How to Navigate a Recession

Mike Coop, chief investment officer, EMEA, for Morningstar Investment Management, on why investors need to get back to first principles when facing a downturn

Mike Coop 15 December, 2022 | 12:11AM
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As investors, the reality is that a recession appears the most likely scenario for many countries. The “R” word tends to incite fear, but every investor will endure multiple recessions in their lifetime. The key is how we deal with them, as they have a habit of bringing out the worst in investors – every single time. Given the long-term nature of investing, enduring the odd recession is a pre-requisite to attaining your full list of financial goals. It is not just about financial discipline, but also having strong foundations that allow you to withstand inevitable setbacks and even thrive when they occur.

More often than not, this carries three requirements, 1) goal-setting as a true north, 2) staying the course with a well-diversified portfolio, and 3) using valuation to get the odds in your favour.

This framework helps give the necessary perspective to address today’s concerns, with common examples including: whether bonds will work as a diversifier this time; if history is irrelevant because the world is changing; and staying invested if a recession is coming.

This Time It's Different?

Yes, high inflation and changing geopolitical conflict does mean today’s economy is different from the past. However, we should not forget the long history of business cycles across all kinds of economic and geopolitical environments. Where does that leave us today? Will a global recession happen in the next 12-to-14 months? According to Preston Caldwell, Morningstar’s head of US economic research, it’s a virtual coin toss – at least in the US, which accounts for around a quarter of the global GDP and over 60% of the global stock market.

"Either way, we expect growth to accelerate again in 2024 as the Federal Reserve lifts off the brakes" Caldwell said. Underpinning this view, resolving supply chain issues has begun to lower the price of goods and should continue to tamp down inflation. Caldwell forecasts that inflation has a reasonable probability of receding to normal levels in 2023 and could even undershoot the Fed’s 2% inflation target by 2024. Of course, this is just one possible pathway, but the analysis is encouraging and plays true to our philosophy – to position portfolios for multiple outcomes, not one deterministic prediction.

What’s the Real Issue Here?

It might not feel like it to clients who feel crunched by interest rates and inflation but asking if there will be a recession – and how to avoid it – misses the point. The true questions people are asking are “Am I OK?” and potentially “Can I do something smart at this time?” These questions are always well intended, but they can be dangerous behaviourally. During such times, it is always healthy to return to the truths of investing during a recession.

Truths of Investing in a Recession

• To get investment returns you need you to take risk – cash is unlikely to help you beat inflation and grow wealth over time.

• Recessions are common (occurring every seven-to-10 years on average), temporary (lasting several years) and eventually followed by economic recovery.

• Stocks tend to front-run the economy, not the other way around. They will also front-run the economy before the recovery happens. This makes market speculation incredibly difficult as you need to get two decisions right (exit point and re-entry point) amid heightened uncertainty. Very few, if any, have this skill.

• Stocks do have a track record of falling before and during recessions because company profits fall and bankruptcies rise. However, they have always recovered lost ground in the years that follow.

• Bonds have a track record of doing well because inflation and interest rates tend to drop. Today, interest rates and bond yields are high enough for bonds to provide this offset.

• The main way you fall short of your financial goals is a permanent loss of capital where you never recoup the losses. These can occur in recessions (such as a low-quality investment that goes bankrupt), so care needs to be taken.

• Three killers that trigger permanent losses are: 1) speculative investments with no basis for their valuation, 2) assets with too much debt, and 3) selling out at the bottom because of behavioural biases.

• Buying shares when they are cheap tends to lead to higher-than-usual returns because markets price in bad scenarios and there is upside if conditions improve.

Reaffirm Goals of Investing

Coming into 2023, it is important to make sure your goals and objectives remain relevant. Given the changes we’ve experienced in recent years, it is not unusual for these goals to have shifted. This includes confirming the timeframe for reaching them. Whatever the outcome of this review, there are big advantages of measuring success in terms of progress to reaching your goals, rather than “beating the market”. This nudges behaviour toward topping up our savings after big market falls as a way to get us back on track to reaching our goals after a market sell off rather than selling out at the bottom. By doing this, we also have the prospect of buying undervalued assets that can offer potential upside.

Using Valuation to Your Advantage

A recession is only one scenario. This vividness bias can lure you into a certain mindset, where you become fixated on recession impacts and forget the full range of potential outcomes. Proper preparation must include positive scenarios, too. Instead of erring on the side of caution every time there is a period of uncertainty, check that you are taking the right amount of risk to reach your goals – one that you can live with in bad times and one that will be enough to at least keep pace with inflation.

To do this, it often makes sense to invest in a diversified portfolio with assets including those that behave differently to others when there is recession – such as equities and high-quality bonds. A portfolio doesn’t need to be complex – it just needs the right exposures to deliver against your goals. As part of this, it is desirable to favour assets that already reflect pessimism about the future. These assets are less prone to falling than assets that are highly popular, have gone up a lot and are priced for the best possible scenario—and therefore, not very likely to occur.

Within equities, we find it imperative to balance exposure between the most attractively valued assets along with stabilisers such as dominant companies with little debt and goods and services that are perennially in demand. Examples can often be found in areas like healthcare, utilities and consumer staples. Finally, unless you need to realign against your goals, you should stick to your strategy. Even in recessionary conditions, you should avoid market timing and macro forecasting – trust the experts who tell you this is a fool’s errand. Ensuring you’re not blown off course should be among your highest priorities, resisting the devil’s temptation to sell in the depths of a recession and miss out on the recovery.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Mike Coop  is Head of Multi-Asset Portfolio Management, EMEA, Morningstar Investment Management

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