Schwab’s 3 Ways to Prepare for a Likely Recession

On Wednesday Microsoft announced plans to lay off 10,000 workers. This is the latest in a series of large layoffs over the past several months that have made headlines, mostly concentrated in the technology and information sector of the economy.

It adds to the growing concerns among many financial analysts that 2023 will bring a recession. That certainly wouldn’t come out of nowhere. For more than a year, the Federal Reserve has been trying to cool inflation by reducing demand in the economy at large, generally through a series of very aggressive hikes to its core interest rate. And this has worked to a significant degree. Inflation has slowed, with the month-over-month rate falling to just 1.2% by December.

Headed into the new year, nobody entirely knows what to expect. Traditional wisdom suggests that a recession is imminent, and the market has begun pricing for that. At time of writing 10-year Treasury bonds had a yield almost 1.3 points below 12-month assets, a phenomenon known as the “inverted yield curve” which typically precedes a recession. Yet the labor market remains strong, the quit rate is high, and the consumer confidence index grew noticeably in December, suggesting that Americans’ personal finances are in good shape.

As Schwab wrote recently, the data is unclear but enough of the signals are worrying. Despite the good news, there are enough danger signs ahead that investors would be wise to start planning for volatility at the least, an outright recession at the worst.

The question is how to do so. What, exactly, should investors do to prepare for a recession? In the face of the current market, Schwab recommends taking three steps.

For more guidance on how to navigate this uncertain period, consider matching with a vetted financial advisor for free.

Equities: Invest For Fundamentals

Investors who buy stocks need to be particularly careful. The stock market tends to take heavy losses during a downturn, which would be a double helping of trouble after a very difficult year in 2022.

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In the event of a recession, profits and revenue for many companies will shrink. That will hurt capital returns and yields alike, making stocks a difficult asset class for investors. To cope with this, Schwab recommends, “investors who actively choose stocks should look for companies that have maintained – and still expect – strong profit margins.”

As a rule of thumb, this means picking companies with strong revenue and proven histories rather than experimental companies or those which expect to grow into profitability over time. In particular, many information technology companies such as app-based services have long operated without turning a profit. Their pitch, essentially, is that they’re continuing to invest and grow, and will eventually turn that growth into strong profits over time.

This may be a good speculative strategy during periods of growth, but it may not be a wise investment during a potential bear market.

Bonds: Invest For Duration and Credit

Two issues may become important for bond investors in a recession.

First, if the economy slows, some companies may have trouble paying their bills. While bonds are generally a safe asset class overall, the creditworthiness of the borrower still matters. For that reason, Schwab recommends that investors should look for higher-credit bonds as a way of hedging against the risk that comes with a slowing economy.

Second, again if a recession occurs and inflation continues to cool off, the Federal Reserve is likely to halt its policy of rate hikes. It may even reduce interest rates again. “[W]e continue to favor adding duration in bond portfolios at times when yields rise,” writes Schwab’s team. By adding duration you can increase the price sensitivity of your bond investments, putting you in a good position to capitalize on the stronger returns that tend to accompany falling interest rates.

This is particularly true during a period of lower inflation, since locking in long-term yields can also produce a good long-term income investment.

Growth: Consider Emerging Market Stocks

One area where Schwab is generally bullish is in emerging markets.

This sector fell considerably over 2022, and was particularly effected by global events such as ongoing COVID-19 disruptions and the war in Ukraine. However with China beginning to emerge from its lockdowns and worldwide supply chains normalizing, global stocks are looking like a better bet than they were before. As Schwab noted, while the S&P 500 “was little changed” in the last few months of 2022, emerging market stocks rose 20% over that same period.

For that reason, Schwab recommends that investors seeking growth should look at emerging market stocks for 2023. This is a sector that it believes will likely perform well, even in the face of a potential recession.

You can read the full market analysis at Schwab’s site here, along with why its experts feel that the economy’s warning signs currently outweigh its strengths.

Bottom Line

With a potential recession on the horizon, investors are beginning to focus on defensive portfolio strategy. In their latest market analysis, Schwab has three recommendations for how you can begin to reallocate assets in case those warnings prove true. It’s also worth considering matching with a vetted financial advisor for free.

Tips For Investing Amid a Recession

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