Preparing Your Investment Portfolio for the Next Economic Downturn
In modern economies, we pretty well understand downturns to be a normal part of the economic process. But recessions lead not only to job losses and economic decline – they also affect investments. Though it doesn’t seem to be true in recent years, the realities of the financial markets are ultimately tied to the real economy. If the economy goes down, investments will follow.
That’s why it’s important to begin preparing your investment portfolio for the next economic downturn now. The economic recovery has been running for a very long time, and is already showing signs of wear and tear. Once the first dominoes in the next recession start to fall, adjusting your portfolio will become infinitely more difficult.
Why the Next Recession is Overdue
The US economy has been in a growth phase since the Financial Meltdown officially ended in June of 2009. That means that we are now nearly 9 years into a recovery, or about 103 months. This is significant given that the average economic recovery lasts only about 58 months. That doesn’t guarantee that the bottom will fall out of the economy, but it certainly points in that direction.
In theory, there’s no reason why the economy must go into a recession. However, all economic recoveries generate excesses that lead to downturns. Some of the factors that cause excess include:
- Debt levels exceeding the ability of the economy to support
- High general cost levels
- In particular, high housing costs
- Economic saturation – people eventually have all the widgets and services that they could possibly need or want
- An increasingly competitive marketplace
- Employers cutting back payrolls to remain profitable amid higher competition
- Excess imports from countries with weaker economies
The current economic expansion is showing signs of each of these excesses. Super low interest rates are only going to keep problems at bay for so long, particularly since the Federal Reserve has been gradually raising rates.
Meanwhile, the financial markets, as well as the housing market, have become increasingly rich. Any weakness it either stocks or housing (and especially the bond market) could tip the economy into a recession in short order. Once it starts, it will continue until the economic purge runs its course.
How the Next Recession is Likely to Play Out
Every recession has its own unique outcomes, but some are so common as to be predictable:
Unemployment. If there is one outcome fundamental of all economic declines, it’s a rise in unemployment. To maintain profitability in a shrinking market, employers reduce staff. Every job lost translates into a stream of purchases that will be interrupted. When millions of people lose their jobs, economic markets shrink even more. That ultimately has a negative impact on stocks, housing and other financial assets.
Debt Defaults. Much of the debt that grows during economic recoveries will never be repaid. Debtors – both individuals and businesses – eventually default on their loans. This is a natural outcome when workers lose jobs and businesses are forced to either restructure in bankruptcy, or close their doors permanently.
Business Closures. Businesses often over expand during economic recoveries. A large concern may open too many branch operations. A small business may expand their physical operation, and hire too many employees. Some of these businesses can survive through various means. But others will simply close their doors forever. And when they do, more jobs will be lost, and more debts will go unpaid. The business owners themselves may join the ranks of the unemployed.
Another Housing Meltdown. The collective results of higher unemployment and rising debt defaults reduces housing affordability. Obviously, an unemployed worker is in no position to purchase a home. Neither is one whose credit has been damaged through debt default. As the pool of potential buyers shrinks, there’s downward pressure on house prices. This is how many homeowners became “underwater” on their mortgages during the Financial Meltdown, and lost their homes to foreclosure. At least some form of that outcome is likely to be repeated in the next recession.
The Likely “Fixes” from the Federal Reserve
As is the case in every recession, the Federal Reserve will be counted on to undo the damage the economic downturn causes. The steps they’re likely to take are thoroughly predictable.
Lower Interest Rates. Even after recent increases in the Fed funds rate, overall interest rates are still near record lows. Cutting a quarter point here, or half-point there, is unlikely to provide much stimulation to the economy, much less the housing market.
Weaker Dollar. This strategy will be used to a) reduce imports, and b) to stimulate exports. The hope is that higher exports will create more jobs. The downside however, is likely to be higher general price levels, as costs for imported goods increase.
Money Printing. Government budget deficits rise during recessions. That’s because tax revenues fall, and government expenses increase to cope with the declining economy. But budget deficits put increased pressure on interest rates. Since government is a preferred borrower, larger deficits crowd out borrowing by the private sector. That puts further downward pressure on the economy.
The government might make up for their budget shortfalls – at least partially – by printing money. This is a process in which the Federal Reserve, and not the bond market, purchases US government debt. This will help to keep interest rates low, but it may also contribute to inflationary pressures. It can create an economic environment commonly known as “stagflation”.
Tax Increases. The government might increase taxes as another way to offset rising budget deficits. But much like rising interest rates and inflation, tax increases can put further downward pressure on economic growth.
Unfortunately, the recent passage of the Trump tax plan could actually fuel a tax increase. Government officials might feel the need to enhance revenues on the heels of the new tax plan.
Preparing Your Investment Portfolio to Weather the Next Recession
Given the predictability of a recession, and the likely outcomes it will produce, how should you prepare your investment portfolio for the coming economic storm?
Reduce Your Stock Positions. Since stocks are generally the most reactive asset class, they’re likely to be hit first and hardest. The best strategy is to reduce your stock positions. That doesn’t mean bailing out of everything you hold, but working to minimize your exposure from this point forward.
For example, you could avoid purchasing new stock positions. You could also begin selling off losing stocks. After all, if a stock hasn’t performed well during an economic recovery, it’s a prime target for a selloff in a decline. In addition, selling off losers will help to create tax losses that can minimize the impact of any tax increases.
Focus on Cash and Cash Equivalents. Cash and cash equivalents serve two purposes. The first is to reduce your exposure to more volatile assets. Since cash is a relatively neutral asset, it’s excellent to preserve purchasing power. The second reason is to have cash available to scoop up stocks and other assets at bargain basement prices, after major declines.
Add Some Gold and Silver to Your Portfolio. Precious metals are one of the best asset classes to hold any time the economic order changes. They’ve traditionally been viewed as the ultimate countercyclical investments. This fact alone makes them an excellent investment choice during times of economic uncertainty.
The Best Ways to Add Gold and Silver to Your Portfolio
You can add gold and silver to your portfolio by purchasing gold and silver bullion. This will give you possession of a real asset, that won’t be subject to default the way paper assets are.
You can also add gold and silver to your retirement portfolio. You can do this through a self-directed gold IRA, that actually enables you to hold bullion in your IRA. Adding a diversification equal to between 5% and 10% of your total retirement assets could provide enough portfolio protection for all of your retirement savings.
Add Some Exotic Currencies Too. Perhaps more than anything else, foreign currencies represent a geographic diversification. You’re not actually making an investment in a foreign country, but you are holding its national currency. One of the best ways to do this is through exotic currencies. That’s because they represent special situations, that often aren’t directly tied to what’s happening in the US.
An excellent example is the Iraqi Dinar. As a national currency of one of the world’s largest oil-producing nations, its value can rise even if economic fortunes in the US and other developed countries are declining.
You don’t have to do anything radical in preparing your investment portfolio for the next economic downturn. It’s mostly a matter of adding two or three new asset classes to your portfolio, while trimming back on more traditional positions.
More than anything else, you’re preparing your portfolio for the next economic recovery. That will only be possible if you can minimize your investment losses between now and then.