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The sky won’t always be sunny. Often, it will cloud over and sometimes it will unleash storms. Markets are a bit like this too, which is why a strategic approach gives you the best chance of investment success in the long run.

During such times, Vanguard’s four investment principles are especially useful, by reminding investors to focus on what they can control and remain disciplined.

Right now, the ‘R’ word – recession – is rearing its ugly head, not just here in the UK but also in other parts of the world.

Recession is when a country’s economy shrinks rather than grows1. It’s a time when, typically, spending falls, job worries rise and profits shrink. Recession is commonly associated with market downturns. If severe, these downturns can veer into so-called ‘bear-market’ territory, which is when stock markets decline 20% or more from their previous peak.

However, we’re not quite there yet – and, as our global chief economist Joe Davis explains in this video, neither is a recession in the United States or Europe inevitable. Whether an economy enters recession or not will depend on a range of factors, including the scale and speed of central bank tightening and how the war in Ukraine will affect energy prices.

Here are eight more factors to consider that could help investors to navigate the rising recession risks:

1. Investors will endure many downturns over their lifetimes.

History shows that larger downturns – specifically, bear markets – are uncommon and temporary. Bear markets are on average shorter than their opposite, ‘bull markets’, and have had far less of an effect on long-term portfolio performance, as the chart below shows.

Global stock prices (31 December 1987 to 30 June 2022)

Past performance is no guarantee of future returns.

Source: Vanguard calculations, based on data from Bloomberg using the MSCI All-Country World Index from 31 December 1987 to 30 June 2022. Percentage monthly data on a total-return basis, with dividends reinvested, GBP terms.

2. Recessions can happen in times of high or low inflation.

They also vary in length and depth. The nature of the shocks hitting the economy and the policy response will determine the type of recession. For example, the US recession that occurred in the wake of the global financial crisis (GFC) of 2007-8 lasted 18 months. The US economic collapse triggered by the Covid-19 pandemic, which was sharper, just two months2. Right now, the global economy is faced with a surge in commodity prices as well as rising interest rates – these developments have increased the risk of a recession with high inflation, both in Europe and the US.  

3. Recessions and stock markets don’t move in tandem.

Although the onset of recession has often led to sharp falls in share prices, stock markets have tended to fall well in advance of the actual recession. Markets have tended to recover quickly too – usually before recessions are over. Financial markets are quick to price in events. The economic data takes longer to come through.

4. Financial markets hate uncertainty;

Often resulting in overreactions until more information becomes available.

This is partly why the best and worst trading days often happen close together3. Trying to time the market can be futile.

5. Staying invested over the long term diminishes the chances of a negative return4.

Making hasty decisions in a downturn can result in expensive errors. For example, if an investor were to sell out of their investment in a downturn, they would realise the market loss and fail to benefit from the subsequent market recovery. As we say at Vanguard, it’s best to tune out the day-to-day market noise and stay the course.

6. Recessions can vary by region.

For example, while developed Western economies shrunk in the aftermath of the GFC, China’s economy held up better, helping to partially offset the fallout. Recessions also affect currencies differently. The dollar has historically been regarded as a safe-haven currency to which international investors flee in times of stress, as we have seen in 2022. A strong dollar against other currencies softens the impact of a weak US stock market for investors outside the United States. It also accentuates the losses experienced by US-based investors in non-US markets. Hence, the declines for investors in British pounds or euros have been less severe so far this year, as the chart below shows.

Stock market total returns, H1 2022

Past performance is no guarantee of future returns.

Notes: Stock market indices used as proxies for each region: MSCI All-Country World (global); S&P 500 (US); Euro Stoxx 600 (Euro area) and FTSE All-Share (UK). Year-to-date index returns, with dividends reinvested, as of 30 June 2022. The performance of an index is not the exact representation of any particular investment. As you cannot invest directly into an index, the performance shown in this table does not include the costs of investing in the relevant index. Sources: Bloomberg, Vanguard.

7. Your asset allocation matters.

A portfolio that diversifies across different shares and bonds is less vulnerable to significant swings in volatility. It’s about having the right balance, depending on your goals and the amount of risk you are willing to take. This is because shares, typically, offer higher long-term returns than bonds but carry more short-term risk. The graph below illustrates this – shares have sometimes enjoyed much bigger gains than bonds, but they have also suffered much bigger losses.

The performance of different investments from 2001 – 2021

Past performance is no guarantee of future returns.

Notes: Returns shown in GBP, with gross income/dividends reinvested. Indices used as proxies – Bonds: Bloomberg Global Aggregate Total Return; Shares: FTSE All-World Total Return. The performance of an index is not the exact representation of any particular investment. As you cannot invest directly into an index, the performance shown in this table does not include the costs of investing in the relevant index. Sources: Bloomberg as at 31 December 2021.

Sometimes bonds and shares fall at the same time, as we saw earlier this year. But that doesn’t detract from the diversification benefits of a multi-asset portfolio.

8. Market downturns lead to cheaper share valuations in the short-term, but higher expected returns in the long run.

Higher interest rates do that for bonds. This is reflected in the latest running of our in-house financial model, the Vanguard Capital Markets Model (VCCM)5, which now forecasts significantly improved long-term returns than at the start of the year. In the case of a global 60% shares/40% bonds portfolio, for example, our median annualised return forecast for the next 10 years has risen by 1.5 percentage points in the six months to June. For a global portfolio made up of just shares it’s risen to 5.6%.

 

1 A recession is usually defined as two consecutive quarters of shrinkage in a country’s gross domestic product (GDP) – an economic measure that group’s together everything spent or earned or produced in a given period. Notably different, though, is the way US recessions are determined by the private National Bureau of Economic Research (NBER), which is based on a wider set of economic indicators and calculated on a month-by-month basis.

2 Based on the NBER definition of recession. See footnote 1.

3 To see just how bunched up the best and worst trading days of the FTSE All-Share index can be, for example, see James Norton’s recent ‘4 common investment myths’. It’s a similar story with the S&P 500, where in USD terms with dividends reinvested, we also found that nine of the 20 best trading days in the 1980-2021 period occurred in down years, while eleven of the worst occurred in years that ended with a positive return.   

4 One Vanguard study based on the investment performance of different US markets from 1935 to the end of last year, for example, found that the chances of experiencing a negative return after adjusting for inflation was 11.3% after 10 years with a portfolio of just shares, compared with 31.4% after one year. The corresponding probabilities for a 60% shares/40% bonds portfolio were similar at 9.3% and 29.2%, respectively. Contrast that with cash where (using Treasury bills as a proxy), the chances of a loss after inflation was comfortably over 40% whether over one year, three years, five years or 10 years.

5 IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modelled asset class. Simulations as of 31 May 2022. Results from the model may vary with each use and over time. For more information, please see the ‘Investment risk information’ section below.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Important information

This article is designed for use by, and is directed only at, persons resident in the UK.

The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.  The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.

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