In focus

Moving from recession to recovery: how can investors position themselves?


Tina Fong

Tina Fong

Strategist

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The world’s largest economy has officially entered recession, but risk assets have already rallied to the tune of a “V-shaped” economic bounce-back. The reality is likely to be a more protracted recovery given the difficulties of lifting lockdown.

So how should investors manoeuvre their portfolios as the economic cycle moves from recession into recovery? This is where an understanding of the stages of the cycle can be a useful guide to asset allocation. While historical returns using the economic cycle is no guarantee of the future path, there is a reassuring rhythm to the performance.

Minding the gap

In defining the stages of the economic cycle, we rely on the Schroders US output gap. Simply put, the output gap measures the difference between the actual and potential output of the economy (measured using GDP). To measure the output gap, we use the unemployment rate and the capacity utilisation rate versus their long run trends. 

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In the chart above, the cycle has slipped firmly into the recession phase with the output gap plunging into negative territory. A move into recovery would mean that the output gap needs to narrow – that is, turn less negative - compared to three months ago. While the market appears to have already priced in a recovery, our model suggests that this is likely to occur in Q4 this year, based on the Schroders Economics team’s baseline forecasts.

What do the recession and recovery phases mean for multi-asset investing?

In the recession phase, the credit class typically shines, particularly high yield. This is because, as companies repair their balance sheets and markets anticipate a rebound in the economy and corporate earnings, the prices of these bonds rise (meaning yields fall). This backdrop also helps equities to recover, although investors tend to favour credit in this environment. Besides being a more defensive asset, the higher yield from owning credit is being supported by accommodative monetary policy by the Federal Reserve (Fed). Compared to the Fed’s support in the wake of the global financial crisis (GFC), credit is this time being further boosted by unprecedented levels of corporate bond buying.

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As investors become more confident that the cycle has moved into the recovery phase - with stronger growth, but still muted inflation - equities typically outperform credit. Interestingly, during the recovery phase, equities are not driven by a re-rating in the market. Re-rating is a change in the amount investors are willing to pay for a company relative to its earnings, or the “price-earnings ratio”.

Instead, equities in the recovery phase are driven by stronger growth in earnings, or specifically earning per share (EPS). Most of the re-rating in the market predominately occurs during recessions, while EPS growth is negative. However, the challenge this time around is that valuations are starting from a higher level which means there is less of a re-rating cushion compared to past recessions.

With the changing of the cycle, it is all about sectors and style

Despite recessions being underpinned by low growth prospects, investors have favoured the consumer-oriented sectors relative to the overall market. While consumer staples are clearly defensive in nature versus the consumer discretionary sector, both segments have outperformed in recessions. This is likely due to the market discounting households receiving a boost in disposable income from lower inflation, oil prices and interest rates. Lower interest rates also help steepen the yield curve during recessions, which improves the profitability of financial companies. Specifically, this means they can receive income on loans based on higher long-terms rates but pay deposits using lower short-term rates.

In comparison, nearly all of the cyclical names such as tech, communications and energy have been left behind by the S&P 500 during recessions. However, there is a general reversal in sector leadership in the recovery phase with the more cyclical areas of the market doing well such tech and industrials.

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In terms of US equity styles, the more defensive areas such as growth/quality stocks, and companies with high dividend yield do well in recessions. Despite their cyclicality, small caps have surpassed their larger peers in the performance stakes. This is because investors are anticipating the recovery in corporate profitability of these companies, which are more sensitive to falling interest rates and the expansion of liquidity from the central bank.

By contrast, recessions have typically been the worst periods for value stocks, given the weak growth and muted inflationary backdrop. However, in the recovery phase, the value trade has typically regained its spark beating the broader market, particularly when the Fed is hiking interest rates. It would appear that value stocks looking “cheap” are less impacted than their more expensive quality/ growth counterparts by the higher discount rate on earnings.

Conclusion

In the recovery phase, equities have historically warranted a higher allocation in the portfolio versus credit as this asset class has tended to benefit from stronger earnings growth. Looking ahead, we need to see a recovery in earnings, as there is a limit to the re-rating in the price earnings ratio, which has driven the latest rally in the equity market.

At the same time, there is a stronger argument for credit in the portfolio as monetary policy remains accommodative, particular with the Fed buying corporate bonds. On commodities, unlike previous recoveries, there is scope to allocate more weighting towards this asset particularly given the severity of underperformance in this recession.

Meanwhile, investors should think about shifting their overweight allocations in the US dollar to riskier currencies but keep some defensive currencies.

In terms of US sector performance during recoveries, the more cyclical areas of the market – such as tech and industrials – have tended to do well. While there is more valuation support for the more cyclical names, tech has unusually delivered stellar returns during this recession, which may curtain their sparkle compared to previous recoveries. Moreover, the value trade has generally outperformed in this phase, although this may prove to be more challenging, with the Fed expected to keep rates at rock bottom for an extended period. Overall, the main takeaway for investors is that there is a more pro-cyclical flavour to asset allocation during the recovery phase.

 

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