Preparing Your Portfolio for a Recession

Over the summer, the U.S. reported its second consecutive quarter of negative gross domestic product (GDP), which spurred a great debate: Is the U.S. in recession? And, is Canada next?

In technical terms, a recession is commonly defined as two successive quarters of declining GDP, the measure used to gauge economic productivity. Yet, the U.S. government declared that the U.S. was not in recession during the first half of the year and many economists agreed. They pointed to economic data that suggested otherwise: low unemployment, job growth, stable industrial production, high demand for durable goods and travel, as well as solid corporate earnings.

Despite many of us feeling as though we are in recession1 – high inflation, rising interest rates and stock market declines certainly haven’t helped to support optimism – there continues to be considerable debate about whether a full-blown recession is imminent. However, there is widespread agreement that we have entered a period of economic slowdown. This is largely due to the actions taken by the central banks in aggressively raising interest rates to manage inflation.

How Do Rising Rates Affect Economies and the Markets?

Today, demand has exceeded supply for many goods and services, which has led to inflation – the increase in prices over time. This is largely a result of actions taken during the pandemic, including the economic shutdowns, which created supply chain problems, as well as unprecedented stimulus. Raising interest rates encourages saving and discourages borrowing by making it more expensive, which in turn helps to reduce spending and demand. While decreased demand can ease inflation, it also slows the economy, which can impact the profitability of businesses and lead to unemployment. Rising rates also increase the cost for companies to borrow money, along with the cost of debt. Sometimes companies pass these costs along to consumers. However, if they cannot, it can impact earnings. Valuations may also go down because the future value of cashflows is lower when a higher discount rate is used. For fixed income markets, there is an inverse relationship between interest rates and bond prices: as interest rates rise, bond prices generally fall. This is why both stock and bond markets have struggled in 2022 as the central banks have raised rates.

Is a “Soft Landing” Possible?

Renowned economist John Kenneth Galbraith once said, “The only function of economic forecasting is to make astrology look respectable.” Perhaps said somewhat in jest, the point is to suggest that nobody knows with certainty how the economy will react over the near term. Yet, it’s not normal for any economy to be in perpetual expansion and economic slowdowns will occur periodically. Economies, like the financial markets, are cyclical. However, recessions can be quite different in their length and intensity. Consider also that this current economic period is not typical – economies were shut down due to the pandemic and supported by mass amounts of stimulus, which led to high inflation and prompted aggressive rate hikes. At the time of writing, labour markets and productivity continue to be stable, so some believe that we may avoid a full-blown recession and achieve a soft landing.

What About My Portfolio?

Longer-term investors should remember that portfolios have been positioned with the expectation that economies and financial markets will experience both ups and downs – this is a normal part of the investing journey. The potential for economies to enter into recession should never be a reason to consider curtailing investment programs. Consider that the stock market and the economy don’t always move the same way at the same time, and predicting how and when stock markets react to recessions is difficult, if not impossible. History has shown that the markets can sometimes begin their climb when economic conditions are at their worst. Looking back at the last seven U.S. recessions reminds us that the S&P 500 Index has, just as often as not, started its climb during the depths of a recession (see chart). After all, equity markets are often forward-looking in nature.

S&P 500 Index Returns During Recession and One & Three Years After Its End

^{Sources: NBER, Returns 2.0; awealthofcommonsense.com/2022/06/timing-a-recession-vs-timing-the-stock-market}/

^{DISCLAIMER: Investing in equities is not guaranteed, values change frequently and past performance is not necessarily an indicator of future performance. Investors cannot invest directly in an index. Index returns do not reflect any fees, expenses, or sales charges.}

At the same time, there are techniques we use to position portfolios to weather these down periods when they do eventually arrive:

Quality – We focus on quality equity investments, which help to protect portfolios during more difficult times. High-quality, well-established companies are often better structured to endure prolonged periods of market weakness. Companies with strong balance sheets, manageable debt and healthy cash flows can better fund their operations through more difficult economic stretches. Many quality companies have a history of continuing, and even increasing, dividend payments during market downturns.

Diversification – Having a well-diversified portfolio can help to reduce portfolio risk. Some sectors tend to hold up better during recessionary environments. For example, the consumer staples sector serves the basic needs of consumers regardless of what is going on in the economy. Different asset classes may perform differently during down periods; for instance, alternative investments often have performance that doesn’t correlate to equities. During times of economic weakness, having exposure to fixed income may also be important. However, given the state of the fixed-income markets to start the year, some investors may be concerned about their exposure. Yet, high-quality bonds may continue to be considerations because interest rates can decline in slower economic times. As interest rates fall, bond prices rise. For investors with specific income needs, fixed-income investments can be structured with maturity dates spaced over time. A “ladder strategy” matches the need for income with the maturity of investments and helps to mitigate future interest rate movements over time.

Of course, the various investments we use to build an investor’s portfolio depend on individual circumstances. Still, all of this points to the importance of having a well-diversified portfolio to spread risk, minimize the potential for loss and provide exposure to the upside opportunities as economies work through the cycle.

Discipline, with a longer-term focus – For most investors, portfolios are constructed with the longer-term in mind, to weather both the ups and downs of the market. Often, those investors who stay the course, by avoiding the temptation to react to short-term market changes, can be better off over the longer term. Challenging market conditions may also present opportunities for longer-term investors to purchase quality investments at better prices; something that was difficult to do for most of 2020 and 2021.

A Pullback, Then More Growth

When recessionary times eventually do arrive, remember that they are temporary. Every economic downturn comes to an end – some more quickly than others. Recall that our most recent recession, at the start of the pandemic, lasted just three months.2 History also reminds us that after every recession, a period of economic expansion and growth follows. Even during the most challenging of times, things can quickly change, so continue to look forward. As always, we remain here to provide support.

_Notes:

• _{https://leger360.com/surveys/legers-north-american-tracker-july-12-2022/}
• _{C.D. Howe Institute. https://www.cdhowe.org/council-reports/cd-howe-institute-business-cycle-council-declares-end-covid-19-recession}