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Months of stock market volatility, rising inflation and rising interest rates have left many investors wondering if a recession is imminent.
The stock market collapsed again on Thursday, with the S&P 500 capping its worst six-month to a year start since 1970. Overall, the year has fallen more than 20% so far. The Dow Jones Industrial Average and Nasdaq Composite have also fallen significantly since early 2022, by more than 15% and nearly 30%, respectively.
Meanwhile, consumer sentiments about the economy have plummeted, according to the University of Michigan’s close consumer survey, dropping 14.4% in June and a record low for the report.
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According to CNBC’s CFO survey, about 68% of CFOs expect a recession to occur in the first half of 2023. Experts’ predictions about the possibility of an economic downturn, however, diverge.
“We all understand that markets go through cycles and recession is part of the cycle we may face,” said financial planner Elliot Herman, partner at PRW Wealth Management in Quincy, Massachusetts.
However, because no one can predict if and when a downturn will occur, Herman urges clients to be proactive and make sure their portfolio is ready.
Diversify your portfolio
Diversification is critical in preparing for a potential economic recession, said Anthony Watson, a CFP and founder and president of Thrive Retirement Specialists in Dearborn, Michigan.
You can reduce company-specific risks by choosing funds over individual stocks because you’re less likely to feel like a company is failing within a publicly traded fund of 4,000 others, he said.
He suggests checking your mix of growth stocks, which are generally expected to provide above-average returns, and value stocks, which typically trade for less than the asset is worth.
“Value stocks tend to outperform growth stocks that go into recession,” explains Watson.
International exposure is also important, with many investors opting for 100% domestic assets for equity allocations, he added. While the US Federal Reserve is aggressively fighting inflation, strategies by other central banks may set other growth paths in motion.
Review bond allocations
Since market interest rates and bond prices tend to move in opposite directions, the Fed’s rate hikes have pushed the value of bonds down. The 10-year Treasury benchmark, which rises when bond prices fall, reached 3.48% on June 14, its highest yield in 11 years.
Despite falling prices, bonds are still an important part of your portfolio, Watson said. If stocks plummet on the way to a recession, interest rates could also fall, allowing bond prices to recover, which could offset equity losses.
“Over time, that negative correlation tends to show itself,” he said. “It’s not necessarily day to day.”
Advisors also consider maturity, which measures a bond’s sensitivity to changes in interest rates based on its coupon, maturity, and yield paid over the lifetime. In general, the longer the maturity of a bond, the more likely it will be affected by rising interest rates.
“Higher yielding bonds with shorter maturities are now attractive and we have maintained our fixed income in this area,” added Herman from PRW Wealth Management.
Assessing cash reserves
Amid high inflation and low interest rates on savings accounts, it has become less attractive to hold cash. However, retirees still need a cash buffer to avoid the so-called “sequence of returns” risk.
You need to be careful when selling assets and making withdrawals as this can damage your portfolio in the long run. “That way you fall prey to the negative series of returns, which eat your pension alive,” says Watson of Thrive Retirement Specialists.
However, retirees can avoid tapping their nest during periods of deep losses with a significant cash buffer and access to a line of equity credit, he added.
The exact amount needed can, of course, depend on monthly expenses and other sources of income, such as Social Security or a pension.
From 1945 to 2009, the average recession lasted 11 months, according to the National Bureau of Economic Research, the official documenter of economic cycles. But there is no guarantee that a future downturn will not last.
Cash reserves are also important for investors in the “accumulation phase,” with a longer timeline before retirement, said Catherine Valega, a CFP and wealth consultant with Green Bee Advisory in Winchester, Massachusetts.
“People really need to make sure they have enough emergency savings,” she said, suggesting 12 to 24 months of cost savings to prepare for potential layoffs.
“I’m generally more conservative than many,” she said, pointing to the more widely touted suggestion of three to six months of expenses. “I don’t think that’s enough.”
With additional savings, you’ll have more time to plan your next career move after a job loss, rather than feeling pressured to accept your first job offer to cover the bills.
“Having enough liquid emergency savings gives yourself more options,” she said.