As recession worries rise, increase resilience of client portfolios

Mike Bell

Mike Bell

The US economic expansion is now the second longest on record. 

While the US is booming, the economy is late cycle, with a very low unemployment rate. Unfortunately, expansions do not last forever. 

Investors who are concerned about a potential downturn may wish to position their portfolios slightly more defensively.

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Here are seven strategies for consideration that could help to increase the resilience of an investor’s portfolio.

1. Move towards neutral in equities but avoid underweights 

History tells us that in the run-up to the start of a US recession, equities can deliver strong positive returns. This highlights the risk of going underweight equities too early.

For example, an investor who called the dotcom bubble too early would have missed out on a return of 39 per cent in the final two years, or 19 per cent in the final year, of the S&P 500 rally.

Once the market starts to price in recession though, equities struggle. Markets have peaked anywhere between zero and 13 months prior to the start of a US recession. Given the difficulty of precisely timing market peaks and troughs, investors may want to consider moving closer to neutral in equities in the late stage of the economic cycle.

Of course, what constitutes neutral should be determined by an investor’s willingness and ability to take risk. 

2. Remain regionally diversified in equities 

A shift in regional allocation rarely helps cushion performance in a market correction.

Investors concerned about a potential recession in the US may be tempted to shift away from US equities into other equity markets, but during US recessions stock markets in all regions tend to fall — sometimes by more than US equities.

During the last two recessions the US dollar appreciated, and it is therefore far from clear that concerns about a US recession should lead investors to shift from US equities into other equity markets. Investors are normally better off maintaining a regionally diversified portfolio.

3. Rotate away from overweights in mid- and small-cap equities 

Small-cap stocks tend to underperform the market during recessions, particularly in the UK. Also, between May 2007 and December 2008, UK mid-cap stocks significantly underperformed the FTSE 100 and have since outperformed by about 200 per cent.

The average UK equity fund has over 40 per cent in mid- and small-cap equities, which is over 20 per cent more than the FTSE All-Share index.

4. Reconsider overweights in growth stocks, add to quality and value stocks 

Growth stocks have often underperformed value stocks during S&P 500 bear markets.

The obvious exception was the global financial crisis, when value underperformed, although this was because of the high weighting of financials in the value index during a crisis in the US financial system.

With banks significantly better capitalised now than they were prior to the last downturn, the next recession is more likely to be a “normal” recession and less likely to turn into a financial crisis.