Experts predict that the global economy will soon be approaching an unavoidable recession. With rising inflation and costs of living, increased layoffs drop in GDP, lower consumer confidence, a bear market, and a deflated economy, it’s easy to see why many analysts believe that the global economy is on its way to a contraction.
According to a Bloomberg survey of economists, the median probability of a recession in the next 12 months increased from 30% in June to 47.5% in July.
While economic downturns aren’t as long as expansions, they can be highly costly to investors. For example, the S&P 500 has dropped an average of 32% during past recessions. This can be a stressful time for investors.
Many people’s first instinct is to cash out and stop investing altogether. But if you are a long-term investor, your first goal should be to learn how to safeguard your investment portfolio and minimize losses. The good news is that you can use methods to protect your assets and see some growth even while the economy is struggling.
Defining a recession
Economic analysts define a recession as two-quarters of negative growth in a country’s gross domestic product (GDP). It is a lengthy and widespread economic decline that lasts more than a few months.
A recession doesn’t happen overnight; it shows symptoms long before it starts. In periods of economic vulnerability, confidence waivers among consumers and businesses, unemployment rates grow, real incomes drop, and sales and production plummet—none of which fosters investor trust or stock market growth. When the economy is struggling, investors become more risk-averse.
Is the stock market a predictor of recession?
Bear markets related to recessions generally start before economic activity and last longer than bear markets not associated with recessions.
Of course, there’s no way of knowing how significant or long-lasting a stock decline will be. Inverted yield curves have historically been the most reliable recession predictor, but they aren’t always accurate. Nevertheless, overreacting to potential recession signs could have costly consequences, so try to stay calm.
Economic expansions often last longer than people anticipate and end with some of the most significant stock-market gains. This is why experts recommend staying on course. Don’t stop investing. Do it regularly and keep costs low. Stocks are often cheapest when prices are dropping.
Diversification is key
Seasoned investors know that it is difficult to predict when a recession will happen accurately, and often it is too late to exit riskier investments when they sense danger. However, a well-diversified portfolio has a much higher chance of returning after being hit during an economic downturn.
Consider buying a basket of different assets—including bonds, stocks, commodities, CRE, and REITs—rather than putting all your money into the stock market. You may also diversify your portfolio by including a variety of small to large firms from many industries and sectors.
If you have enough capital, it might make sense to think global. Investing in foreign and domestic assets can weather economic slumps better than putting all your eggs in one basket by sticking to investments from one country.
How to pick stocks during a recession
Even though recessions don’t happen often, they can cause economies and portfolios to drop quickly, leading investors and companies to become much more conservative. When risk premia rise, the prices of risky assets generally fall. (Risk premia is the minimum return investors expect from a risky investment over and above what they could get with a less-risky alternative.)
Gold and bonds have historically done the best during recessions, while high-yield bonds and commodities have generally fallen alongside equities.
That said, there are still opportunities to make money from stocks. For example, the safest bets during a recession are stocks of large and reliably profitable companies with a history of weathering bear markets. In addition, businesses with solid balance sheets and healthy cash flows tend to do far better than those with substantial debt or experiencing significant declines in the demand for their products.
In the past, the consumer staples sector has outperformed other sectors during recessions because it provides essential items that people need and will continue to purchase regardless of the state of the economy.
Staples include food and beverages, alcohol, tobacco, household goods, and toiletries. Meanwhile, appliance shops, auto producers, and technology providers may suffer losses as customers and businesses reduce spending on these categories.
Commercial properties as an inflation hedge
Stocks, bonds, and other assets may fall in a recession as consumers cease spending, jobs are lost, and businesses reduce their investments. But certain parts of the market do well in a downturn. Real estate is one of them.
Real estate is an asset class proven to create wealth and safeguard against inflation. Many experts even call it recession-resistant. As a result, sophisticated investors often use commercial real estate loans as a haven in choppy waters.
But not all commercial properties are created equal, and some are hardier than others during an economic contraction. Those that outperform the market usually possess four specific qualities: a good location, sufficient cash flow, modest capital needs, and solid fundamentals and functionality.
The recession-resistant CRE classes include self-storage facilities, mobile home parks, suburban multitenant offices, and medical office buildings.
Earlier, we published a blog called The Best Commercial Real Estate Assets to Invest in During a Recession. Read it to know more about these recession-resistant CRE categories and why it might make sense to hold them in your portfolio.
Buying REITs to weather the storm
Companies that can control costs while capitalizing on rising prices are more likely to succeed in an inflationary environment. For example, certain real estate investment trusts (REITs) may do well during this time, as their cost structures are less impacted by inflation and may reap the benefits of inflation.
A REIT is a corporation that owns and manages the real property. REITs pay generous dividends, one of their most appealing features to investors seeking current income. In addition, the future value of a REIT is easier to predict because the revenue streams are contractual.
REITs are also less vulnerable to exploitation and underperformance because they must legally distribute at least 90% of taxable income to investors.
Unlike C-Corps with excessive free cash flow—which frequently leads to internal scarcity and mismanagement of corporate resources—REITs have a more disciplined approach in which investors are paid first.
Read Investing in Resilient REITs Stocks During a Recession for more information on this matter.
Positioning investments for recovery
A recession might seem like the end of the world, but it rarely lasts. The US (as do most other countries) have fiscal and monetary policy tools available to help promote recovery. Once the imbalances that caused the recession are corrected, economies usually rebound even without policy support. It’s essential to keep this in mind if you are an active investor.
To sleep better at night, build up your savings and emergency fund. Knowing that you have cash for unexpected events—that you don’t need to dip into your investment portfolio should life throw you a curveball—will make you less emotional about your investment decisions.
Think long-term, and don’t be swayed by investor anxiety. Remember that as the recovery unfolds, what were seen as recession risks (such as high operating leverage and reliance on economic momentum) may become advantageous for growth and small-cap stocks that have fallen out of favor during the downturn.
When the economy rebounds, mortgage-backed securities and corporate debt of all grades become more appealing. Market recovery is typically good news for commodities, too, since greater economic activity increases demand for raw materials. That said, it’s important to remember that commodities are traded globally; thus, the US economy doesn’t have sole control over the demand for these materials.
During a recession, riskier assets such as high-yield bonds and stocks tend to decline while US Treasuries and gold appreciate. Conversely, stocks of large companies with reliable, consistent cash flows and dividends typically outperform economically sensitive stocks during periods of instability. Certain types of CRE and REITs may also be used to manage the impacts of inflation on a portfolio.
When recessions occur, it’s vital to concentrate on your long-term goals and manage your risks while limiting exposure and setting aside cash to invest during the recovery. While there is no way to determine when a recession will strike accurately, investors can use diversification and careful risk management to protect their portfolios while waiting to profit from a rebound.