It’s been an explosive first quarter for financial markets this year. We’ve seen the collapse of a US bank, a forced takeover of Credit Suisse by its rival UBS and continuing interest rate rises from the world’s major central banks. There are also rising risks of a recession in the US, the world’s largest economy.
Investing in the middle of a downturn can invoke feelings of fear. But this can be the best time to take a position – you just need to know where to look. As always with investing there are no guarantees.
Predicting short-term market moves is mostly impossible. However, brave investors are willing to look beyond the day-to-day price fluctuations in financial markets and take investment positions when fear levels are high.
They’re looking beyond the current situation, to a time when a slowing economy prompts the Federal Reserve (Fed) and other central banks to cut interest rates. The motivation for taking positions in the current environment is clear – investors can pay a steep price for missing out on the early days of a market rally.
Impact of missing the best 10 days in the UK stock market (2000-2022)
Past performance isn’t a guide to future returns. Source: Lipper IM, from 03/01/2000 to 30/12/2022. Figures based on £10,000 starting investment.
The chart above is a sobering prospect, and one many would want to avoid.
Below are some investment theories to help you to make decisions when uncertainty is high.
This article isn’t personal advice. If you’re not sure what’s right for you, ask for financial advice. Investments and any income from them can rise and fall in value, so you could get back less than you invest.
Economic upgrades
As we move through the year, there are pockets of good news emerging from the gloom.
The Bank of England changed its view on the UK’s forecasted recession for 2023 when it met in March and upgraded its second quarter growth forecast for the UK economy. It now expects the UK to grow slightly in the three months to June, reversing its previous expectation of a 0.4% contraction.
It also expects real household disposable income to stabilise, and for inflation pressures to ease. This is a welcome development for investors. There’s often been a close link between stock market performance and economic recessions and one of the main drivers in the decline in stock markets during a recession is a collapse in corporate earnings.
Analysis from Schroders shows, historically earnings per share growth has been negative in the US during most economic downturns as top line growth of companies gets hit by a slump in economic activity. While this research is linked to the US, it can be extrapolated to most global markets. So, if there’s no recession, then corporate profits should be maintained.
There’s also good news for investors even if there is a recession. Markets don’t tend to wait for the bottom in earnings, and share performance has picked up strongly at the end of previous recessions when share valuations have been ‘cheap'.
Dividend stocks
When fears are high, and economies are slowing down, it’s common for shares to fall and bouts of ups and downs to occur. This doesn’t mean that all stocks are equal.
On the contrary, certain factors can help make a stock look attractive in all environments, for example, high dividend yields. In fact, dividends have been more stable than earnings when past recessions hit.
The reason why dividend stocks have tended to outperform during a recession is that high dividend payers like to maintain their dividends even in a recession. They tend to draw down on their cash reserves even if their earnings slip. That’s why, in previous recessions, the dividend pay-out ratio – dividends as a proportion of earnings – has tended to rise. This can make dividend-paying stocks even more attractive in an uncertain and worrying economic environment. Though dividends are never guaranteed.
The Fed and its impact on stock markets
Since early March, expectations have risen that the Fed will cut interest rates by the summer. The market now expects 75 basis points of cuts by January 2024. The prospect of interest rate cuts has been a powerful elixir for the riskier end of the market, which is why US tech stocks have performed well in March.
Financial markets are forward-looking, and investors like to price in anticipation of what might happen in the future. Historically, a pause in interest rate rises can be good news for stocks, with the main US stock market returning 8.2% on average, in the three months after the Fed reaches its terminal rate.
However, it’s worth remembering that the size of the rate cut matters. A large rate cut might not benefit stocks, as it could cause panic about the dire state of the economy. Instead, a moderate cut of 25 basis points could have the largest positive impact on financial markets in the current environment.
UK interest rates rise to 4.25% by Bank of England – what it means for annuities and mortgages
The new ‘safe havens’
Throughout this bout of volatility spurred by stress in the financial system, traditional investments like US government bonds haven’t responded as you’d expect.
Below is the two-year US government bond yield. Yields move in the opposite direction to prices – as prices rise, yields fall and vice versa. As you can see, this has been extremely volatile, with bond yields surging and prices falling. This isn’t what’s expected from a ‘safe haven’ asset like US Treasuries.
Instead, gold, and big tech have been some of the most resilient assets since the collapse of Silicon Valley Bank in early March.
When US government debt isn’t the harbour in the storm, investors might turn to gold, and more recently mega tech, which have large cash flows and strong balance sheets.
Investing in gold - 3 fund ideas
Two-year US government bond yield
Past performance isn’t a guide to the future. Source: Bloomberg, 28/03/2023.
The recent bout of volatility in financial markets has produced winners and losers, you just need to know where to look.
Even when there’s turbulence and fear in financial markets, there can be an investment for every season.
5 economic indicators to navigate stock markets in 2023
Kathleen Brooks is Founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.