By: Clint Pekrul, CFA
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.
RELATIVE PERFORMANCE DURING A SESSION
The question we face is how to allocate capital, given that we don’t know precisely when the next recession will occur. Some readers might be familiar with the world’s largest hedge fund – Bridgewater’s All Weather Portfolio. The fund is technically a global macro strategy that invests in various asset classes across the globe. The fund’s premise is to balance risk (i.e. Investment uncertainty) across multiple markets to take advantage of broad trends. The methodology does not necessarily try to time the market, but remain invested for the simple reason that it’s incredibly difficult to know precisely where we are in the business cycle (e.g. contraction or expansion).
By remaining fully invested and balancing portfolio risk, the fund can participate in market gains while not being too susceptible to a decline in any single market. At Peak, we follow a similar strategy whereby we seek to balance risk across multiple asset classes in such a way that we’re not overly concentrated in any single market (from a risk standpoint), while at the same time maintaining positive exposures to broad asset classes. While we might not hit the proverbial “home run” in a strong, upward trending market, we are positioned defensively to not “strike out” at the wrong time.
In summary, it’s difficult to know when we are officially in a recession (hindsight is always 20/20). Based on historical observations, we have some idea of which asset classes might hold up better in a recession. The challenge is knowing when to effectively rebalance into these asset classes. Our approach is to remain fully invested and balance portfolio risk across multiple markets.