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Recession Proofing Your Investment Portfolio – The Best Asset Classes To Survive A Downturn!

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;

Gold vs S&P (US equity) performance during 2008-10 recession.

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.

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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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6 Reasons Why Rental Property Is Always A Winner

There are a whole host of investments out there, each with unique risk, liquidity and feasibility characteristics. I firmly believe in diversifying your portfolio, but for this post I want to share why I’m a fan of property investment and think that it’s something everyone should and can invest in. Not forgetting its an actual physical asset you can touch and feel – here are my 6 reasons;

Steady income with tax deductible expenses

The rental income you get on property investment provides a source of steady, passive income. This is unlike equity investments where not all companies pay out a dividend. In addition, you have control over the property (i.e choice of tenants, renovation, structure) whereas with equities – you have a negligible, if any influence over the strategic, operational or financial decisions of the company!

Owning a rental property is like owning a business, in that pretty much all expenses related to running the property are deductible from the rental income – which lowers your tax bill. Of course, there is no escaping property taxes but you can be smart and optimize your tax deductible expenses….legally.

Tenant pays down your mortgage

Most people take out a loan secured on their rental property, i.e. a mortgage – in order to purchase the property. As part of the loan, there will be monthly payments – which will include a mixture of loan repayment and interest. To service these payments, you rent out the property to earn rental income, and essentially this income covers the monthly mortgage payment and (hopefully) leaves a surplus/profit every month.

So basically, your tenants are paying off your mortgage. As a result, your outstanding loan reduces and the interest on that loan becomes lower (due to a lower loan balance). In time, you may increase the rent due to either a buoyant rental market or through your additional work/renovations you carried on the property.

Through this combination of lower monthly loan repayments and higher rent, your profits and cashflow increases. Eventually you want to get to a position where your rent pays off the entire mortgage, and you no longer owe the bank. This takes time, but it can be sped up with lump sum down payments where possible. T

The aim should be to get the property free of debt – making it a low risk, high return strategy in the long-run.

Inflation hedge

Property prices like most markets are subject to economic cycles and the micro-economics of supply and demand. However if you are prepared to stay invested in property for the long haul, you will find that the real returns of property are positive, i.e. after adjusted for inflation effects – the rental and capital appreciation of a property exceed the inflation rate.

This is not the case for all equities or fixed income investments. For the last 40 years both the US and UK residential property market returns have exceeded the rate of inflation. This particularly is due to the progressive increase in property prices rather than rental yields. Of course, the returns vary within regions, and that’s where location becomes a huge factor in your property investment strategy.

Sail through those economic cycles

Consider these economic scenarios that illustrate that if held over the long term, your property investment is a safe bet:

  1. Low interest rate environment => Cheaper to borrow/refinance mortgage => more house purchases => house prices increase. GOOD FOR LANDLORDS
  2. Higher interest rate environment => More expensive to borrow => fewer house purchases => mortgage payments higher => people more inclined to rent. GOOD FOR LANDLORDS
  3. Supply of housing exceeds demand => House prices stagnate/reduce => more purchases due to lower prices => eventually pushes up house prices. GOOD FOR LANDLORDS.
  4. Demand for housing exceeding supply => Can be good for house prices, rent or both. GREAT FOR LANDLORDS!

Of course, the above is just a basic implication model, and there are other factors that can contribute to the housing market, i.e. regional housing micro-structure, global credit event (i.e. Credit Crunch of 2008-2010), rental ceilings, property taxes etc.

Ariel view of properties

Leverage!

A key feature of property investing is the ability to benefit from ‘leverage’.

For example, to buy a £200,000 property would cost you just £62,000 (assuming 25% mortgage, £5k refurb, and £2k legal costs) rather than the full £207,000.

If the property price then increased over two years to £250,000, upon selling the property you’d receive £100,000 (£250,000 – £150,000 outstanding mortgage), a phenomenal 61.2% return on cash invested, while also receiving rental income.

While this is true, the reverse also holds. If the property value declines from £200,000 the investor experiences negative equity and his/her loss on investment is also amplified due to leveraging (borrowing).

Of course, the recent stamp duty changes and tax laws introduced by the UK Government on buy-to-let property has significantly reduced cashflow for landlords. As a result, investors have become less incentivized to acquire further properties fulfilling the Government’s intentions. Despite this, there are still many property investment strategies available to investors, including;

  • ‘Flipping’ (developing and selling the property in the short term)
  • House in Multiple Occupation (HMO)
  • Short-term lets including Air-BnB
  • REITs (Real Estate Investment Trusts)
  • Crowdfunding (see below)

On a budget…try Crowdfunding

Owning properties is great, but with the higher deposit requirement for buy-to-lets or rental properties, it means you can have a lot of capital tied into one property…not forgetting the taxes and any refurbishment costs.

Real estate crowdfunding allows you to invest in real estate along with other investors, usually through a platform that will propose real estate deals and take care of all the work, like listing deals, doing all the legal work, and then managing the property. This allows you to invest as little as £1,000 into a residential or commercial real estate project for potentially 8 – 13% annual returns based off historical data.

This beats the return from £1000 in your savings account! With real estate crowdfunding investing, there’s also physical asset that’s backing your investment – similar to direct investing.

In addition, crowdfunding is great for people who want the hassle of tenants or renovations and essentially want a ‘hands off’ approach once the investment is made.

Essentially, it allows an investor to invest in a variety of property deals (residential, commercial, industrial) with a much lower capital injection. Click here for a list of recommended crowdfunding platforms.

What about the recession?

The last recession in 2008 onwards was driven by irresponsible lending to house buyers, complex credit products and greed. On top of that, the banks and lenders had rubbish capital buffers and so suffered wild losses – and had to be bailed out, severely affecting the markets, economy and consumer confidence. This time around there is more regulatory scrutiny over financial products, lending and bank capital adequacy. In other words, we are unlikely to see large corrections in house prices – although that’s not to say they won’t be affected.

Consumer confidence is hit in a recession and people are less likely to spend and invest, which reduces house prices. And the property investor needs to be prepared to ride these out – especially if s/he doesn’t have a need to sell. Note that a recessionary environment also provides opportunity to purchase assets at a discount!

I would always recommend investing in property for the above reasons. Refer to Global Property Guide for a useful source on property trends, statistics and news across the world. As mentioned at the top of this article, rental properties should form part of a diversified portfolio thus aiming to spread risk. Of course, all investments should be entered with a thorough due diligence.

Property investment is a great way to generate a passive income. Another way is through a profitable, online business. If you are keen to learn about setting up an online presence, developing unique digital marketing skills and generating an impressive income online, click here to get started!

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