Investing ahead of a recession: 5 mistakes to avoid | Capital Group Canada | Insights

Insights

ARTICLES  |  OCTOBER 2019

Investing ahead of a recession: 5 mistakes to avoid

Think the next recession is around the corner? See five common mistakes investors make when preparing their portfolios for elevated volatility.

It’s been a summer to remember for investors, but for all the wrong reasons. The yield curve invertedtrade conflicts intensified and the U.S. economy showed more signs of its cycle age. But just as the summer inevitably turns to fall, investors may be wondering if the economy is moving into its next stage too. Could a recession be on the horizon?

Maybe. Maybe not. Recessions are notoriously difficult to predict, even when signals are starting to flash red. But that doesn’t mean investors should do nothing. Since the stock market tends to lead the economy by several months, it’s often better to be proactive. Late in the economic cycle can be a good time to re-evaluate portfolios, ensuring they are properly balanced and positioned for elevated volatility.

Some may think the best way to prepare portfolios for a recession is to drastically reduce stocks in favour of bonds. The problem with this approach is that it requires a soothsayer-like ability to time the markets. Some of the strongest returns can occur during late stages of an economic cycle and immediately after a market bottom, so being wrong on either turning point can be devastating to long-term returns. A more realistic approach may be to maintain an appropriate balance between equities and fixed income but upgrade the quality of both. 

Upgrade your stock portfolio

In volatile markets, investors often tilt their equity portfolios toward value investing and focus more on dividend stocks. This can be an effective way of reducing portfolio risk, but it can also give investors a false sense of security if they don’t know what they’re buying. Here we highlight three common assumptions often made by investors when they look to increase their value-oriented allocation followed by a suggestion for what may be a better way to upgrade equity portfolios.

Assumption #1: Value investing will always reduce volatility.

Reality: Value indices can be just as risky as the broader market. Portfolio risk is commonly measured by standard deviation, downside capture ratio and average drawdown. If moving to a value portfolio ahead of expected volatility, you’d want these measures to show lower risk than the overall market. But surprisingly, we see exactly the opposite for both the Russell 1000 Value Index (the most common benchmark for large-cap value investing) and the Morningstar Large Value category (a composite of value-oriented mutual funds) over the last 10 years.

The takeaway? Not all value is created equal. It can be more effective to hold a mix of dividend-paying stocks than a value index.

Assumption #2: Value investing is the same as dividend investing.

Reality: Many stocks in value indices don’t pay dividends. Dividend-paying stocks have tended to hold up better during periods of volatility, so investors may benefit from more dividend exposure ahead of a recession. But don’t assume every value fund will make dividends a priority. About 22% of stocks in the Russell 1000 Value Index paid dividends of less than 0.1%, as of December 31, 2018.

Assumption #3: Value investing only includes high-quality companies.

Reality: Low-quality and distressed companies are commonly included in value portfolios. Around 40% of the rated companies in the Russell 1000 Value Index were BBB- or lower (as of December 31, 2018), including many high-yielding dividend payers. Companies often appear solid on the surface but carry significant debt burdens and may be on the cusp of losing their investment-grade credit rating. A missed payment or a downgrade could send share prices tumbling, so investors should focus on higher quality companies that are most likely to maintain consistent dividend payments.

What can be done instead?

Investors looking to reduce equity volatility ahead of a recession should consider more rigorous fund screens and not assume that any product with a “value” label will help them achieve their goals. As we see with the Russell 1000 Value Index, even the flagship benchmark for value investing falls short in many ways. Consider a screen that includes funds with the following factors:

  • High percentage of dividend-paying stocks
  • High percentage of companies with credit ratings of BBB and above
  • Low fund-risk metrics, including average drawdown, downside capture ratio and standard deviation

One portfolio to consider is Capital Group Capital Income BuilderTM (Canada). This equity-income mandate aims to deliver a smoother contour of results by focusing on companies that offer growing and sustainable dividends.

Upgrade your core bond portfolio

Fixed income investments can provide an essential measure of stability and capital preservation, especially when stock markets are volatile. But here too, investors often make assumptions that their portfolios are safer than they really are.

Assumption #4: In a low-rate world, I should reach for yield to get income.

Reality: Reaching for higher yield can be risky. High-yield credit spreads have tightened. When that has happened in the past, credit has significantly lagged U.S. Treasuries. Bond funds with more high-yield exposure also tend to have higher correlations to equity, something investors should avoid in their core bond holdings if they are trying to reduce portfolio volatility.

Assumption #5: Short duration will help reduce volatility.

Reality: Shortening duration probably won’t help as the Fed is done hiking rates for now. Investors often turn to short-term bonds for lower interest rate risk, but that is usually most beneficial in a rising-rate environment. Following the Fed’s rate cut in July, markets have been pricing in five more rate cuts by the end of 2020.

What can be done instead?

Consider an allocation to a fixed income mandate that offers low-to-negative correlation to the equity market. This will help the overall portfolio maintain a degree of stability if equities swoon. Capital Group World Bond FundTM (Canada) takes a cautious approach to risk within global bond markets by focusing on investment-grade holdings (rated BBB/Baa or better).

Maintain a long-term perspective

Recessions can be painful, but investors who are well-prepared and maintain a long-term investment horizon should be comforted that economic declines have been relatively small blips in economic history. Over the last 65 years, the U.S. has been in an official recession less than 15% of all months, with the average recession lasting just under a year. Maintaining a balanced, well-diversified portfolio can help investors avoid the pitfalls of market timing, while being prepared for the relative short-term volatility that comes with recessions.


Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, non-investment-grade debt. This index is unmanaged, and its results include reinvested distributions but do not reflect the effect of sales charges, commissions, account fees, expenses or income taxes.

© 2019 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

Russell 1000 Value Index measures the results of the large-cap value segment of the U.S. equity universe.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

Unless otherwise indicated, the investment professionals featured do not manage Capital Group‘s Canadian mutual funds.

References to particular companies or securities, if any, are included for informational or illustrative purposes only and should not be considered as an endorsement by Capital Group. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds or current holdings of any investment funds. These views should not be considered as investment advice nor should they be considered a recommendation to buy or sell.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and not be comprehensive or to provide advice. For informational purposes only; not intended to provide tax, legal or financial advice. We assume no liability for any inaccurate, delayed or incomplete information, nor for any actions taken in reliance thereon. The information contained herein has been supplied without verification by us and may be subject to change. Capital Group funds are available in Canada through registered dealers. For more information, please consult your financial and tax advisors for your individual situation.

Forward-looking statements are not guarantees of future performance, and actual events and results could differ materially from those expressed or implied in any forward-looking statements made herein. We encourage you to consider these and other factors carefully before making any investment decisions and we urge you to avoid placing undue reliance on forward-looking statements.

The S&P 500 Composite Index (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2019 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.

Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, "Bloomberg"). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, "Barclays"), used under licence. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

MSCI does not approve, review or produce reports published on this site, makes no express or implied warranties or representations and is not liable whatsoever for any data represented. You may not redistribute MSCI data or use it as a basis for other indices or investment products.

Capital believes the software and information from FactSet to be reliable. However, Capital cannot be responsible for inaccuracies, incomplete information or updating of the information furnished by FactSet. The information provided in this report is meant to give you an approximate account of the fund/manager's characteristics for the specified date. This information is not indicative of future Capital investment decisions and is not used as part of our investment decision-making process.

Indices are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

All Capital Group trademarks are owned by The Capital Group Companies, Inc. or an affiliated company in Canada, the U.S. and other countries. All other company names mentioned are the property of their respective companies.

Capital Group funds and Capital International Asset Management (Canada), Inc. are part of Capital Group, a global investment management firm originating in Los Angeles, California in 1931. The Capital Group companies manage equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.

The Capital Group funds offered on this website are available only to Canadian residents.


Related Insights