Is it time to recession-proof your investment portfolio?

Assessing recession probabilities for the US economy and exploring whether recession-proofing your portfolio actually shields you from a bear market

At a Glance

1. As the Fed continues to tighten financial conditions to bring down inflation, a growing sentiment in the market suggests that the US consumer is starting to feel the brunt of high interest rates amidst dwindling savings, causing them to cut down spending.

2. While a number of consumer businesses have started to show weakness as a result of declining consumer demand, the overall US economy is still growing, thanks to a resilient labor market.

3. In this post, we explore how to recession-proof our investment portfolios by investing in “defensive” businesses. “Defensive businesses are resilient in the face of an economic slowdown because they sell products that consumers cannot live without; think grocery, electricity, staples, medicines, etc.

4. During the 2008 Global Financial Crisis, while the S&P 500 earnings fell 35%, “defensive” sectors earnings fell an average of 7%. Meanwhile, if an investment portfolio contained 50% allocation to “defensive” sectors during that period, it would be outperforming the S&P 500 index by 10%.

5. While recession-proofing your portfolio does not guarantee you positive returns, it protects (to a certain extent) you from market volatility. Depending on your risk appetite, you could always design your portfolio to contain various degrees of volatile assets.

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Are we heading for a recession?

Last week, JPMorgan downgraded Dollar General stock citing that Dollar General's core customer base is already showing signs of recessionary behavior due to diminishing “pandemic-related savings” and “rising inflation”.

As the Fed continues to tighten financial conditions to bring down inflation, news is surfacing everyday that suggests that the US consumer is starting to feel the brunt of high interest rates amidst dwindling savings, causing them to cut down spending.

While a number of consumer businesses have started to show weakness as a result of declining consumer demand, the overall US economy is still growing, thanks to a resilient labor market.

But the longer rates stay high, the risk of a recession grows.

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An update to the Economic Scenario Map

The Federal Reserve held rates steady at 5.25-5.5% in the FOMC meeting last week, while indicating that there might be one more hike later in the year.

The Fed also laid out its projections for the economy as demonstrated in the following chart:

Fed’s economic projections from the September FOMC 2023

The Fed revised up their projections on Real GDP, Inflation and the Unemployment rate. While the expectation of the Fed funds rate is unchanged from previous expectation at 5.6%, the expectation for 2024 and 2025 fed funds rate have been revised higher.

With the updated projections from the Fed, I have updated my Economic Scenario Map. Here, I present to you the latest version, along with S&P 500 targets.

The US Economic Scenario Map and S&P 500 targets

😶Status quo:

• We are in an environment where Core PCE Inflation, while at elevated levels, is slowly expected to trend downwards.

• As Core PCE inflation trends lower, we expect to witness a mild slowdown in the labor market.

• Since labor market isn’t expected to materially slow down, the US economic growth will be positive.

• S&P 500 target = 4400-4600

From here on, the US economy can take a few predictable paths next. Let’s explore:

📈 Higher for Longer:

• In this scenario, Core PCE Inflation will remain at high levels (at or greater than 3.7%).

• We may witness a weaker labor market, but not materially worse.

• The US economy will still grow positively, but slowly.

• The Fed funds rate will be higher than the current rate of 5.25-5.5%

• S&P 500 target = 3700-4000

• The economy will eventually tip into recession from here.

🚀 Productivity Acceleration:

• In this scenario, Core PCE Inflation will drastically decline, because of a slowdown in spending.

• Labor market will weaken, but not deep enough to create a recession.

• Real GDP will grow positively and slowly.

• This will trigger the Fed to lower interest rates, which will set the stage for the next phase of economic acceleration and expansion.

• S&P 500 target = 5000+

📉 A deep recession:

• In this scenario, Core PCE Inflation will drastically fall similar to the scenario of “Productivity Acceleration”.

• However the slowdown in spending will cause the labor market to materially weaken.

• This will result in negative economic growth, hence a recession.

• S&P 500 target = 2900-3300

• Usually, a recession often triggers other contagion events and the cycle can be vicious on the way down.

💣 A stagflationary recession:

1. In this scenario, Overall Inflation will remain higher than the Fed’s target.

2. However, with higher interest rates and higher cost of borrowing, businesses may start to lay off people, which would weaken the labor market.

3. The US economic growth will decline, into negative territory, triggering a recession.

4. S&P 500 target = 2900 or less

5. This is a catastrophic outcome as it might destabilize long term prospects of the US economy and the US dollar.

So, are we heading for a recession?

Out of the 4 possible economic scenarios, 3 of them involve a recession in the near future. In order for the economy to pivot into “recovery” mode or early “productivity acceleration” mode, we have to believe all the stars will align just perfectly, and the US avoids a recession. Today, the economic data is not pointing to the stars aligning all that perfectly.

So, the wise thing would be to buckle up!!

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What does it mean to recession-proof your portfolio?

The US economy would enter an official recession if and when there are 2 consecutive quarters of negative GDP growth. During a recession, business revenues and earnings fall as demand wanes.

The following chart shows how S&P500 companies’ earnings fell during past recessions.

How much do earnings fall for S&P 500 companies during recessions

We can see that S&P 500 earnings fall an average of 34% during recessions (without the Global Financial Crisis in 2008-2009). This is huge!!!

So, is our portfolio doomed if there is a recession?

Not so fast.

Did you know that while 75% of companies experience a revenue decline during a recession, 14% of companies actually experience revenue and profitability growth during the same period?

Enter the “defensive” sectors!

A defensive company provides consistent dividends and stable earnings regardless of the state of the overall economy and the stock market. There is a constant demand for their products, so defensive businesses tend to be more stable during the various phases of the business cycle.

These are the characteristics of a business that would be considered “defensive”:

1. The business sells things which people cannot live without

2. The business has pricing power

3. The business is profitable and earnings grow no matter what

Healthcare, Utilities, Staples, Grocery and Addictive Pleasures are all consumer industries that come to mind that fulfill all the requirements of a “defensive” sector. No matter the business cycle, people need to

🍎 buy groceries to eat food (Walmart, Coca Cola, Pepsi)

💡pay utility bills to use electricity and gas (NextEra Energy, American Water Works)

💊 buy medicines if they are sick (Pfizer, Johnson & Johnson)

🛁 clean up after themselves (Procter & Gamble)

🍷 buy alcohol and cigarettes if they are addicted (Philip Morris, Molson Coors)

When investors anticipate an economic slowdown , they tend to allocate an increasing portion of their funds to invest in “defensive” companies. In other words, they are “recession-proofing” their portfolios. “Defensive” companies, by their nature should not experience rapid revenue and earnings decline, and therefore protect the investors (to a certain degree) from market volatility.

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Does recession proofing your portfolio actually work?

During the Global Financial Crisis (GFC) in 2008-2009, S&P 500 earnings fell 39% between Q1 2008- Q1 2009. During the same period, S&P 500 price fell 53%.

In the meantime, the “defensive” sectors such as Healthcare, Staples and Utilities suffered an earnings decline that is significantly lower than that of the S&P 500. In fact Healthcare earnings actually grew during this period of time.

As a result, while Healthcare, Staples and Utilities sectors fell 37% on average, it outperformed the S&P 500, which had fallen 53% during this time period.

In other words, had your portfolio was 100% allocated to S&P 500, you (investor) would have a net return of -53.9%.

On the other hand, had you designed your portfolio to contain 50% in S&P 500 and the remaining 50% in Healthcare, Utilities and Staples, you would have a net return of -42%. Hence, you will be protected by 10%.

Earnings and Price decline across all S&P 500 sectors during the Global Financial Crisis

You may be thinking the following:

🤔🤔🤔 The S&P 500 fell 53%, when its earnings dropped 35%. In that case, since Utilities earnings fell just 10%, shouldn’t the Utilities sector fall around 20%, instead of 46%?

My take: Unfortunately, the market does not function with linear logic. If the markets worked linearly, it would have made portfolio allocation decisions much simpler. But alas, Volatility is heartless!!!

🤔🤔🤔 I went through the whole process to re-allocate funds to recession-proof my portfolio. Yet my return is still negative. So, what’s the point?

My take: The point of re-allocation is to protect yourself from volatility. With the example above, we allocated 50% in S&P 500 and 50% in Healthcare, Staples and Utilities. As a result, our portfolio was protected by 10% from further declining. Depending on your risk allocation, you could always redesign your portfolio to contain various degrees of volatile assets.

Furthermore, I have demonstrated how recession proofing your portfolio can actually shield you (to an extent) from the market volatility. In this example, I have a $10,000 portfolio and I have built 3 different portfolio scenarios:

1. Portfolio A: This portfolio has 100% of its funds in the S&P 500.

2. Portfolio B: This portfolio has 75% of its funds in the S&P 500 and 25% in the “defensive” sectors.

3. Portfolio C: This portfolio has 50% of its funds in the S&P 500 and the remaining 50% in “defensive” sectors.

How recession-proofing your portfolio can shield you from market volatility

We can see that in the event of an earnings recession (when earnings fall anywhere between 5-20%), a higher allocation in the defensive sector will indeed shield (to some extent) you from market volatility.

But, before you decide to invest in “defensive” sectors to recession-proof your portfolio, is it important to address the following points:

1. A recession-proof industry or a company is not risk-free or even low risk. Stock prices are subject to fluctuations for a myriad of different reasons. Therefore, if you choose to invest in a defensive company, please make sure that you fully understand the business and the risks associated with investing in a single business. If you choose to invest via industry ETFs, make sure you do your due diligence accordingly.

2. While “defensive” sectors can often protect your investment portfolio from market volatility during a bear market, “defensive” sectors usually underperform the S&P 500 when economic and earnings outlook improve and market volatility dissipates.

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That’s all for today. Thanks for reading!! If you found today’s piece insightful, please do not forget to leave a comment and share with your network. See you all on Thursday.

Amrita 👋🏽