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Increasing interest rates, high inflation and a regional banking crisis have many people convinced a recession is on the way.
The Federal Reserve raised the federal funds rate to its highest level since 2007 in May, marking the tenth consecutive rate hike since March 2022. 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 remains well off its Jan. 3, 2022 high, adding to the sentiment that a 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 be particularly risky during 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 an overall economic slowdown, its stock price can fall quickly and the company may even fall into bankruptcy.
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 travel companies such as cruise lines or airlines.
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 stocks of companies with little to no earnings. 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.
In recent years, many companies have used cheap debt to finance their operations, hoping to show revenue growth and worry about earnings later. But as the economy slows, revenue growth is harder to come by and with higher interest rates, investors want to see more in the way of earnings today. These companies can be hit by both a business downturn and a reduced valuation because of higher rates.
Many consider cryptocurrencies like Bitcoin to also be speculative. Cryptocurrencies don’t have intrinsic value because they don’t generate anything for their owners, such as dividends or earnings. Cryptocurrencies experience volatile price swings, and may see significant losses during a recession.
What investments should investors hold on to?
Recessions do not 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 staying 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.
– Georgina Tzanetos contributed to a previous version of this article
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.