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OPINION

Preparing for recession

Preparing for recession
February 9, 2016
Preparing for recession

First, we should avoid equities. There's a strong correlation between annual changes in UK industrial production and in the All-Share index - of 0.46 since 1990. Falls in output are highly likely to be accompanied by falls in share prices. This isn't simply because recessions reduce corporate earnings. It's because they also reduce investors' appetite for risk.

Defensive stocks are little help here. In the last recession, even utilities and tobacco stocks fell heavily. Defensives are only relatively defensive. They should fall by less than the market, but if the market falls a lot, this still means big losses. The case for defensive stocks is that they outperform on average over the long term, not that they rise during recessions.

Secondly, we should avoid many high-yielding assets. High dividend yields can be a sign that investors fear a cut in the dividend, or that the company will suffer badly in a downturn, and recessions cause such fears to be realised - as investors in housebuilders and mortgage lenders learned in 2008.

Much the same is true for high-yielding bonds. In recessions, credit risk rises, causing prices of these to slump.

You might reply that such assets can bounce back sharply after the recession, as we saw with housebuilders in 2009. However, you can only profit from this if you stick with them during massive losses and heightened fears of the companies collapsing entirely. Few investors have the discipline or wallets to do this.

Thirdly, cash and high-quality bonds do protect us against recession. Although equities are positively correlated with output growth, gilt returns are negatively correlated. They would probably do well in a recession partly because investors would flee to safe havens, and partly because they would anticipate a resumption of quantitative easing.

Yes, near-zero returns on cash are unattractive. But they are much better than the double-digit losses one might incur on equities in the event of a recession

There is, though, one asset that might be even better than cash: foreign currency. Sterling tends to fall in recessions, giving profits to UK holders of US dollars, Swiss francs or euros. Again, this is because recessions cause a flight to safe assets, and sterling is regarded as a risky asset. Sure, there's a risk of negative interest rates on foreign currency. But history suggests that, in a recession, these would be offset by rising exchange rates.

It's for this reason that there might be a case for gold. Brian Lucey at Dublin's Trinity Business School points out that gold is not a particularly safe haven, as it only rarely rises when equities do very badly. However, the tendency for sterling to fall in bad times means that holders of gold might see its sterling price increase even if the dollar price doesn't do much.

It is, therefore, pretty obvious how we can protect ourselves from recession. What's not at all obvious, however, is whether we'll need such protection. In fact, this might not be knowable at all because recessions might be inherently unpredictable.

Herein lies our problem. A recession-proofed portfolio would underperform badly if the risk of recession recedes because stock markets would rise - perhaps a lot - in this event. Granted, such a portfolio wouldn't fall very much: the relatively low volatility of gilts would limit our losses. But we would miss out on some nice gains. In this sense, there is an acute trade-off between risk and return.

In this context, it's important to consider your target wealth. If your assets are sufficient to fund your lifestyle until you die, you don't need to chase big returns. The price of recession-proofing your portfolio - missing out on potentially big profits - might therefore be worth paying. Some of us, however, are not so lucky. For us, the trade-off is more awkward.