How To Recession-Proof Your Portfolio

13 mins

How To Recession-Proof Your Portfolio

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What is a recession?

In 2006, UK Prime Minister Gordon Brown promised he had put an end to boom and bust – and deemed the UK to be on a stable economic trajectory. A year later, the global economy started to implode in the biggest recession since the ‘30s. Awkward…

Recessions are an unfortunate part of economies – they destroy businesses, put people out of work, and permanently alter the way the world works. But what are they, what causes them – and how can you prepare for the next one? Let’s plunge in.

What is a recession? The technical definition of a recession is two consecutive quarters of negative economic growth, using gross domestic product (GDP) as a measure. But the US National Bureau of Economic Research (NBER) has a broader definition: "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales".

No matter how you define it, the underlying meaning is still the same: recession is the economy shrinking. This is just part of the business cycle – periods of growth followed by periods of contraction. Think of it as two steps forward, one step back: according to the NBER, each economic expansion since 1945 has lasted an average of 58 months, compared to 11 months for each contraction.

Why should I care about recessions? Recessions have a massive impact on the economy: they affect asset prices, interest rates, and unemployment – and can even bring about permanent changes to laws and politics. In other words: recessions can and will affect your finances. Understanding what causes a recession and the effects it can have will let you invest better during one – like a Targaryen, you could come out of the fire unscathed.

In this Pack, we'll look at what brings about winter recessions and how they affect economies – so you can be prepared when the next one hits. First off: what pushes an economy off the edge?

What causes recessions?

What causes a recession? It’s not entirely clear – each recession is unique, with its own combination of causes. But looking back, we can see some common triggers of economic downturn. All are in some way linked to lower spending: something happens that makes people hang on to their cash instead of splashing out.

One such trigger is inflation. If an economy starts growing too fast, it can "overheat": everyone who can be employed is employed, and the economy is producing as much as it can. Demand for goods and services outstrips supply, which sends prices up as people jostle for limited numbers. And all the money that’s not being spent on goods and services can’t be invested into growth, because there’s no one left to employ.

As prices rise, people become inclined to spend less (and save instead) as things cost more. But when everyone does that, the economy begins to suffer. Businesses struggling with increased costs might need to sack employees to stay profitable. Those poor souls usually have to reduce their spending even more, further slowing the economy. It’s a vicious cycle – and it can reach a point where the economy begins to contract.

Inflation can happen for reasons other than fast growth: a big rise in oil prices, perhaps triggered by war or trade disputes, can also drive prices up. More on that in our Commodities Pack.

Raising interest rates is one way to tackle inflation – but high interest rates can also bring about a recession. Higher rates makes borrowing money more expensive and saving money more advantageous, which discourages investment. Fewer businesses will start up in these conditions and existing ones will be less willing to expand – that reduction in spending can trigger a recession.

In that scenario, the problem is reduced liquidity – it’s harder to get your hands on cash and so there’s less spending. Low liquidity can also come about by a credit crunch: when lenders become unwilling to lend and so credit becomes elusive. A big shock to the market – like 2007’s mass default on mortgages – can cause some financial institutions to rack up heavy losses or even collapse. That can give other banks the heebie jeebies, scaring them into holding on to their cash and not lending to each other.

Banks that finance their operations by borrowing from other banks might collapse as a result (or sometimes governments step in and bail them out). Because of the risky, default-ridden environment, the financial institutions still standing will typically charge more to borrow and lend more conservatively. In the resulting armageddon, lending to businesses and individuals plummets. And the cycle continues...

Big market shocks are key: the last two US recessions were both triggered by an overpriced bubble bursting. In 2001, it was dot-com stocks and in 2007, it was real estate. In each case, the sudden crash in asset prices scared consumers and they reduced their spending – which brought on a recession.

No matter what causes a recession, once one hits all hell breaks loose. Next, we’ll look at what exactly happens during a recession: brace yourself.

Investing in a recession

What happens during a recession? Things tend to go pear-shaped. Panic begets panic, and as businesses collapse from a lack of credit or try to save money by laying people off, unemployment starts to rise. That increase in unemployment means people have less to spend, which reduces demand... making businesses struggle even more, which can lead to further unemployment… things get bad. In the last recession, around nine million jobs were lost in America alone.

What happens to share prices? The plummeting economy spooks investors, who start to flee volatile investments. Share prices will decline, particularly for companies with high debt levels (because investors worry that they might not be able to repay their loans and will shut down).

Some firms might benefit from a recession though, as investors search for safer options: consumer staples like Unilever and P&G are often the last to suffer (because their products are necessities). Other pretty essential industries like utilities and defense also do well – the consistent dividends that companies in those areas pay combined with their stable business models mean they’re sometimes seen as “recession-proof” 🛡

How about bonds? The riskiest corporate bonds will typically see massive price falls – few investors will be willing to take a gamble in a recession. But government bonds will usually see prices rise (and thus yields fall) – the UK and US governments are extremely unlikely to default on their debt. Not all sovereign bonds are equal though: in mid-2011 some Greek bond yields shot up more than sevenfold as investors became increasingly scared the country was going to collapse (it hasn’t, yet).

And other assets? Recessions tend to slash the value of currencies: investors don’t want to invest in a country undergoing a recession, so they pull their cash out and look elsewhere. The lower demand for the currency then depresses its value. Commodity prices also tend to fall – as economies slow, they need fewer materials.

All of these prices might fall before a recession actually starts – if investors think one is coming, they’ll start to sell. Ironically, that could itself trigger a recession…

What does this mean for my investments? If you think a recession is approaching, you might want to follow the pros’ lead and get out of your riskier investments before they go belly-up. But once hit, a recession can be a great opportunity for buying assets. Warren Buffett is fond of this approach, arguing that a market crash can offer great opportunities for buying shares of good companies at discount prices. When the market rebounds, you might have done quite well for yourself by running into the chaos while everyone else was running away.

That’s if the market does rebound, though. Next, we’ll look at how recoveries come about – and how they don’t.

How economies recover

How do recessions end? With the economic world collapsing around them, governments and central banks of shrinking economies come to the rescue to try and rebuild. To end a recession, they have to stimulate spending – and they have a number of tools to achieve this. The first line of defense is normally to slash interest rates. Lowering the cost of borrowing and making saving less productive encourages people to take out loans and start spending – and investing, in an effort to find returns.

But rate cuts might not be enough – if interest rates are already low to begin with, pushing them down to zero might not make much of a difference. In which case, governments might try to boost the economy with fiscal stimulus: borrowing and spending tons of money (on infrastructure projects, for example) to try and kickstart private spending. The thinking is that all the people working on these projects will have more money in their pockets that they’ll spend... in the economy. More on how this works and the debate behind it in our Economics 101 Pack.

That's not always feasible though. Some countries might be overwhelmed by their level of debt during a recession and go the route of austerity instead: cutting government spending to try and reduce debt. In those cases, central banks might turn to quantitative easing – in which they print money, distribute it to commercial banks, and encourage them to pass that money on to the public through loans in the hope that increased liquidity will stimulate the economy.

What affects a recovery? The competence of officials is crucial in determining how quick a recovery is, or if one happens at all. Forced to work with imperfect information, it’s not an easy job – economic data is always delayed and you can never know how long a policy will take to impact the economy. Sometimes officials make bad decisions and miss good ones: some economists think a greater increase in the supply of cash could have stopped the last crisis from being as bad as it was.

There’s also a theory that what causes a recession affects how long the subsequent recovery takes. One study found that recessions as a result of financial crises (like bank collapses) are more difficult to bounce back from than recessions caused by overheating or inflation. It’s not entirely clear why that is – but it may be down to the debt everyone ends up with after losing loads when financial institutions collapse.

How can I profit from a recovery? Stocks tend to do brilliantly during a recovery. You could join the droves of investors searching for the great returns that stocks can offer when interest rates are low – and taking the risks that come with them. That translates into higher demand for stocks with big growth potential – and higher prices when it’s time to sell.

In a complete reversal of what happens during a recession, companies with high debt levels usually do well in a recovery: they’ll benefit from low borrowing costs, allowing them to expand faster. Bonds can also be a good bet – their prices generally rise as interest rates fall (though they typically don’t perform as well as stocks during a recovery period).

All this knowledge is great in theory, but it’s only of use if you can actually put it into practice. Fortunately (or unfortunately!), it looks like you might have a chance to soon. Finally, we’ll talk about the next recession – coming soon to cinemas near you.

Predicting the next recession

Is a recession coming? The general consensus is that we’re in the final stages of the economic cycle: this period of US economic expansion is about to become the longest ever, and all good things must come to an end. The global economy is slowing down, historically reliable warning signs are flashing, and investors are starting to prepare.

It’s not really a question of if a US recession is going to hit anymore – it’s a question of when. Some people think it could be this year, others think we’ve got until 2020 or 2021. But the r word is coming at some point in the next few years. And because globalization has brought everyone closer together – many different global economies are inextricably intertwined through trade – the pain will be globally distributed too.

What will cause it? There are a few theories out there. The economy could overheat, like we talked about in Session Two. Right now, growth is strong and US inflation is 2% – the US Federal Reserve’s target level. If it rises further, the Fed might raise interest rates to reduce it. But if those rate hikes slow down the economy at the same time as the positive effects of recent tax cuts start to fade, it could prove to be too much for the economy to handle – and it might start to shrink. Higher US interest rates can hurt other economies too – they strengthen the dollar, making it more expensive for emerging markets to repay their dollar-denominated debts.

Another possible cause could be an implosion of corporate debt. In the US, corporate debt (excluding financial firms) is now a bigger chunk of the economy than it's ever been. The "credit spread" – the difference between the premiums that lenders charge more and less risky borrowers – is almost as low as it was before the last crisis, which might suggest lenders are getting a little too comfortable with risk. If interest rates rise and companies find it harder to pay off debt, we could start to see defaults – and enough of those can significantly hurt banks and investors, which would in turn bring the economy to a halt.

A final bringer of recession could be the trade war between the US and China. If that escalates further into more tariff hikes, the US economy will be hit with pricier imports and fewer exports. And the global economy would also be affected: the prices of American and Chinese goods around the world would likely rise to offset firms' higher materials and production costs, which would slow down other economies. That reduced global demand would then trickle back to the US, resulting in even fewer exports... and the possibility of a recession. Research firm Moody's Analytics thinks an all-out "trade conflagration" could trigger a US recession by the end of 2020.

How bad will it be? It’s impossible to say – but some think it could be quite bad because we don’t have the tools to fight it. The last crisis was so grim and the recovery so slow that interest rates are still relatively low. So when the next downturn does hit, central banks won't have much room to slide and dice those rates – and thus may not be able to stimulate the economy as much.

The last recovery’s policies have also left us in a vulnerable position. Increased government spending after the last recession has left countries with a lot of debt – meaning that more spending might not be possible, particularly in emerging economies like Brazil. And countries will have to work together to create the rising tide to lift the world’s economy, but there’s always the question of politics – economic nationalism (every country for itself) could be a problem.

Whatever does happen, you’re now well-positioned to deal with it. Being prepared and informed is the most important thing. Number one tip? Stay glued to Finimize during the crisis… we’ll help get you through in one piece.

In this Guide, you’ve learned:

🔹A recession is when an economy shrinks

🔹Recessions can be caused by inflation, high interest rates, market shocks, or credit crunches

🔹When economies collapse, stocks, currencies, and corporate bonds tend to fall in value – but government bonds do well

🔹Stocks perform really well in a recovery – but the success of one depends on central banks and governments carefully managing policies

🔹A recession will likely hit soon... and we may not be able to tackle it with as much force as last time

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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