Anticipating Recessionary Pressures in Investment Planning

Ian Wood, CFP, CIM, MFA-P

While inflation is characterized by an increase in prices in an economy, a recession is generally defined as two consecutive quarters of negative real GDP growth; that is, the inflation-adjusted growth of an overall economy.  Higher inflation obviously has a significant impact on this definition.   The two concepts are a double-edged sword in today’s economic climate and it will impact the conversations you may be initiating with your concerned clients:

Definitions.  Historically, recessions aren’t rare, as they tend to occur every four to five years on average.  So, a recession is less of an “if” than a “when” question.

A recession is a reduction in the output of an economy, which on an individual business level, would translate to a reduction of profits.  This may cause economically sensitive companies to reduce staff to save costs, thereby increasing the unemployment rate, and decreasing the dollars spent in the economy as unemployed people have less money to spend, especially for goods and services that are spiking in price due to inflation.  This in turn decreases demand for non-essential goods and services, further reducing the profitability of economically sensitive companies, and so the cycle continues.  

Recessions hurt profitability and put investment returns at risk, in other words. What are the mechanisms used to combat recession and inflation from a monetary point of view?

Central bankers must balance out the monetary policies for each concern as best as they can.  Given the choice between a recession and hyper-inflation, history shows that recovering from a mild recession is typically easier for a developed economy, and therefore it would seem to be the preferable outcome.  That may be impacting the decisions of central banks which have been raising rates quickly and significantly over the past few months.

We have seen a significant pullback in the US and Canadian equity markets since the beginning of 2022. Unlike other past market downturns, the current situation should hardly come as a surprise.  Much of the decrease has come from companies that were fundamentally overvalued, such as many tech companies and less mature companies that require larger proportions of debt financing to operate.  They will more significantly feel the impact of rising interest rates against their profits. 

This pullback in pricing has affected the exchange indices that hold the companies, which has led to an overall market downturn, fueling concerns of increased risk for many investors.   

At the same time, interest rates and bond prices move in opposite directions, so as interest rates have risen quickly, the prices of existing bonds have decreased, making the bond market less attractive for many investors concerned about further rate increases. The sensitivity of bond prices to changes in interest rates is known as duration.  The higher the duration, the more sensitive the bond price will be to changes in interest rates. 

So, as financial advisors, how do we help our clients with their financial plans with such great uncertainty?

Remembering that recessions occur regularly, we can look for companies that have been historically resilient in previous recessions and sectors that are less economically sensitive in nature.  We can look for companies that are able to pass along increases from their costs onto their consumers.  We can use fundamental analysis to look for companies with strong balance sheets and income statements that are well poised to benefit from increases in interest rates being put in place to cool inflation concerns.  For fixed income, we can pay attention to the duration of the bonds we are using to minimize the impact of potential future rate increases.

Bottom Line: the question clients should be asking their advisor is not if a recession is coming, or whether they feel inflation is a long-term concern.  They should be asking how the advisor has put together their portfolio recommendations in anticipation of economic changes and how those portfolio recommendations remain suitable throughout economic cycles. 

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