Australia’s economy has been the envy of the world, not having had a recession in over 30 years. The only notable exception being the transitory contractional blip in 2020 which passed us by without fuss in the throw of the pandemic. This privileged track record has left many commentators calling it “the miracle economy.” Which, it really is. Strong labour markets, declining interest rates and the resource boom of the 2000’s has allowed us to be the benefactors of a very prosperous nation indeed. However, such sustained prosperity comes with its perils. One such hazard being the tendency for us to forget. Periods of booms are inevitably followed by periods of bust, usually only regularly enough for the last slow down to have passed from memory. These corrections that bring our irrational exuberance back down to earth are the equivalent of the police shutting the music off at a street party that has got out of hand. It’s no fun but might be for our own good.

I’m Chris Bailey, financial planner at Prosperity Planners. In this video I am going to tell you why we may be heading for a recession and what investors can do about it.

Disclaimer: Before we begin, while I am qualified to provide financial advice, I obviously have not taken into account your personal circumstance when producing this video. So please make sure you consider the appropriateness of information discussed having regard to your own objectives, financial situation and needs.

Periods of expansion and contraction in economies should be thought of as a normal part of the economic cycle and both phases serve a function. When economies slow, it’s the macro machine telling us that things have overheated. Usually, these periods are characterized by a significant decline in economic activity, reduced income, increased unemployment, and a general reduction in productivity. Obviously, this isn’t fun. However, it also curbs inflation and corrects asset prices that have inflated to unsatiable levels. Business and industries that are inefficient fail which allows for resources to be directed towards more productive uses. Through monetary and fiscal policy, the severity of these contractions can be diminished which can be the right thing if done prudently. Though, often intervention is overdone, mollycoddling the economy by increasing debt, which only defers the hangover and mounts its severity.

There are storm clouds on the horizon that indicate we could be in for one of these periods. Inflation has been in the headlines and has been talked about to death over recent months. Less discussed is the yield curve. A yield curve is a graphical representation of the interest rates on bonds with a range of maturities. It shows the yields of bonds with short-term maturities to yields on bonds with long-term maturities. Usually, it slopes upward, reflecting the fact that investors typically demand higher rates of return for taking on the additional risk of lending money over longer periods. Normally, it should look like this:

However, currently yield curves are “inverted” meaning that the short-term yields are greater than long-term ones. Currently, in Australia they look like this:

And in the US the yield curve looks like this:

This is a strong indicator that we might be in for a hard landing. The inverted curve is the markets’ view that recession is looming, and has proven to be remarkably accurate. Over the past 60 years, the inverted yield curve has been a precursor to a recession in the US every time with only one false-positive in the mid-1960’s. Though, there was still an economic slowdown during this period.

It is the difference between long duration bonds and short duration bonds that provides the most insight. Here we see the spread between 10 year US treasuries and 2 year US treasuries by subtracting the 10 year yields with the 2 year yields.

The grey bars indicating the times of recession show that markets being forward looking are highly efficient at pricing securities. Each time the blue line fell below zero, the economy experienced a recession usually up to 18 months later.

While economies and share markets are related they are not the same. What’s interesting is when we juxtapose yield inversions with this chart that shows how share markets have behaved in the wake of these inversions:

Looking closely, we can observe there is significant disparity in the severity of share market response. While it’s understandable that yield inversions do not come as welcomed news to investors, we cannot observe that they provide any reasonable predictive ability for investors to pre-emptively benefit from this information ahead of time.

Looking at the 2008 financial crisis as an example. In February 2006, the US yield curves inverted, indicating a potential economic downturn. However, in the following 12 months, the S&P actually posted a positive return of 14.25%. Subsequently, the yield curve became upward sloping again in June 2007, well before the market experienced its infamous downturn from October 2007

If an investor had tried to time the market based on the initial yield curve inversion, they would have missed out on significant gains during that period. And if they had then bought back into the market when the yield curve normalised, they would have ended up purchasing stocks right before the crash occurred.

This principle of the unreliability of yield inversions and stock returns remains valid when we expand our analysis beyond just the US market and include other developed markets such as here in Australia, the UK, Germany, and Japan, spanning a period of almost four decades. When we examine yield curve inversions in these markets since 1985, we find that they are not reliable indicators of future stock market corrections. Out of the 14 instances of yield curve inversions, in 10 of these cases, equity investors actually experienced positive returns in their respective markets after three years.

In other words, investors who used yield curve inversions as a signal to exit stocks may have missed out on significant gains in equity markets within three years in 10 out of the 14 instances of yields inverting.

In their 2019 paper titled "Inverted Yield Curves and Expected Stock Returns," Eugene Fama and Kenneth French delved into this phenomenon. While they recognized that there is strong evidence supporting the idea that the slope of the yield curve can predict future economic activity, they did not believe it to be useful in predicting stock returns. Their analysis focused on three portfolios from the perspective of a US investor: testing a US Market portfolio, a World Ex-US Market portfolio, and a World Market portfolio. The objective was to test whether an actively managed strategy of shifting from equities to treasuries based on yield curve inversions would enhance portfolio returns.

After conducting their analysis, Fama and French arrived at the conclusion that there is "no evidence that yield curve inversions can help investors avoid poor stock returns." They found that shifting from equities to treasuries in response to yield curve inversions would only result in missing out on the equity premium, thereby reducing expected portfolio returns. In essence, they argued that attempting to time the market using yield curve inversions would be detrimental to portfolio performance.

The question remains, “what can investors do about this?” Naturally the answer is – it depends. Like all things in investing, how you should respond is going to be unique to you. It is in times like this that good, non-conflicted advice is going to pay the most dividends. Investors without a clear strategy, robust asset allocation and risk framework are the ones that will be caught out. Warren Buffets famous adage rings true “it’s only when the tide goes out that you see who has been swimming naked.”

Younger accumulators should be taking this as an opportunity to test their resolve. Fair weather investors and those who hope to pre-emptively predict market movements are the ones that stand to lose the most. Timing markets is a mugs game. Instead, younger investors should be focused on building resilience in their portfolios and protecting their greatest asset which is their human capital. The best hedge younger investors have is the ability to continue to derive an income, which will ensure that they are not forced to redeem holdings in their portfolio if markets were to contract. Even better, would be for accumulators to continue to direct surplus cash towards their portfolios, particularly during times when markets have fallen out of favour. Investing in every season, with no effort to pick winning stocks or time markets has proven to be the best strategy.

Many studies have demonstrated this. A simple exercise to highlight this is by reviewing the impact of being out of the market and missing the best trading days over a given period. In our charts we have seen that 1980 was one of the most pessimistic times to be invested. However, those who decided to invest in the S&P 500 at this time of peak pessimism would have been handsomely rewarded had they simply adopted a buy and hold approach. A $10,000 portfolio invested at the peak of pessimism would have grown to be $1,082,309 by December 2022.

Had this investor attempted to time markets and only missed the five best trading days during this time period, their portfolio would have reduced to $671,051.

If this investor missed the 30 best days, their portfolio by the end of the period would have reduced to $173,695.

Lastly, had they missed the 50 best days, then for all their efforts, would only have $76,104 at the end of this period.

For pensioners and retirees who are relying on their investments to provide income, the answer isn’t as clear cut. People are living longer and retiring sooner, meaning that capital longevity presents a tricky problem for those who are relying on their portfolio to support a comfortable retirement. The jury is still out on best practice when it comes to managing investment drawdowns. This is particularly true in the initial years of retirement due to what’s called “sequencing risk.” Sequencing refers to the risk that the order in which investment returns occur can impact the value of an investment portfolio, especially if withdrawals are being made from that portfolio. This risk is normally associated with the phase either right before and right after the start of retirement.

Consider an individual who has just retired and is beginning to draw down their investment portfolio for living expenses. If the market performs poorly in the early years of their retirement, they would need to sell more of their investment to meet their living expenses, which can erode their portfolio quickly. If the market recovers later, these individuals have less money remaining in their portfolio to benefit from the upswing.

Many contend that the “4% rule” is an optimal retirement strategy. This rule of thumb suggest that a retiree can withdraw 4% of their initial investment portfolio in the first year of retirement, and then adjust that amount for inflation each subsequent year, with relatively low risk of running out of money. If we were to review how the 4% rule has fared in light of sequencing risk, we can see that this is not an optimal strategy. In this chart we see the range of outcomes when the 4% rule had been applied to 60/40 portfolios since the year 1900:

Source: FINSIA "How Safe are Safe Withdrawal Rates in Retirement? An Australian Perspective"

Over the last century, this may have been a reasonable strategy for many investors. However, clearly, this presents a serious problem for investors who experienced a negative return in the initial years of their retirement. For those unlucky enough to have experienced poor market performance in their retirement opening years meant they would need to have a drastic reduction in lifestyle or risk running out of money. Beyond this, the 4% rule relies on historic data. While historic data is often used as a proxy for future expected returns, the reality is that expected returns are in fact likely to deviate from historic averages and more conservative assumptions should be used.

In my view, asset allocation is everything when it comes to retirement planning. Rather than relying on “rules of thumb” a better approach would be to focus on the right ‘mix’ of investments. Sufficient capital should be held in defensively oriented asset categories such as cash and high credit quality, short duration fixed interest securities. Ideally, there would be adequate allocation to these “defensive” asset classes to act as a volatility dampener when the proverbial hits the fan. This portfolio exposure should be able to satisfy several years’ worth of expense requirements to mitigate the need to draw down resource when markets are depressed. This won’t always be feasible for every retiree and counsel from a trusted advisor is strongly encouraged to ensure that you find the right approach for you.

If you have found this information useful then please consider sharing this with a friend. If there are any other financial planning questions that you might have, please feel free to let me know by commenting, or connecting with me directly. Thanks for watching.