a central bank misstep, increasing interest rates too far and ultimately choking the economy) then one would likely see demand for private credit faltering first, new investment levels falling, directly impacting corporate profits and an increase in default levels. Finally, a rise in unemployment and a fall in consumer spending creates a vicious cycle of demand destruction. In this scenario asset classes that would likely outperform, and therefore warrant a higher weight in a multi-asset portfolio would be, in fixed income; government bonds, and the safer areas of investment grade credit. In equities; quality equities prevail during periods of tighter financial conditions and bond proxies (so called for their dependable income streams in the form of dividends) such as utilities, consumer staples and defensive REITs, and in alternatives; macro funds and other strategies that actually benefit from higher volatility.
Overall, there is a wide range of asset classes that have the ability to outperform during sharp risk-off moves, whilst allowing you to remain invested. As mentioned earlier, the reason for using such a wide range is that the cause of the recession largely determines which asset classes will prevail.
In the case of a supply-based recession, the asset mix would need to be rethought. These types of recessions occur after prolonged periods of supply shocks (for example a war or pandemic) or a reversal of the globalisation we saw in the last few decades. These types of recession tend to manifest through stagflation – a combination of high inflation and low growth. Slowing growth is often the cure for higher inflation (because demand/spending falls), however, when higher inflation is not brought on by increasing levels of demand, and rather issues with global supply, the problem can persist for much longer. During these periods, assets like gold and inflation-linked bonds normally perform well, whilst ‘real’ assets such as real estate and infrastructure are also useful hedges. Government bonds, previously the cornerstone for recession-proofing for central banks overtightening, can be caught in the eye of the selloff. In equities, the tilt towards quality will likely serve you well, but the entry point remains key as these assets are often in high demand so can be expensive, and potentially vulnerable if investors decide they’re overpriced in a world of higher interest rates and inflation.
At Saltus, we don’t profess to be able to predict each recession perfectly. Rather, at times like these, we focus on ensuring our portfolios are adequately protected. Currently, our portfolios are more liquid and more diverse than they have been over the previous years and have a higher quality equity mix than the broad market, without taking aggressive factor tilts. There have been new managers added across all 3 main asset classes; equities, fixed income, and alternatives, specifically to weather an incoming storm. We even opened our first US Treasury position in over a decade, having previously struggled to see value in this asset class. We hope, with this blend, we will find parts of our portfolios offer the necessary protection to leave us in good shape to benefit from the opportunities whenever and however they present themselves. Year to date, our approach has been validated by strong performance relative to most of our peers. However, we are not complacent. We remain vigilant, looking for opportunities to better protect our investors, and also looking for opportunities – picking up bargains from investors who are less well prepared than ours.
All authors have considerable industry expertise and specific knowledge on any given topic. All pieces are reviewed by an additional qualified financial specialist to ensure objectivity and accuracy to the best of our ability. All reviewer’s qualifications are from leading industry bodies. Where possible we use primary sources to support our work. These can include white papers, government sources and data, original reports and interviews or articles from other industry experts. We also reference research from other reputable financial planning and investment management firms where appropriate.
The views expressed in this article are those of the Saltus Asset Management team. These typically relate to the core Saltus portfolios. We aim to implement our views across all Saltus strategies, but we must work within each portfolio’s specific objectives and restrictions. This means our views can be implemented more comprehensively in some mandates than others. If your funds are not within a Saltus portfolio and you would like more information, please get in touch with your adviser. Saltus Asset Management is a trading name of Saltus Partners LLP which is authorised and regulated by the Financial Conduct Authority. Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested. Tax rules may change and the value of tax reliefs depends on your individual circumstances.
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