One of the issues that likely will worry investors in 2023 is the possibility of suffering through a recession. A recession would have an impact on both the daily life, and the working life of citizens. But it will also impact our investments, as a recession would affect corporate earnings, interest rates and valuations of different asset classes.
A Recession is the Most Likely Scenario for Many Countries
Mike Coop, Chief Investment Officer, Europe, Middle-East & Africa for Morningstar Investment Management agrees that “as investors, the reality is that a recession appears the most likely scenario for many countries”.
However, it is impossible to know both the severity and duration of any potential recession. According to Preston Caldwell, Morningstar’s head of U.S. economic research, it’s a virtual coin toss—at least in the U.S., which accounts for around a quarter of the global GDP3 and over 60% of the global stock market. He stresses the need to look beyond 2023: "Either way, we expect growth to accelerate again in 2024 as the Federal Reserve lifts off the brakes" Caldwell said.
It's not all bad news for 2023.The resolution of supply chain issues has begun to lower the price of goods and should continue to tamp down inflation. Caldwell forecasts that inflation has a reasonable probability of receding to normal levels in 2023 and could even undershoot the Fed’s 2% inflation target by 2024.
How to Deal with a Recession, Or What Should I Do Now?
Coop also stresses the fact that every investor will endure multiple recessions in their lifetime. The key is how we deal with them, as recessions have a habit of bringing out the worst in investors. He offers 3 recommendations for investors to deal with a recession (which are the foundations of Morningstar Investment Management):
- Goal Setting as a True North: Coop says that it is important to make sure your goals and objectives remain relevant. “Given the changes we’ve experienced in recent years, it is not unusual for these goals to have shifted. This includes confirming the timeframe for reaching them. Whatever the outcome of this review, there are big advantages of measuring success in terms of progress to reaching your goals, rather than beating the market”.
- Stay the Course with a Well-Diversified Portfolio: Coop recommends erring on the side of caution every time there is a period of uncertainty, adding “Check that you are taking the right amount of risk to reach your goals—one that you can live with in bad times and one that will be enough to at least keep pace with inflation.” How to do this? Simply by having a diversified portfolio including assets that behave differently to others when there is recession—such as equities and high-quality bonds.
- Use Valuation to Get the Odds in your Favor: Coops also thinks that it “is desirable to favor assets that already reflect pessimism about the future as these assets are less prone to falling than assets that are highly popular, have gone up a lot and are priced for the best possible scenario—and therefore, not very likely to occur. Within equities, we find it imperative to balance exposure between the most attractively valued assets along with stabilizers such as dominant companies with little debt and goods and services that are perennially in demand. Examples can often be found in areas like healthcare, utilities and consumer staples”.
The Real Issue is Fear, Which Might Lead to Bad Behaviour
According to Coop, asking if there will be a recession—and how to avoid it—misses the point. The true questions people are asking are “Am I okay?” and potentially “Can I do something smart at this time?”
While these questions are always well intended, they could lead to dangerous behaviours, and so it is always healthy to center back on the truths of investing during a recession. According to Coop, these are the truths of investing in a recession:
- To get investment returns you need you to take risk—cash is unlikely to help you beat inflation and grow wealth over time.
- Recessions are common (occurring every 7—10 years on average), temporary (lasting several years) and eventually followed by economic recovery.
- Stocks tend to front-run the economy, not the other way around. They will also front-run the economy before the recovery happens. This makes market speculation incredibly difficult as you need to get two decisions right (exit point and re-entry point) amid heightened uncertainty. Very few, if any, have this skill.
- Stocks do have a track record of falling before and during recessions because company profits fall and bankruptcies rise. However, they have always recovered lost ground in the years that follow.
- Bonds have a track record of doing well because inflation and interest rates tend to drop. Today, interest rates and bond yields are high enough for bonds to provide this offset.
- The main way you fall short of your financial goals is a permanent loss of capital where you never recoup the losses. These can occur in recessions (such as a low-quality investment that goes bankrupt), so care needs to be taken.
- Three killers that trigger permanent losses are: 1) speculative investments with no basis for their valuation, 2) assets with too much debt, and 3) selling out at the bottom because of behavioural biases.
- Buying shares when they are cheap tends to lead to higher-than-usual returns because markets price in bad scenarios and there is upside if conditions improve.
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