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BLOG: No two downturns are the same

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Written by: Oliver Jones
29/07/2022
Although the global economy is still growing at a respectable rate, clouds are gathering on the horizon. The risk of a contraction next year is rising, so how should we adjust if the outlook deteriorates further?

We think what may help investors weather the next recession could be quite different to what served them best in the last few. It’s not just whether the economy is flagging that will matter, but why.

No two downturns are the same — to borrow from Anna Karenina, each is unhappy in its own way.

It can therefore be helpful to divide them into two basic categories: those driven mainly by falling demand, and those where falling supply dominates. Not every recession is easy to put into one box or the other, but it is still a useful exercise for guiding strategy.

Demand-driven recessions

The first type of recession has been more common in recent years. The global financial crisis fits this description, as does the brief downturn in 2001 after the bursting of the dotcom bubble.

Falling demand dominated in the earliest stages of the Coronavirus shock too, though it has bounced right back. We’re now dealing with the repercussions for supply.

Turning the clock back further, the deep recession of 1981/82 falls into this category too; policymakers deliberately crushed demand to tame inflation. In this demand-led type of recession, both economic output and inflation typically fall.

Usually, conventional government bond values rise in these circumstances (inflation-protected bonds less so), helping to cushion the blow of declining stock prices. The pattern within stock markets can vary a lot depending on the precise circumstances.

But you might typically expect the worst performers to include the stocks of commodity producers (as commodity prices fall), along with those in other sectors highly dependent on the economic cycle  –  like banks, industrials, and discretionary consumer products.

At the other end of the spectrum, more defensive sectors like healthcare, utilities and consumer staples – where profits tend to fluctuate less with economic ups and downs  –  may hold up better.

Supply-driven recessions

The second type of recession includes those of 1973–75, 1980 (distinct from 1981–82) and 1990. All of these followed major disruptions to global energy supply – the OPEC oil embargo, the Iran-Iraq War and the First Gulf War, respectively.

In these supply-driven recessions, output falls but inflation remains high or rises because of increased energy costs, which flow into all areas of the economy.

Conventional government bonds may therefore not provide the same offset to losses in the stock market because inflation makes their fixed income payments less attractive (but inflation-protected bonds may perform a bit better than conventional ones).

The patterns within stock markets may look quite different from those in a demand-driven recession too. For example, the stocks of commodity producers may perform relatively well, while some companies that might otherwise prove defensive (like producers of consumer staples with slim margins) may struggle with rising input prices. Finally, gold may fare much better than in demand-driven recessions, given the inflationary implications.

What about the next one?

There’s a good chance the next downturn won’t be a purely demand–driven one. Although rising interest rates will bear down on demand, we may not have seen the last of the disruption to global supply either.

With China sticking to its tough zero-Covid policy, we cannot rule out further disruption to global manufacturing supply chains.

Meanwhile, Russia is preventing crops from leaving Ukraine’s Black Sea ports. And it has sharply cut gas deliveries to parts of Europe again recently.

A full shut-off would probably cause another surge in global energy prices, adding to the likelihood of the second type of recession. We’re adapting our portfolios accordingly – for example relying less than usual on conventional government bonds for protection – while favouring inflation-linked bonds and gold.

Oliver Jones is asset allocation strategist at Rathbones

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