Interactive Investor

How to invest during a recession: top tips and tactics

18th November 2020 09:00

Tom Bailey from interactive investor

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We explain what a recession is, why it matters to investors and run through the potential investment winners and losers. 

To understand a recession, we first need to understand economic output and growth. In its most basic sense, economic output is the total value of all the goods and services that an economy produces over a given period of time. This is usually expressed as Gross Domestic Product, or GDP. In 2019, the UK economy had a GDP of $3.162 trillion.

Economic growth is when an economy’s output increases, usually expressed as a percentage increase in GDP. So, for the sake of mathematical simplicity, imagine an economy with a total output (or GDP) that equalled $100 in 2018. If, in 2019, that had grown to $101, the economy would have experienced a GDP growth rate of 1%.

It is good when economies are experiencing positive economic growth, often referred to as “expansion” – and this is the default position for modern economies. However, capitalist economies are also cyclical. Around every 10 years, economies experience a contraction in their output, sometimes called “negative growth”. This means the total output of an economy has fallen over a certain period of time. Simply put, the economy has shrunk. If an economy experiences a contraction for two consecutive quarters (three-month periods) or more, it is said to be in recession.

This is the case for the UK economy right now, as well as many other economies around the world, due to the Covid-19 pandemic. Because of the lockdown, the total output of the UK economy fell almost 20% in the second quarter of 2020 following a 2.5% decline in the first quarter. Importantly, output fell for two consecutive quarters, meaning the UK technically entered a recession.

The UK economy grew at its fastest rate on record in the third quarter of 2020 to bounce out of recession, growing by 15.5%, but there are fears of further hurdles to recovery. A second recession shortly after the first is called a double-dip recession.

How do recessions work?

As mentioned, GDP is a measure of economic output and a recession is defined as a fall in that output. So to understand how recessions work, one of the best approaches is to take economist John Maynard Keynes’ formula for GDP. Keynes saw GDP composed of several inputs: consumption plus investment, plus government expenditure, plus exports, minus imports. In a recession, one or several of these inputs will have taken a serious fall. So, for example, consumers may decide to start spending less. If spending falls by enough, that can, in theory, cause an economy to fall into recession.

The process, however, is dynamic. Often, the different components of GDP interact. This creates somewhat of a chicken and egg scenario. For example, if people spend less, there is less demand in the economy. Faced with lower demand, some firms may be forced to reduce their workforce. Fearing a loss of income, workers stop spending as much or delay large purchases.

In an economy, the spending of one consumer or business is another’s income, so less spending results in less income. This, in turn, results in less spending by those who now have lost out on that income.

Another good lens through which to view recessions is to imagine them as a time when demand for money has increased. So, for example, in a recession, businesses prefer to save their earnings rather than invest in equipment, increase inventory or hire workers. Likewise, consumers, fearful of their income or job prospects, would rather save their money than spend it on new goods and services.

What does this mean for investors?

The important question, however, is what this means for investors. Generally, recessions are associated with low stock market prices. The price of a stock is supposed to represent the current value of the company’s future cash flows. Cash flows are created by the earnings of a company. Lower spending in an economy means lower earnings.

As a result, if the perceived earnings prospect of a company falls, so too does its share price. During a recession, a company’s future earnings will be seen to have decreased. On top of that, companies go bust in a recession, so markets also factor in that risk in share prices. As a result, it is normal for most stock prices to decline before or during a recession.

So, for example, during the global financial crisis, the S&P 500 index fell by around 57%. During the tech crash, the US market fell by around 49%. Likewise, recessions in the 1960s, 1970s, and early 1980s were all accompanied by large market declines. 

However, sometimes markets decline without an accompanying recession. Sometimes this is the case because the market has convinced itself a recession is coming. For example, one of the largest market declines took place in 1987, despite there being no recession. More recently, markets saw two major falls in 2018, both broadly because of a perception that US central bank interest rates were going up. Either way, there was no accompanying recession. However, in each of those incidents, markets quickly rebounded.

In a prolonged recession, prices can sometimes take longer to recover – although it often depends on the type of stocks considered The important point to remember, however, is that market declines often end up happening before a recession is officially declared or recognised.

Complicating factors

There are also several other complicating factors. Occasionally, a country’s stock market does not represent the underlying economy of the country, meaning that a recession does not always result in a market decline. For example, the FTSE 100, the UK’s main market index, is composed of companies that collectively make about 70% of their earnings abroad. As a result, the index often reflects the conditions of the global economy.

If there was a recession specifically confined to the UK, its impact on the FTSE 100 index may not be so severe for two reasons. First, businesses listed on the FTSE 100 would still be able to make money  abroad, unencumbered by the UK’s recession. Second, a UK-specific recession should result in the devaluation of the pound. Companies in the FTSE 100 that earn their profits abroad in other currencies will see an increase in their profits when they are converted back into sterling.

In contrast, companies in the S&P 500 earn around 60% of earnings from the US, meaning its fortunes are much more closely tied to that of the domestic US economy. However, even the S&P 500 can appear disconnected from its own economy. Most recently, the S&P 500 has continued to do well, despite the US experiencing a severe recession, in large part owing to the increasing dominance of big tech companies. 

So while stocks tend to do worse when an economy is shrinking, it is not always so straightforward due to the specific characteristics of a stock market and the companies listed on it.

Different types of stocks

Not all stocks are the same, with some going up or down more than others in different economic conditions. Stocks with prices that are more sensitive to the overall health of the economy are generally called “cyclical stocks”.

When thinking of cyclical stocks it is worth remembering the idea explained above of a recession being a period in which demand for money increases. If consumers are prioritising saving over spending due to a recession, there will be certain products or services that they stop spending money on first. This will include “luxuries” such as holidays, new clothes or so-called large ticket purchases including household appliances or a new car. Therefore, in theory, companies involved with the provision of these goods and services suffer more.

Other examples include oil and energy companies. If output is lower, as happens in a recession, there is less demand for energy, resulting in a fall in the price of oil, which is bad for oil companies. Banks are also cyclical, with more loan defaults during tough economic times.

As Richard Hunter, head of markets at interactive investor, notes: “Examples of cyclical shares are those which will suffer from lower consumer spending and/or unemployment, such as retailers, airlines (less travel, especially the lucrative business market) and banks (higher defaults on loans).”

The opposite of cyclical firms are defensive companies. To understand defensive stocks, think back to the consumer who prioritises saving over spending in a recession. While the consumer can cut back on spending on holidays or new trainers, there are some goods and services that they will not be able to reduce spending on. No matter how bad the economic conditions, most people will still try to pay their water bill. Another example are so-called consumer staples, such as food, household goods and hygiene products, that are all deemed a necessity.

Hunter adds: “Defensive shares tend to fare better and will usually still fall, but relatively less. These are shares where consumer demand will hold up, such as utilities (water, electricity, gas) and supermarkets. More recently one can also add tobacco firms to this list (inelastic demand) and even higher-end retailers, the logic here being that the very wealthy are relatively unaffected by recession.”

As a rule of thumb, companies that are seen as cyclical perform worse in a recession and companies that are defensive perform better. It is also sometimes the case that cyclical stocks do better in an economic upturn and defensive stocks less so.

Other types of stocks also perform better or worse in a recession. One of the clearest examples of this is companies deemed to be “quality growth”. Such stocks are usually defined as those of companies with higher and more reliable profits. These companies are seen as more likely to survive and perform well in a recession. As a result, investors often flock to them during a recession, bidding up their prices. This is partly why US tech companies have done so well in recent months. 

Other defensive assets

There are, of course, other assets that perform better during a recession. One of the most commonly cited is government bonds. During recessions, bonds typically do better for several reasons. First, they are usually seen as safer than stocks. Governments of advanced economies tend not to default, while the income produced by a bond (the coupon) is fixed. This often means that investors rush into bonds during a recession, sometimes called a “flight to safety”, bidding up their prices. Second, governments often respond to recessions by lowering interest rates. Bond prices have an inverse correlation to interest rates – so when interest rates go down, bond prices go up and yields fall.

Another example is gold, often called a safe-haven asset. The yellow metal is seen as a place of relative safety during economic turbulence - gold doesn’t go bust, after all. However, its attraction can also increase in recessions when interest rates are low. Gold, unlike bonds, produces no income. However, if low rates mean bond yields are low the relative attractiveness of gold increases. This is playing out currently in the Covid-19 recession, with gold recently hitting several new record highs.

Reducing risk?

So, if we know that some companies do better than others in a recession, why not just buy these assets when it looks like a recession is coming? Mostly because recessions are notoriously hard to predict before they happen.

Andrew Brigden, chief economist at London-based Fathom Consulting, published research in 2019 showing that out of 469 recessions around the world since 1988, the International Monetary Fund (which hires a lot of smart economists to predict recessions) has a pretty dire record of correctly identifying them ahead of time. He says: “Since 1988, the IMF has never forecast a developed economy recession with a lead of anything more than a few months.” So if IMF economists cannot predict recessions ahead of time, it is unlikely that individual investors will be able to do so.

So, rather than trying to time the market, the better option for investors is to ensure they have a portfolio that can withstand an economic recession. This means having a portfolio that includes assets that should do well during economic growth and some that will do better during a recession. As is usually the case with investing, diversification is key. This allocation, however, must be chosen ahead of time.

As Teodor Dilov, a fund analyst at interactive investor, says: “A diverse basket of investments is usually the most efficient way to protect capital. It is up to the individual to determine which risk profile their situation fits in, but that usually includes a broad mix of equities, fixed income and some alternatives, as well as different sectors and themes on a portfolio level. A recession could bring more uncertainty to the current environment, hence more volatility and higher risk of losing money.”

One of the most popular options is a mix and match between equities and bonds, with the most common being 60% in equities and 40% in bonds, also known as the 60/40 portfolio. As noted above, equities generally do best when an economy is growing and bonds perform best when an economy is in a recession. Having exposure to both means that investors should be able to catch the upside in both. As the table below shows, during each major recession, a 60/40 split between equities and bonds has held up better than a 100% US stock portfolio, when measured peak to trough. For example, in the 2008 global financial crisis, a 60/40 portfolio lost just 36% compared to a 52% loss for a portfolio that had 100% in US equities.

  100% US stocks 60/40 stocks/bonds 60/40 US/international US quality stocks
Max drawdown -52.6% -40.2% -59.4% -22.7%
Covid-19 -20% -22% -41.6% -3.2%
2008 GFC -52.6% -36.6% -57.9% -22.7%
Early 2000s -46.3% -40.2% -59.4% -22.7%
Early 1980s -15.8% -9% -21.9% -6.1%

Source: Secor Asset Management; US Stocks: S&P 500; Bonds: Bloomberg Barclays US Treasury Index; International Stocks: MSCI World excluding USA; US Quality Stocks: MSCI US Quality Index

Fund options

For those looking to construct a portfolio with a classic equity/bond split, Dilov suggests looking at the Vanguard LifeStrategy fund range. He says: “The most conservative option within that range is the Vanguard LifeStrategy 20% Equity Fund, which provides 20% exposure to global equities and 80% exposure to global bonds. For investors with a more balanced profile, the Vanguard LifeStrategy 60% Equity Fund may be a good fit. It provides 60% exposure to global equities and 40% exposure to global bonds via several index-tracking funds run by Vanguard.”

Dilov continues: “Managed by a highly experienced and well-resourced team at Vanguard, the range stands out with a clear and well-defined investment process and consistently produced strong risk-adjusted returns relative to peers. With an ongoing charge of just 0.22%, these funds are the ultimate, globally diversified one-stop shop.”

Certain actively managed funds will provide some sort of protection in a recessionary environment. For example, global funds look well placed on paper to protect wealth in uncertain times, particularly those with a quality focus on defensive growth businesses. One example is Fundsmith Equity, one of interactive investor’s Super 60 fund choices, which in the first quarter of 2020 fell by 7.9%. In contrast, over the same period the average Investment Association fund in the Global sector lost 15.4%.

Given that global fund managers, whether they are income or growth focused, have the flexibility to invest wherever they see fit, such funds should, in theory, hold up better when markets fall sharply than those constrained to investing in a single region. Other global fund examples that focus on or have a notable amount of exposure to defensive growth businesses include Rathbone Global Opportunities, Mid Wynd International investment trust (LSE:MWY) and Trojan Global Equity.

Another option is to consider the small number of wealth preservation investment trusts, which prioritise protecting investor capital. The four trusts that meet this description are Capital Gearing (LSE:CGT), RIT Capital Partners (LSE:RCP), Ruffer Investment Company (LSE:RICA) and Personal Assets (LSE:PNL). Each has a low weighting to equities and plenty of defensive armoury, such as low-risk inflation-linked bonds and a small weighting to gold.

Other defensive options include multi-asset funds. Owing to their greater levels of diversification through investing across various asset classes, such funds should be better equipped to weather a market storm than equity funds that either invest globally or focus on a particular region. The funds with the lowest equity content have less than 35% of their assets in equities and sit in the Investment Association’s Mixed Investment 0-35% Shares sector.

The final option is absolute return funds. Such funds aim to protect investors’ capital during more turbulent times and therefore fulfil their roles as a diversifier in a portfolio. The reality, though, is that absolute return funds have a chequered history at meeting their objectives. Investors should, therefore, tread carefully when considering the sector.

*This article was originally published in August 2020. It was updated on 18 November 2020 to include latest GDP data for Q3 2020.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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