- JP Morgan strategist John Normand says clients are growing increasingly nervous about where markets are headed.
- He used historical data to determine which assets perform best in an economic downturn.
- He also highlighted specific trades that have paid off when the economy falls from the late-cycle stage into a recession.
Calls of a pending downturn are growing increasingly common as the global asset expansion enters its 10th year since the financial crisis.
So far this year there’s been some small hints that we’re getting into the late-cycle phase of the market.
For example, cracks have begun to appear in emerging market asset classes as the US central bank continues to withdraw liquidity.
According to JP Morgan’s cross-asset strategist John Normand, the events of 2018 “seem like a teaser for how a business cycle downturn in late 2019 or 2020 would impact markets”.
“Almost every client meeting includes questions about where the economy and markets sit within the cycle, and what this positioning implies for asset allocation over the next 6 to 12 months,” he said.
In view of that, Normand has produced some detailed research into late-cycle investing to determine which assets perform best in a recession.
And as this chart below shows, if you think the pieces are in place for a market downturn, it’s probably time to get defensive:
It’s a detailed chart, but focus on the orange and red lines — they show how various assets perform when markets move into the late-cycle and then recession phase.
And historical data shows all the usual safe bets perform well, with cash, bonds and precious metals (gold) all holding their value.
“On average over the business cycle, such defensive trades lose more often than they gain because economies spend more time expanding than contracting (the average expansion has lasted about five years, and the average recession about one year),” Normand said.
“But regardless of the decade, the proportion of defensive trades that is profitable rises to between 60% and 80% during recessions.”
The next question is one of timing. When should you adjust your portfolio?
Probably soon, if you agree with billionaire hedge fund manager Ray Dalio that 2019 is shaping up as a dangerous year for the economy.
“The highest and most consistent returns tend to be generated with holding periods of either two years before and one year after the event, or one year before and after, highlighting some benefit to positioning early,” Normand said.
But if a recession does hit, it’s best to get back on the hunt for bargains. Normand said the average recession lasts for one year, so parking your assets in cash for two years after the recessionary event substantially limits returns.
On a more specific level for sophisticated investors, Dormand also highlighted the long/short trades that perform best when the market is getting late in the cycle.
And if you’re looking for guaranteed late-cycle returns, he said shorting high-yield US corporate debt against US treasuries has been the only strategy with a 100% success rate.
For now though, markets aren’t pricing in a sharp downturn.
“The sense of anxiety is more palpable in client discussions and in the news flow than it is in investor positioning,” Normand said.
But as the US Fed continues on its path of tightening monetary policy and withdrawing USD liquidity, it may pay to consider how to adjust your portfolio in the face of a pending downturn.