Our Long-Term Capital Market Assumptions (LTCMAs) at J.P. Morgan Asset Management are structurally optimistic, but we cannot fail to acknowledge the potential short-term pain that may come with the end of the current cycle.
How can investors ensure their portfolios survive the short term so they can thrive in the long term?
The answer would be fairly straightforward if recessions were all alike and had a predictable impact across markets and investor types. But they’re not, and they don’t. We can’t predict how the next recession will unfold. But we can provide a framework to help investors prepare for the late-cycle risks most relevant to their investment needs and objectives.
Lessons from Recession Experience
An analysis of developed market recession experiences over the past four decades — and the resulting sequence of market reactions for each — informs our framework. Our findings serve as a stark reminder that recessions do not always spur equity sell-offs, credit defaults, and a flight to quality driving Treasury prices up. Markets can respond violently and bounce right back, or simply shrug off a recession altogether. Market responses do not occur in a fixed sequence.
We formulate four plausible recession scenarios, identifying their possible triggers and the potential market responses under each. While recessions will always be painful, the intensity and nature of that pain can vary greatly.
- In recessions caused by monetary tightening, emerging market assets will suffer alongside a strong US dollar.
- Recessions characterized by corporate caution pose particular risks to stocks and credit markets.
- A recession following a trade war is likely to come with non-linear effects on near-term growth and inflation, with emerging market assets the likely underperformer.
- In the United States, with its consumer-driven economy, a weaker demand impulse following a consumer retreat is likely to keep inflation contained.
Possible Downturn Scenarios
Source: J.P. Morgan Asset Management. For illustrative purposes only.
Facing into the Late Cycle
Against this framework, we evaluate the likely impact of these scenarios and market responses for different types of investors. The good news is, in general, we see investors as somewhat more resilient than in the past. They are taking steps to diversify portfolios, structure them to their specific needs, and incorporate asset allocation solutions. But concerns remain.
- For pension funds, the key risk today is that plans will drag their sponsors under, especially in a corporate caution scenario with severe equity downturns. Managing pension portfolios through recessionary environments will require monitoring a number of risk factors beyond just asset price performance. These could include negative cash-flow risks, derivatives usage, and illiquid allocations.
- Sovereign wealth funds and endowments and foundations are primed to weather recessionary environments well, but only if they can manage their spending commitments and avoid becoming a forced seller in illiquid markets. This is particularly important because these investors have allocated heavily to private assets, given that expected returns from stocks and bonds have moved lower over the cycle.
- Individual investors with higher equity allocations, such as those in the United States, will be hit hardest by a recession but may also have the greatest ability to bounce back, depending on their income level and age. Investment vehicles such as target date funds build on age-related resilience and may further improve resilience in the long run by actively managing investors’ needs through to retirement. Additionally, multi-asset structures may be able to effectively manage portfolios through a period of market weakness.
Building resilience in a downturn requires all investors to assess the quality of the recessionary environment and to understand the risks they bear and their capacity to bear them. Such an appraisal is critical in order to survive the short term and thrive in the long term.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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