A Recession Is Possible, but Far From Certain. So How Should You Consider Positioning Your Portfolio?

Executive summary:

  • We believe a very high level of conviction that a recession will occur is necessary before investors start overweighting or underweighting equities. This is because changes in portfolio positioning can have significant negative or positive impacts on investment outcomes. Our current U.S. recession probability of 55% does not meet our high-conviction threshold.
  • Given the uncertainty over a recession, there are other incremental steps that investors may want to consider instead. These include making adjustments to a portfolio’s market beta and credit exposure.
  • A portfolio that is more aligned with market-like risks will likely experience more market-like returns—and less over/under-performance depending on the direction of markets.

With the market pausing to once again contemplate whether the recent U.S. economic strength will continue or if the cumulative effects of tightened monetary policy will lead to a much-anticipated recession, investors are asking themselves how they should be positioning their portfolios. In other words, ahead of a potential recession, just how defensive should they get? Or, should they get defensive at all? This is the big question the market has been wrestling with for well over a year.

Big decisions can have big consequences

The answer to this question matters a great deal, because a portfolio positioned for a recessionary environment will likely significantly underperform if a recession does not occur. On the other hand, a portfolio positioned specifically for an economic downturn is likely to significantly outperform if a recession strikes. This underscores the significant negative or positive impacts a positioning decision can have on investment outcomes.

Too often, the debate over portfolio positioning is boiled down to a single risk-on/risk-off decision. In other words, it’s seen as a black-and-white decision with only two possible choices: the investor either overweights or underweights equities relative to bonds (in relation to their long-term policy asset allocation). The problem with making such a yes-or-no decision is that given the significant portfolio impacts likely to occur, an extremely high level of conviction in the outcome is required on the part of the investor. In other words, you shouldn’t switch from a risk-on position to a risk-off position just because you think a recession might occur. You better believe one is coming down the pike—or you stand to lose out on thousands of dollars.

To help illustrate this, consider the fact that during extended periods of economic uncertainty, 20% equity market moves are not unusual. So, let’s say an investor decides to shift to a risk-off mode by underweighting equities by 10%—but a recession fails to materialize. A soft-landing scenario plays out instead, and in response, the market goes up by 10%. In this instance, the investor’s theoretical portfolio would underperform their policy by 1.00%. If the market goes up even further—let’s say 20% instead of 10%—the result would be 2.00% in underperformance. This underscores why the bar for establishing your belief in an upcoming recession should be set very high.

At Russell Investments, our current U.S. recession probability over the next 12-18 months is 55%—or slightly better than a coin flip. That’s very, very far from certain. We would need our recession chances to be significantly higher to meet this threshold of high conviction. Because we’re nowhere close, we are currently neutral to policy allocations with respect to our equity and fixed income preferences.