Are We Headed Toward a Recession?
Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Many economists think a recession is a real possibility over the next year. In fact, Morningstar’s chief U.S. economist Preston Caldwell suggests that there’s a 30% to 40% chance that we’ll experience a recession in the next 12 months. Joining me to discuss that prospect as well as how investors can recession-proof their portfolios is Christine Benz. Christine is director of personal finance and retirement planning for Morningstar.
Good to see you today, Christine.
Christine Benz: Hi, Susan. It’s great to see you.
Dziubinski: Macroeconomic events are nearly impossible to predict. So, why does there seem to be this such a widespread concern about the U.S. slipping into a recession in the next year?
Benz: Right. The fundamental underpinning for those concerns is the fact that the Federal Reserve has been on this aggressive campaign of raising interest rates. The goal of doing so is to slow down the economy and in turn to slow down inflation. The worry is that the Fed will push a little too hard and inadvertently slow down the economy a little bit more than it might have hoped. And another thing that we’re seeing is the bond market appears to be flashing some warning signals about a recession as well. So, what’s called the yield curve, which shows you that the yield that you can obtain for bonds of differing maturities, Treasury bonds typically of differing maturities, is showing that you can get paid more today for short-term investments than you can for long-term investments. That’s signaling that bond market participants think well, those bond yields are going to go down at some point. And so that’s one of the considerations as well that historically this so-called yield-curve inversion has been a signal that the economy is going to weaken. In fact, it’s been a close to foolproof signal.
How Have Various Asset Classes Performed During Economic Downturns?
Dziubinski: You and your colleagues are doing terrific work on diversification and correlations. As part of that project and that white paper that you worked on, you’ve also been looking at how various asset classes have performed during economic downturns. That’s what we’ll talk a little bit about today. And let’s start with equities. How have they done in sort of previous recessionary environments?
Benz: Well, equities have not been great, as you might expect, because stocks tend to respond to the economic environment, especially if the company is selling discretionary goods or services, people pull back in recessionary times. When we examined previous recessionary periods we found that stocks in five of eight of the recessionary periods that we examined did have losses during those periods. Three of the eight periods, they did not have losses, but nonetheless that’s kind of food for thought when we think about how our portfolios might behave. We probably wouldn’t want to over-rely on the equities to be great performers; they will oftentimes experience some losses during a recessionary period.
Dziubinski: How about bonds?
Benz: Bonds are the star of the show, in recessionary environments, especially high-quality bonds. I wouldn’t put too much faith in lower-quality bonds, which will tend to be very much beholden to what’s going on in the economic environment. But when we looked at the category that had the best performance during recessionary periods, high-quality bonds, especially Treasury bonds, really delivered. So in eight of those eight recessionary periods that we examined historically, bonds came through with flying colors and had positive returns, and they also exhibited a negative correlation with equities. Which is one reason why we come back to this idea that a balanced portfolio is a good place to be for a variety of market environments.
Dziubinski: What about cash investments? What do you think investors should be expecting there during an economic downturn?
Benz: Everybody’s excited about cash today. The yields are the best of anything going, right? The key consideration is yes, indeed cash will hold its ground in a recessionary environment because that’s part of the deal, right? But what I would not be surprised about is to see yields taper down. And, of course, if you’re buying any short-term security—cash or short-term bonds or anything like that—that’s the risk you face, that you’re having to see your bonds mature or see your CD mature and you’re having to reinvest in a lower-yield environment. That’s a consideration, I think, for people who might say, “I love cash today.” Just be careful because you do face reinvestment risk. One countervailing point, though, is that inflation will tend to cool off in a recessionary environment. So, that’s less of a headwind for you as a cash investor then when inflation is high as it has been over the past year and a half or so.
Dziubinski: Then what implications are there for investors today putting together their portfolios, managing their portfolios, what should they be thinking about?
Benz: I do think that if you’re looking at ballast for your equity portfolio, so say maybe you have 70% of your portfolio in stocks. The best ballast, the best category for a weakening economic environment, will be that high-quality bond portfolio. Very plain-vanilla. I wouldn’t necessarily dabble in lower-quality bonds if I’m looking for ballast. That high-quality fixed-income portfolio with a heavy dose of government bonds is going to be your friend in a recessionary environment. You don’t need to get fancy. In fact, I would look for the cheapest product that you can find. A total bond market index, for example, would have a healthy dose of Treasury bonds and other government-related bonds, which would tend to perform pretty well in a recessionary environment.
Dziubinski: Christine, thank you for your time today. We really appreciate it, and we also appreciate your tips for how we should be thinking about our portfolios in case of a recession. Take care.
Benz: Thank you so much, Susan.
Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.