The US recovery is now the second longest on record. There is nothing to suggest it will end in the near future, so the broad prognosis for risk assets remains good. But as we discussed in our
Turning the dial paper, expansions do not last forever. For those investors who are concerned about an equity market downturn, we outlined a number of shifts in allocation that might increase the resilience of a portfolio. 1
1Turning the dial: Portfolio considerations in the late cycle, Karen Ward & Michael Bell, J.P. Morgan Asset Management, September 2018
Here, we consider these seven strategies in more detail.
1. Move towards neutral in equities but avoid underweights
In the run-up to the start of a US recession equities can deliver strong positive returns. This highlights the risk of going underweight equities too early. For example, an investor who called the dot-com bubble too early would have missed out on a return of 39% in the final two years, or 19% in the final year, of the S&P 500 rally. Once the market starts to price in recession though, equities struggle. Markets have peaked anywhere between zero and 13 months prior to the start of a recession. Given the difficulty of precisely timing market peaks and troughs, investors may want to consider moving closer to neutral in equities in the late stage of the economic cycle.
Late cycle equity returns can be very strong
S&P 500 RETURNS AROUND MARKET PEAKS
% price return, before and after market peak
Source: Standard and Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. Market peaks are defined as the peak of the S&P 500 prior to a US recession, as defined using US National Bureau of Economic Research (NBER) business cycle dates. Past performance is not a reliable indicator of current and future results. Data as of 31 August 2018.
2. Remain regionally diversified in equities
A shift in regional allocation rarely helps cushion performance in a market correction. Investors concerned about a potential recession in the US may be tempted to shift away from US equities into other equity markets, but during US recessions stock markets in all regions tend to fall—sometimes by more than US equities. When you add in the fact that the dollar appreciated during the last two recessions, it’s far from clear that concerns about a US recession should lead investors to shift from US equities into other equity markets. Investors are normally better off maintaining a regionally diversified portfolio.
US recessions don’t mean US equities underperform
EQUITY MARKET MAXIMUM DRAWDOWN IN GBP % price return
Source: FTSE, MSCI, Standard and Poor’s, TOPIX, Thomson Reuters Datastream, J.P. Morgan Asset Management. Maximum drawdown is calculated using price index level data and is shown for all indices where available. Market peaks are defined as the peak of the index prior to a US recession, as defined using US National Bureau of Economic Research (NBER) business cycle dates. Past performance is not a reliable indicator of current and future results. Data as of 31 August 2018.
3. Rotate away from overweights in mid- and small-cap equities
Small-cap stocks tend to underperform the market during recessions, particularly in the UK. Between May 2007 and December 2008, UK mid-cap stocks underperformed the FTSE 100 by 18% and have since outperformed by 200%. The average UK equity fund has over 40% in mid- and small-cap equities, which is over 20% more than the FTSE All-Share.
Small-cap equities often underperform during recessions
FTSE SMALL-CAP/FTSE 100 RELATIVE PERFORMANCE
Relative total return index level, rebased to 100 in