Winter is coming

“Winter Is coming” is the motto of House Stark from HBO’s critically acclaimed Game of Throne’s television series. The meaning behind these words is one of warning and constant vigilance. The Starks, being the Wardens of the North strive to always be prepared for the coming of winter which hits their lands the hardest. You may be asking, what does this have to do with investing? We believe that the same analogy can be made for asset allocation. Instead of winter, investors need to consider the potential of an upcoming recession. Let’s be clear, we do not believe the odds of a recession for 2019 are particularly high. In fact, we do not hold a high conviction that any of the typical signs of recession are present today. However, we are clearly in the later stages of this economic cycle. In the United States, this is currently the second longest economic expansion post World War II and as of July, will be the longest expansion in history. Although the play is not over, we are clearly in the third act. 

Knowing that we are closer to the end than the middle stage of the economic cycle, how should we consider an asset allocation strategy to weather the next recession? To answer this question, we looked at the previous six recessions in the U.S. (1974, 1980, 1981-1982, 1990, and 2008) and how various indices/asset classes performed. Specifically, we looked at the performance of U.S. stocks (S&P 500 Index) , U.S. government bonds, U.S. investment grade corporate bonds, U.S. high yield bonds, gold, oil and the Canadian dollar through the 12 and 24 months prior to the recession (viewed as late cycle), during the recession, from the equity market peak to trough, 1 year following the trough and finally 12 and 24 months after the recession (viewed as early expansion).

What perhaps may be surprising to many is that there was not a clear and consistent relationship of performance with respect to commodities and currency in each of the previous six recessions. For example, the year prior to the recessions of 1974, 1980 and 2008, gold was a great investment with an average return of 67%. But gold was a terrible investment during the recessions of 1981-82, 1990, and 2001 with an average loss of -16%. A similar inconsistent relationship occurred for oil and the CADUSD. 

However, as the table below illustrates, there are some ‘big picture’ themes that emerge and none of them should be a surprise. 

It should come as no surprise that the S&P 500 typically outperforms US government bonds over the two-years leading into a recession. During the previous five recessions, the average annualized returns of the S&P 500 and US government bond indices have been 8.3% and 6.1% respectively (it should be noted fixed income data was not available for the 24-month period ahead of the 1974 recession).

In the twelve months prior to a recession the decision between equities and bonds isn’t quite as clear cut. Equities outperformed government bonds in three of the six recessions by an average of 9.5%. However, the benefits of holding bonds during a recession becomes abundantly clear with the S&P 500 Index and US government bond index returning on average -7.7% and 12.5% respectively during the past six recessions.

We continue to hear (and in fact have preached it ourselves) that equities historically continue to rally following an inverted yield curve and ahead of a recession. While this is true, what we would highlight from our work is that if investors are concerned with regards to the risk of a recession within the next 24 months, then it is not too early to start shifting an asset allocation more defensively. Or in other words, don’t pick up nickels in front of a steam roller. This metaphor was created to illustrate the willingness of investors to pick up historically small relative gains from equities while ignoring the massive destruction that slowly bears down on them (pun intended). Keeping this in mind and given where we are in cycle, taking advantage of rallies to reduce equities and allocating the proceeds into fixed income may be worth considering. This strategy may result in underperformance over the short-term, but performance will be validated should the recession (and bear market) strike.

Apart from the 1990 recession, investors were rewarded by improving the quality of their bonds twelve months leading into a recession. On average, US government bonds have outperformed US credit by 4.0% twelve months leading into a recession. The exception of 1990 saw US credit outperform US government bonds by less than 1.0% so investors were not necessarily penalized materially by increasing the quality of their fixed income. US high yield data does not exist prior to the 1990 recession but since that period US government bonds, US credit and US high yield have returned on average 9.5%, 8.1% and 1.7% respectively, fitting nicely with the narrative of the importance of improving the credit quality of the fixed income in a balanced portfolio prior to a recession.

Nothing groundbreaking here but the speed in which a portfolio is transitioned back into equities will likely be more important coming out of the next recession with respect to capturing the upside of a recovery. Generally, investors have not given up material returns by holding either US credit or US high yield over equities coming out of a recession. Over the past four recessions (three for high yield), the S&P 500, US credit and US high yield averaged approximately 44%, 17% and 46%.

We believe in the next recession, the shift back into equities will become more important with respect to upside potential over bonds since fixed income yields today are materially lower than in the past. For example, by the end of the recessions in 1990, 2001 and 2008 the yield on a 10-year US government bond was 8.1%, 4.8% and 3.5%. Since the financial crisis of 2008, the low of the US 10-year government bond yield was 1.36% (July 8ᵗʰ, 2016) and may likely be much lower by the end of the next recession. Due to the prevailing low interest rate environment, we expect it will be more important to allocate back into equities faster with respect to maximizing portfolio returns.

We believe where we are in the economic and market cycle, and where we may be heading in the next 24 months, that starting to shift from equities into bonds can reduce the potential downside risk without materially giving up much upside. The average peak to trough sell-off in equities over the past six recessions has been approximately -36%, and with many Canadians’ investment horizons becoming shorter over the past decade (i.e. older median population age and therefore closer to retirement), investors may not have the luxury of time nor the appetite to wait and recoup the losses experienced in an equity bear market. We are not suggesting a recession or bear market are imminent, however we do need to be respectful of the duration of the current economic cycle and where we are within it. And therefore, we believe that a balanced asset allocation with an eye to shifting more defensively over the coming year may serve investors well.

In Game of Thrones Ned Stark says “when the snow falls, and the white winds blow, the lone wolf dies but the pack survives” which is an interesting way to also think of your asset allocation within your own portfolio.

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