The U.S. economy fell into a technical recession following back-to-back quarters of negative gross domestic product (GDP) growth in the first half of 2022, as rampant and broad-based price inflation affected businesses and consumers.
As economists and market analysts look ahead to 2023, they agree that the country will begin to experience the real pain of an economic downturn. While experts can debate the size and scope of an economic contraction, how can households and investors shield themselves from the storm clouds? That’s what many people would like to understand.
Defensive Stocks
First, which sectors should be on an investor’s radar?
This past spring, Goldman Sachs released its recession manual to help prepare clients for a downturn. The document noted that in the five recessions since 1981, the top four sectors have been consumer staples, energy, health care, and utilities.
Meanwhile, higher interest rates have made high-yield savings accounts, money market funds, and certificates of deposit (CDs) more attractive. However, with the real interest rate (inflation-adjusted) still negative, it might not be enough to protect the net worth of families.
This is where dividend investing comes into play, as it can generate passive income.
A dividend is the distribution of a company’s earnings to shareholders that is paid out monthly or quarterly. For example, PepsiCo’s annual dividend yield is 2.66 percent, meaning it pays investors $1.15 per share every three months.
There are several types of dividend stocks in the U.S. stock market, including dividend “aristocrats” and dividend “kings.” The former are businesses that have raised their dividend payouts for a minimum of 25 straight years (e.g., ExxonMobil, Target Corp., Walmart). The latter are companies that have increased their dividends for at least 50 years (e.g., 3M, Coca-Cola, Procter & Gamble).
“Dividend growth stocks tend to be of higher quality than those of the broader market in terms of earnings quality and leverage,” S&P Global analysts wrote in a paper (pdf). “Quite simply, when a company is reliably able to boost its dividend for years or even decades, this may suggest it has a certain amount of financial strength and discipline.”
The New York Stock Exchange in New York City, on June 29, 2022. (Julia Nikhinson/AP Photo)Inflation Bonds
In today’s inflationary environment, one of the most popular investment tools has been inflation-protected bonds, or I-bonds.
Investors can open a Treasury Direct account to purchase them. Interest on I-bonds is calculated by combining a fixed rate with an inflation rate based on changes in the Consumer Price Index. I-bonds became attractive when they started delivering a yield of 9.62 percent in May.
When investors factor in volatility and uncertainty, it becomes “a no-brainer,” according to Mel Lindauer, founder and former president of the John C. Bogle Center for Financial Literacy.
One disadvantage of I-bonds is that investors can purchase only a maximum of $10,000 a year. That’s because they are primarily intended for small savers and investors.
Large investors prefer Treasury inflation-protected securities (TIPS), which also include an element of inflation protection. Investors face no constraints when purchasing TIPS.
TIPS, unlike I-bonds, may be subject to short-term financial loss because their market value may fluctuate before maturity, according to Lindauer.
There also are funds that invest primarily in bonds that adjust their principal values in line with the rate of inflation, such as Fidelity’s Inflation-Protected Bond Index Fund (FIPDX) or Vanguard’s Inflation-Protected Securities Fund Investor Shares (VIPSX).
Is the US Dollar Still King?
The U.S. Dollar Index (DXY), which measures the greenback against a basket of currencies, has been on a tear in 2022, rallying about 14 percent, to around 109.00.
The greenback’s strength has been buoyed by rising demand for conventional safe-haven assets. Global investors have been fleeing to the dollar in response to the Federal Reserve’s tightening campaign, volatility in the equities arena, and weakness in other major currencies, such as the euro, yen, or British pound.
U.S. dollar banknotes in front of a displayed stock graph. (Dado Ruvic/Reuters)
Is it too late for investors to dive into currency investing, or is there more room for growth? Market experts anticipate an elevated U.S. dollar for some time, particularly if the global economy slips into a recession and the Fed becomes more aggressive.
There are several dollar-related funds, with the most popular vehicle being the Invesco DB US Dollar Index Bullish Fund (UUP).
Does Gold Still Glitter?
Gold has been the premier safe-haven asset during times of chaos. But why has the yellow metal tumbled about 6 percent, to less than $1,800 per ounce, in an inflationary climate and slowing economy?
There have been two main reasons: a surging U.S. dollar and rising Treasury yields.
A stronger dollar is bearish for dollar-denominated commodities (such as gold) because it makes them more expensive for foreign investors to purchase. In addition, gold typically is sensitive in a rising-rate economy because it lifts the opportunity cost of holding non-yielding bullion.
But the precious metal could be resurrected should the Federal Reserve change course and cut rates in response to a sharp economic downturn.
ETFs for Recessions
Since the beginning of the coronavirus pandemic, exchange-traded funds (ETFs) have exploded in popularity for both passive and active investors. They have been around for more than three decades, but ETF demand has spiked amid tax advantages, lower costs, and thematic investing. On an international scale, the value of assets managed by ETFs is more than $10 trillion.
While there is an ETF for nearly everything in the global economy, are there any ETFs that could weather a recession storm? Market experts typically recommend ETFs that specialize in dividend-appreciation companies, consumer staples, food, and low volatility.
Some of the most popular ETFs that invest in these areas include Vanguard Dividend Appreciation Index Fund ETF Shares (VIG), iShares U.S. Consumer Staples ETF (IYK), First Trust Nasdaq Food & Beverage ETF (FTXG), and Invesco S&P 500 Low Volatility ETF (SPLV).
Updating Investment Strategies
Investment experts contend that one of the best methods to employ is to update trading styles.
A common investing tactic is dollar-cost averaging. This is when investors regularly purchase shares of stocks or ETFs in about the same amounts, usually each month. By engaging in this practice, retail investors can avoid buying at all-time highs, prevent themselves from trying to time the market, and eventually lower the average share price.
Another simple measure is diversification.
During the 2020–2021 market euphoria phase, for example, investors poured into tech stocks, such as Alphabet (Google) or Netflix. This might have worked in an easy-money environment, but a tightening climate requires diversification. So, an updated portfolio during a recession could include exposure to real estate investment trusts, commodities, index funds, emerging markets, and bonds.
At the same time, it’s crucial not to over-extend a portfolio, becoming almost unmanageable for average investors.
In addition, many seasoned and novice traders make either one of two mistakes: trying to time a bottom or panic selling. Both are risky bets, especially for long-term investors, since they might lose out on enormous gains. Market strategists assert that recessions and bear markets are the best periods to build positions to achieve long-term goals.
“Historically, there are way more positive years in the investment markets than there are negative years,” financial adviser Tyler Ozanne told Bankrate, a personal finance company. “In a recession, and a corresponding negative market environment, it is good to remember that better investment days are probably ahead.”