Many people believe that a recession is imminent due to factors such as rising interest rates, high inflation, and a banking crisis in certain regions. The Federal Reserve has raised the federal funds rate consistently recently, with another hike in May, bringing it to the highest level seen since 2007. In 2022, a surge in demand and a strained global supply chain, along with Russia’s invasion of Ukraine, contributed to U.S. inflation reaching its highest level in four decades.
Furthermore, the S&P 500 is still far below its peak on January 3, 2022, which contributes to the belief that an economic downturn is probable.
If a recession occurs, these are the investments you should avoid considering.
What investments should you avoid during a recession?
Predicting and navigating recessions can be difficult. Some investments that are typically considered safe may actually be riskier depending on the economic conditions.
High-yield bonds
During a recession, it may seem like a good idea to sell all your stocks and invest in bonds. However, it’s important to note that high-yield bonds can be especially risky.
Investing in high-yield bonds with credit ratings below investment grade is riskier than government debt securities. These bonds belong to companies that are often smaller, have higher debts, and have lower overall quality. During market downturns, they are more likely to run into trouble.
Stocks of highly-leveraged companies
It is best to steer clear of companies with high levels of debt on their balance sheets when entering a recession. Such companies are more susceptible to a decline in stock prices during a recession. Suppose a company is met with reduced demand and a general economic slowdown. In that case, it may have difficulty repaying its debts, causing a rapid drop in stock prices and potentially leading to bankruptcy.
If a company is currently struggling to overcome business challenges, it may not be a wise investment choice for a cautious investor, even if it has the potential to rebound in the future when the economy improves.
Consumer discretionary companies
During prosperous times, consumer discretionary stocks are in high demand. However, the products and services offered by these companies are not essential to everyday living, like healthcare or utilities. Examples of such businesses are Tesla, cruise lines, and airlines.
During an economic downturn, people tend to spend less, which can negatively impact certain industries, such as consumer discretionary companies. These companies are more affected by changes in consumer sentiment and economic cycles, and their performance can worsen in times of financial uncertainty.
Other speculative assets
High-risk, high-reward investments, like penny stocks or stocks of companies with minimal earnings, fall under the category of speculative assets. Penny stocks refer to small companies traded at low prices and are not usually listed on major exchanges. These companies often do not provide financial information, making penny stocks a risky investment with little transparency for investors.
In the past few years, several companies have relied on low-cost debt to fund their operations with the expectation of increasing revenue and dealing with profits later. However, due to the economic slowdown, attaining revenue growth is challenging, and investors are seeking immediate earning returns, especially with the rise in interest rates. Consequently, these companies may suffer from a decrease in business activity and a dip in their stock values due to high-interest rates.
Cryptocurrencies, such as Bitcoin, are often seen as speculative since they lack intrinsic value and do not generate dividends or earnings for their owners. Additionally, during a recession, they may experience significant losses due to their volatile price swings.
What investments should investors hold on to?
Don’t withdraw all your investments during a recession. Instead, consider buying long-term investments that have reduced in value but hold potential for growth when the market recovers. It’s important to distinguish between which investments to keep and which to sell.
According to Sid Vaidya, the U.S. chief investment strategist at TD Wealth, investors should prioritize preserving their capital in the short term and seeking long-term investment opportunities by choosing higher-quality investments. In the current environment, it is crucial to carefully select how they expose themselves to the market and avoid speculative areas.
According to Vaidya, it is important to focus on companies with strong balance sheets and investments in secure fixed-income options such as Treasuries, mortgage-backed securities, and credit instruments such as investment-grade bonds.
High-quality securities such as Treasuries and mortgage-backed securities provide stable income and stability over time.
Bottom line
In a recession, it’s essential to remain invested rather than sell off your positions for cash. However, the quality of your investments is vital. To minimize risk, steer clear of highly indebted businesses, high-yield bonds, and speculative investments. Instead, opt for high-quality government securities, investment-grade bonds, and companies with secure balance sheets.