16 Mar Guide your investors: How to prepare for a recession
With inflation continuously rising, interest rates climbing and the energy crisis in full bloom, many economists feel a global recession is inevitable. In this context, it is good practice for financial advisors to prepare their clients by taking both portfolios and personal balance sheets into consideration.
A country is officially in a recession after two consecutive quarters of decline in gross domestic product. This means at least six months of economic downturn that results in a reduction in economic output, consumer demand and employment.
A large majority (85%) of the top Canadian and U.S. investment professionals believe there will be or already is a recession in 2023, according to the Natixis Investment Managers Survey published in February 2023.
Though devastating, recessions have a lot to teach us. Analyzing past recessions can help us better prepare for future economic downturns. Indeed, recessions have grown shorter and far less frequent over the decades, in large part because policymakers have sought to better understand their causes.
Avoid the recession mindset trap
Most investors understand that markets go through cycles and recessions are part of this, but when all signs seem to point towards an impending economic downturn, clients tend to become skittish.
Indeed, a recession is much more than falling stocks. It’s something that happens specifically to you, your job security, your earnings, your emergency savings, and your household budget. Some events, such as losing your job, may force you to borrow money or to take a side hustle.
Therefore, it is common for investors’ emotions to take over. While normal, this phenomenon can be harmful for their portfolios. By better understanding these reactions, financial professionals can help their clients avoid falling victim to those impulses.
Behavioral economics has identified three main behaviors of investors during uncertain times:
- Herd behavior occurs when individuals in a group act collectively in an irrational manner, such as selling or buying certain stocks.
- Affect is characterized by individual impulsive actions driven by fear.
- Loss aversion is a form of tunnel vision in which investors attach greater importance to their losses than to their gains, thus limiting their risk taking.
Advisors can help by being present, accessible and 100% transparent with their clients. They should also actively listen and engage with their clients to help them make informed decisions. To learn more about the psychological effects of recessions, read the blog How to reassure investors in times of volatility.
Some of the best investment strategies
While it is important to provide psychological support to clients, the primary goal of a portfolio manager is to help investors achieve their financial goals. The following sections outline some strategies to do just that.
Portfolio review
A portfolio review is a great place to start, because it provides a detailed look at your clients’ overall financial goals and ensures that any contingency plan is consistent with their long-term financial goals. It also allows them more wiggle room in their personal budget, should they need it.
Portfolio diversification
Diversification is an absolute must when preparing for a possible economic recession. It allows you to balance risk and reward in your clients’ investment portfolios so that their exposure to any one type of asset is limited. Add stocks from recession-resistant industries that tend to do well during economic downturns, including consumer staples, grocery, alcohol brands and cosmetics.
Budget review
A solid financial plan is one that should include a review of household cash flow, yet many financial advisors do not do this. Given that inflation has driven up the price of gas, food and other household necessities, many clients are likely to spend more than their monthly income on these everyday essentials.
A personal budget review by a financial advisor can help clients identify where they can cut costs and conserve as much funds as possible. It’s also a great way to show clients how to live well within their means and without debt.
Cash reserves
Amid skyrocketing inflation and low savings account yields, fewer and fewer people tend to hold cash. However, a recession can lead to a job loss or reduced income, general economic instability and limited opportunities for job change or salary growth. That’s why in a bear market a cash reserve is not a mere luxury, but a must-have. In fact, having a cash reserve is one of the most common personal financial recommendations advisors make.
Focus on your long-term financial goals
While a recession can cause tremendous upheaval in one’s life, investors who are well prepared and manage to remain focused on their long-term investment goals should be reassured that economic downturns have historically been relatively short-lived.
In fact, if we look back, the U.S. has only been in recession for 15% of the last 65 years, with the average one lasting less than a year. In this context, clients who approach a recession proactively can weather the storm and come out of it in a stronger economic position than before.
The right technologies can help investors survive a recession
Financial advisors have their hands full during times of market upheavals since they need to be present and available for their increasingly panicked clients. Fortunately, the right financial tools and solutions can help by automating the bulk of the work.
Automated portfolio rebalancing solutions save advisors significant time and allow them to stay aligned with their clients’ long-term investment objectives and the overall risk level that they consider acceptable. In a bear market, this is especially critical. Automated portfolio rebalancing software also assists advisors by making calculated portfolio adjustment suggestions based on predefined criteria for multiple accounts at a time, which saves time and boosts efficiency.
All-in-one portfolio management solutions can also be invaluable when all signs seem to point towards an economic downturn. These solutions combine sophisticated risk analytics with comprehensive portfolio management, operations, compliance and accounting tools on a single platform. They allow advisors to manage and prioritize communication with their clients, access client history and use predetermined investment guidelines, so that they can make suggestions based on reliable and relevant data. The result is more clarity, efficiency and, ultimately, a better-client relationship.
What is a recession?
A recession is officially defined as two consecutive quarters of negative country’s gross domestic product. More generally, however, a recession refers to a significant, widespread and prolonged downturn in economic activity lasting at least six months. It results in a reduction in economic output, consumer demand and employment.
The last recession, termed the “Great Recession,” took place between 2007 and 2009, and was the worst financial crisis in the United States since the “Great Depression” in the 1930s. It resulted in a collapse of the housing market, banks on the brink of bankruptcy, massive stock market losses, dilapidated retirement portfolios and record high unemployment.
Is recession coming in Canada?
Probably. According to a survey released by Natixis Investment Managers, 150 of the top 174 investment professionals in the U.S. and Canada believe the economy is already in a recession or will be in a recession in 2023.
Four-decade high inflation
Inflation and recession are sometimes linked – to battle high prices, banks raise interest rates, which triggers an economic slowdown. The housing sector, which is already showing signs of a slowdown and price drop in many markets, is especially vulnerable to rising interest rates used to control inflation.
Layoffs and unemployment
The clearest signal that a recession is looming, say economists, is growing job losses and a surge in unemployment. Historically, an increase in the unemployment rate of three tenths of a percentage point over the previous three months was a reliable predictor of an impending recession. However, in 2023, unemployment rates are staying historically low, while inflation and recession risks are growing.
What happens to interest rates during a recession?
High interest rates are set to cool down both the housing market and consumer spending in general. These are typically a sign that a recession is on the horizon or has begun. Indeed, as the Bank of Canada embarks on a historically aggressive hiking cycle to reign inflation, there will be fewer qualified mortgage borrowers, less activity on the real estate market and less investing in general.
How long does a recession last?
Over the past 65 years, the average recession has lasted less than a year and the trend is downward. In fact, the U.S. has been in recession only 15% of the time during this period.
What happens in a recession?
Economic recessions are typically thought of as short-term events having a temporary impact. However, as history has shown, a recession can have far more lasting consequences on economic growth.
For example, high unemployment, declining incomes, and reduced demand for goods and services can force families to delay or forego their children’s education. Inaccessible credit markets and reduced consumer spending can halt the creation of small businesses, and larger, more established companies may be reluctant to invest in research and development.
This is just some of the lasting damage a recession can do, reducing consumer confidence and potentially stifling confidence in the next generation.