Even with long-term assumptions for the capital markets leaning toward optimism, investors must gird themselves for potential short-term pain as the current cycle comes to an end — something easier said than done as recessions do not have a predictable impact across markets and investor types.
“We can’t predict how the next recession will unfold,” wrote Sorca Kelly-Scholte, John Bilton, CFA and Vincent Juvyns of JP Morgan Asset Management. In a post published by the CFA Institute, they set out a framework to help investors prepare for the late-cycle risks most relevant to their investment needs and objectives.
The framework, they explained, was developed from an analysis of developed-market recessions and the resultant sequences of market reactions for each over the past four decades. They noted that recessions do not always devolve into equity sell-offs, credit defaults, and a flight to quality spurring higher Treasury prices. “Markets can respond violently and bounce right back, or simply shrug off a recession altogether,” they said.
The framework laid out four plausible recession scenarios:
- During a period of monetary tightening, inflation could prompt a recession that sees emerging-market assets suffering alongside a strong US dollar;
- In recessions characterized by corporate caution, a change in tax regime could negatively impact stocks and credit markets;
- Recessions that follow a trade war are likely to feature non-linear effects on near-term growth and inflation, with particular risks of underperformance for emerging-market assets; and
- A retreat in consumption, particularly for consumer-driven economies like the US, will likely keep inflation contained.
“Against this framework, we evaluate the likely impact of these scenarios and market responses for different types of investors,” the analysts said. While investors today are generally somewhat more resilient because of better diversification, needs-based structuring, and asset-allocation solutions for portfolios, they noted several concerns.
“For pension funds, the key risk today is that plans will drag their sponsors under, especially in a corporate caution scenario with severe equity downturns,” they said. To navigate such recessionary environments, pension funds must monitor risk factors aside from asset price performance, including negative cash-flow risks, derivatives usage, and illiquid allocations.
As for sovereign wealth funds, endowments, and foundations, the key to weathering recessionary environments is to manage spending commitments and avoid becoming a forced seller in illiquid markets. “This is particularly important because these investors have allocated heavily to private assets, given that expected returns from stocks and bonds have moved lower over the cycle,” the analysts noted.
Finally, individual investors with higher equity allocations are set to take the hardest hit from a recession, but may also be most able to bounce back depending on their age and income level. Target-date funds build age-based and long-run resilience through active management of investors’ needs, and multi-asset structures could also help portfolios manage through periods of market weakness.
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