Does an economic downturn impact markets?
It can be tempting to predict where the economy or earnings cycle is heading. That is, in theory, we could pick when (or which part of) the market is about to weaken and seek shelter until it reaches a cyclical low. The challenge, of course, is that this approach is notoriously difficult to do because you need to predict the future twice – once to get out of risky assets at the right time and again to re-enter them at the bottom of the cycle.
Even the market has difficulty pricing in such signals. For example, in mid-2018 the global bond markets started pricing in a deteriorating economy while global equity markets were pricing in a further expansion. Then it suddenly reversed in late-2018, as equity markets priced in a decline while bond markets did the opposite. This shows that investors have a hard time pricing economic declines.
So, what does that mean in a multi-asset portfolio context? To us, it means a few things. First, a key when dealing with fears of a severe global recession is to distinguish between true risk (a negative long-term knock to corporate fundamentals) and negative sentiment (investors repricing their expectations).
For more than 100 years, prices have oscillated around the fundamental return. An economic recession can dent the fundamentals temporarily, however it rarely causes permanent impairment.
Source: Morningstar Investment Management calculation, U.S. stocks are represented by the S&P 500 and its predecessors. Time frame: 1870-2015.For Illustrative purposes only.
During the financial crisis of 2007 to 2009, prices fell far more (as a function of negative sentiment) than corporate fundamentals. Such periods are an opportunity to add value.
Source: Morningstar Investment Management calculation. For Illustrative purposes only. Note: Total Return is the return of the S&P 500 Index, Fundamental Return is the return of total payout yield plus the growth in total payouts, Growth expectations is the market's implied growth rate assuming a constant cost of equity.
Adding Value in a Downturn
We believe investors can benefit by buying into negative sentiment, especially if they are willing to take a long-term view. The long-term nature should not be underestimated given most economic recessions prove temporary and are recoverable in the investor timeframe.
By taking such an approach, we can be anti-cyclical (or "contrarian") when others aren't. Furthermore, sustaining a recession will likely be easier if the motive is to be fearful when others are greedy and greedy when others are fearful, to paraphrase Warren Buffett. We seek to not only sustain downturns, but to help our investors profit from them. This tends to be possible because negative sentiment is often exacerbated in a crisis. For evidence, we show the difference between changes in sentiment and fundamentals during the Great Financial Crisis of 2007 to 2009.
The second consideration in a multi-asset context is to diversify our risk drivers. This goes beyond questions about the recession or whether inflation may rise during the recovery period. We may seek to understand the answers to these questions (and many more) within the context of valuations, but also by acknowledging the role of uncertainty.
Diversification is not only about spreading your eggs
Diversification is an important tool to manage uncertainty, however we believe it must go beyond "spreading your eggs across multiple baskets". To us, it is about understanding the underlying risks to assets – whether that be economic or market risk factors – not just correlations or volatility.
For example, corporate bonds and equity markets can behave very differently, yet both are susceptible to an economic shock (damage to corporate earnings could cause equity values to fall and bond spreads to widen). All else being equal, this offers less diversification than holding equities with an unrelated asset such as inflation-linked bonds or nominal government bonds. The message is to diversify against fundamental risks if you want to reduce the impact of an economic recession.
Bringing this together, we don't necessarily buy into the rhetoric that one should sell based on fears of a severe global economic recession. Naturally, we want to be diversified to reduce the impact of any downturn, but by taking a long-term view, we should only really care about a permanent impairment to earnings. Moreover, if the economic cycle meaningfully dents corporate profits in the near term, we may have the opportunity to buy into the negative sentiment and ride it out until the cycle reverts. This is one of many areas we can add value, by maintaining a long-term view when others won't.
This commentary does not constitute investment, legal, tax or other advice and is supplied for information purposes only. Past performance is not a guide to future returns. The value of investments may go down as well as up and an investor may not get back the amount invested. Reference to any specific security is not a recommendation to buy or sell that security. Investors should be aware of the additional risk associated with funds investing in emerging or developing markets. The information, data, analyses, and opinions presented herein are provided as of the date written and are subject to change without notice. Every effort has been made to ensure the accuracy of the information provided, but Morningstar Investment Management Europe Limited makes no warranty, express or implied regarding such information. Except as otherwise required by law, Morningstar Investment Management Europe Limited shall not be responsible for any trading decisions, damages or losses resulting from, or related to, the information, data, analyses or opinions or their use.