8 Things Investors Should Consider Doing to Hedge Against a Recession

FINANCIAL ADVICE | GUIDANCE | INSIGHTS | OBSERVATIONS 

The first interest rate reduction in 4 years was a milestone event for the U.S. economy. The 0.5% reduction was welcomed by companies and consumers alike, coming after 3 years of hikes at the fastest pace since the 1980s. Fed officials have penciled in more interest rate cuts by year’s end compared to the single cut that they projected in June. Why?

The Fed raises or cuts interest rates in response to inflation and employment. When the Fed started raising interest rates in 2022, officials wanted to get consumer prices to stabilize. But the consequent reduction in consumer demand means that the economy is static. If it slows too much, and actually starts contracting, then that’s a recession.

The million dollar question is this: is the Fed cutting rates because it has succeeded in bringing down inflation or because the economy is in danger of a recession?

Key Findings

  • Keeping a balance between interest rates and employment is the Fed’s main goal
  • Reductions in interest rates aim to boost consumer demand and avert a recession
  • The slow U.S. GDP growth increases the risks of a recession
  • Hedging against a recession is prudent for investors to mitigate risk in their portfolios
  • Proper diversification is one way to potentially minimize the volatility within a portfolio
  • Increasing exposure to bonds and investing in defensive stocks may provide greater stability
  • Focusing your investments in high quality companies can help to mitigate risk
  • Cash & cash equivalents offer both liquidity and stability
  • Options and other tools can also hedge against a recession

Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk.

Reductions in interest rates are generally designed to boost demand and avert recessions rather than cause them. A reduction in rates tends to make it easier to borrow, so people spend more on everything – from consumer goods to homes and business equipment.

The Fed’s 0.5% reduction in the interest rate comes in response to inflation and employment. Keeping the balance between them is the Fed’s goal – and a delicate tightrope walk.

At the same time, central bankers expect unemployment to rise higher this year to 4.4%, up from 4.2% as of August 2024.

In the past, the U.S. economy has often entered a recession after a series of rate hikes, and this has cost many people their jobs. In the last year, unemployment has been ticking higher as hiring slows sharply.  One economic indicator sparking fears of a so-called hard landing for the economy was the disappointing jobs report on August 2. Some economists are seeing rising risks that the economy could slip into a contraction.

A reduction in interest rates typically aims to stimulate economic growth, but under certain conditions, it could inadvertently contribute to a recession. Here are 5 possible contributors:

  • Sign of Underlying Weakness: When interest rates are reduced sharply, it may signal that the economy is in trouble. This perception can erode business and consumer confidence, causing people to spend and invest less, leading to a recession.
  • The Economy Grows Too Fast: While rate cuts can stimulate spending and investment, if the economy grows too fast, it may lead to inflation. The Federal Reserve adjusts rates to prevent this ‘overheating’ of the economy.
  • The Unemployment Rate Stays High: This is a major concern for the economy.
  • Lower Interest Rates Lead to a Weaker U.S. Dollar. This may slow economic growth and increase recession risk, especially in our globally interconnected economy.
  • Consumer Spending Decreases: While lower interest rates reduce borrowing costs, they also reduce returns on savings. This may lead to a decrease in disposable income for those reliant on interest from savings.

While we do not believe that a recession is imminent, elevated risks make it a possibility, particularly in the latter half of 2024 or 2025. The odds of a recession remain low to moderate, though exact predictions vary depending on the source. If you are someone who wants to prepare your portfolio for the potential of a recession, here are things to consider doing now:

Hedging against a potential recession is a prudent strategy for investors to protect their portfolios.

 

How Can Investors Hedge Against a Recession?

1. Have a Plan and Stick with It

Before a recession even hits, having a financial plan will help you weather the storm.  Recessions are a part of our economic cycle, and if you’ve thought through what you should do before and during the recession, as well as how you’ll react, you’ll put yourself in the best position you can to come out the other side in good shape.  Create an investment strategy that you can continue to execute on if times do get tough and make sure you stay disciplined.

2. Diversify across Asset Classes

Stock Concentration Risk is the risk of loss when all your funds are allocated in too few investments, and is increased considerably in a recession where certain asset classes experience more significant losses. As an example of this danger, the NASDAQ tech-heavy index dropped about 30% over 2022 This was devastating for those with few investments outside this asset class.

Diversified portfolios tend to perform better during market turbulence.

Diversification generally reduces the risk of losses from a downturn in any single asset class.  You should consider allocating investments across stocks, bonds, real estate, commodities, and even international markets.

3. Consider Increasing Exposure to Bonds

Bonds, especially U.S. Treasury bonds, are traditionally considered safe-haven assets during recessions. As equity markets decline, bond prices often rise, particularly longer-duration bonds.

You may consider adding more government bonds or high-quality corporate bonds to your portfolio. In a recession, fixed-income products such as bonds may provide stable returns when equities may suffer losses.

4. Consider Investing in Defensive Stocks

Defensive sectors, such as consumer staples, utilities, and healthcare, tend to be less affected by economic downturns since demand for these products and services remains steady.

Consider stocks of companies in these sectors, as they offer more stability during a recession. Dividend-paying stocks can also provide income even if stock prices fall.

5. Hold Cash or Cash Equivalents

Cash allows you to take advantage of opportunities as they arise during a downturn. Cash equivalents like money market funds or short-term Treasury bills offer safety and liquidity.

Keep a portion of your portfolio in cash or highly liquid assets to remain flexible during a recession.

6. Focus on High-Quality Companies

Companies with strong balance sheets, consistent cash flows, and low debt are better positioned to survive economic downturns. Consider investing in blue-chip stocks and avoid companies with excessive leverage or volatile earnings.

7. Consider Investing in Real Estate

Reduced interest rates lower mortgage costs, which often boosts the real estate market. Real estate, especially rental properties, can provide a steady income stream even during economic downturns. Real estate investment trusts (REITs), particularly those focusing on residential and commercial properties in high-demand areas, are well positioned in economic downturns.

Direct investments in rental properties can also be a good hedge, especially in markets with stable demand.

8. Consider Utilizing Options and Other Hedging Tools

Financial derivatives like put options allow investors to protect against potential losses in specific assets. Consider options strategies on key holdings or indexes to mitigate downside risk during a market downturn.

By adopting a balanced approach and preparing ahead of time, investors can hedge against a recession while seeking to preserve capital and maintaining opportunities for growth.

We all know that prices may drop by a large percentage and stay low for an extended period, and so we encourage our clients to maintain a sufficient cash cushion in their checking account to ride out any temporary drop in their portfolio value.

In conclusion:

Managing financial risk is crucial for mitigating against uncertainty in your portfolio and staying on track toward long-term financial goals in a recession. The process needs discipline and regular reviews, and most often involves diversification, staying informed, setting clear investment goals, and maintaining a disciplined approach to your investment strategy.

If you have questions about your specific circumstances, or want to talk about developing a financial plan to effectively address your goals and aspirations, please get in touch.

We welcome the opportunity to chat with you and wish you every success in the future.

Disclosures:

The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein or as a recommendation of any kind. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

A diversified portfolio does not assure a profit or protect against loss in a declining market.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.