How to invest in a recession

The UK economy is technically in recession. The economy contracted in the second half of last year, meaning that we have now met the official definition of two consecutive quarters of negative growth. The good news is that it looks set to be relatively mild one.

But being in any form of recession is bad news for the government, who face an election sometime this year and have unambiguously failed in their pledge to ‘grow the economy'. It also makes life difficult for the Bank of England’s rate-setters, who were already weighing up the risks of persistent inflation against the risks of ‘overtightening’ and plunging the economy into an even deeper contraction.

The economy is not the stock market, but there's little doubt this is a tricky time for investors, too. So what does history teach us about navigating a recession? And why might things be different this time?

What is a recession?

Put most simply, in a recession, a country's economy shrinks. Typically, we see job fears rise and household spending drop, meaning that company earnings falter as a result. Recessions are also associated with market downturns, and sometimes these prove severe. Since 1987, global stock prices have entered 'bear market' territory three times, losing more than 20 per cent from their previous peak.

Economists like to think of economic performance as a stylised cycle, which moves through expansion, peak, contraction and trough (see chart). 

The first step towards recession happens after a peak: growth falters and the economy begins to contract. When growth has been negative for two consecutive quarters, the economy ‘technically’ enters recession. Output declines until the economy reaches a trough – at this point growth becomes positive, and the business cycle starts anew. The recession is over, and the economy begins its ascendancy towards another peak. 

Lessons from history

History tells us that the first stage of a recession is usually bad for stocks. US research from investment manager Pimco looked at the performance of the S&P 500 and medium-dated Treasury bonds between 1953 and 2022 (see table). Over the period, equities typically lost 26 per cent during the ‘first half’ of a recession.

Source: Pimco

Equities rebounded strongly in the second half of a recession (by 22 per cent, according to the Pimco data) – even as the economy continues to contract. Thanks to a combination of cheap valuations and expectations of a future recovery, stock markets can recover quickly – far faster than the real economy, in any case.

Though equity returns tend to struggle during the first half of a recession, bonds have generally performed better, as the table shows. This inverse relationship means that holding a portfolio of both equities and bonds has historically given investors protection, with bonds offering some upside as equities fall in the early stages of an economic contraction. 

What is different this time?

But a recession this year could be particularly unusual thanks to the persistence of high inflation. In normal times, we would expect central banks to cut interest rates during a downturn to make borrowing cheaper and reinvigorate spending again. Yet despite anaemic growth, central banks might feel compelled to keep interest rates high until they are confident that inflation has been quashed. Rob Morgan, chief analyst at Charles Stanley, told Investors Chronicle that “the current situation is completely different and far more challenging” than we might see ordinarily. 

This makes the timing of a policy pivot harder to predict. Analysts at Goldman Sachs looked at previous hiking cycles in G10 economies. They found that on average, they lasted 15 months, while 75 per cent of the time, economies saw rate cuts within a year of the final interest rate hike. In the UK, the BoE started raising interest rates in December 2021, and have held them at 5.25 per cent since August 2023. The hiking cycle lasted almost two years, and rate cuts are not expected until sometime towards the middle of the year. From this juncture, it doesn’t look like this is going to be an ’average’ cycle. 

This matters for investors because pivots matter to markets. According to Morgan, a change in the direction of interest rate policy “has often led to large market rebounds”. But the about-turn could be far more sluggish today: “markets are now acknowledging a more drawn-out process, which potentially means more collateral economic damage along the way”, he said.

This tough balancing act was borne out in the latest rate-setting meeting. Two members of the Monetary Policy Committee voted for rate hikes, while one voted for a cut. Hawks remain attuned to wage pressures and signs of persistent inflation, while the single dove warned that "the Bank rate needed to become less restrictive now".

The door to rate cuts has certainly been opened, but the news that the UK has entered recession may not have much influence on the Bank's thinking. Imogen Bachra, head of non-dollar rates strategy at NatWest, thinks that rate-setters are still more worried about signs of inflation persistence than activity. This means that recession is “arguably less important” for both the BoE and markets than labour market and inflation figures.

As a result, investors could face a difficult period of economic contraction and higher interest rates. Schroders strategist Tina Fong told Investors’ Chronicle that “the performance of equities is seriously challenged in a stagflationary environment” as stock prices face squeezed profits from lower economic growth, and valuations undermined by higher interest rates. At the same time, high inflation means that “government bonds may not provide the protection needed in the portfolio”. According to Fong, if inflation – and by extension the base rate – remains high, “then a traditional balanced portfolio is in for a choppy ride in the months ahead”. 

Beware hard and fast rules

While equities usually decline during recessions, defensive sectors like consumer staples and healthcare historically tend to deliver the strongest returns, as the table below shows. But Fong stresses that there is “no hard and fast rule in defining sectors as being defensive or cyclical”, adding that even ‘cyclical’ industries can behave very differently from one another. 

She points out that some of the most rate-sensitive cyclical sectors (think consumer discretionary and tech) tend to rebound before a recession concludes. Industries that take a hit in the early stages of a recession can quickly bounce back as markets look ahead to a recovery in economic activity and corporate earnings. 

Average returns of US equity sectors vs overall market 1973-2023

Source: Schroders Economics Group, March 2023, excess return performance based on sector compared to the overall market

There is no such thing as a ‘typical recession’

Though it may feel as though we are facing a particularly challenging set of circumstances today, it is also worth stressing that every economic cycle is different. 

During the brief recession of 2020, the US stock market troughed less than a month after the start of the contraction. In this instance, markets looked through the collapse in economic activity, and rallied in anticipation of a sharp rebound in growth. In contrast, the Great Depression was the longest US recession of the 20th century, and it took nearly three years for the S&P 500 to reach a bottom.

Despite a wealth of forecasts, at the start of a recession no one is sure how long it is going to last – or how severe it is going to be. This makes predicting market reactions even more difficult. Deutsche Bank analyst Jim Reid notes that “even if we get a mild one it can still be bad for markets if no one knows at the time it's going to be mild”. 

In the face of uncertainty, diversify 

Last year proved exceptionally difficult for investors, with both equities and bonds struggling in the face of sharply rising consumer prices. But analysts caution that investors should not abandon a balanced portfolio in the face of a darkening economic outlook. According to Charles Stanley’s Morgan, “investors will be assisted by renewed diversification benefits of holding both equities and bonds in a portfolio”, which can offer protection in a wide range of potential scenarios. 

Morgan notes that bonds could offer an upside if a deep recession means interest rates are cut quickly – a scenario that could prove more challenging for equities. On the other hand, if we do avoid a recession, “many areas could live with inflation being that little bit stickier as long as growth comes through and earnings are largely unscathed”. This kind of ‘soft landing’ could benefit equities more than bonds.

Vanguard research also shows the gains from diversification, even in choppy waters. Using US data, analysts looked at the investment performance of different markets from 1935 to 2022, and calculated the chance of experiencing negative real returns. After a year, a portfolio of shares alone had a 31 per cent chance of making a loss after inflation, which fell to 11 per cent after 10 years. The corresponding probabilities for a 60/40 portfolio were 29 per cent and 9 per cent respectively - though time horizons and risk appetite mean a relatively equity-heavy portfolio will remain the right choice for many investors. For context, an investor holding cash saw a more than 40 per cent chance of a loss after inflation over a one-year and ten-year period. 

Don’t try to time the market

The uncertain outlook means that investors, as ever, shouldn’t try to time the market. Charles Stanley’s Morgan notes that “a recession can cause volatility in prices, but there’s no knowing when the low point will come – or if it has already passed”. He adds that “trying to time the market is usually a losing battle”. 

Jumana Saleheen, chief economist at Vanguard, also notes that the best and worst trading days often occur close together: financial markets hate uncertainty, and can ‘overreact’ until more information becomes available. Vanguard research found that nine of the twenty best US trading days in between 1980 and 2021 occurred in down years, while eleven of the worst occurred in years that ended with a positive return. 

Stay invested

This is why it is important to stay invested, even though it sometimes feels as if that requires an iron will. Schroders fund manager, Nick Kirrage, agrees that “when markets dive, too many investors panic and sell”. He adds that “the irony is that historically many of the stock market’s best periods have tended to follow some of the worst days”. 

2021 research from Schroders showed that someone investing £1,000 in the FTSE 250 35 years ago would have made £43,595 had they stayed invested over the entire period. But this figure drops to just £24,156 if you take out the best 10 days over the period, and collapses to £10,627 if you miss the best 30 (see table). 

Source: Schroders

But this sometimes takes a strong stomach, particularly if your savings goals are several years away: Kirrage points out that the period between 1987 and 2021 saw investors to navigate Black Monday, the bursting of the dotcom bubble and the global financial crisis. As we face a period of significant uncertainty from high inflation, rising rates and stagnant growth, the old adage “it's not about timing the market, but time in the market” comes to mind. It might be an old one; it is also a good one.