It’s a prevailing topic. The inverted yield curve must mean a sure sign of a recession. It’s coming.
We haven’t had a recession for many years, but we know it could mean pay cuts, job losses, and uncertainty. We also know that the word “recession” causes worry and stress. As if there isn’t enough worry and stress!
And, what will a recession do to the investment portfolio? Should we be taking action now?
It’s important to remember that the markets are driven by fear and greed – two sides of the same coin. Each as dangerous as the other. Fear often causes us to sell at the wrong time, and greed drives us in the opposite direction.
To quote the venerable Yoda:
Fear is the path to the dark side,
Fear leads to anger,
Anger leads to hate,
Hate leads to suffering.
Well, maybe anger and hate are a little extreme in this case, but fear certainly does lead to suffering.
It’s important to be able to pause…, and gain some perspective. This will help us calm any notions of fear, focus on the facts, to help position ourselves appropriately Especially with regard to the investment portfolio.
What could cause an economic slowdown that would lead to a recession? A slowing of activity by the US consumer, who has been keeping that economy going at a strong pace. Trade wars will add to costs for the consumer, and disrupt global supply chains. A spike in the price of oil. Add political disruption (plenty of that at the moment), and we could end up in a recession. All very likely.
The inverted yield curve is suggesting that investors are buying longer term US government bonds at a higher rate than shorter term govvies. When they do this they drive the price of the longer bonds up, and the yields on those bonds goes down. If investors are spooked by something (like a trade war), they’ll buy in greater quantities, going for safety with a longer maturity. So they are parking in the safest bet, with a longer maturity. In doing so, they are not deploying their money to invest in the economy, instead that money is sitting on the sidelines in safety. This drives down the longer term yields, and they will drop below yields of similar bonds with a shorter maturity. It’s an investment anomaly caused by fear.
At a certain point a recession becomes a self-fulfilling prophecy. The money used for capital projects and investment gets sucked out of the system and parks in govvies. Few Chief Executives will invest when market indicators hint at an economic slowdown. These executives are judged by their quarterly results, and a slight dip in the quarter’s performance will result in a punishing of the share price, and likely cost him or her their job within a few quarters. Besides why would they take the risk of deploying capital on expansion if whatever they produce can’t be sold due to a recession? So they will park the cash, pay down debt, buy back shares, or pay a special dividend – anything to keep shareholders happy.
This puts us as individual investors in an interesting situation. Fear has crept into the markets, yet the equity markets are within sight of historic highs. The US consumer has slowed recent activity, but spending is still strong. The US housing market also looks healthy. There could well be a recession coming, but the fundamentals don't look as bad as in previous recessions – the 2007 US housing debacle comes to mind. So if we do go into an economic slowdown, the underlying structure still seems quite sound, pointing to a shallow dip. But a recession none the less.
There are few important points to remember.
- Prior to a recession, the equity markets have historically posted very strong returns - don’t sell too soon
- The current environment of low interest rates means that many bonds pay very low yields. These are usually the safest bonds. Many people are trying to maximize yield. This is not the time to maximize yield. This is the time to ensure bonds serve their function in a portfolio - safety
- Fears of recession will bring fear into the markets, causing volatility (and suffering)
- Periods of volatility are good for rebalancing the portfolio, to sell highs and buy lows
- Equity indexing, or buying ETFs, will result in a market-like experience - ensure you have the appropriate ETFs that will mitigate volatility, or move to proven active managers
- Finally, and most importantly, a recession does not mean the end of a bull market, this bull market still shows indications of continuing for a long time, even through a recession
Just as the seasons are a natural cycle, recessions are also a natural component of the economic cycle. We prepare for the seasonal changes by wearing or shedding more clothing. In a similar way, we prepare and position ourselves for economic fluctuations, in particular as it relates to our investment portfolio.
Pausing to understand the underlying causes of fear, and working through the mechanics of what to do will help us weather the storm. There will always be storms, and some will be worse than others. But we prepare for storms in the same way as we would prepare for anything, including a coming recession – by understanding what’s coming, making appropriate adjustments, and taking advantage of any opportunities.