In the following excerpt from her recent webcast, “Your 2022 Midyear Portfolio Checkup,” Morningstar director of personal finance and retirement planning Christine Benz discusses:
- Is a recession coming in 2022?
- What types of stocks and bonds do well during a recession.
Watch the full webcast: “Your 2022 Midyear Portfolio Checkup.”
Christine Benz: Now I want to talk about something that has only recently been in the headlines, which is the idea of recession or a softening economy, if not a full-blown recession. So, I want to talk about the fundamental underpinnings of recession, why we’ve been hearing more recessionary talk recently.
Is a Recession Coming in 2022?
And the key reason is that there is concern that if the Fed continues to act aggressively, which I think there is widespread agreement that they should act aggressively to stamp out inflation, if they act too aggressively, they could overshoot and inadvertently push the economy into a recession or at least slow it down dramatically. So, that’s the fundamental underpinning for why we’ve been hearing about recession more and more in terms of the headlines.
The quantitative expression of recession and why economists are thinking about recession is what’s depicted here on the yield curve. So, I’ll just describe what we’re looking at starting with that green line on the screen. This was the yield curve through the end of the first quarter of 2021, and this is kind of a normally shaped yield curve. The basic idea is that the shorter-term investors, the ones who are owning two-year bonds and three-year bonds, they’re getting paid less in terms of their yields for their bonds than the investors who are assuming all that interest-rate risk and holding 20- and 30-year bonds. Those people are getting paid more for the risk that they’re assuming. One thing that we’ve been seeing this year in terms of this yield curve is a little bit of flattening. So, long-term bondholders are saying, “Well, you know what, you may not need to pay me quite as much because I think that yields will actually be going down.” And this yield curve, the flattening yield curve, and certainly what’s called an inverted yield curve where the short-term bondholders are actually getting paid more to hold their bonds than are the long-term bondholders, this has historically been a really good predictor of recessions. This is what has sent market watchers kind of chattering about potential recession, this concern that the yield curve is exhibiting this flattening pattern, which is indicating that some bond market participants are expecting some economic weakness, they’re expecting that before long the Fed actually may be stepping off the brakes with respect to interest rates, they may be lowering interest rates, which would make those long-term bonds, even though their yields aren’t high in absolute terms, that would make them worth more than newer bonds that might come on line with lower yields attached to them. So, just food for thought. Nothing to get carried away with respect to your portfolio, but something to keep in the back of your mind as you’re thinking about repositioning.
What Types of Stocks and Bonds Do Well During a Recession
And the really tricky part of this recessionary talk is that the categories, the hardest-hit categories, some of them, especially in the fixed-income space, are the things that you want in your portfolio in a recessionary environment. So, high-quality bonds tend to be very, very good performers in recessionary environments, in part because recessionary environments typically spur a flight to quality, and high-quality bonds are one of the key high-quality investments that investors look to, but also because interest rates often decline in recessionary periods, which makes high-quality bonds worth more. It elevates high-quality bond prices. So, I think a key thing to think about as you’re thinking about your portfolio is, even as you might be inclined to throw bonds overboard given how poor their performance has been in the first half of 2022, they tend to be good ballast for equities in some sort of an economic weakness or recessionary environment. So, I would say, beware of drastic all-or-nothing measures with respect to your fixed-income exposure in your portfolio. You probably want to maintain some exposure to high-quality bonds to protect you in a recessionary scenario.
On the equity side, this is another interesting and perhaps a little bit counterintuitive thing. Some of the areas that have held up best in 2022–so commodities, energy investments–could actually underperform in a period of slack economic growth, which I think is an argument for not loading the boat with them even though their performance has been really great, and they’ve probably held your portfolio aloft to the extent that you’ve had them in your portfolio. You want to be careful about overdoing them because of their sensitivity to the economic environment.
On the other hand, when we think about categories that tend to hold up well in recessionary environments, healthcare stocks tend to do well in such a period. Consumer staples stocks also hold up well. Really, anything that consumers will continue to buy regardless of what’s going on in the economy, so that’s paper towels, that’s drugs that people need to take, those tend to be quite recession-resistant. They are things that you’d want to maintain ongoing exposure in your portfolio to.