It’s worth preparing your portfolio in the event of an economic downturn. This article presents some of the options available to protect against a significant drop in the markets.
It’s been over 10 years since the last recession, and as business cycles tend to last between 8 to 10 years, many are wondering whether we’re due a slow down in the economy and a recession.
A recession is essentially a business cycle contraction when there is a general decline in economic activity. Usually, key macroeconomic indicators such as GDP, investment spending, capacity utilization, household income, business profits, and inflation fall for at least 2 consecutive quarters.
A key financial market indicators is the 2-10yr Treasury note spread. This is difference in yield between the 2yr and 10yr Treasury notes, and indicates the general shape of the yield curve, i.e. positive (upward trending), negative (downward trend) or flat. When investors expect weaker growth, low inflation and easier Fed policy, the yield curve flattens or inverts.
See below graph of the 2-10yr spread, with the key recessionary periods (1980-82, 1990-92, 2000, 2008-09) highlighted. You can see that the spread is close to, or at zero just before the recession;
With the current spread at around 0.1% and the yield curves of most developing nations either flat or inverted, it makes sense to consider those assets available to investors as a ‘recession’ hedge;
Gold
Gold (and silver) has been a reliable medium for thousands of years because of its quality as financial insurance, a store of value, and its tangible nature.
Gold has long been known as a safe haven for investors in times of chaos in the general equity markets. The run to gold during recessionary periods (demand > supply) creates an uptick in the value of the commodity.
The most recent recession occurred between 2007 and 2009. It was a brutal and long economic downturn that was driven by the housing crisis and reverberated around the world. To give you an idea of how painful this period was for investors, the S&P 500 Index was down roughly 37% between December 1, 2007, and May 30, 2009!
But what happened to gold? The price of the yellow metal rose 24%! It wasn’t a straight rise — gold was down around 10% at one point — but it never fell as much as stocks. Overall gold held its value at a time when stocks just kept falling.
Exchange-traded funds (ETFs) like SPDR Gold Shares (NYSEMKT:GLD) or iShares Gold Trust (NYSEMKT:IAU) track the price of gold, and are probably the easiest and quickest way to get gold into your portfolio as you don’t have to worry about taking delivery of the metal.
Jewelry demand (makes up 50% of gold demand) is more resilient than you’d probably imagine. And with gold jewelry demand coming primarily from India and China, a U.S. recession won’t necessarily change the desire for jewelry in those countries. Gold jewelry is also a status symbol, and as these countries move up the socioeconomic ladder, demand for gold jewelry is likely to rise over time.
See below the annual returns for gold compared to the S&P 500 during the last recession. You can see that gold outperformed the US equity benchmark in this time;
Government bonds
The reason why bonds do well in bad times is that they’ve always been considered a risk-off or ‘safe’ asset. U.S. treasuries, and especially long-term government bonds, are thought of safe, solid investments as there is very little chance of default on those assets by the government. The U.S. is not likely to go bankrupt even during a recession.
During recessionary periods, Investors are risk-averse and tend to shy away from credit risk, such as corporate bonds (especially high-yield bonds) and asset-backed securities (i.e. mortgage-backed securities), since these investments have higher default rates than government securities.
Investors will therefore seek safety and invest into government bonds, say U.S. Treasury bonds. As a result, the prices of risky bonds go down as people sell and the price of Treasury bonds increases. See below a chart of 3 long-term government bonds (UK gilts, German Bund, US 10yr Treasury) compared to the S&P 500 during the last recession. Note that while the bonds provided positive returns in 2008 compared to the circa 37% downturn in equities, the volatility of the S&P 500 (helped by people piling into cheaper equities) resulted in higher returns in S&P 500 compared to the bonds in 2009 and 2010.
Of course, the introduction of the quantitative easing (printing money) programme and numerous rate cuts in the US, Eurozone and the UK after 2010 resulted in significant positive returns for those sovereign bond securities.
Consumer staples
Even in the worst of times, consumers still buy the same amounts of staple goods like toothpaste and toilet paper. Historically, consumer staples equities have held up best out of any sector during hard times.
When the S&P 500 plummeted 49% during the dot-com crash, consumer staples as a group were up 1.2%. Although they fell 29% from peak to trough during the financial crisis, they actually performed the best of any sector.
Another benefit consumer staples provide is their low volatility. Companies in the sector rarely experience sharp price declines. Because of this, they have had the fewest bear markets of any S&P sector.
Consumer staples perform well in downturns also because of their reputation as high-quality dividend stocks. If a company can pay out even in the worst of times, investors will buy it. In addition, many of the consumer staple companies paying dividends have actually increased their dividend payments year on year!
McKinsey found that earnings in this sector remained nearly steady in every recession dating back to 1980. Put simply, consumer staples are cycle-agnostic.
See below a chart from Gallard Research comparing the performance of the consumer staples subindex and S&P 500 during the last recession. While the subindex did lose value, it was less than half of the value lost by the S&P 500 during the period;
Cash
Risk-averse and unsophisticated investors will often stash their cash in money market funds when they get nervous about the markets. While these funds do provide a high degree of safety, they should only be used for short-term investment.
Moving a good portion of your portfolio to cash or a CD (certificate of deposit), you can still make around 2-3% (guaranteed) based on today’s risk-free rate. While it’s pretty modest, you’ve got to weigh a guaranteed return against the possibility of missing out on further gains or the possibility of losing money.
Go short!
It’s very, very likely that if you’re anticipating a recession then the equity markets will undergo a large dip. If you’re willing to take a risk, why not go net short in the equity markets? As a retail investor, you can do this by investing in those ETFs that go up when the underlying equity market it tracks goes down. This is known as a leveraged Inverse/Short ETFs, and they seek to provide X times the opposite return of an index for a single day.
Of course, as they’re leveraged they carry larger than normal risk – so you have to know what you’re doing and have a stop in place! Click here for a list of leveraged short ETFs.
Conclusion
Recessions can be emotional times for investors and the general public. If you have an investment portfolio, ensure it is well diversified. The above asset classes are some ideas that can be implemented into your portfolio.
However, the best way to protect your income during a recession is to have a variety of income sources you can rely on (not just your employment or your investment portfolio). This is why I recommend starting an online business and generate a sustainable, passive income.
To learn more, click here.
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