The very mention of a downturn can strike fear into the hearts of investors. Economics tends to be cyclical in nature and while steady periods of growth are revered with widespread speculation, they’re usually followed by a profound decline.
We currently live in challenging times for world economies. Uncertainty surrounding the United Kingdom’s Brexit alongside ongoing trade wars between the United States and China have sent some clear warning signs that investors may be facing some challenging times in the near future.
(The future of finance in the UK is conditioned primarily by Brexit, and could prompt an economic slowdown. Image: Institute for Fiscal Studies)
The UK isn’t alone in its uncertainty. With four possible outcomes of Brexit in the coming months leading to wildly different GDP forecasts, the United Kingdom is just one of many nations operating in a fragile economic climate.
But is it possible to successful invest within the volatile markets of a recession? Here are a few points on how to wisely develop your portfolio while navigating the potentially choppy waters of an economic downturn.
Coming to terms with a recession
It could be useful to clarify what is meant by the use of the term ‘recession’, as well as ‘economic downturn’.
(Chart illustrating the impact of the financial crash and the slowdowns within the global economy that followed. Image: The Economist)
Essentially, a recession is the name given to a sustained period of economic decline. Economists typically agree that two consecutive quarters of negative Gross Domestic Product (GDP) growth can be defined as a recession, but this isn’t always the case. It’s also worth noting that GDP acts as a measure of all the goods and services produced by a country over a pre-designated period.
There are plenty of factors that can contribute to a recession, which is why many economists avoid predicting their arrival with much certainty. In 2008 the collapse of the US housing market sparked a worldwide downturn, while other factors like governmental change, natural disasters, and new legislation can all be big contributors.
Recessions take shape as a result of a widespread loss of confidence from consumers and businesses when it comes to spending money. This, in turn, leads to stagnant incomes, loss of sales and ultimately production. Unemployment generally rises due to cutbacks in industries and national leaders face the challenge of kickstarting a weak economy to remedy the effects.
Right now you may be wondering how it’s even possible for anyone to build a successful portfolio from these circumstances, let alone those looking to make intelligent investments.
As they’re intrinsically linked to the financial markets, recessions tend to point towards more instances of risk aversion from investors as they plot methods of keeping their money safe from damaging losses of value. However, the cyclical nature of finance means that recessions must give way to recovery sooner or later. Let’s take a deeper look into some of the opportunities presented to investors during a time of severe financial difficulty:
Can opportunities be identified?
Recessions are terrible things that can severely impact the lives of millions, possibly billions of individuals worldwide.
But many negative events can come with some opportunities attached. And while recessions represent a considerable burden on the world financial markets, they can also offer some extremely high-value prospects for new investors.
When a recession takes hold, asset prices typically fall hard. This means that investors who were previously priced out of making meaningful revenue from stocks, bonds, mutual funds, real estate, private businesses to name but a few, can suddenly find themselves presented with considerably lower costs than a year or two prior. As other investors are forced to part with their assets, you could swoop in and grab yourself a bargain.
(The Financial Times highlights the inverted yield curves within US Treasury bonds as a sign of a coming recession – as evidenced by historical trends within this chart. Source: FT)
The Financial Times recognises that the US Treasury yield curve has inverted due, largely, to ongoing trade wars. Further to the chart above, the newspaper also reported that UK yield curves on two and ten-year gilts inverted over the past summer – indicating that there are challenging times ahead for investors.
Naturally, when market predictions appear ominous, bearish investor sentiments become more prominent. The Financial Times reports that in the current climate, the price of gold is “soaring.” With “the price of the yellow metal rising above $1,500 per troy ounce for the first time in six years” back in August.
Prolific investors will always be on the lookout for opportunities to buy low and sell high, and even though the markets will no doubt show volatility, there’s a good chance that as a recession subsides, the assets you’ve bought into will begin to regain their true value.
With this in mind, it’s worth exploring the prices associated with specific stocks and bonds. If their respective values appear to be outstandingly low compared to their value outside of the economic downturn, you could be looking at a good opportunity to gain money as the market recovers.
Searching for value in capital markets
When it comes to equity markets, the perceptions that investors hold of heightened risk typically leads to the urge for seeing higher potential rates of return for holding equities. For their expected returns to rise higher, current prices would need to drop. This happens when investors sell off riskier holdings and transition into safer securities like government debt.
This is what makes equity markets fall prior to recessions. As investors grow fearful of seeing the collective values of their assets decline, they take a series of steps in order to retain as much value as they can.
Safety in investing by asset class
History tells us that equity markets have a pretty useful habit of acting as reliable predictors of upcoming economic downturns, so it’s important to pay close attention to the optimism or pessimism of traders within this particular field.
However, even if the equity markets are in the midst of a deep decline, there’s still cause for optimism among investors. Assets still have the ability to undergo a period of outperformance, so it can often pay to keep your ear to the ground and hunt for small pockets of clear blue skies amidst the cloud-covered horizon.
Can efficiency be found within stock investing?
Stock markets can be volatile places even at the best of times. But history shows that there’s still plenty of security that can be found by investing during a recession.
One of the safest places to invest across a range of markets can be found within the stocks of high-quality companies that have been in existence for a long period of time. While this may not guarantee security, these types of businesses have shown that they can survive prolonged periods of financial difficulty in the past.
Indeed, the NASDAQ-100 index has experienced notably less profound volatility as it recovered from 2008’s crash than stock indexes comprised of less affluent companies.
Naturally, companies with credible balance sheets and little debt regularly outperform businesses with significant operating leverage and weaker cashflows. So it’s worth looking to established organisations for a little solidity when times get tight.
Will diversification remain a safe bet?
Even in the gloomiest of financial forecasts, always diversify your bonds. Even if you come across a company that appears to be thriving amidst an economic downturn, it’s vital that you diversify your assets.
Markets are extremely jittery when the world’s news is littered with closures and the falling GDP of nations and currencies. The landscape can change with little warning, and while diversification may not be a flawless way of thriving amidst the inevitable rainy days, it stands a much better chance than taking up the option of piling your faith into one company that looks stable today with no guarantee for tomorrow or the day after.
The world of finance hasn’t been brimming with confidence for some time now, and while investments should be made at the holder’s risk, there are certainly plenty of opportunities out there to build a respectable level of profits even in the midst of an economic downturn. Above all, stay patient, look out for emerging trends and make sure you diversify your investments.