The Recession We Feared Is Happening. What Should Investors Do?

The Recession We Feared Is Happening. What Should Investors Do?

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Thomas Lee, CFA

Chief Investment Officer

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A historic downturn indicator has proven accurate again in 2020—but it happened for a reason we didn’t see coming. We provide a plan for investing in a recession.

Last year we published a blog focusing on investors’ concerns that the long-running bull market in US equities was nearing an end and the economy was on the verge of a recession.The impetus for this concern was the inversion of the Treasury yield curve—from 10 years to three months—that occurred over the summer. Some may recall other concerns, such as trade tensions with China and even simply the length of the expansion, which had broken the record of 120 consecutive months set in 2001. But the yield curve was the focus, since an inverted yield curve has historically been a reliable indicator of a pending recession. 

That indicator proved accurate again in 2020—but not for any of the reasons we considered then. A virus originating in China in the second half of 2019 spread around the globe, shuttering economies and stagnating global growth. Its impact on the US economy alone has been stunning. GDP peaked in the fourth quarter of 2019 and was in decline for the first two quarters of 2020, meaning we’re officially in a recession. These results aren’t surprising given the rapid shuttering of the economy that occurred in April and the limited reopenings of May and June. 

US real GDP growth, annualized

US real GDP growth, annualized

Source: Federal Reserve Bank of St. Louis, 8/7/2020. For illustrative purposes only. Not a recommendation to buy or sell any security.

Under normal circumstances, current uncertainty would have resulted from a national election that could shift the balance of power in Washington in less than 80 days. But the election is taking a back seat to a pandemic that continues to rage. As long as this situation continues, it will be hard for the economy to recover to Q4 2019 levels. But the outcome has been entirely different for investors. Let’s take a look at how they’ve benefited while the real economy has suffered.

How long will the Fed’s COVID-19 response help?

Amid widespread job losses and housing fears, several broad-based US cap-weighted equity benchmarks and aggregate bond indexes are near or above their all-time high-water marks. Unprecedented fiscal and monetary stimulus programs have unequivocally benefited investors. Below is a quick summary of the US fiscal and monetary response to COVID-19 to date, not considering negotiations underway in Washington on further stimulus.

Stimulus table

These actions have helped to put dollars in consumers’ pockets and drive real interest rates further into negative territory. But enthusiasm for stimulus programs perceived to benefit wealthier investors may wane as we consider the path forward. The current stalemate in Washington surrounding the next stimulus package provides a glimpse into what this might look like.

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10-year constant maturity real rate

10 years constant maturity

Source: Federal Reserve Bank of St. Louis, 8/7/2020. For illustrative purposes only. Not a recommendation to buy or sell any security

A three-point plan for investing in a recession

Despite a speedy recovery for risk assets, investor questions have grown in number: What does all this stimulus mean for the future? Is the worst behind us? Is now the time to reposition my portfolio?

We could see the virus spreading to new hot spots, triggering further shutdowns as the stimulus spigot runs dry, putting equities under pressure. We could also see material vaccine progress sending the equity market to new all-time highs. A whole range of outcomes exists between these two extremes. If history is any guide, we should expect a bumpy path ahead to a brighter tomorrow. Against this backdrop, to invert a phrase from Daniel Kahneman, investors need to think slow, not fast. In short, avoid reacting with emotion and develop a plan thoughtfully, following these steps: 

Consider liquidity needs. Seeking liquidity from acutely risk-averse markets can be painful, forcing investors to realize a loss and eliminating potential for recovery. Investors need to consider the income required from their portfolio and develop a plan to generate it without liquidating growth-oriented assets for a defined period of time. An allocation to lower-risk assets, like Treasuries or high-grade municipals, may tide investors over during future dislocations. The goal of a liquidity plan is to give a portfolio time to recover from a stressful event.   

Revisit your benchmark policy portfolio. Is it adequately diversified? Does it have holdings that are expected to perform reasonably well in any environment, regardless of economic growth or inflation? Most advisors can assist investors if they feel their portfolio lacks this level of diversification.  

Track the improved portfolio closely. Short of a high level of conviction in a specific asset class, the diversified policy portfolio is what the investors want to own. Achieving this outcome means adjusting on day one to get an actual portfolio aligned with the policy portfolio’s targets and putting in place a methodology to rebalance back to the targets as markets move in the weeks and months ahead.

The bottom line

Today’s uncertainty is arguably higher than one year ago as the ongoing pandemic drives economic outcomes. There’s plenty of opportunity for the situation to get worse before it gets better. Careful planning and a range of tools tailored to specific client goals will allow investors to navigate these challenging times. 

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.