How should you invest during a recession?

A recession is a period of falling economic activity. It is generally defined as a decline in gross domestic product (GDP) – the value of goods and services produced in an economy – for two or more consecutive quarters.

Recessions are a normal part of the business cycle but, unfortunately, they can come with some nasty consequences. Especially if the downturn is severe rather than mild. Vulnerable businesses can go under, and others make cutbacks, which often means redundancies and fewer jobs available.

Are we in recession now?

According to the most recent data, the UK fell into recession in the second half of 2023. The Office for National Statistics (ONS) estimated that GDP fell by a worse-than-expected 0.3% between October and December, following a decline of 0.1% in the previous three months. This is only a small contraction, which is why many economists are referring to it as a ‘technical recession’.

The UK economy has been broadly flatlining, with some quarters slightly rising and others falling. This contrasts with a full-blown recession where a more significant contraction takes place, for instance when the first Covid-19 lockdown sent the economy plummeting in 2020.

Notwithstanding the mild recession, the UK economy has fared better than many economists feared a year ago, when some were predicting a sharper downturn. It is also expected to be short-lived, with GDP expected to pick up from the start of 2024. Europe has experienced a similar trend with its economy avoiding recession by the narrowest of margins.

Like the UK it has struggled to regain momentum following the pandemic, restricted by high inflation and rapid interest rate hikes to combat it. A surge in energy prices in 2022 — triggered by Russia’s full-scale invasion of Ukraine early that year — was particularly painful and Germany in particular continues to falter from falling Chinese demand and high energy costs.

The US economy appears more resilient and has so far confounded predictions that the higher interest rates necessary to control inflation would bring about recession. US consumers, representing much of the economy, have continued to spend at a solid rate. However, at some point they may run out of steam and a recession can’t be ruled out.

Worries about heavy borrowing by the US government could also upset financial markets, ultimately making borrowing more expensive, plus growing losses in commercial real estate could strain the financial system. For now, though, the outlook appears better than for many other big economies.

How do markets react to a recession?

Ordinarily, central banks cut interest rates during a recession to make borrowing cheaper and reduce the burden of debt on businesses and households and reinvigorate spending, which can also boost markets.

Conversely, they raise them when things are booming to reign in excess demand that pushes prices up too quickly. This can have a dampening effect. However, the current situation is less clear cut. Authorities are still dealing with inflationary pressures at the same time that economies are weakening, so they must be cautious about cutting interest rates too quickly from the current restrictive levels.

If they cut too fast, then inflation could accelerate as the economy speeds back up. However, cut too slowly and they could cause more economic pain than necessary to keep inflation under control and close to the generally accepted target of 2%. Thankfully, inflation does now seem to be falling back and markets expect central banks to cut interest rates, possibly quite sharply, as more evidence emerges this is being sustained.

What this means for investors is mixed. Markets stand to benefit from falling interest rates that subsequently lower borrowing costs and stimulate demand.

Bond investors would welcome lower inflation and lower interest rates, and it’s generally good for shares too. However, if rates fall very sharply that might be because economies are really struggling, and some sectors and companies would likely suffer from reduced demand, implying there are both winners and losers in a more recessionary scenario.

In the meantime, investors are grappling with how long interest rates might need to be kept at current levels, how quickly they might be cut, and where they might settle. The longer the process takes, the worse the economic damage could be, potentially meaning a deeper recession, and the gloomier things may become for markets.

Investors have already reacted to this, swinging between optimism that interest rate cuts are just around the corner and a more pessimistic view that they may be several more months away. Meanwhile, US share indices have hit new highs regardless thanks to the strong returns from the technology giants, which investors seemingly assume will be resilient in a recession.

What do past recessions tell us?

It’s intuitive that investing during a recession should be avoided. However, that’s not necessarily the case. Research from Schroders revealed that in the past century the US share market nearly always begun to recover before recessions ended. Economic downturns do not last forever, and if history is a guide, a good way to avoid losses in a recession is to take a long-term approach and ignore the noise.

You don’t even have to get the timing anywhere near perfect. Someone investing in a global index fund on the worst possible occasion in 2007 – the market's peak before the great financial crisis – would have achieved a 7.7% average annual return in the years since even though there was a very poor period at the start*. Please note past performance is not a reliable guide to future returns. It is also worth noting that all recessionary periods and subsequent recoveries are different.

*Source: FE Analytics, L&G Global Equity Index Fund total return (income reinvested), bid-to-bid basis, 11/10/2007 to 01/02/2024.

Six tips for investing during a recession

1. Get your house in order

You should never compromise your financial security for long-term gain. Before considering investing there are some important things to have in place. Any high-interest debt such as loans and credit cards should be paid off, and you should build an emergency fund in case life throws you a curve ball.

Losing your job or unexpected expenditure such as a car or boiler repair means you need to have some cash in reserve to draw on. One rule of thumb is this should cover three to six months’ expenditure – though what is appropriate will depend on circumstances.

If you are employed, you should also prioritise your workplace pension in order to receive valuable contributions from your employer, as well as tax relief which boosts the size of your pot.

2. Diversify

Focusing too much on one type of company or one sector will tend to increase volatility. Investors typically build portfolios of various shares and other assets so that they are not overly reliant on any one investment or asset class performing well – this is known as diversification.

As investment great Sir John Templeton put it, “The only investors that don’t need to diversify are those that are right 100% of the time”. Nobody is, so the sensible thing to do is to prepare for different outcomes and spread your money around so you are not reliant on a single company or type of business.

3. Avoid market timing

Many investors obsess over exactly when to invest, but trying to time the market is usually a losing battle. A recession can cause volatility in prices, but there’s no knowing when the low point will come – or if it has already passed.

We can conclude from studying stock market history that investing at a market bottom during a recession tends to lead to excellent returns. Some of the strongest returns can occur immediately afterwards, which makes things all the more frustrating for the market timers. That’s one reason to keep invested, the other is that exiting the market interrupts the flow of dividends, interest and other income, which can make up a substantial portion of returns over time.

4. Own 'inevitables'

Knowing where to invest during a recession is tricky, as most businesses will face extra challenges. However, invest in good quality businesses and time tends to be on your side. Invest in a poor-quality one and it isn’t. A focus on quality can be especially important during a recession when investors prize resilient earnings and a strong balance sheet.

Certain businesses have an ‘economic moat’ around them. For instance, offering a unique proposition, dominating market share through a superior product or unparalleled channels of distribution. In these circumstances, it is hard for newcomers to penetrate the market, so the strong are likely to get stronger. Some sectors are also naturally more resilient to economic downturns, for instance, food and beverages, healthcare and utilities owing to their greater share of essential rather than discretionary spending.

That said, more turbulent times in markets can offer opportunities to stock up on investments of all types at favourable prices and hold them for the longer term.

5. Avoid vulnerable businesses

If things take a nasty and unexpected turn for the worse, avoiding weaker businesses that are less likely to withstand a significant downturn is sensible.

The worst performers during a recession are usually businesses that have a lot of debt, are tied closely with the economic cycle – perhaps in terms of consumer or industry spending – or are otherwise speculative and reliant on securing further funding from increasingly wary investors. Companies that fall into any of these categories have the potential to go bankrupt, leaving little or nothing for shareholders.

Those that do manage to avoid this fate, having teetered close to the brink, can make highly profitable recovery stories, but it is very risky backing low-quality and distressed companies, especially if not well diversified.

6. Just keep going

Provided you can afford to, keeping up the investing habit through difficult times makes sense. By investing monthly, for instance, an investor ends up buying more shares or units when prices become cheaper and fewer when they become more expensive. This can be a great way to invest because if you keep buying the market falls you could, over time, turn volatility to your advantage.

No one can precisely call the market tops and bottoms, so the advantage of dripping money into the market is that you don’t need to worry that you are putting all your money in at the peak. It can remove a lot of the stress associated with trying to time markets. Through Charles Stanley Direct you can invest regularly from cash into funds in an ISA or Investment Account from as little as £50 per month.