CaptionImage by Arek Socha from Pixabay 

With the market pausing to once again contemplate whether the recent U.S. economic strength will continue or if the cumulative effects of tightened monetary policy will lead to a much-anticipated recession, investors are asking themselves how they should be positioning their portfolios. In other words, ahead of a potential recession, just how defensive should they get? Or, should they get defensive at all? This is the big question the market has been wrestling with for well over a year.

Big decisions can have big consequences

The answer to this question matters a great deal because a portfolio positioned for a recessionary environment will likely significantly underperform if a recession does not occur. On the other hand, a portfolio positioned specifically for an economic downturn is likely to significantly outperform if a recession strikes. This underscores the significant negative or positive impacts a positioning decision can have on investment outcomes.

Too often, the debate over portfolio positioning is boiled down to a single risk-on/risk-off decision. In other words, it’s seen as a black-and-white decision with only two possible choices: the investor either overweights or underweights equities relative to bonds (in relation to their long-term policy asset allocation). The problem with making such a yes-or-no decision is that given the significant portfolio impacts likely to occur, an extremely high level of conviction in the outcome is required on the part of the investor. In other words, you shouldn’t switch from a risk-on position to a risk-off position just because you think a recession might occur. You better believe one is coming down the pike—or you stand to lose out on thousands of dollars.

To help illustrate this, consider the fact that during extended periods of economic uncertainty, 20% equity market moves are not unusual. So, let’s say an investor decides to shift to a risk-off mode by underweighting equities by 10%—but a recession fails to materialize. A soft-landing scenario plays out instead, and in response, the market goes up by 10%. In this instance, the investor’s theoretical portfolio would underperform their policy by 1.00%. If the market goes up even further—let’s say 20% instead of 10%—the result would be 2.00% in underperformance. This underscores why the bar for establishing your belief in an upcoming recession should be set very high. 

At Russell Investments, our current U.S. recession probability over the next 12-18 months is 55%—or slightly better than a coin flip. That’s very, very far from certain. We would need our recession chances to be significantly higher to meet this threshold of high conviction. Because we’re nowhere close, we are currently neutral to policy allocations with respect to our equity and fixed income preferences.

High conviction is a high bar to meet. So what other strategies could investors deploy?

It’s important to understand that if an investor doesn’t have enough conviction to express strong preferences in terms of equity and fixed income, there are other relative positioning strategies within both asset classes that can be adjusted to meet the current market environment.

For instance, most active managers tend to maintain a risk-on posture in their portfolio positioning. This is generally reflective of the fact that in any given cycle, markets usually spend more time going up than down. The way many think of this is in terms of portfolio beta relative to the market. Specifically, equity portfolios that demonstrate a higher-than-market beta move faster than the market in both directions. This means that portfolios that have a beta greater than 1.00—the market beta—will tend to go up faster when the market is rising, and decline faster when the market is falling. 

An alternate to selling equities: Adjusting your portfolio’s market beta

To put this into context, let’s say you’re an investor who thinks that a recession is likely, but you lack the conviction to pull the big lever and underweight equities. In this instance, I believe that a prudent next step would be to examine your portfolio’s market relative beta. If your equity portfolio carries a significantly higher beta than the market, it will likely outperform in a rising market and underperform in a falling market. Assuming your base expectation is that a recession will likely lead to falling markets, I’d argue that it would be a sensible step to consider bringing your equity portfolio beta down closer to 1.00—if not slightly below that. This can be accomplished by introducing exposures to factors like low-volatility and high-quality stocks that tend to outperform in declining markets. A recent article from my colleagues Evgenia Gvozdeva and Eric Thaut reviews how certain equity factor exposures have performed during the various market regimes, including before, during and after recessions.

What fixed income strategies could be considered?

Looking at fixed income strategies, our research shows that credit exposure tends to be the most impactful lever as it pertains to market-relative performance. Most bond managers maintain a strategic overweight to credit, as we do at Russell Investments. Corporate bonds tend to perform similarly to equities (albeit not as dramatically) during both economic recession and expansion scenarios. Understanding how your portfolio is positioned relative to pro-cyclical exposures and your view of the cycle is important at all times—but arguably no more so than when recession probabilities are high.

If you’re an investor that believes a recession is more likely than not, and you’re holding a large credit overweight in your portfolio, you may want to consider taking steps to reduce the amount of credit in your portfolio. Effectively, this amounts to de-risking your fixed income portfolio in light of heightened recession risks. 

The bottom line

Before making any alterations to your portfolio amid potential recession risks, it’s vital to first understand how the risk positioning of each asset class you’re exposed to—for instance, equities or fixed income—intersects with the market outlook for that specific class. This has been an area of focus with both our fund clients as well as our advisory clients, where we design risk management frameworks for understanding positioning and offer tools to help clients adjust their portfolios to align with their expectations. 

In the context of today, this means that if you feel a recession is more likely than not, it would probably be counterintuitive to have a significant risk-on position in equities—as equities are expected to sell off during a recession. Just as important, however, is understanding that moving to a risk-off position doesn’t have to mean selling stocks or bonds. As outlined above, there are measures you can take to ensure that your portfolio positioning matches your economic expectations that do not require you to pull the ultimate risk lever of overweighting or underweighting equities. 

Simply put, if your portfolio is more aligned with market-like risks, then you will likely experience more market-like returns—and less over/under-performance depending on the direction of markets. Ultimately, since most active managers are relatively risk-on in their positioning, this intra-asset class risk reduction can be an effective way to become more defensive in environments where recession risks are elevated, but still far from certain.

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