It seems like everyone is talking about a recession these days. Everywhere I go, I hear retail investors talking about how they expect a big recession to come soon because the yield curve has inverted, we’re 10 years into a bull market, because of trade war uncertainty, or any other myriad of reasons.
Now personally, I don’t think a 2020 global recession / financial crisis is a done deal. I still think there’s many things that global governments or central banks can do to stave off a recession short term.
But there’s no denying that eventually, a recession will need to come along. Recessions are part and parcel of the debt cycle. For as long as an economic system has debt, there will always be financial cycles and recessions.
So it’s always good to be prepared.
When will the next recession come?
I think there’s no denying that at this point in the cycle, the risks of a recession are elevated. We’re 10 years into a bull market, making this the longest we’ve ever gone without a recession (US recession) in modern history.
And at the same time, cracks are starting to show in global growth. I think global economic growth has been slowing for a while now due to debt and demographics levels (high debt and aging populations), and the trade war merely exacerbated the issue by forcing a radical shift in supply lines.
So at this point, I think the underlying risks are already there. It just needs a catalyst to spark off a global crisis or risk off mode. Something like HK Dollar Peg breaking, a sudden big escalation in the trade war, or a WeWork bankruptcy could probably do the trick.
What will the next recession look like?
Making such predictions can sometimes be a fool’s errands, but I think that the 2 key themes that will define the next crash are liquidity, and the private-public market valuation disconnect.
There are already signs of liquidity issues, a notable one being the Neil Woodford Funds. The underlying problem here is taking illiquid assets, packaging them up, and trading them on a stock exchange. This gives the illusion of liquidity (units traded on a stock exchange) in an asset class where there is no true underlying liquidity.
And as investors in Neil Woodford funds found out the hard way, once you start pulling money out in bulk, these funds are unable to meet redemption requests due to lack of liquidity in the underlying assets, so the funds get gated, and investors start panicking.
Since 2008, the number of such funds globally has gone up tremendously, and I think this could be a big issue during the next recession when investors all crowd to the exit at the same time.
Private-Public market valuation disconnect
The second one goes like this. Everybody these days “knows” that private equity and venture capital (basically private investments) outperform public investments (public traded securities) over the long term. Since 2008, a lot of money has crowded into this PE/VC space. This has created a valuation disconnect between private markets and public markets.
The easiest way to see this in action, is to look at Uber or WeWork. The private market thinks that these are fantastic companies and values them at $65 billion (for Uber). The public market? They think it’s more like well below $50 billion. And let’s not even get started on WeWork (50 billion to 7 billion valuation overnight).
The big problem with private investments is that they are not valued at mark to market, simply because there is no market for those investments. So the valuation you put on the balance sheet is what you think the investment is worth. And of course if you are a PE fund manager whose bonus depends on the performance of your investments, you’re going to “think” that the investment is worth a lot of money.
The problem comes when you want to sell these investments. Nobody is going to buy at the price you “think” the investment is worth. It used to be that the exit strategy of choice for PE/VC was IPO, but as WeWork found out the hard way, that’s not always going to be possible.
It’s still quite orderly for now, but if we get a big global recession or crisis, then all hell can break loose.
What to own in the next recession?
I think that a recession needs to be looked at in 2 phases. There will be a bunch of assets that perform well during the panic phase (ie. when the market crash is happening and people are panicking), and another class that will perform well during the recovery phase (ie. when the panic is over and global governments / central banks are coordinating to stimulate growth).
What will do well in panic phase?
US Treasuries – The classic US Treasuries. US Treasuries perform well in every market crash / risk off moment, and I don’t expect the next recession to be any different. In times of market volatility, investors will flood into USD denominated assets, and more specifically US Treasuries. And if the US Federal Reserve is forced into cutting interest rates further (which it probably will), this merely adds fuel to the fire.
Gold – The logic here is loosely the same as US Treasuries. In a risk-off, especially when investors do not want exposure to forex or country/political risk, they will buy gold as a safe haven asset. Gold price goes up, making you a happy investor. I hear a lot of investors out there who run the same argument about Bitcoin. I definitely get the argument, but I don’t know Bitcoin well enough to comment on it. So for an old fashioned investor like me, I’m probably still sticking to gold.
Cash – There’s a saying about cash that I really like: Cash is like oxygen. When it’s there, you don’t notice it. When it’s gone, it’s the only thing that matters. Nobody thinks about cash in the good times when you can easily sell assets to raise cash. In a crash scenario where your assets are underwater, and cash is hard to come by, cash is all that matters. So in a crash, the 1 to 2% yield you get on your cash is still much better than the -10% or more that you’re getting on other riskier asset classes.
What will do well after the recession (recovery phase)
Now we need to make a couple of assumptions here. The way I see it, the most probable way out of the next recession involves global central banks setting interest rates at or close to zero, while global governments inject fiscal stimulus into the economy (infrastructure spending, helicopter money etc). The details and how we get there are of course impossible to predict, but this is the broad idea.
And the net results of these moves, is that because so much new money will be going into the system, it will create inflation. Now this needs to be differentiated from the inflation we saw the past 10 years, which was mainly asset price inflation.
In the past 10 years, interest rates were set close to zero. Without any clear incentive to spend the money, the most logical way to profit from this was to borrow money at zero interest rates, and invest it. And just about everyone did that. So things like stocks, real estate etc all went up, but consumer price inflation stayed the same.
But in the next recession, because interest rates are already close to zero bound, further cutting of interest rates is going to have limited effect. The real stimulus will come when governments enact huge fiscal stimulus. So this is money that will be spent (whether it is building roads or just going directly into the hands of spenders), and money that will go directly into the real economy. This will drive up consumer price inflation, and create a scenario markedly different from what we saw the past 10 years.
Gold – What asset do you really want to own when inflation is high, and global currencies are in a mess due to competitive devaluations? Whatever list it is, gold probably ranks pretty high.
Real assets – Similarly, real assets like real estate perform well. Real estate is limited, so no matter how much money is printed, you still can’t get more real estate in the world. With high inflation, you’re also able to increase rents on real estate, while the amount of debt remains the same (and at low interests), which is a great recipe to make money.
Stocks with pricing power – Stocks are an interesting one. Not all stocks perform well in a high inflation scenario, only those with pricing power. Here’s an amazing quote from Warren Buffet that explains it:
“Companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.”
I know what you’re thinking. This is easier said than done. Everybody would want to buy a company like that if they could identify it. And that’s absolutely right.
The past 10 years of low interest rates and excess liquidity have created a scenario where growth companies thrive. It’s created an era of Ubers and WeWorks and growth at all costs.
But in the next recession, companies that have pricing power, and that generate good (positive) cash flow are those that are going to be prized. How to spot them though, is the million dollar question.
And it’s also for this reason that I think passive indexing is going to underperform in the next recession. In high inflation scenarios, just buying a passive index may not be enough to guarantee returns. Good active manager, who able to identify companies with pricing power, will outperform the index.
Now for obvious reasons, nobody knows with certainty what the next recession will look like, or when it will come.
But in this article, I’ve tried to make an educated guess, based on information available to me at this point in time, of what the next recession will look like, and what asset classes will perform well.
What do you think? Share your thoughts below!
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