How to invest during a recession: top tips and tactics

We explain what a recession is, why it matters to investors and run through the potential investment winners and losers. 

A global recession is on the cards in 2023 if moves by central banks to raise interest rates fail to cool red-hot inflation.

The risk is that higher interest rates will weaken economic growth, tipping the economy into recession.

The World Bank is the latest to warn that interest rate hikes could lead to a recession. In a study, it found that “the world’s three largest economies – the US, China and the euro area – have been slowing sharply”. It added: “Under the circumstances, even a moderate hit to the global economy over the next year could tip it into recession.”

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Below, our guide explains what a recession is, and offers some ideas on the types of shares and funds that could give investors some defensive ballast.

What is a recession?

To understand a recession, we first need to understand economic output and growth. In its most basic sense, economic output is the total value of all the goods and services that an economy produces over a given period. This is usually expressed as Gross Domestic Product, or GDP.

Economic growth is when an economy’s output increases, usually expressed as a percentage increase in GDP.

It is good when economies are experiencing positive economic growth, often referred to as “expansion”. However, capitalist economies are also cyclical. Around every 10 years, economies experience a contraction in their output, sometimes called “negative growth”. This means the total output of an economy has fallen over a certain period. Simply put, the economy has shrunk.

If an economy experiences a contraction for two consecutive quarters (three-month periods) or more, it is said to be in recession.

In the second quarter of 2022, the UK economy contracted by 0.1%. If there’s a negative reading for the third quarter, then the UK will be in recession.

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How do recessions work?

As mentioned, GDP is a measure of economic output and a recession is defined as a fall in that output.

So, to understand how recessions work, one of the best approaches is to take economist John Maynard Keynes’ formula for GDP. Keynes saw GDP as composed of several inputs: consumption plus investment, plus government expenditure, plus exports, minus imports.

In a recession, one or several of these inputs will have taken a serious fall. So, for example, consumers may decide to start spending less. If spending falls by enough, it can, in theory, cause an economy to fall into recession.

What does this mean for investors?

Generally, recessions are associated with lower stock market prices, so higher levels of volatility than usual.

The price of a stock is supposed to represent the current value of the company’s future cash flows. Cash flows are created by the earnings of a company. Lower spending in an economy means lower earnings.

If a company’s perceived earnings’ prospects fall, so too does its share price. During a recession, a company’s future earnings will be judged to have decreased.

On top of that, some companies struggle or go bust in a recession, so markets also factor in that risk in share prices.

Complicating factors

However, there are several other complicating factors. Occasionally, a country’s stock market does not represent the underlying economy of the country, meaning that a recession does not always result in a market decline. For example, the FTSE 100, the UK’s main market index, is composed of companies that collectively make about 70% of their earnings abroad. As a result, the index often reflects the conditions of the global economy.

If there was a recession specifically confined to the UK, its impact on the FTSE 100 index may not be so severe for two reasons. First, businesses listed on the FTSE 100 would still be able to make money abroad. Second, a UK-specific recession should result in the devaluation of the pound. Companies in the FTSE 100 that earn their profits abroad in other currencies will see an increase in their profits when they are converted back into sterling.

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Different types of stocks

Not all stocks are the same, with some going up or down more than others in different economic conditions. Stocks with prices that are more sensitive to the overall health of the economy are generally called “cyclical stocks”.

As Richard Hunter, head of markets at interactive investor, notes: “Examples of cyclical shares are those which will suffer from lower consumer spending and/or unemployment, such as retailers, airlines (less travel, especially the lucrative business market) and banks (higher defaults on loans).”

The opposite of cyclical firms are defensive companies, those that provide goods and services that consumers view as essential. Companies that fall into the defensive camp include utilities and consumer staples, such as food.

Hunter adds: “Defensive shares tend to fare better and will usually still fall, but relatively less. These are shares where consumer demand will hold up, such as utilities (water, electricity, gas) and supermarkets. More recently, one can also add tobacco firms to this list (inelastic demand) and even higher-end retailers, the logic here being that the very wealthy are relatively unaffected by recession.”

Diversification is key

Rather than trying to time the market, it is more prudent for investors to ensure they have a portfolio that can withstand an economic recession. This means having a portfolio that includes assets that should do well during economic growth and some that will do better during a recession.

As is usually the case with investing, diversification is key. It is up to the individual to determine the risk profile for their situation, but usually such a portfolio includes a broad mix of equities, bonds, and some alternatives (such as property and infrastructure), as well as different sectors and themes.

The 60/40 rule – having 60% invested in shares and 40% in bonds – is widely viewed as a simple and effective way of gaining adequate diversification to smooth out the peaks and troughs that are par for the course of investing in the stock market.

A fund that invests in this manner is Vanguard LifeStrategy 60% Equity. It provides 60% exposure to global equities and 40% exposure to global bonds via several index-tracking funds run by Vanguard. It is a member of interactive investor's Super 60 picks and one of our Quick-start Funds, which are aimed at beginner investors. Check out below our recent interviews with  Vanguard’s Mohneet Dhir to get an overview of how the Vanguard LifeStrategy funds invest.

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Fund options

Certain actively managed funds will provide some sort of protection in a recessionary environment. For example, global funds look well placed on paper to protect wealth in uncertain times, particularly those with a quality focus on defensive growth businesses. One example is Fundsmith Equity, another of interactive investor’s Super 60 fund choices.

Given that global fund managers, whether they are income or growth focused, have the flexibility to invest wherever they see fit, such funds should, in theory, hold up better when markets fall sharply than those funds constrained to investing in a single region. Other global fund examples that focus on, or have a notable amount of exposure to, defensive growth businesses include Rathbone Global Opportunities, Mid Wynd International Investment Trust (LSE:MWY) and Trojan Global Equity.

Another option is to consider the small number of “wealth preservation” investment trusts, which prioritise protecting investor capital. The four trusts that meet this description are Capital Gearing (LSE:CGT), RIT Capital Partners (LSE:RCP), Ruffer Investment Company (LSE:RICA), and Personal Assets (LSE:PNL). Each has a low weighting to equities and plenty of defensive armoury, such as low-risk inflation-linked bonds and a small weighting to gold.

Other defensive options include multi-asset funds. Owing to their greater levels of diversification through investing across various asset classes, such funds should be better equipped to weather a market storm than equity funds that either invest globally or focus on a particular region. The funds with the lowest equity content have less than 35% of their assets in equities and sit in the Investment Association’s Mixed Investment 0-35% Shares sector.

The final option is absolute return funds. Such funds aim to protect investors’ capital during more turbulent times and fulfil their roles as a diversifier in a portfolio. The reality, though, is that absolute return funds have a chequered history at meeting their objectives and investors should tread carefully when considering the sector.

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How bonds perform in a recession

There are other assets that usually perform better during a recession, and one of the most cited examples is government bonds.

During recessions, bonds typically do better for several reasons. First, they are usually seen as safer than stocks. Governments of advanced economies tend not to default, while the income produced by a bond (the coupon) is fixed. This often means that investors rush into bonds during a recession, sometimes called a “flight to safety”, bidding up their prices.

Second, governments often respond to recessions by lowering interest rates. Bond prices have an inverse correlation to interest rates, so when interest rates go down, bond prices go up and yields fall.

However, it has been a dismal year so far for bonds, with soaring inflation and higher interest rates causing bond prices to plummet. This has led to bonds and shares unusually falling in tandem and negatively impacting portfolios that invest in both asset classes, such as the 60/40 strategy.

The fixed income that bonds pay becomes less valuable when inflation rises. At the same time, bonds become less attractive when interest rates rise as there’s greater competition from cash returns and better deals available from newly issued bonds.

Therefore, the outlook for bonds hinges on inflation. On the one hand, the bond market sell-off in 2022 could have gone too far, with investors pricing in too much inflation and too many interest rate hikes.

The big risk, however, is that inflation does not cool. If it persists, then central bankers could continue to raise interest rates even during a recession. This does not bode well for bonds.