With the recession drums beating louder following 10 straight interest rate rises in Australia, it’s worth dusting off the recession playbook to ensure that investor’s portfolio can withstand the heat.
A recession is a period of temporary economic decline during which trade and industrial activity decline, generally identified by a fall in GDP in two successive quarters. Recessions are a normal part of the business cycle, but it is the depth of a recession that investors should consider most. A deep recession is normally characterised by high unemployment.
Dan Moore, portfolio manager at Investors Mutual, says that markets are forward looking so they usually fall well before a recession actually starts, often 6-12 months before. Share markets also tend to bottom well ahead of the economy recovering, and quite often when the news is at its worst, which explains why sometimes the best time to invest is when the news flow seems like the worst possible time.
The table below shows share market returns from the S&P 500 in the US during the last 11 recessions. The key takeaways are that the average negative return from the S&P 500 during the 12 months before a recession was -3% and that the average return for the 12 months after a recession was 16%.
Most recessions are characterised by rising unemployment, but this indicator also lags financial markets. In November 2007 the share market peaked before the GFC and unemployment was 4.7%. The market ultimately bottomed in March 2009 and unemployment reached 8.7%. Unemployment only started to improve in November 2009, but by that time the share market had already risen 50% from the March lows.
Hugh Dive, portfolio manager with Atlas Funds Management, believes that the sectors that tend to do well during a recession are those that offer non-discretionary goods and services or benefit from cost-conscious consumers trading down during hard times. These sectors include utilities, health care and consumer staples such as supermarkets.
Moore also likes Telcos in difficult economic times.
Sectors that tend to do poorly during recessions include discretionary retailers, construction companies and some real estate according to Dive.
Investors seeking to protect themselves during a recession / downturn should seek specific qualities from their investments. Moore suggests investing in companies that are industry leaders with a competitive advantage as they usually have higher profit margins that can help ride out the storm. A strong balance sheet, which generally means lower debt levels is very important to ensure the company can avoid dilutive equity raisings if the downturn becomes severe. Recurring revenue and a capable management team also make a difference in tougher times.
Moore says that Telstra and Brambles both look well placed and both companies are industry leaders that sell essential products and services.
Dive nominates CSL to be well placed to deal with tough economic times as historically in the US, plasma donations have risen when the economy is suffering. CSL’s health products are not linked to the economic cycle and its balance sheet is strong. One of CSL’s major competitors on the other hand is also financially stressed which could provide CSL with a tailwind in years to come.
According to Dive, during recessions, investors want to own companies that generate consistent cash flows to service debt, invest for growth, pay dividends and potentially acquire weaker competitors that may be available at a discount.
For example, during the GFC the Australian banks strengthened their competitive position with Westpac taking over St George and CBA taking over BankWest. Similarly in 2009 Amcor took over Alcan Packaging in a move that propelled the company on a course to become the largest packaging company in the world and raise its margins.
Both Dive and Moore warn investors against selling out of their investments in anticipation of a recession. Moore says always having some cash is useful to take advantage of market falls, but increasing cash holdings in anticipation of a recession is fraught with danger. This is largely because economists are famous for predicting far more recessions than actually occur, and even if there is a recession an investor must also be able to pick when markets are likely to bottom and then have the stomach to reinvest.
With storm clouds gathering, investors should ensure their investment strategy can withstand, and ultimately benefit from, a downturn should one eventuate.
Mark Draper writes for the Australian Financial Review each month - this article featured during April 2023.