How to invest in a recessionary period
Commentary
In these times of uncertainty and global conflict, many countries are coming to terms with the possibility of entering into a recession. As investors become aware of a potential recession, some may panic and make ill-advised decisions. According to Forbes “a recession is a significant decline in economic activity that lasts for months or even years”. A recession is usually characterized by a contraction in gross domestic product (GDP) over two consecutive quarterly periods, rising levels of unemployment and contracting measures of income for an extended period.
For prepared and well informed individuals, a recession can potentially be an investment opportunity through premeditated risk-taking. However, for the majority, such times often bring significant challenges and uncertainty as many persons may face salary cuts, job loss and a general rise in poverty owing to the contraction in economic activity. In addition, many investors may also be challenged by significant losses on investments with little to no clarity on how to proceed with the recoupment of losses.
What to avoid
In a recessionary environment, riskier assets are usually the worst-performing and include investments in companies that are highly leveraged, cyclical or speculative. Highly leveraged means that companies or assets use a significant amount of debt to fund their operations and structure. As overall demand for goods and services falls, revenues and in turn profits also decline. With a high debt structure, the repayment amount in terms of interest and principal will be elevated and there is a high probability that such companies may not have the funds to meet such mandatory payments, thus increasing the risk of default. As a result, these companies’ stock prices tend to fall sharply whilst the yield on their bonds will soar as investors demand a higher return as compensation for the additional risk.
The income and profits of cyclical assets and companies are influenced by the upturn and downturn of the economy. Cyclical sectors include construction, manufacturing, travel and leisure. Thus, in an economic boom, such assets and companies tend to do well as consumers have more discretionary income as employment is high and overall demand is growing. In a recession, however, the resulting job loss causes consumers to reduce their discretionary spending such as travel, eating out at restaurants and leisure activities. Consequently, cyclical assets tend to suffer and often lose their value.
Speculative investments are those with a high degree of risk where investors are very focused on taking maximum advantage of price fluctuations in the market to make significant returns in a short period. Little thought is given to the fundamental value of the security and the main focus is on price movements. Speculative investments can be of many types including stocks, currencies, antiques, commodity futures and cryptocurrencies.
Assets and Companies that are not as affected by recessions
While the effects of a recession is usually widespread, the degree of contraction differs across industries and companies. Investors should seek out companies with a low debt burden, good cash flow and strong balance sheets. When faced with a contracting economy, such companies often have the financial flexibility to accommodate for the fall-off in demand.
Assets in defensive sectors are usually sound investments during a recession as such sectors provide goods and services that have a relatively inelastic demand. These sectors include Consumer Staples, Healthcare, Telecommunication services and Utilities. Although these sectors may not be attractive during a boom market, during a recession these stocks are quite valuable as they represent the basic necessities and therefore are more likely to remain stable.
Dividend-paying stocks are also very good investments during a recession as they may offer consistent distributions of cash through dividends. These dividend-yielding stocks often come in the form of companies with a strong track record and an established business model, many of which are popular and recognizable brands. While these stocks may not have the highest yields, they provide an opportunity for passive income.
Investment grade bonds which have a relatively low risk of default are also suitable during recessionary periods. A bond can be described as a loan given to a company or government by an investor. By issuing bonds, governments and companies are now in debt to the investors of that bond and must repay the amount lent with an agreed-upon interest rate by a specific date. Bond rating agencies like Standard & Poor’s and Moody’s use alphanumeric designations to identify a bond’s credit quality rating. Bonds with a rating of BBB- (on the Standard & Poor’s scale) or Baa3 (on Moody’s scale) are considered “investment grade” while bonds with lower ratings are considered “junk” or “speculative”. Speculative grade bonds have a higher probability of default and are thus avoided in times of recession.
Fixed income securities provide a good diversification strategy for an investor’s portfolio as the coupon payments associated with the bond can be used to cushion the reduction in an individual investor’s income that may result from any job losses or salary cuts.
Investing in mutual funds is also viewed as less risky when compared to investing in individual stocks. A mutual fund is a financial vehicle that pools funds from investors to invest in securities like stocks, bonds, and other securities. Mutual funds are operated by professional money managers who have the relevant expertise and experience, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. Instead of investing in one company like bonds or stocks, managers of mutual funds invest in many different companies to obtain a diversified portfolio of investments through one purchasable security. Investors thus gain exposure to a specific basket of securities rather than a single investment, allowing the losses in one security to be offset by gains in another.
Unemployment and wage cuts are an unfortunate and sometimes unavoidable reality during a recession. Consequently, building cash reserves and creating an emergency fund during a recession will prove useful as it creates a buffer to allow the payment of rent and other obligations without taking on more debt or in the case of job loss. The emergency fund should be robust enough to cover at least six months of necessary expenses.
The slowing of economic activity is accompanied by rising prices due to supply chain disruptions caused by the pandemic and the conflict between Russia and Ukraine and thus presents another challenge for investors. In an effort for portfolio gains and returns to outpace inflation, investors should seek assets that appreciate in value at a rate greater than the current rate of inflation and include assets such as gold, commodities, real estate and equities. Commodities and gold are backed by real assets, thus their prices tend to rise in value alongside inflation. Bonds with a variable interest rate or floating rate bonds and inflation-linked bonds, should be favored over those that pay a fixed interest rate.
Investors must also be wary of stagflation which is the dual threat of economic stagnation and persistent inflation and occurs when economic growth stalls (less than 2% per annum), unemployment increases and inflation is high. The current environment is exhibiting two of the three primary characteritistics, thus the probability of stagflation occurring is relatively high. Investment-grade floating-rate and inflation-linked bonds can be considered in the event of stagflation, while a defensive equity strategy is favored.
Investing during a recession does not need to be a confusing or anxiety-filled experience, however, it should be one in which investors are properly informed. Investors should not have a knee-jerk reaction to the deteriorating economic landscape which sometimes leads to panic-selling and incurring large losses. A sound investment strategy should serve as an anchor to help investors stay the course. In addition, creating a balanced portfolio that will perform in the long term through all stages of a market cycle is also critical.
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