Prepare Your Client Portfolios for

the Next Recession

Prepare Your Client Portfolios for the Next 

Recession

No one can forecast when the next recession will occur, but correctly positioning a portfolio for tomorrow’s risks is vital. Often, interest rate hikes precede a recession, and we are entering a new rate hiking cycle. It’s important to understand current market conditions before you can formulate a plan to prepare.

First, what’s up with the market?

In broad terms, the economy is doing well. A low unemployment rate, high corporate earnings, and other good leading economic indicators are all constructive signs of a strong economy. However, central bank policy, inflation, and the Russian-Ukrainian conflict are being labeled as primary drivers of current market volatility. The constant stream of surprising news has been hard for markets to absorb. In summary, markets abhor uncertainty and generally grind higher on positive surprises to the upside.

A quick shift in Fed policy!

The Fed has a dual mandate; to keep both unemployment and inflation in check. Following the Great Financial Crisis, U.S. central bankers intermittently used both rate cuts and an asset buying program, commonly referred to as quantitative easing, to stimulate the U.S. economy. As unemployment and inflation remained low, these accommodative policies helped spur a growing economy and ever-increasing asset prices. Today, as inflation is reaching 40-year highs, the Fed is looking to quickly shift to a more restrictive, tighter monetary policy. This begins with the Fed raising short-term rates by 25bps at their March 16th FOMC meeting.

  Federal Funds Effective Rate (FEDFUNDS) | FRED | St. Louis Fed (stlouisfed.org)

In addition to rate hikes, the Fed has indicated they will end their asset buying program as their balance sheet has grown to nearly $9 Trillion. This policy shift is designed to stop adding, and then start removing, liquidity from the financial system and could raise long-term interest rates as the money supply shrinks. The speed at which the Fed ends quantitative easing is the biggest unknown. Markets are trying to decide whether these two Fed actions will cause a proverbial hard landing or if the Fed can work some magic to soften the economic blow.

  Federal Reserve Board - Recent balance sheet trends

How high is Inflation?

Inflation is quite high at over 7.9%! To put it in perspective, over 50% of the U.S. population wasn’t alive in 1982, the last time American consumer prices were rising this fast.

It’s important to remember that inflation is the rate of change in prices. It also compounds over time. 

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  CPI Home : U.S. Bureau of Labor Statistics (bls.gov)

Even if the inflation rate decreases over the coming months, which most economists expect, prices will still be rising. For example, let’s say a gallon of milk costs $3. With 10% inflation, the price would increase 30 cents to $3.30 per gallon. If the inflation rate was then cut in half to 5%, the new price would still be another 17 cents higher, up to $3.47. Taming inflation is important, especially when sudden jumps in inflation can cause price spikes from which recovery is hard.

The U.S.’s higher-than-forecasted, and more-persistent-than-anticipated rate of inflation has led to more uncertainty. The central bank, which was initially calling for only three rate hikes this year, seems to have capitulated to market conditions. Now, investors are pricing in up to six or seven rate hikes including some larger moves of 50bps or more.

How will the Russian’s invasion of Ukrainian affect the global economy?

In short, no one really knows. Markets seem to be pricing in some level of economic pain. As NATO and the U.S. impose sanctions on Russia, global trade will certainly be hurt. It is widely believed that a full-scale war will have spillover effects involving more countries, further exacerbating high energy prices and already stretched supply chains. These global economic stressors add to rising prices and may need to be addressed through more rates hikes. Additionally, a new cyberwarfare battlefront could emerge where financial systems, power grids, and governmental entities are targeted.

Hedging your portfolio for a recession.

While a recession can happen unexpectedly, in recent history they have been caused by Fed reactions to economic conditions like we are experiencing today. Knowing the Fed is taking actions that likely precipitate the next recession, building recession-resilient portfolios is prudent and can be simpler that you think. The stock market usually moves into a bear market cycle ahead of economic recessions, as the stock market is considered a leading economic indicator.

Leading up to the Great Financial Crisis, a traditional 60% stock and 40% bond portfolio (the most common strategic allocation) performed well. But during the 2008 bear market, most asset classes became correlated to each other in a downward spiral. This meant that most, if not all, of the benefits of the strategic diversification were lost as the 60/40 portfolio still dropped 36%.

During protracted bear markets, portfolio losses can cause poor and emotional decision making, delays in planning, and slower compounding of returns. The impact to portfolios is amplified if an investor removes risk from portfolios after the damage is done – thereby reducing their ability to recover from those losses.

We believe the best way to prepare today for a future recession and bear market is by allocating to MSCM’s tactical strategies. Portfolios that include tactical allocations may be large beneficiaries when a bear market occurs. In fact, our results show that adding a sleeve of TPSR to an existing 60/40 portfolio over various market conditions (not just during bear markets) enhances a portfolio’s return profile while reducing risk.

TPSR as an allocation!

TPSR is our low-fee, tactical ETF strategy that uses a rules-based investment approach to transition between offense and defense depending on market conditions. This strategy has more than five years of audited track record that has produced strong returns with proven risk management. 

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Most investors (and advisors) want to participate in rising equity markets but be able to quickly become defensive when markets sell off. We built our tactical strategies with this premise in mind.

TPSR performed well during the COVID-19-induced bear market.

We largely avoided the 2020 bear market by getting out of our equity positions when the market sold off in February, and reallocating to equities when the market environment improved in early April 2020. This resulted in a smoother ride for our clients and portfolios that considerably outperformed the S&P 500. The investors that use our strategies were thankful to have that peace of mind during a tumultuous market event.

Our process uses models and rules to create consistent and repeatable investment decisions. Our strategies, compared to common strategic allocations, have a low correlation (even negative during bear markets), lower annualized volatility, lower value at risk, and lower drawdowns. We use large, highly liquid ETFs to minimize costs, move quickly when needed, and make sure we are not capacity constrained.

You can increase the odds of your clients making good decisions and strengthen their portfolios with the addition of tactical investing strategies. We believe that taking a measured, risk managed approach is prudent and the best way to capture upside gains with downside protection in the current macro environment.

The next 10 years will most likely be very different from the last 10 years. Ensure your client portfolios are prepared for the next recession and bear market!

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