Trader Notes: Recession Playbook

Trader Notes : Recession playbook

The economy typically goes through a few business cycles namely Expansion, Peak, Recession, Depression, Trough and Recovery. This article aims to show how investors and traders can position during the recessionary phase of the cycle.

What Happens During A Recession?
The National Bureau of Economic Research (NBER) definition of a recession is a significant decline in economic activity across the economy lasting more than a few months that will affect employment and real incomes. Aggregate demand will fall as consumers tighten their belts, especially in discretionary spending. Industrial commodities will underperform as companies cut back on spending and investment anticipating lower demand ahead. Typically, the central bank will begin easing monetary conditions to help cushion the impact of the economic downturn by lowering interest rates. Investment managers tend to turn defensive during such times and allocate more to sectors like utilities and consumer staples which tend to outperform growth sectors during a recessionary environment. The tech sector tend to be tricky this time as it will experience the effects of decreased spending but would also see better valuation with lower interest rates. With the market expecting rates to fall, we could possibly see NDX outperforming the SPX in the period leading up to a recession.

What Can We Do During A Recession?
Investors
For long-term investors, a recession provides the opportunity to accumulate equities at a cheaper valuation. From an allocation perspective, it might be a good opportunity to diversify into other markets like Europe and Japan that are cheaper and further away from the credit contraction the US is experiencing. To hedge against a recession, investors can look to:

• Increase allocation to Treasury bond ETFs like TLT:xnas or IEF:xnas expecting rates to fall and safe havens to do well. Reduce allocation to equities.
• Buy Gold ETFs like GLD:arcx or Gold Spot (XAUUSD)
• Selling equity covered calls on existing holdings to generate yield
• Selling equity puts as a way to accumulate equities for the long-term and generating yield in the process.
• Selling an Index CFD like US500 or a small cap future like Russell 2000 (RTYM3). Small caps tend to underperform in a recession.
• Increase allocation to Utilities ETFs like iShares S&P Global Utilities Fund (JXI:arcx) or The Utilities Select Sector SPDR Fund (XLU:arcx)
• Increase allocation to consumer staples ETFs like VDC:arcx and KXI:arcx

Traders
For traders who wish to take advantage of a possible slowdown in economic activity / recession, you can look to:

• Selling an Index CFD like US500 or a small cap future like Russell 2000 (RTYM3). Small caps tend to underperform in a recession.
• Long Interest rate futures like 2 year treasury futures ( ZTM3), 10 year treasury futures ( ZNM3) or Selling short the micro 2-year yield contract (2YYK3) / micro 10-year yield contract (10YK3)
• Reduce/go short high growth consumer discretionary ETFs (XLY:arcx, IYC:arcx, VCR:arcx,) via CFD.
• Go short Copper futures (HGN3) / Copper CFD (COPPERUSJUL23) and Crude oil futures (CLM3) / Crude oil CFDs (OILUSJUN23)
• Go long Gold spot (XAUUSD) or Gold futures (GCM3)
• Typically in a recession, carry trades get unwound and currencies like JPY and CHF tend to strengthen. Traders can look to sell USDCHF, EURCHF, GBPCHF or USDJPY, EURJPY, GBPJPY crosses. Commodity currencies (AUD,NZD and CAD) also tend to underperform - AUDJPY, NZDJPY, CADJPY are attractive pairs to consider on top of the direct play against USD.

In most cases, the recession typically begins before we see major news agencies reporting that a recession is here. Markets move in anticipation of economic activity slowing down and hence the moment we see trends in inflation falling, credit activity declining and labour market slowing, sensitive markets like bond futures will tend to move higher in a flight to safety and in expectation of lower rates while commodities tend to underperform. The price action in these markets would usually offer some insight to where the economy might be heading before slower growth numbers are officially reported and hence it can be useful to watch these markets.