In this article you will find out more about:
Challenges for Investing during a Recession or Economic Slowdown
Average Performance of Different Sectors during Business Cycle
Sector performance during business cycleHow to Implement a Sector Ration Strategy
Challenges for Investing during a Recession or Economic Slowdown
Investing in 2023 requires investors to deal with topics like economic downturn, recession, inflation peak and interest hiking which are all-around and influencing the performance of everybody's portfolio. Worrying about future returns, many started to think about how to best protect their portfolio for such potentially upcoming recession period.
First of all, how does a recession look like? How to know if there will be a recession? How severe will it be? Is a sell-off with declines of >20% likely? Does sector rotating make sense - into which sectors should you invest during which phase of a business cycle? Maybe even liquidate positions and hold only cash to have enough dry powder to fully benefit from buying opportunities in the following recovery phase?
Certainly, a recession would have a negative impact on stock market returns but as always, nobody can really predict with certainty if a recession will come, when and how severe it will become. But for those investors who are convinced that economic downturn is ahead, which are best stocks to own for a recession? Well, although that answer is almost impossible to give for single stocks, there was done some serious research for overall business sectors and their performance during previous recessions. Even though results seem promising, investors should always bear in mind potential deviations resulting from influencing factors like technological developments, supply chain disturbances, pandemic lockdowns, protective trade policies or even sanctions.
The Business Cycle Concept and Stages of Business Cycle
Before talking about the performance of sectors during a recession, we need to look at the concept of a business cycle which was introduced by Wesley C. Mitchell and Arthur F. Burns in 1946. A business cycle is the natural fluctuation of economic activity that occurs over time. This includes periods of economic expansion, during which businesses and employment are growing, and periods of economic contraction, during which businesses and employment are shrinking. The length and severity of these cycles can vary, but they typically last between four and eight years.
The US economy experienced 11 business cycles between 1945 and 2009, with the average length of a cycle lasting a little less than 6 years. The average expansion during this period has lasted 58.4 months, while the average contraction has lasted only 11.1 months.
The business cycle is driven by a variety of factors, including changes in consumer demand, interest rates, and government policies. During periods of expansion, consumer spending and investment tend to increase, leading to higher levels of economic growth. However, as the economy reaches full capacity, inflationary pressures can begin to emerge, and the central bank may raise interest rates to slow down the economy. This can lead to a slowdown in economic activity and the start of a contraction, potentially ending with a severe recession.
What Is a Recession And How To Identify a Recession
A recession is commonly understood as when the GDP growth declines two quarters in a row.
The International Monetary Fund (IMF) defines a recession as a decline in annual per‑capita real World GDP (purchasing power parity weighted), backed up by a decline or worsening for one or more of the seven other global macroeconomic indicators: Industrial production, trade, capital flows, oil consumption, unemployment rate, per‑capita investment, and per‑capita consumption.
For the US, the National Bureau of Economic Research (NBER) identifies recession based on how the LEI index (leading economic indicators), an aggregation of 10 indicators, is changing YoY:
Average weekly hours in manufacturing
Average weekly initial claims for unemployment insurance
Manufacturers' new orders, consumer goods and materials
ISM Index of new orders
Manufacturers' new orders, nondefense capital goods, excluding aircraft orders
Building permits, new private housing units
Stock prices, 500 common stocks
Leading Credit Index
Interest rate spread, 10-year Treasury bonds less federal funds
Average consumer expectations for business conditions
Although both methods for assessing economic conditions are looking into similar areas of the economy, there are still some differences in the underlying indicators. Accordingly, there might be different outcomes with regards to the assessment if a recession is ahead and when it starts - or not. That leads especially to the challenge to find the right timing for performing a sector rotation in a portfolio.
How Recessions Usually Started and Ended in The Past
Following a McKinsey analysis from 2009, all four recessions before 2009 started with a decline in sales and EBITDA of the consumer discretionary sector (sensitive to economic decline) while the energy sector was usually hit very late.
As indicators for the beginning of a recovery after a recession could be identified in three of four recessions before 2009 high consumer discretionary and IT spending and the return to real EBITA growth in these sectors.
Impact of Recession on Stock Markets
How do stocks perform before, during and after a recession? Since the stock market is pricing in future economic developments, it usually performs worse before a recession than during a recession and needs in average around five to eight months to bottom during the recession in order to start going up already towards the end of a recession.
One of the most well-known stock market recessions in recent history is the 2008 financial crisis, caused by the collapse of the housing market and the subsequent failure of several major financial institutions in the US. This led to a significant drop in stock prices, with the S&P 500 index losing almost 50% of its value between October 2007 and March 2009.
However, since the 1920 recession the S&P 500 has produced out of 15 recession periods in only eight a negative return. During three recessions negative performance of the S&P 500 was more than 20%. Except from these three extremes, there were also seven periods with positive returns. This could be also used as a good indication that staying in the market was better than trying to time the market.
Which Sectors Perform Well in a Recession
During business cycles, the performance of different sectors of the economy can vary. Investment returns of stocks from companies within the same industry tend to move in similar patterns. That's because the prices of stocks within the same industry are often affected by similar fundamental and economic factors.
Typically, during an expansion phase of the cycle, consumer discretionary, technology, and industrials sectors tend to perform well as consumer spending increases and businesses invest in growth. In contrast, during a recession or contraction phase of the cycle, defensive sectors such as utilities, consumer staples, and healthcare tend to perform better as they provide essential goods and services that are less sensitive to economic downturns. It's important to note that the market performance during business cycles can be affected by a number of factors (see influencing factors further above), and past performance is no guarantee of future results.
Average Performance of Different Sectors during Business Cycle
In 2019, Bartolini and Dong from SPDR Americas Research had a closer look at the US stock market and analysed seven recessions and recovery periods together with 12 expansion and 11 slowdowns since 1969 in order to find out which sectors usually tend to perform best and worst during each of the four refined stages of a business cycle.
Following their analysis, during
Slowdown phase of the business cycle, best performing sectors were Consumer Staples and Health Care (average period return around +14%). Worst performers still showed a positive average return between +2.5 and +5.5%.
Recession periods Consumer Staples and Utilities outperformed the market with a hit rate above 85% and an average period return between -2.9% and +1.0%. All other sectors showed significantly lower return rates (-3.5% - -21.6%).
Recovery phases, all sectors had shown 2-digit positive average returns, with Consumer Discretionary and Real Estate performing best (average return between +33% and +39%).
Expansion phases, all sectors generated positive average period returns, with Financials and Technology as leading sectors (between +18 and +21%) and Utilities as lagging behind (+7.6%).
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How to Implement a Sector Rotation Strategy
If European investors want to replicate the investment idea of overweighting specific sectors during a business cycle, the following ETFs should cover the above-mentioned sectors (no investment recommendation!):
However, there are many influencing factors (e.g., monetary or fiscal policy measures) which could alter historical return patterns significantly. Therefore, past performance is never a guarantee of future results!
Investors can take steps to protect themselves during a stock market recession. One strategy is to diversify their portfolio by investing in a variety of different stocks and sectors, rather than putting all their money in one stock or sector. Exchange-traded funds (ETF) offer also retail investors the opportunity to broadly diversify their portfolios with small investment amounts at very low cost and high liquidity.
Further interesting reading
The Economist - Recession Watch - coverage of the turmoil afflicting financial markets and the global economy
McKinsey Global Economics Intelligence executive summary, August 2022
Morningstar - 15 Charts Explaining an Extreme Year for Investors
Morgan Stanley - Investing in 2023: A Year to Be Patient and Selective
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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