Dark economic clouds appear on the horizon for consumers, investors and businesses around the world.
The supply chain havoc caused by business disruption during the pandemic has been turbo-charged by a rebound in activity after pandemic lockdowns have ceased.
War in Ukraine has switched off large portions of the agricultural supply of staples such as wheat, and concerted efforts by the EU to end reliance on Russian oil have led to fossil fuel prices hitting all-time highs.
Both of these events have created the perfect storm of inflation headwinds, causing consumer spending to fall and reducing disposable incomes for luxury goods.
Despite the existence of other indicators of economic expansion (such as low unemployment and a booming residential property market), these are soon expected to pave way for a recession in the UK in late 2022 or early 2023. Mortgage approvals have fallen to the lowest level in two years, and spiralling wage bills have held back corporate margins, resulting in a wave of profit warnings recently issued to the stock market.
‘Economists are now separated into two camps; those that believe a recession is inevitable and necessary for the long-term health of the economy. The second group expect that the Bank of England will stall the economy but manage to narrowly avoid a technical recession.
In either case, a few successive quarters with depressed economic growth will change the mindset of businesses and investors. Growth has been low in real terms since 2012, but, pandemics aside, it has remained between 0.3% and 0.6% per quarter.
It may mark a backstop against the “rebound” of most blue-chip companies since pandemic restrictions eased. Recruitment taps have recently been switched fully open and Capex plans were restarted. How long that optimistic activity will continue is uncertain.
To prepare for the coming recession, investors could take two key steps:
- Assume that the momentum of interest rate rises will continue
Central bankers in London, Washington and Brussels are determined to cut inflation, regardless of the collateral damage.
This means that investors should be prepared for rates to rise (albeit temporarily) above equilibrium which may be as high as 3% in the UK – a rate not seen for over a decade.
Have stock markets really priced in the future trajectory of this curve? It remains to be seen. The best economics textbooks would support the notion that markets are efficient and that this information is already priced in, but this does not account for why markets have continued to fall as rates have risen. These slow downward movements have indicated that the market didn’t fully expect central banks to move this quickly. Further equity market falls could be on the cards as inflation proves to be persistent.
This means investors would be wise to not lock into 3 or 5-year savings bonds, as the current crop of offers will be probably rendered uncompetitive with successive rate increases on the cards.
- Consider your largest sector exposures
In a recessionary environment, you could consider the sectors you are exposed to in your equity and bond portfolio. Your brokerage account should be capable of providing you with a quick sector analysis at the click of a button. If that fails, take a look at the Fund Factsheet for any large ETF or fund holdings you have for insight breakdowns of their holdings.
Essential goods such as utilities, infrastructure and defence are considered ‘defensive’ stocks because demand for their services does not reduce during a period of fiscal contraction. Luxury goods, however, including experiential products like holidays and entertainment, are the hardest hit as consumers begin to cut their discretionary spending on ‘optional’ items in their budget.
If you’re a diversified investor, you will own or be exposed to holdings across a wide range of sectors which will help your portfolio weather this storm with grace. Diverse sector holdings are almost guaranteed in broad index-tracking funds such as those that track the S&P 500 or the FTSE 100, as these indices contain businesses from a variety of industries.
In conclusion
There is no way to total protect a portfolio from recession, particularly amid rate rises.
One reason for this is that it’s impossible to predict the future accurately when it comes to economic events. While economists may make predictions with confidence, the predictions of different economists sometimes give different projections, which reduces the credibility of each. They can’t both be right. If economists could accurately time the market, they would all be rich, and retire in comfort from the financial returns of making well-timed bets rather than working as economists. ‘Macro’ hedge funds that seek to make abnormal returns from market-timing are not consistently successful, which demonstrates that even with all the money in the world to hire the sharpest economic minds, predictions don’t always come true.
The second reason it’s difficult to protect your portfolio in 2022 is that as interest rates begin to rise, investor discount rates (their demanded rates of return) also rise. Rising expected rates of return always have a negative impact on investments such as bonds and equities because these investments offer a fixed pattern of future returns, that will be worth less if investors suddenly discount future flows at a harsher rate to reach a present value.
In such a scenario, the total value of all financial markets will naturally fall and only brand new investors who are moving from cash into equities or bonds will feel the benefit of buying at higher dividend or coupon yields than prior to the price correction.
Rather than trying to make a concrete prediction and taking wild risks on the back of it, it’s wiser to consider a range of likely outcomes and ponder how your strategies would pan out in each. Choosing the strategy that does least badly in a range of scenarios will hopefully provide peace of mind that, whatever happens, your personal finances will survive and even thrive beyond.