Market Views: How should investors prepare their portfolios for recession risks?
Asia’s economic outlook is worsening as the global economy decelerates.
An inverted yield curve set economists on edge for a US recession in late April, and Singapore prime minister Lee Hsien Loong warned of hard times ahead amid high inflation, tightening monetary policies and the ongoing Russia-Ukraine war.
Additionally, the Federal Reserve plans to increase rates by a half percentage point in June - the third hike this year, with at least two more on the way - to curb inflation, policy meeting minutes showed on Wednesday (May 25).
In China, Asia's largest economy, growth has slowed and economists have dropped their median forecast for this year to 4.5% - below China's official target of 5.5%.
“The conditions for a recession are growing, notably the pressures facing US consumers. And so too are the quantitative signals, notably the inversion of the 2 to 10-year yield curve, which has been a reliable indicator of impending recession in the past," Tina Fong, economist at Schroders, said late last month in a note.
Inflation is also rising fast in Asia, which is pushing central banks into a more hawkish stance. The Asian Development Bank forecasts inflation in East Asia to reach 2.4% this year, up from 1.1% in 2021, and 3.7% in Southeast Asia, up from 2% last year.
Asia, like the rest of the world, is confronting three major shocks this year but the impact of each varies greatly across Asian economies.
China’s Omicron wave and related lockdowns, the war in Ukraine and the related higher commodity prices and the Federal Reserve's tightening policies all send ripple effects through markets and asset classes. Against this background, AsianInvestor asked fund managers how the investors are preparing their portfolios for a possible coming recession.
The following responses have been edited for brevity and clarity.
Rob Almeida, global investment strategist
MFS Investment Management.
With financial conditions tightening and growth slowing, companies face too many cyclical and secular pressure points to maintain record margins. While a return to pre-Covid-like growth and structurally lower cash flows will create a less favourable market environment than many are used to, this only matters for those who own the market.
For example, during the late 1970s, when equity market returns were flat or negative, there were plenty of companies that navigated high inflation and took advantage of the struggle of others to create value for shareholders. At that time, the dispersion of return between above-and below-average companies was stark.
Company fundamentals, whether you are investing in stocks or bonds, will be the main drivers of investors’ returns. In my view, owning quality, cash-flow-generating assets, regardless of style or category, is the portfolio construction roadmap to follow. While the market environment ahead may prove less favourable than that of the recent past, we believe there will still be companies that can compound value over time. In summary, allocate capital responsibly, which to us means funding organisations that we believe will be around, and successful, for many years.
Andy Budden, investment director
In times of adversity, investors will naturally wonder if they should reposition their portfolios, change their asset allocation or look for a bottom in prices... Our advice when it comes to navigating volatile markets is to focus on smart investing – keep a long-term investment horizon and focus on relevant research, solid data and proven strategies.
While emotions may arise during volatile periods, making emotional investing decisions can be hazardous. Recognising behaviours like anchoring, confirmation and availability bias – in other words the tendency to rely too heavily on the first piece of information we are given or the most readily available data, and to interpret and favour information that confirms one's prior beliefs – may help investors identify potential mistakes.
Diversification of portfolios can also help lower risk. While a diversified portfolio doesn’t guarantee profits, spreading investments across a variety of asset classes can help investors buffer the effects of volatility.
Ultimately, investors who tune out the news and focus on their long-term goals are better positioned to plot out a wise investment strategy.
Marcella Chow, global market strategist
JP Morgan Asset Management
Investors are concerned that interest rates will be raised too much too quickly, which could tip the economy into a recession. However, our baseline view is that US inflation can moderate without a recession because the Fed will do its utmost to engineer a soft landing for its economy. In the near-term, market volatility may continue until investors have more clarity on the Fed’s tightening plans.
We believe fixed income remains a good tool to hedge against market volatility in the current environment due to two reasons. Firstly, equity returns have recently exhibited almost five times the volatility of fixed income returns, therefore fixed income assets can provide a more stable income stream compared to equity.
Secondly, the recent widening of credit spreads has made corporate credits an attractive proposition from a valuation perspective, while we expect default rates to remain low throughout this year due to strong corporate fundamentals. Investment grade bonds provide much coveted downside protection to slowing growth momentum while offering investors a steady income stream. High yields may also offer exposure to market risk-on sentiment while reducing overall portfolio volatility.
Vincent Mortier, group chief investment officer
In our outlook, a global recession is not the base scenario, but clearly stagflationary risks appear widespread. In a fragmented world, investors will need to look for sources of positive real returns and gain exposure to assets that can protect against high inflation/low growth, as well as look for resiliency and opportunities that may arise due to a de-synchronised economic cycle and different paths in fiscal and monetary accommodation. Amid the erosion of strong relative equity appeal versus bonds, a more balanced allocation is appropriate at this stage. We believe investors should further increase diversification while not increasing risk. We’ve seen that investors are not positioned for a global recession because they do not feel that financial conditions will tighten too much, and that fiscal policy will continue to provide some support. Having said that, it is not time yet to be aggressive in terms of risk taking, but on the contrary to have some hedges in place and liquidity in portfolios. On a medium- to long-term perspective, equities remain the engine of returns. Additionally, the mobilisation of capital towards the green transition, and the regulatory wave supporting it, should build a structural case for ESG investing, current and future leaders.
Hyde Chen, head of investment strategy of asset management, managing director
After the challenging market backdrop so far this year, the key question for investors remains whether the Fed can rein in inflation without tipping the US economy into recession.
The stagflationary momentum means multi-asset portfolios are likely to remain volatile. Directional calls are rather risky in this environment, in our view, as geopolitics and central bank policies could quickly swing sentiment. As a result, we prefer to focus on alpha opportunities within major asset classes.
The valuation of equities has been moving closely with real interest rates - Higher real rates are driving the decline in valuations. Historical data also shows that value has outperformed growth in periods when inflation has been above 3%. As a result, we expect a continued period of outperformance by value segments of the market, reflecting attractive relative valuations, a backdrop of elevated inflation, and tailwinds for the energy sector.
Another factor likely to outperform is quality which has tended to benefit during periods of economic contraction. Quality stocks with consistent profits and strong balance sheets have also traditionally served as a safe haven when a flight to quality occurs.
Moreover, diversifying with alternatives can help long-term investors reduce overall portfolio volatility and manage risks around inflation and rising rates. Some hedge fund strategies are well placed to outperform in volatile or falling markets. Private markets and real assets can help investors preserve real wealth over the long term if inflation stays high and their total return is not closely correlated with other asset classes.
Florian Ielpo, head of macro, multi-asset
Lombard Odier Investment Managers (LOIM)
The possibility of a recession has triggered a significant rotation across investors’ portfolios essentially along three lines: from growth equities to quality equities, from assets to cash and from naked exposures to hedged exposures. Equities and more importantly growth equities have now been consistently ditched by investors – be they retail or institutional ones. Quality has emerged as a style that investors are now increasingly fancying: their “bond-like” properties can be seen as an interesting play as a recession draws near.
Second, with central banks raising the return on cash and earnings’ prospect becoming more uncertain, diluting portfolio exposures into cash can make a lot of sense. It was the key to sailing through the ugly 70s period: today looks increasingly similar and good reactions of the past can guide today’s good decisions.
Finally, the quest for hedges shows investors’ growing nervousness: the demand for equity volatility and rates volatility strategies has been strong as of late. Also, trend following strategies – be they intraday or more standard CTA types of trend strategies – have grown in popularity, being historically solid hedges when macro conditions deteriorate. A combination of all three elements makes sense now: too soon to sell everything, but soon enough to get prepared ahead of a larger macro shock.
Dwyfor Evans, head of Asia Pacific macro strategy
State Street Global Market
The trifecta of tighter monetary conditions, Ukrainian conflict and a surge in Chinese Covid cases have heightened recession risks more broadly for the global economy, while inflation continues to be the dominant narrative.
Although recession risks are seemingly on the rise, it is worth noting that the current slowdown in growth is happening from elevated levels. However, given the sheer volume of negative economic risks, safer haven assets look to offer more value at this point so we do favour a more defensive stance.
In the equity space, we prefer strong earnings and seek better fundamentals, hence overweights in US, emerging markets (excluding Asia) — primarily Latin America — and developed markets Asia. In contrast, emerging Asia is a preferred underweight along with Europe on growth concerns.
In the fixed income space, we continue to favour USTs on signs that the monthly changes in US inflation have begun to slow with growth risks to the fore; we also favour hard-currency emerging markets debt, while shorting US high yield. In light of growth concerns, we prefer to be neutral or underweight commodities, while in FX, we have positive biases in the JPY – the traditional safe-haven play and the AUD as a rates catch-up play. We are underweight growth sensitive currencies such as GBP and CAD.
Jason Brady, president and CEO
Thornburg Investment Management
I agree with the consensus view that we are going to be entering a recession in the next year, but this is likely to be a short-lived and mild recession lasting between 6 to 12 months. With consumer demand likely to ebb and liquidity falling, this creates an environment for falling valuations. The temptation is thus to ‘buy the dip’, but the alchemy of success, particularly as we approach a recession, is a balanced portfolio.
Until now, growth names led the market. But now, they are falling behind – meaning that cash flow-generative companies and cash flow yields serve as a counterweight to falling growth. Areas like European tech, which has been beaten up, feature high-quality global businesses with strong margins and recurring revenues. These names can be inexpensive additions to portfolios. Equally, fixed income should be part of a balanced portfolio. While an approximate 2.75% on the 10-year yield may not look attractive, it is a flat real yield considering inflation predictions over the next 10 years. Despite the recent fall in stocks, bonds have provided ballast over the past few weeks, compared with the past six months.