How to recession-proof your investment portfolio

Given all the problems thrown at the global economy lately, from a pandemic to the Russia-Ukraine crisis and resurgent inflation, perhaps the biggest shock is that it hasn’t crashed into recession already. There’s still time.

All the warning indicators are flashing red and we could be heading there sooner than people realise.

It won’t be any flash-in-the-pan recession, either, but could prove nasty, brutish and long, says Ernst Knacke, head of research at wealth and asset manager Shard Capital.

“Our fear is the economic downturn in Europe could be on par with the Great Depression of the 1930s,” Mr Knacke says.

That was preceded by the “roaring 20s”, when artificially cheap credit and loose monetary policy from the US Federal Reserve created an unsustainable boom and then the inevitable bust.

The Fed has been repeating that policy mistake since the financial crisis in 2008, doubling down during the pandemic, and now we'll pay the price.

Supply shocks, the US-China trade tensions, surging food and energy costs, rocketing prices and stretched consumers are creating “demand destruction on steroids”, Mr Knacke says.

At the same time, Fed chairman Jerome Powell has belatedly decided that the era of easy monetary policy is behind us and is tightening as growth weakens. This will only add fuel to the fire.

“Add the risk of the Third World War and we believe it’s become impossible to achieve a so-called soft landing,” Mr Knacke says.

Europe is particularly vulnerable. The continent is facing its biggest conflict since 1945, while Germany is coming under increased pressure to sanction Russian oil and gas imports, a move its politicians fear could cut gross domestic product by 6 per cent.

The weakening euro and sterling will further stoke rising prices by driving up import costs and the depression could “last not months, but years”, Mr Knacke says.

Too many are in denial. “If you are not seeing the flashing red lights, it’s time to wake up,” he adds.

Mr Knacke isn’t alone in his fears. This month, the Bank of America’s chief investment strategist, Michael Hartnett, wrote in a client note that inflation shock is worsening, the interest rate shock is only beginning and a “recession shock” is coming.

In that scenario, stocks and bonds will struggle, while cash, commodities and cryptocurrency could outperform, he said.

Goldman Sachs predicts a 35 per cent chance of a recession in the next two years.

A classic recession warning sign is also blinking. It’s a technical one, but history suggests that it is reliable.

The yield curve plots the interest rates of government bonds with different duration, say, from two to 30 years. Typically, long-term bonds offer higher yields but when recessions loom, this goes into reverse as investors fear trouble down the track.

It’s called an inverted yield curve and “we had one in March”, Kareem Rathore, partner and financial adviser at Hoxton Capital Management, says.

“In the last 26 times the curve has inverted, it ended in recession 22 times.”

With the Fed expected to increase lending rates by 0.5 per cent in May and again in June, Mr Rathore says a recession is “fairly likely”, but that they are notoriously hard to predict.

“If the Ukraine crisis gets worse, or supply chain issues sort themselves out, central banks could turn less hawkish. Even if interest rates do increase, borrowing money is still cheap by historical standards,” he says.

Mr Rathore lists other positives: “Corporate earnings are still growing, consumers have a large savings margin, unemployment is low and wages are increasing.”

However, if recession does strike, it could be brutal for stock markets and he predicts a drop of between 30 per cent and 50 per cent from today’s highs.

While frightening, that could be a buying opportunity for the brave.

“Markets will most likely recover fairly swiftly as they did after the Covid-19 recession. It could be a good time to buy, with stocks undervalued by the panic selling. It’s almost like a sale on stocks,” Mr Rathore says.

Central bankers must raise interest rates and tighten their monetary policies regardless of the recession risk as inflation is now raging out of control, he adds.

“In the US, it is currently 8.5 per cent with no sign of slowing down. This is eroding the purchasing power of consumers’ income, savings and investments. Central banks have no choice,” Mr Rathore says.

G7 business activity is surprisingly strong and that gives grounds for optimism, John Knobel, market strategist for online broker Skilling, says.

“Any signal of a recession will show up in the earnings reports of the big cap companies and, so far, the earnings season looks solid,” he adds.

The US can cope with higher interest rates, so there is no need to panic, Mr Knobel says. “Stock market volatility has increased, but shares should continue to provide investors with good returns over the short, medium and long term.”

History shows that stock markets can protect your wealth by outpacing inflation, Mr Knobel says.

“Look for good companies with a low price/earnings [P/E] ratio, low debt and steady cash flows for your core portfolio.”

There is always something to worry about and investors need to look beyond short-term fears, says Aziz Alnaim, lead portfolio manager at the Mayar Responsible Global Equity Fund.

Second-guessing the future is impossible as nobody can say for sure whether we are heading for a recession or how markets will respond.

Remember, they actually surged after the pandemic. Similarly, we have no idea how the Ukraine war will turn out, Mr Alnaim says.

“Putin could announce ‘mission accomplished’, global energy prices could fall in response and inflation would follow. Alternatively, the conflict may deepen,” he adds.

Investors should stay calm and focus on companies that have experience in navigating difficult macroeconomic conditions, with strong competitive advantages to maintain their market position, Mr Alnaim says.

“Since 2008, we have been through pandemics, trade wars, natural disasters and a global financial crisis,” he says.

“Yet, if you had invested in the MSCI World 15 years ago and closed your eyes, on opening them today you would find your investment trebled.”

Recessions come in different shapes and forms, David Morrison, senior market analyst at Trade Nation, says.

“We had a short and sharp recession in early 2020 due to the pandemic, while the recession after the financial crisis was drawn out. In both cases, central banks and governments helped stave off the worst effects with huge dollops of monetary and fiscal stimulus.”

They may struggle to do that again, at least while inflation is high, but recessions come round quite regularly, so don’t be too downbeat.

“We’ve also suffered them in the early 1990s, 1980s and mid-1970s, and survived,” he says.

Mr Morrison isn’t worried by the bond yield curve.

“The inversion must be deep and last for a significant period. The recent one lasted a few days.”

He remains upbeat as unemployment is low and earnings are high, but cautions that central banks are treading a fine line and liable to make mistakes.

A recession cannot be ruled out, but history shows you should stay invested and hold on for the recovery. Keeping a balanced portfolio with a blend of shares, bonds, cash, gold, commodities and cryptocurrency will help you weather the worst.

If the downturn is serious and job losses rise, you may have bigger worries than how your portfolio is performing, Mr Morrison says.

“Maybe it’s a good time to learn a new skill.”

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