How to invest for a recession

Investing for a recession requires quite a different mindset to conventional investing.

Normally you are relying to some extent on growth in the economy to help increase the value of your investment over time.

That dynamic no longer operates during a recession when there is a significant, widespread and extended decline in economic activity.

It is particularly important to prepare for a recession because they are a normal part of the local and world economy and can prove quite costly to investors.

In the US, for example, since 1937 the average recession driven fall in the share market as measured by the S&P 500 has been 32%, which most would agree is a significant dent in any portfolio.

A recession hits all asset classes

Of course, it is not just share markets that feel the pain during recessions, with all major asset classes including property, bonds and even cash all impacted in different ways during a downturn.

Bonds and gold may improve during a recession, although that depends on whether it is of the inflationary or deflationary variety – with all indications being that inflation will be present in the next downturn for Australia.

It is not all bad news though, with many investors such as the world’s greatest – Warren Buffett – consistently using downturns as a perfect time to build an investment portfolio that will stand the test of time and be highly profitable once economic growth restarts again.

The biggest lesson we can learn from the Buffett approach is not to meet a recession by panicking and running to cash to avoid losses.

Timing markets is very difficult so it is better to gradually adapt to a slowdown than to react with massive, all or nothing changes.

So, what are some of the strategies to use during a recession to ensure that this natural and cleansing pause in economic growth leaves us in a better financial position and as a more assured and confident investor?

Quality counts

One of the most cleansing things about a recession is that it can show what is really important.

As Buffett famously said, “It is only when the tide goes out do you discover who’s been swimming naked.’’

The tide really goes out during a recession when some investments that look great when everything is growing suddenly are exposed as lacking the durability to last through different economic conditions.

These factors apply across all asset classes because once you subtract economic growth from the equation it is the real basics that matter – cash flow, manageable debt levels, profitability and the ability to generate a return and pass on costs in difficult circumstances.

So, the first rule of investing for a recession is to look for quality investments that have solid, steady cash flows and pay dividends.

That is why shares in exciting growth opportunities become less sought after as the chances of a recession are rising while at the same time larger, blue chip and sometimes boring companies come to the fore.

It is a similar situation for property – as a recession approaches an existing property with a solid tenancy and yield becomes more appealing than a vacant piece of land with no yield but plenty of opportunity.

Other than choosing your own investments through the lens of a potential recession, there are other easier ways to ride through hard times.

For the Australian part of a portfolio, choosing a good value manager is a lower stress way to navigate the choppy waters of a recession so a well-managed, low fee listed investment company (LIC) such as Australian Foundation (ASX: AFI) or Argo (ASX: ARG) is an easy way to play it.

Both LICs pay strong dividends and actively buy the pick of companies in the ASX200 when they trade at good prices so that takes a lot of the hard work out compared to choosing your own shares.

When markets are racing, investments such as the big LICs may not keep up with the pace because they are not built to jump on the latest trend but they are a rock-solid way of generating returns during a downturn.

Similarly, a market exchange traded fund such as State Street’s ASX 200 ETF (ASX: STW) is another low fee way to invest in the biggest and strongest companies, generating reasonable dividends and charging small management fees.

For easy international exposure, the best approach is to either buy through a managed fund (either listed or unlisted) or to get direct diversification through ETFs such as that provided by Vanguard’s US Total Market ETF (ASX: VTS) and All World ex-US ETF (ASX: VEU) in just two listed ETFs.

Again, if you want to pick and choose various markets and proportions that is a valid strategy but remember that in a recession, the biggest stocks are often the safest so buying through ETFs is a good way to get that exposure cheaply.

Investing in property

Property can be a good investment during a recession, often rising strongly during inflationary surges.

However, it can be susceptible to sell offs as interest rates rise, due to the improving relative yields on offer through cash and term deposits.

On the property side of the ledger, if you don’t want to go through the perils and choices of choosing and financing your own investment property, diversification and some reasonable yields are available through something like the Vanguard Australian Property Securities Index (ASX: VAP).

It gives broad exposure across retail, office, industrial and diversified property trusts, although obviously you can try to pick your own winners by selecting individual property trusts.

Bonds picture is cloudy

Traditionally government bonds can be a good place to make money in recessions but there are risks, particularly when interest rates are very low and trending higher.

That is because buying bonds through a bond fund gets you bonds with a current yield, so if the yield for new bonds is rising over time, the price of your bond portfolio will fall because it now has an inferior yield.

Investment grade corporate bonds can also fare well during a recession, although they may suffer also if interest rates continue to rise.

Some of the easiest ways to get exposure to Australian bonds are through products like iShares Core Composite Bond ETF (ASX: IAF), SPDR Australian Bond Fund (ASX: BOND), Vanguard Australian Fixed Interest Index ETF (ASX: VAF) and BetaShares Australian Government Bond ETF (ASX: AGVT).

In general bonds are a nice counter-cyclical exposure within an overall portfolio because they tend to rise at a time when the share market is falling, helping to smooth out some volatility.

Bonds rarely shoot out the lights performance wise but there is a reason they are usually staple investments for many fund managers.

Timing the recovery

One of the most important things to remember when investing for a recession is that you need to keep monitoring what is happening to anticipate any economic recovery.

That is tough to do because when stocks are falling there is no way of knowing when they will turn bottom out and start to turn around.

It can often feel very bleak and a tough time to invest at this stage but it is also when the big profits are made by switching your portfolio from value to growth to take advantage of the coming recovery.

Recessions are often shorter and sharper than bull markets but one thing is for sure, there will come a time when the hammered down growth stocks are an appealing long-term investment and those safety stocks you have bought for the recession – such as consumer staples, health and telcos – will start to struggle as growth returns.

Recovery can be the time to use margin loans

One of the great things about the share market is that you can fine tune your investments any way you like, rebalancing towards growth as fast or as slow as you feel is appropriate.

That is also the case about using higher risk strategies such as margin loans which can be diabolical during recessions because they magnify losses but ideal in a recovering market because they magnify gains and allow you to broaden your exposure without pouring in extra cash.

The other thing to notice is that markets tend to move early and en masse, so the current sell off in technology stocks and rallying within mining and commodity stocks is a sign that many investors are pulling their horns in and preparing for a recession already.

Whether that recession is around the corner or will come at all is always difficult to know but with the chances of a downturn rising, knowing how to weather a downturn has rarely been more important.