The likelihood of a recession in the next year is over 50% in our view. While we can’t time the beginning of a recession, we can observe how various asset classes have performed over prior economic contractions. The past isn’t necessarily a perfect guide, but it can be informative. We can draw some conclusions about how asset prices might behave in a recession, and set expectations about performance.
Technically, a recession is a period when economic growth (GDP) contracts over two consecutive quarters. Recessions tend to be few and far between. That’s to say, the economy generally expands, and asset prices rise. But when the economy contracts, investors tend to shun risk assets, such as equities, in favor of safer assets, such as cash or high quality, short term Treasuries.
For equities, a recession can be problematic for high flying momentum names (at least initially). Given their higher valuations, momentum stocks have further room to fall when economic conditions deteriorate. Eventually, a momentum strategy will buy down-trodden stocks on the way back to recovery, but the initial drawdown can be painful. Conversely, low volatility stocks (i.e. equities that exhibit less than average price variability) tend to hold up better in a recession than momentum stocks. However, low volatility stocks can lag the major averages in an expanding economy. From a geographic standpoint, emerging markets tend to underperform developed markets during a recession. But longer-term, the risk of investing overseas can pay off in the form of above-average returns.
During a recession, dividend paying stocks can provide a cushion against declining equity prices. In general, dividend paying stocks tend to have better than average balance sheets, and can withstand an economic slowdown better than companies that can’t sustain a dividend.
For fixed income, a recession can be problematic for corporate bonds, specifically higher yielding debt issued by companies with below average credit ratings (so
called “junk bonds”). At a high level, the fixed income market is divided into investment grade bonds (e.g. mortgage backed securities, highly rated corporate debt and U.S. Treasuries), and lower-rated corporate debt. In a recession, cash flows tend to come under pressure, which makes paying debt service a challenge. As a result, the market can discount high yield bond prices. But, longer-term, the risk of default can be offset by higher than average yields.