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Investing in a recession

Covid-19 has plunged the world into an economic downturn. So how should doctors respond?

The global coronavirus pandemic continues to wreak havoc on the world economy, potentially triggering one of the most rapid descents into recession that we have ever seen. Investors will naturally be alarmed and considering their response – but it is worth saying that the nature of this particular recession is unprecedented and, as such, it is even more important to proceed with caution.

What is a recession?
The National Bureau of Economic Research defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”. That is true of the current downturn, but the run-up to it has clearly been highly unusual.

Typically, recessions are caused by similar factors. One example is an overheating of the economy following a prolonged period of economic growth leading to low unemployment and higher inflation. Another common cause is an asset price bubble, such as the rise and fall of stocks in 2000. An inversion of the yield curve on US Treasury bonds, when bonds due for repayment sooner offer higher yields than their longer-term counterparts, is also a common leading indicator of recession, often signalling a downturn to come in 12 to 24 months.

However, some recessions are triggered by unexpected events, as is the case this time around. Such shocks can happen at any time of the business cycle, even when economies are expanding. The lockdown forced upon much of the world by Covid-19 is the perfect example of a recession driven by a shock that came completely out of the blue.

How the stock market is affected by a recession? 
What does this mean for investors? Well, in the run-up to recession, it is almost always more risky assets that fall in value first. Stock markets – share prices – are usually hit hardest as investors flee to less risky assets. Note, however, that such sell-offs happen in advance of the recession, as investors respond to signals of what is to come.

Moreover, stock markets have a habit of falling like a rock, but rising like a feather; typically, by the time the recessionary outlook is clear, it is too late to take action. In recessions caused by a shock, this is even more true, since there is less opportunity to see what lies ahead.

For this reason, the best way for investors to respond to recession is often to think about where in equity markets they are invested – and to consider repositioning towards more defensive areas.

Defensive equities are defined as those stocks that tend to hold up better during tough economic times , often because they are in companies whose performance isn’t highly connected to the economic cycle. Food retailers are a good example: people still need to buy their groceries each week, even when the economy is mired in recession. As a result, shares in these businesses tend to be more resilient. Healthcare companies and utilities fall into the same category.

How other asset classes fare during a recession
Recession also has an impact on other asset classes. In the fixed-income market, bond prices often move inversely to the business cycle. This is because the actions usually taken by governments and central banks in response to recession – in particular, cuts to interest rates – drive bond prices up and attract investors accordingly. Also, investors in equities will look for “safe haven” assets such as bonds as the outlook deteriorates, thereby pushing prices up further.

Again, however, the current crisis poses particular problems. Even before Covid-19, interest rates in much of the world were at rock bottom levels, having not recovered since policymakers’ efforts to mitigate the effects of the global financial crisis. There is not much room for further monetary policy stimulus of the sort that would ordinarily boost bond prices.
Gold is another asset that is often popular during tough economic periods or anxiety about financial markets. The precious metal is regarded as a store of value that offers safety during a downturn while also protecting investors from inflation – unlike, say, cash, which might otherwise be a safe haven asset. But while gold may get a boost during recession amid a general flight to safety, it often loses its shine very quickly as the economy moves past the deepest point of recession and investors begin to move back into more risky assets.

One other asset class to consider during a recession is real estate. Returns on property tend not to be closely correlated with those on other assets – that is, they don’t move in the same way at the same time – so this can be a good way to spread your bets. Property can also be a reliable and stable source of income. The downside to property, however, is that it is an illiquid asset – that is, physical property, is difficult to buy and sell quickly, which doesn’t suit many investors.

What now?
The bottom line is that investors confronted with recession need to tread carefully – and all the more so in the current unusual downturn. More defensive assets may provide some protection, but they will also underperform as markets move into recovery phase and other assets attract more attention. Moreover, getting the timing right on investment decisions is notoriously difficult – and mistakes can prove very costly.

For these reasons, your best response to recession may be to stay put. Investors who already have well-diversified portfolios built with a blend of different asset classes will be able to weather the storm. And your aim should be to focus on the long-term outlook, rather than trying to second-guess the short term. Think about your long-term investment goals, not about what might or might not happen next week.

Content correct at time of writing and is intended for general information only and should not be construed as advice.

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