All information is correct as at 31 December 2022 unless otherwise stated.
High energy costs and rising interest rates mean the UK economy is expected to shrink throughout 2023 and into the first half of 2024.
The UK isn’t alone in this regard. The International Monetary Fund (IMF) expects a third of the global economy to be in recession in 2023, with the world’s three largest economies – the US, the EU and China – all expected to stall.
Given the gloomy outlook, many investors might be wondering how stock markets will react to recessions, and what the implications are for how you manage your portfolio.
This article is not personal advice. If you are unsure whether a course of action is right for you, seek advice. Past performance is not a guide to the future. All investments and any income they produce can fall as well as rise in value so you could get back less than you invest.
What happens in a typical recession?
For many companies, lower economic activity has meant lower earnings. Businesses respond by cutting costs, including job cuts. Rising unemployment reduces the bargaining power of workers and therefore wage inflation falls. Households have less to spend, so this brings overall inflation down too. Central banks target stable inflation and cut interest rates to stimulate a recovery. But lower rates act with a long lag, so there’s no immediate rebound.
Falling corporate earnings can also lead to increased defaults on corporate bonds. These losses make lenders more risk averse. So, while central bank interest rates fall, companies often pay a higher premium over the rate paid by governments. So do mortgage borrowers.
Governments can choose to boost spending to support economic activity. However, their revenue is also likely falling since taxes are linked to incomes. So, when governments increase spending during a recession, they also increase borrowing.
Alternatively, they can choose to follow an austerity agenda, restricting spending to avoid excessive borrowing.
The balance between the two can be influenced by the bond market. If investors think governments are borrowing too much, its cost of borrowing can rise, undoing some of the benefit of their increased spending.
The impact of a recession on markets
In a typical recession, more risky assets have tended to perform poorly relative to ‘safer’ assets. Though remember past performance is not a guide to the future.
Falling earnings have typically pushed stock prices lower. By contrast, government bond prices have risen as they benefit from falling interest rates and expectations of lower inflation.
Corporate bonds have tended to underperform government bonds because lower earnings cause balance sheets to deteriorate and defaults to rise.
Higher-risk smaller companies have also normally fallen more than their larger competitors because their businesses are more vulnerable as banks become more cautious on lending.
Defensive stocks with more predictable income, like healthcare companies, have tended to hold up better than businesses that are more sensitive to the economic cycle, like consumer discretionary stocks.
Emerging markets can also fall more than developed markets as investors avoid higher-risk investments.
If one country goes into recession, its currency will fall relative to the rest of the world. When the whole world heads into recession, the US dollar is likely to gain due to its role as the world’s reserve currency.
A roadmap for this recession
Given widespread expectations of a recession, this might read like a roadmap for the year ahead. It’s not, but there are three things to think about.
First, the list above assumes perfect hindsight on the start and end dates of a recession. But, no-one knows when the downturn will begin and end.
Second, the best returns have normally come when economies emerge from recession – and the market recovery usually starts before the recession ends. When the turn comes, investment strategy needs to turn too. And accurately timing this turn is close to impossible. Past performance, as we all know, is never a guide to the future.
Third, it’s worth remembering that every recession is different. If there’s a recession in 2023, it’s likely to be the most anticipated recession in almost 50 years. This means investors are already factoring in some of the bad economic news.
Moreover, investors aren’t just observers of the economic cycle. They also help drive it. Cycles are driven as much by the human psychology as by economic fundamentals.
Investors’ exuberance leads to greater risk tolerance, leading to increased lending to low-quality credits, leading to rising defaults and therefore a rise in risk tolerance - and so the cycle continues.
What are the lessons for investors?
Nobody can accurately predict when the economic cycle will reach a top or bottom. Nor can they sit on their hands and wait for the cycle to become extended in one direction or the other. On average, recessions have come along every eight years over the last 200 years. So too have recoveries from these recessions.
It’s usually best to stick with your investment strategy during a recession, waiting for the inevitable recovery. In the meantime, you can aim to reduce the vulnerability of your portfolio to downturns by diversifying across different asset classes, different countries and different sectors. It’s the simple, but perennially important point about eggs and baskets.
Recession or not, diversification remains the most important word in investment.