While it would be Utopian to have the economy grow at a stable rate, economic recessions are a fact of life and are as unavoidable as the setting of the sun. The economy has a cycle that involves both periods of growth and expansion, and periods of decline and recession.
What Is a Recession?
A recession can be defined as an extended period of significant decline in economic activity, including negative gross domestic product (GDP) growth, faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes and weakening sales and production. This is not exactly the environment that would lead to higher stock prices or a sunny outlook on stocks.
Other aspects of recessionary environments as they relate to investments include a heightened risk aversion on the part of investors and a subsequent flight to safety. However, on the bright side, recessions do eventually lead to recoveries and follow a relatively predictable pattern of behavior along the way.
Here are tips on how to keep your investment safe in a recession.
Keep an eye on the horizon
The real key to investing before, during and after a recession is to keep an eye on the big picture, as opposed to trying to time your way in and out of various market sectors, niches and individual stocks. Even though there is a lot of historical evidence of the cyclicality of certain investments throughout recessions, the fact of the matter is that this sort of investment acumen is beyond the scope of the ordinary investor. That said, there’s no need to be discouraged because there are many ways an ordinary person can invest to protect and profit during these economic cycles.
To begin with, consider the macroeconomic issues of a recession and how they affect capital markets. When a recession hits, companies slow down business investment, consumers slow down their spending and people’s perceptions shift from being optimistic and expecting a continuation of recent good times to becoming pessimistic and uncertain about the future.
Within equity markets, the results are pretty obvious. As people become uncertain about prospective earnings, they perceive a greater amount of risk in their investments, which broadly leads investors to require a higher potential rate of return for holding equities. Of course, for expected returns to go higher, current prices need to drop, which occurs as investors sell their higher risk investments and move into safer securities, including government debt. This is why equity markets tend to fall, often precipitously, prior to recessions as investors shift their investments.
Recessions and specific investments
In fact, history shows us that equity markets have an uncanny ability to serve as a leading indicator for recessions. For example, the markets started a steep decline in mid-2000 before the economic recessionary period between March 2001 and November 2001. But even in a decline there is good news for investors: there are pockets of relative outperformance to be found in equity markets.
When investing in stocks during recessionary periods, the relatively safest places to invest are in high-quality companies with long business histories, as these should be companies that can handle prolonged periods of weakness in the market.
Also, traditionally, one of the safe places in the equity market is consumer staples. These are typically the last products to be removed from a budget. In contrast, electronic retailers and other consumer discretionary companies can suffer as consumers hold off on these higher end purchases.
Investing in fixed income in a recession
Fixed-income markets are no exception to this line of reasoning. Again, as investors become more concerned about risk, they tend to shy away from it. Practically speaking, this means investors steer clear of credit risk, meaning all corporate bonds (especially high-yield bond) and mortgage-backed securities because these investments have higher default rates than government securities. Again, as the economy weakens, businesses have a more difficult time generating revenues and earnings, which can make debt repayment more difficult and could lead to bankruptcy as a worst-case scenario.
Investing in commodities in a recession
Another area of investing you may want to consider in the context of a recession is commodity markets. The general rule to understand about these investments is to keep in mind that growing economies need inputs, or natural resources. As economies grow, the need for natural resources grows, and the prices for those resources rise.
Conversely, as economies slow, demand slows and prices go down. So, if investors believe a recession is forthcoming, they will sell commodities, driving prices lower. However, commodities are traded on a global basis, and local economic activity is not the sole driver of demand for resources such as oil, gas and steel, so don’t necessarily expect a recession in Nigeria to have a direct impact on commodity prices.
Will the sun come out tomorrow?
To conclude, the best advice to investing during recessionary environments is to focus on the horizon and manage your exposures. It is important to minimise the risk in your portfolio and maintain your capital to invest in the recovery.
Of course, you’re never going to time the beginning or end of a recession to the day or the quarter, but seeing a recession far enough in advance isn’t as hard as you might think. The real trick here is to simply have the discipline to step away from the crowd and shift away from risky, high-returning investments during times of extreme optimism, wait out the oncoming storm, and have an equal discipline to embrace risk at a time when people are shying away from it to get ahead of the cycle.
Courtesy: http://www.investopedia.com
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