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What happens in a downward shifting economy?

The crisis has moved from healthcare to an economic one as expected by some and feared by most. A necessary lockdown imposed by the government has resulted in:

  • Poor demand

  • Contracted manufacturing activity

  • High rate of unemployment

All in all, stunted economic growth. Which over a prolonged period will result in a recession. Much like the rest of the world.

Cities like Mumbai are going through a rough patch and have asked for help from the central government. Unfortunately, since the virus is still spreading in the country, we can’t predict how worse it can get. Or how long will the virus last? And thus, how long will the recession last?

All this makes it difficult for us to judge the extent of the damage to the economy. The best anyone can do is look at historical facts and make an educated guess. Track how assets have performed in such periods and form a game plan.

So, how does a downward shifting economy affect asset performances?

During a recession, economic activity contracts followed by declining corporate profits. (Most corporates announcing their results this quarter (Q1FY21) are expecting deep cuts in revenues and profit going forward.)

All this culminates into falling stock markets as people anticipate poor performances. (Which is what we are experiencing now). And hence greater price fluctuations (high volatility) during this period.

This makes stocks, as an asset class, the most sensitive to economic changes. And Bonds least sensitive and likely to perform better than stocks.

How do different sectors perform during and after a downward shifting economy?

Sector performances in and around recessions have been similar from recession to recession. 

Although we have never advocated the top-down approach to investing it’s important to know how they react in different economic scenarios. 

The sectors that have fallen the least or recovered the most after the fall are:

1. S&P BSE Healthcare

2. S&P BSE Technology

3. S&P BSE FMCG

The ones that have fallen the most or recovered the least are:

1. S&P BSE Capital Goods

2. S&P BSE Bankex and Finance

3. S&P BSE Metal

Health care and consumer staples topped the markets in the major sell-off in recent months

Which is not surprising. As defensive sectors like FMCG, Healthcare and Utilities have performed well during recessionary periods. And they didn’t fall much and recovered well with healthcare and FMCG leading the pack. 

But Utilities hasn’t done as well. And what’s odd is that technology, which has been long-considered an economically sensitive sector, performed well.

But Cyclical sectors are likely to perform well after the recession bottoms out

Historical trends indicate that cyclical sectors perform well after the recession bottoms out. These include Financials (banks and NBFCs) and Consumer Discretionary sectors like Automobiles, Consumer durables etc. 

Their recent performance in the stock markets shows them as the laggards in the recent rally. Thereby adding impetus to this theory.

So, does that mean investors should switch from defensive to cyclical yet?

Maybe. Maybe not. Although it does seem like the markets have begun to recover we cannot be sure. As there is still no clarity on the containment of the virus. Therefore, the markets are likely to remain volatile. And there is no certainty that the recovery will be smooth. 

We are yet to experience more fallouts as we get deeper into the recession. More incidents like the Franklin Templeton Debt Fund might surface. There could be more defaults and issues going forward.

What does that leave us with?

Investors can look at sectors for investment avenues, how they have behaved and how they will behave in a downward shifting economy. But use them only as filters to find great companies to invest in.

Stick to the bottom-up approach of investing. For now:

  • Focus on buying ‘Wonderful companies (available) at fair prices’. The key is to focus on the company’s valuation and its underlying business.

  • Stay far far away from leveraged businesses no matter how tempting they might seem. These times are plagued with a lot of uncertainty. And is, therefore, a very bad time to run a leveraged business. They will be the first ones to get hit and probably go down under.

Furthermore, if you cannot tolerate volatility, stick to Fixed Deposits. And even consider allocating some money to Gold. 

But keep in mind that a recession is a bad time to take on any additional risks. Therefore, before investing you must keep some money aside in the form of an emergency fund. Six to nine months of living expenses saved in a low risk, a highly-liquid instrument such as a fixed deposit.

Long-term investors should stick to their investment plans

As markets fall investors panic. Which is normal and quite common. But what follows is a flurry of rash decisions which isn’t in your best interests. Therefore, as a long-term investor, you must accept that volatility is a part of the stock markets. Business cycles are a reality. And extraordinary events will give rise to market volatility.

Tune out any toxic influences urging you to trade, time the market and make sudden shifts in strategy. Avoid any news items or analysts that can’t think beyond this week’s headlines. Instead, seek out investors who focus on the long-term.

Knowing this will keep you calm eliminate any kind of fear. It will prepare you to deal with what's happening around and stick to a well-devised long-term plan: a good plan with a great strategy in place. Remember, only the soundest investment strategies have withstood volatility.

Hence the key to surviving a downward shifting economy is to have a plan. A plan that:

  • makes sense regardless of short-term market conditions. 

  • works for you in a good and a bad market. 

  • at any given point in time reflects your long-term goals. 

If you already have one, stick to it. And if you don't it’s a good time to form one.