With inflation at its highest since 1981, how can you focus your portfolio towards investments to weather a recession?
This past June, inflation peaked at 9.1% from one year ago – the highest CPI print since 1981 – as measured by the Consumer Price Index, published by the Bureau of Labor Statistics, although the CPI measure has since subsided to 8.2% in September. In response, the Fed began an aggressive campaign of rate increases to tamp down inflation, raising the Fed Funds rate from near zero to roughly 4% since March.
Not surprisingly, the S&P 500 lost about 19% this year through November 7, according to Bloomberg, as investors feared the effects of both higher interest rates and a slowing economy. Often overlooked, however, is that rising rates punish bond portfolios – since most bond prices are inversely correlated to interest rates. As such, a broad measure of investment grade bonds, the Bloomberg Aggregate Bond Index, lost about 16%, this year through November 7, according to Bloomberg.
But inflation and efforts to tame it aren’t the only headwinds impacting financial markets. The war in Ukraine, midterm elections, a soaring U.S. dollar (and plummeting foreign currencies), rising tensions between China and Taiwan, along with recession fears are all contributing to significant investor anxiety.
So, what exactly does this convergence of economic and world events mean for your portfolio?
It certainly brings into question the all-weather efficacy of traditional 60/40 portfolios – split between ‘riskier’ higher-returning equities and ‘safer’ lower-yielding fixed income. Theoretically, during times of heightened market volatility, a balanced portfolio approach should smooth out returns. If the stock market takes a hit, bond values might help anchor the portfolio, and vice versa. But not this year.
A balanced portfolio consisting of 60% stocks and 40% bonds lost roughly 18% YTD through November 7, 2022, as calculated using the S&P 500 index and the Bloomberg Aggregate Bond index for stocks and bonds, respectively.
In its attempt to rein-in inflation via a rapid series of interest rate hikes, the Fed’s efforts should, in theory, slow the economy. Higher rates generally discourage borrowing by both businesses and consumers, thus reducing both capital investment and consumer spending. Can the Fed succeed in its mission to slow the economy just enough – but not too much, such that a recession occurs?
There is, however, some good news to be found in the current environment. We may be closer to the end of the rate hike period than we are to the beginning. Even the most bearish projections don’t see interest rates being lifted much higher, though some Fed officials do see the Fed funds rate reaching 5% next year. At some point, growth and (hopefully) inflation may cool enough to satisfy the Fed’s objectives of dampening inflation.
For the time being, we may suggest focusing on high-quality investments and striving to remain as liquid as possible so you can gradually begin putting your cash back to work for you, whenever that moment arrives.
In the meantime, consider allocating your portfolio towards investments that may better weather a recession. Along with defensive stocks, you may consider exploring certain municipal bonds, Treasuries, and high-quality corporate bonds with your financial advisor, though noting that any recession can increase the default risk of some municipal and corporate bonds. Additionally, you may then also consider increasing your allocation to non-dollar-denominated international assets , as these instruments may potentially present an opportunity should the dollar reverse direction and head lower.
While nobody can consistently predict the future of financial markets, we all can prepare for whatever the markets may bring our way.
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