Economic recession: Causes and impact (2)

Inflation Rate: Intuitively, an economic recession should trigger a decline in the inflation rate, however, experience across various countries shows that the root cause of the recession will determine how the inflation rate is impacted. Where a decline in aggregate supply occasions a recession, an inflationary trend is triggered as a knock-on effect of the high prices of factors of production. On the other hand, a recession induced by a slump in aggregate demand often triggers a deflation as disposable income and consumer spending shrink.

Impact of economic recession on securities portfolios

Fixed Income Portfolios: During an economic recession, fixed income portfolios often exert more resilience; given that the instruments characteristically have guaranteed returns, and could be ‘risk-free’ (for instance government securities).

Consequently, sovereign bonds often witness increased demand pressure during an economic recession, which pushes up the bond prices and portfolio valuations. Nevertheless, should the monetary authorities increase the purchase of fixed income instruments in the secondary market, yields are bound to crash as systemic liquidity expands. It is worth noting that if the government expands domestic borrowing (through the bond market), as a way out of the recession, an upward pressure on interest rates will mount and reduce the value of bond portfolios. Equity Portfolios: An economic recession is bound to have the most immediate impact on equity portfolios, given the correlation between economic indicators, earnings performance of companies and stock market indices.

The expectations of a recession or an actual recession often trigger a crash in the stock prices, as investors exit equity holdings for safer asset classes such as cash and government securities. In addition, investors often adjust dividend expectations and risk premiums in stock valuations, hence making the intrinsic prices less attractive. Consequently, equity portfolios are severely impacted as stock market prices and indices shrink

How can Portfolios be made Recession-Proof?

An important strategy for investing before, during and after an economic recession is to keep an eye on the big picture, with limited attention to the historical evidence of the cyclicality of certain investments. Ordinarily, when confronted with a recession, risk-averse portfolio managers may adopt a strategy that is favourably disposed to safer securities such as treasury bills and government bonds, as opposed to corporate bonds (especially high-yield bonds) and mortgage-backed securities, since these instruments are riskier than government securities.

Similarly, in the equities market, blue chip stocks across consumer goods, industrial goods and pharmaceuticals are often perceived to be recession-proof. Some strategies that can be adopted to combat the negative effects of a recession on portfolios include:

Diversify investments: This is referred to as the golden rule. However, it is important to note that different asset classes perform well or poorly at different times. The key strategy is to always ensure that a portfolio is diversified across asset classes and geography, such that, if one is doing badly, another may be doing better, helping to hedge against concentration risk. Look beyond economic data: Usually, economic data releases are backward-looking. At the onset of an economic slowdown, economic data might suggest otherwise, contradicting everyday experiences. Similarly, economic recovery takes time to fully reflect in published data

Reconsider ‘cash’ as a safe haven: Inflation impacts the purchasing power of cash over time. Although the nominal value of money when invested as cash is secure, it should not be considered a “risk-free” option. Furthermore, rushing out of a perceived volatile market might deprive one of the opportunity to make quick returns when the market rebounds

Check for over-exposure: Different sectors and asset classes are known to respond differently at different stages of the business cycle. Pharmaceuticals, consumer goods and industrial goods are relatively more resilient in a recession, compared to banking, insurance and construction sectors. The norm is to always hold sizable resilient asset classes during recessionary periods

Think long-term: Since a recession is technically defined as two (2) consecutive quarters of negative growth in GDP, it might be valid to consider six (6) months in the average lifetime of a portfolio as not long. The most important consideration, however, is to ensure that the portfolio meets the stipulated investment policy, and is well diversified at any time

In summary, it is important to note that all investments are subject to risk. Even the ‘safer’ bond portfolios have interest rate, issuer default and inflation risks. Diversification does not guarantee an impressive return or protection against a loss in a declining market. Market concerns in a recession naturally raise anxiety about the prospect of portfolio declines and prompt risk-averse investors to run to ‘safety’.

Nevertheless, irrespective of the phase of the business cycle an economy is in, the most important consideration is for portfolio managers to have an asset allocation strategy that matches their risk tolerance and long-run portfolio objective.