What is a recession?
The economists on both U.S. and Canadian committees use a similar definition of recessions: a deep, pervasive, and lasting economic downturn. In Canada, the C.D. Howe Institute Business Cycle Council (a prominent economic think-tank) is the main organization that monitors the economy’s status and advises the government when, in their opinion, the economy enters or exits a recession. In the U.S, the National Bureau of Economic Research Business Cycle Dating Committee carries out the same function.
While the entrance to a recession often happens quickly, the recovery can be quick or long and drawn out. Recessions are sometimes categorized by the pattern of economic activity’s resemblance to a letter of the alphabet.
V-shaped recession: A recession that involves a sharp drawdown in economic activity followed by a quick recovery.
W-shaped recession: Happens when the economy contracts, briefly recovers, and then dips into another (or sometimes more than one) recession.
What are the causes of a recession?
The economy is subject to the Business Cycle, which has four distinct stages:
- Expansion
- Peak
- Contraction
- Trough
A “recession” collectively refers to the latter, downward-turning part of the economic Peak, the Contraction in economic activity, and the beginning part of the Trough phase as economic decline slows and prepares to reverse to the upside.
Economic shock
Broadly speaking, there can be many causes of recessions, but they are normally triggered by a shock to the economy. For example, the COVID-19 recession (Q1-Q2 2020), which was triggered by the global pandemic and the associated lockdowns, caused a shock to both the supply and the demand sides of the global economy. The COVID-19 recession is an example of a swift “V-shaped” recession.
Mortgage bubble
In 2008-2009, the bursting of the U.S. subprime mortgage “bubble” panicked investors and disrupted the U.S. economy for a more prolonged period, taking over a year for the U.S. economy to regain traction. This was still a V-shaped recession.
Tech wreck
At the beginning of the 2000’s, we experienced the “Tech Wreck”: a recession triggered by the prolonged unwinding of unrealistically high valuations that overly enthusiastic investors assigned to technology stocks. This was a shallower recession from a Gross domestic product (GDP) perspective, but it took longer to recover, and showed some characteristics of a W-shaped recession, with starts and stops on the road back to more pronounced economic growth.
Rise of interest rates
Increasing interest rates can also influence the economy and the financial markets. Some recessions have resulted because of central banks increasing their interest rates in an effort to cool down an overheating economy or to decrease inflation levels.
What are the indicators of a recession?
There are a few signs of a recession that most people are familiar with:
- Two consecutive quarters of negative GDP growth.
- An increasing unemployment rate, whether slow over months or a quick jump, is a sign of concern.
Source: Refinitiv Datastream, NBER Business Cycle and quarterly U.S. GDP Data. From January 01, 1965 to September 30, 2022.
You can prepare your personal finances for a recession. Read more in this article.
What can be the effects of a recession in your portfolio?
Typically, during a recession, the equity markets whether Canadian, U.S. or international will underperform due to lower corporate earnings, valuation multiple compression and higher market volatilities. Small/Mid cap stocks should underperform compared to the large-cap companies due to their weaker financial strength and higher debt ratio.
Fixed income historically tends to outperform stocks during recessionary periods, especially government bonds, which are generally safer than corporate bonds. Within corporate credit, high quality investment grade bonds tend to outperform during recession compared to high yield bonds, as default rates are expected to be higher for non-investment grade bonds during an economic downturn.
Investors should be psychologically prepared for their investment portfolio to be negatively impacted during a recession.
What are an investor’s best practices in a recession?
A recession, as with any market downturn, is not a time to panic. Normally when recession stories start to disseminate in the news, it’s too late to benefit by selling stocks and bonds – the drawdown in equity or fixed income prices has usually already happened by the time investors read about it in the newspaper. Investors who sell after the market has dropped substantially, usually are setting themselves up to miss the future rally in asset prices (which will likely happen just before news outlets begin reporting that the recession is over!)
Stay invested
The good news: recessions in the past have always been temporary, and investment performance tends to be positive from recessionary lows. The average length of recessions in the U.S. since WWII has been around 11 months and the 2008 Financial Recession was the longest one during this period (18 months). Investors should avoid panic selling and stay invested throughout the recession phase in order to benefit from the market recovery opportunities. According to J.P. Morgan, the 10 best investment days over the 20 years ending in 2021 occurred after the big declines of the 2008 financial crisis and the 2020 pullback during the onset of the Covid-19 pandemic.
Below is an illustration of why investors should stay invested instead of attempting to time the markets2:
Source3
Always diversify your assets
A well-diversified portfolio can help investors to weather through different market cycles. Depending on the investor’s risk tolerance level, a strategic asset allocation between asset classes, sectors, investment strategies and geographical regions should be able to reduce the overall portfolio volatility while providing investors with long term growth opportunities.
Set up a systematic investing plan
Investors should also consider starting or maintaining a systematic investment plan, this approach will help remove some of the emotional effects such chasing highs during up markets and panic sell during down markets. With a disciplined systematic investing plan, investors are able accumulate investment assets over time and benefit from down markets to lower the average cost of the portfolio holdings.
Manage your stress level
A recession will cause the stock market to correct but it’s important to remember that your loss on the screen only becomes real when you sell. That said, if you can’t sleep at night, it could be an opportunity to review your risk tolerance. Managing your emotions is of the utmost importance, try not to panic, even the best constructed investment portfolios will experience periods of negative returns.
What investment opportunities can a recession bring?
1. Invest in High quality dividend growth stocks
Dividend growth stocks tend to have competitive advantages and are leaders in their respective industry. The majority of dividend growth stocks have wide economic moats and healthy balance sheet; these companies can grow their profits during a strong economy while remain resilient during recessions. The cash-rich nature of the dividend growth stocks provides investors with reliable dividend payments regardless of the economy conditions and strong downside protections during down markets.
Dividend growers have consistently outperformed the broader market in down market years since 2000:
| Down Years (2000 to 2022 YTD) | 2022 YTD | 2018 | 2008 | 2002 | 2001 | 2000 |
|---|---|---|---|---|---|---|
| S&P 500 Dividend Aristocrats Total Return Index (rendement net) |
-8.7% | -2.7% | -21.9% | -9.9% | +10.8% | +10.1% |
| S&P 500 Total Return Index | -17.7% | -4.4% | -37.0% | -22.1% | -11.9% | -9.1% |
| Dividend Growth Outperformance | +9.0% | +1.7% | +15.1% | +12.2% | +22.7% | +19.2% |
Source: Morningstar, January 1, 2000 to Nov 29, 2022
2. Invest in healthcare sectors
The healthcare sector provides both stable dividend and defensive characteristics. Demand for healthcare services will always occur and tend to increase as the population ages and people are enjoying longer lifespans. Many large cap healthcare stocks can generate durable cash flow, due to their diverse product offerings, and can be profitable even during recession periods. These are attractive defensive investment characteristics.
Healthcare Companies have delivered over 20 years of steady earnings growth & stable share performance relative to broad markets:
Source: Bloomberg. Trailing 12-Month Earnings per Share, as at 2022-09-30. Earnings rebased to $100 at January 1, 1999.
3. Execute covered call strategies
By using a covered call strategy, portfolios can draw on three main sources of potential total return:
A. Capital appreciation of the
underlying equities in the portfolio
B. Dividend income from the
portfolio
C. Premiums earned from writing call options
The market volatilities will surge significantly during recession periods, which will result in an increase option premium. The increased premium collected through option writing should result in increased cash flow and provide additional downside protection for the client’s portfolio. This can be an ideal environment for covered call strategies.
4. Invest in value stocks
During a recession value investing tends to hold up better than other types of investment strategies. Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic value (what the asset is worth). Value stocks are generally in mature industries, have predictable growth and earnings even during a recession.
No one can predict with accuracy when a recession will come or how long it will last. What we know is that investors who have a disciplined approach, a diversified portfolio, and stay invested throughout the various market cycles tend to be rewarded with long term capital growth.
Key takeaways:
- Definition of a recession is a deep, pervasive, and lasting economic downturn.
- There can be many causes of recessions, but they are normally triggered by a shock to the economy, e.g . COVID-19.
- The best practices for investors during a recession are: stay invested, always diversify your assets, set up a systematic investing plan and manage your stress level
- Recession can bring investment opportunities, like investing in value stocks, covered call strategies, specific sectors and dividend growth stocks
1 National Bureau of Economic Research, Peak to Trough months since 1945, "US Business Cycle Expansions and Contractions, https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions”
2 Returns are based on the S&P 500 Total Return, best days are those with the highest daily returns between Jan 1, 2002 and Dec 31, 2021. https://www.cnbc.com/2022/03/09/you-may-miss-the-markets-best-days-if-you-sell-amid-high-volatility.html
3 CNBC & J.P. Morgan Asset Management analysis using data from Bloomberg. Returns are based on the S&P 500 Total Return, best days are those with the highest daily returns between Jan 1, 2002 and Dec 31, 2021. https://www.cnbc.com/2022/03/09/you-may-miss-the-markets-best-days-if-you-sell-amid-high-volatility.html
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