Positioning a Portfolio for Recession
While economic growth and corporate profits have been robust, economic growth appears to be slowing. Real gross domestic product (GDP) increased at an annualized rate of 3.1%, as per the final estimate from the Bureau of Economic Analysis. Nonetheless, the yield curve is flat, meaning there is little difference between short- and long-term interest rates for government notes and bonds. In fact, at the end of the first quarter of 2019, both 2-year and 10-year Treasury yields slid below the Fed funds rate.
When the yield of a longer-term security falls below that of a shorter-term security, the yield curve is said to be “inverted.” In the past, this has been an indicator of a potential recession in the economy, or a sign of a potential stock market peak. Economists define a recession as two consecutive quarters of negative gross domestic product (GDP).
Which Asset Classes are Best in a Recession?
Certain asset classes perform better than others in a recession. Fixed income securities and dividend-paying equities are one example where the income generated from interest and dividends provides a return that partially compensates for the potential price declines and increased volatility. Within equities, sectors that are less cyclical, like consumer staples and health care, may perform better than more cyclical sectors, like industrials and materials.
However, even the fixed income market has sectors that perform poorly in a recession. Investors tend to avoid risk and therefore may shy away from the credit sector for fear of increase in the default rate. The High Yield sector is a prime example; the value of these bonds increases more from improvement in the financial viability of the company that issues the bond than interest rate moves. In a recession, these companies may have a tougher time generating revenue and profits and servicing debt. In the government bond sector, mortgage-backed securities (MBS) have higher default rates than government securities. Investors tend to exit riskier assets, a term called a “flight to safety.”
The following chart indicates the performance of several asset classes during the past two recessions. Although this is not meant to encourage a move of assets into a single asset class, it shows the importance of diversification, since some asset classes perform better in a recession.
What Does this Mean for Investors?
The potential of a recession highlights the need for diversification, especially in a retirement plan. Intermediate-term bonds proved to be a portfolio stabilizer in the past two recessions, averaging a 4.61% return, versus the S&P 500 index which declined 20.78%. Longer-duration bond exposure fared even better, since long-term rates fell and the longer maturity resulted in a more significant price increase than an intermediate- or short-term bond. Even if the economy continues with moderate growth, the yield-curve inversion may indicate that we are now in the late stages of the economic cycle. Therefore, portfolios should be reviewed and rebalanced in order to minimize exposure to over-valued asset classes. It also may be a good time for younger employees to increase their contribution, considering the potential depressed prices and their long-term time horizon.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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