Our portfolios are ready for a recession… and the recovery.

A well-telegraphed recession

The market outlooks for 2023 are starting to come through, and they make for unhappy reading. As Martyn mentioned in the introduction of our Quarterly Investment Update, they’re usually best ignored entirely. Talk of recessions is being ramped up.

The UK has just brought one onto itself, Europe has been forced into one by Russia, according to the Federal Reserve the US needs one, and China is torn between controlling Covid and stimulating growth. Whatever the reason, 2023 will be the year where consequences (intended and unintended) lead to a synchronised global slowdown.

Cash is a tempting mistake

When recession talk picks up, imaginations can run riot. What will happen if house prices fall? How bad will the equity market downturn be? What’s the job situation going to look like? The temptation in this situation is to move to cash and ‘sit it out’. But this is usually the wrong thing to do. Instead, remembering that equities recover over the long run is helpful.

It’s also important to acknowledge the job of a multi-asset portfolio is to smooth returns during times of stress. Traditionally, holding bonds and foreign currency alongside equities has done the job well. But traditions evolve, and at 7IM, we try to move ahead of everyone else. A big part of the way we have guided portfolios through the recent downturn is to have a market-leading alternatives capability.

7IM’s unashamedly conservative approach has recessions in mind

What goes on in the conventional part of the portfolio is equally important, though. Managing this part is a careful balancing-act between smoothing returns in the short-run and capturing the long-run returns on offer to meet our clients’ savings goals.

One way to do this is to adjust the amount of equity we hold through the cycle – this requires full-time monitoring by a team of professional investors, a lot of quantitative and qualitative economic analysis and is certainly not something clients should consider themselves, no matter how tempting it may seem. Another is to make sure the equities we do hold are properly diversified across geographies and sectors – avoiding concentrated positions is key to managing recession risks.

Finally, we can look to find equity replacements. Equities tend to deliver the strongest returns over the long run, but at certain points in time there are other asset classes that offer similar potential.

So instead of buying shares (which offer you a slice of a company’s profits), you could invest in the company’s bonds (lending to that same company). Most of the time, shares should return more than lending, but occasionally the opposite is true.

Right now, corporate bond yields can be anywhere between 5–10%, depending on the company. That’s a high hurdle rate for equity returns, which tend to need companies to predictably grow their earnings, which is difficult in a recession. By contrast, strong credit returns simply require companies to pay their debts – much more likely in a recession.

Another example is Put-Selling, which is akin to selling insurance on the equity market. The more nervous investors are, the more they pay for insurance; currently, equity investors pay over 3% per month to protect against market falls. Steadily receiving ‘premium’ payments is a moneymaker over the long term – there’s a reason insurance companies are some of the oldest businesses in the world!

In most scenarios, the insurance premium is so high that equity markets would have to rally by more than 30% in a very short space of time for put-selling to underperform. Given that we’re still not far from alltime equity highs and just approaching a recession, the chances of this are extremely slim. Equity-like returns when equities are struggling is exactly the kind of ‘risk assets’ our clients should be exposed to in a recession.