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Increasing interest rates, soaring inflation and a sliding stock market have many people convinced a recession is on the way.
The Federal Reserve in July agreed to raise the federal funds rate to a range of 2.25 – 2.5 percent, marking the fourth consecutive rate hike since March of this year. U.S. inflation hit a 40-year high in 2022 amid soaring demand, an already-strained global supply chain and Russia’s invasion of Ukraine.
Additionally, the S&P 500 suffered its worst start to a year since 1970, entering a bear market on June 13, 2022 after falling over 20 percent from its Jan. 3, 2022 high, further strengthening the sentiment that recession is likely.
In the event a recession does hit, here are some investments you should consider avoiding.
What investments should you avoid during a recession?
Recessions can be tricky to predict, and even trickier to navigate. Investments you might traditionally think of as safe might in fact expose you to more risk depending on the economic environment.
Your first instinct might be to let go of all your stocks and move into bonds, but high-yield bonds can become particularly risky in the event of a recession.
High-yield bonds, with credit ratings below investment grade, are riskier than government debt securities, and are highly susceptible to market downturns. The issuing companies are often smaller, indebted and of overall lower quality, and in times of market uncertainty can be more likely to run into trouble.
Stocks of highly-leveraged companies
Companies carrying high levels of debt on their balance sheets should be avoided during a recession. The price of a highly indebted company is more likely to fall during a recession. If a company struggles to pay back its debts due to decreased demand and overall economic slowdown, its stock price can fall quickly.
Although indebted companies can tumble in a recession and present investment opportunities later on, a defensive investor should stay away while the company faces clear business challenges that must be overcome.
Consumer discretionary companies
Consumer discretionary stocks are popular during boom times, but their goods and services fall outside of everyday essentials like utilities and healthcare. Well-known consumer discretionary companies include Tesla and Nike.
This sector can be particularly susceptible to recessionary pressures, as the economy slows and people start spending less. Consumer discretionary companies move more dramatically with consumer sentiment and economic cycles, which can worsen in times of financial uncertainty.
Other speculative assets
Speculative assets are high-risk, high-reward investments such as penny stocks or emerging market stocks. Penny stocks are small companies whose stocks trade for very low prices. They’re not typically listed on major exchanges, and often do not provide financial information, giving investors little transparency and making them risky investments.
Emerging market stocks are shares of companies in developing countries outside of the U.S. These countries are considered to be in growth mode, making them quite risky with less transparency and significant political risk. Although this is not the case for all emerging markets , their emerging status still presents significant risk.
Many consider cryptocurrencies like Bitcoin to also be speculative. Cryptocurrencies experience volatile price swings, and may substantially eat into returns during a recession.
What investments should investors hold on to?
Recessions do not automatically mean that you should pull out of all your investments. A decline in stocks can mean opportunities for investors to buy valuable long-term investments at discounted prices. Distinguishing between what you should let go of and what you should stay invested in is a crucial first step.
“Generally, investors should consider balancing capital preservation in portfolios in the short-term with staying invested for longer-term opportunities. In this environment, how you get exposure is of paramount importance. We would recommend investors focus on higher-quality investments and avoid more speculative areas of the market,” says Sid Vaidya, U.S. chief investment strategist at TD Wealth.
This means equities focused on companies with resilient balance sheets, high-quality fixed income like Treasuries and mortgage-backed securities and credit instruments like investment-grade bonds, Vaidya adds.
Treasuries and mortgage-backed securities are higher-quality securities that offer consistent income and stability.
It’s important to stay invested during a recession and not simply empty out your positions into cash – but the quality of your investments is crucial. Avoiding highly indebted companies, high-yield bonds and speculative investments will be important during a recession to ensure your portfolio is not exposed to unnecessary risk. Instead, it’s better to focus on high-quality government securities, investment-grade bonds and companies with sound balance sheets.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.