What if there is a recession?
There has been a lot of talk in the financial news media in
the past few weeks about increasing probability of a recession in the U.S.
Citigroup was out recently with an alarming report that, in their view, the
risks of a global recession have increased materially. The primary reason they
cite is concern that U.S. economic growth is slowing and because of that, the
risk of recession has increased. Another argument for supporting the idea of
recession focuses on U.S. corporate earnings growth, which has been negative
for the past several quarters, and declining corporate profits have led to
recessions in the past.
There is no question that concerns over a recession have
added to market volatility this year. Market volatility has been further
exacerbated by concerns over slowing growth in China, plummeting oil prices,
and a change in Federal Reserve policy. But what is the real risk of a
recession actually occurring?
Recent growth in the U.S. measured by GDP has been slow, to
wit Q4-15 real GDP growth of about 1%. We have to remember that the recent
decline in oil prices and oil-related activity has had a material impact on the
economy. Also, the theory that negative corporate profit growth will lead to
recession also has to be put into context: if one excludes the energy sector
from S&P500, corporate profit growth was a reasonable 5% in 2015 and is
expected to be about that level in 2016. Employment in the U.S. remains stable
and reasonably healthy and unemployment claims continue to decline. Housing
remains strong and growth in consumer spending is also expected to remain
healthy in 2016 at about 3%. The point is there is very little evidence aside
from earnings, that the U.S. is on the verge of recession. The concern over the
strength of the Chinese economy also appears to be misplaced: U.S. exports to
China represent a very small 1% of GDP; and Barron’s magazine recently cited
economist Michael Lewis who found that not a single recession in the post-World
War 2 economy could be traced to foreign economic woes.
So what is the point of all this? 1) We think concerns over
a U.S. recession are overblown; and 2) even if there is a recession, we know
that that are ways to position portfolios to reduce the impact of a recession.
What are some of those ways? Diversification by asset class can help to reduce
portfolio volatility because of differing correlations of returns. For older
clients who cannot withstand higher volatility, allocations can be more skewed
towards fixed income investments which have a low or negative correlation with
stocks. Through tactical asset strategies, investment managers can reduce overall
equity exposure in a client portfolio or increase holdings in sectors with lower
volatility (such as utilities or consumer staples). In other words, there are ways to mitigate the
risk of recession through proactive risk management, with the classic strategy
in this regard being asset class diversification, and maintaining a financial
plan that not only includes an appropriate investment strategy but also reduces
the temptation to time the market by imparting investment discipline. Clients will
be better positioned to weather a potential recession if their portfolios are
properly positioned in accordance with a sound financial plan.
