A six-point checklist to safeguard against recession

Well thank goodness for that. We’ve made it past the end of June, and in doing so completed a half year that no investor is likely to want repeated. 

There have been some brighter spots - the commodity and oil-rich UK stock market has done better than most - but if you’ve kept your head above water financially in the year to date, consider it a job well done.

As we face the second half of 2022, one key question arises. Are we heading into a recession this year or next? If yes, then two further questions follow. What should we do with our investments? And, equally important, what should we not?

A couple of months ago, this would have been a more nuanced question. Jay Powell was still talking about engineering a ‘softish’ landing for the US economy. Today that seems almost childishly optimistic. And the Federal Reserve (Fed) chair now hedges his bets by saying that a recession is not an ‘intended outcome but certainly a possibility.

My strategy colleagues here at Fidelity now believe there is a 60 percent chance of a hard landing in which central banks push the economy into recession, by accident or by design, in order to rein in dangerously rising inflation expectations. 

They think the chance of a soft landing, taming inflation with no significant economic pain, has halved to just 20 percent.

That chimes with the message from Goldman Sachs, which thinks the decision to front-load the necessary rate hikes with back-to-back 0.75 percent increases this northern-hemisphere summer, raises the chance of a recession this year to 30 percent. If that doesn’t materialise then they think there’s a 25 percent chance that it comes next year which means overall the odds of a recession by the end of 2023 are about one in two. A coin toss.

Two other signals point to a recession at some point fairly soon:

First, the difference between the yield on short-dated government bonds and on those maturing further out is negligible. This is what investors mean when they say the yield curve is flat or inverted. What it tells us is that investors think interest rates are too high today and so won’t need to be high in the future. It’s not failsafe but as a canary, in the coalmine, the yield curve has a good track record.

A second worrying signal is what is happening in the commodity markets, and in particular with copper, thought to be the most economically sensitive of all the metals. 

Copper is found in many manufactured goods, from cars to household appliances. It is a key component in construction. As such it is rightly viewed as a bellwether of the global economy. That’s why it’s sometimes called Dr Copper and why it is worrying that its price has fallen by 14 percent by June this year to a 16-month low. It’s a quarter down since the high point in May 2021 at what now looks like peak re-opening. May last year is also, as it happens, the point at which the US stock market’s valuation multiple topped out, since when it has fallen by a third.

As usual, the financial markets have done a better job of spotting trouble ahead than the experts. And, as ever, to paraphrase Jimmy Goldsmith, by the time you see the bandwagon it’s too late. The really smart money would have started betting on a recession at the time everyone else was getting excited about the post-pandemic recovery.

The moment when the market pivoted from optimism to pessimism may be long gone but that does not mean the question of whether a recession is on its way is now redundant. 

The market has gone some way to pricing in an economic slowdown but like the rest of us, it is sitting on the fence. A mid-teens price-earnings ratio makes sense if the worst outcome can be avoided. In a full-blown recession, there are plenty of downsides still to be explored.

So, there’s still merit in positioning our portfolios for further pain. I’d suggest a mixture of Dos and Don’ts, though of course before making any investment decisions you should seek advice from your financial adviser. 

Top of the To-Do list is to buy quality. The companies usually best placed to pull through a recession are those with solid balance sheets, decent profit margins, and strong positions in their markets. 

Once the light appears at the end of the recessionary tunnel, no one will care about quality and the rubbish will rise to the top. But we’re a long way from that point. Consider sticking to the best for now.

The same thinking points to defensive companies, those selling goods and services that we can’t do without such as food, household products, utilities, insurance, and critical infrastructure. Cyclical stocks will have their day as we move through the recession but, again, we are not there yet.

Third, buy protection. As the recession is confirmed, it may well become clear that central banks won’t be able to deliver the interest rate hikes they have planned. Government bonds yielding more than 3 percent will seem rather interesting if interest rates head lower once more. Consider locking in some of that yield now.

Finally, look to diversify. The outperformance of the UK this year was by no means the conventional wisdom in January. Likewise, preferring China and emerging markets is a minority view today. Investors in Shanghai and Shenzhen took their medicine through Beijing’s regulatory squeeze and the zero-Covid months. Things could look up from here.

And what not to do? First, don’t try and time the market. You probably won’t catch the bottom, just as you probably missed the top at the start of the year. Second, and most importantly, don’t become more bearish as the market falls. It’s human nature to do so. Resist it.

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