Recession stocks: How to invest during a recession

Close-up of stock market board
Josh Warner
By :  ,  Market Analyst

What is a recession?

An economy is in a recession when it is shrinking as industrial output and international trade slump, businesses pull back on investment, consumers tighten their purse-strings and people lose their jobs. It is widely-accepted that an economy is in a recession once Gross Domestic Product (GDP) – which is a broad measurement of the size and health of an economy - has declined for two consecutive quarters, although other indicators are also taken into account.

The major economies around the world are actively growing the majority of the time but recessions are regarded as a natural part of the business cycle.

Read more: Economic indicators to watch as a potential recession looms

 

How long do recessions last?

Recessions vary in length and severity, and particularly bad ones are known as depressions. The Great Depression is often cited to have lasted a decade between 1929 to 1939, but was technically comprised of two separate recessions that, combined, lasted for over four years and resulted in painful hangovers.

Notably, recessions have not been as harsh nor lasted as long since the end of World War Two, with the average recession having lasted around 11 months. For further perspective, the 2008 financial crisis led to a recession that lasted around 18 months, while the recession that hit when the Covid-19 pandemic erupted in early 2020 only lasted a couple of quarters before the global economy started to bounce back.

Read more: A history of stock market crashes

 

Will there be a recession in 2022 or 2023?

The world was hoping to finally overcome the significant economic challenges posed by the pandemic when it entered 2022 but has only been met with a raft of new problems that threaten the recovery and raise the likelihood that we could be heading into a recession this year or next.

Inflation is the central problem right now. Having risen to its highest level in decades, we are yet to have reached peak inflation and this will continue to push up costs for businesses and prices for consumers. Virtually everything has rocketed in price in 2022 whether its fuel, food, fashion or furniture, and wages continue to grow at a slower pace and force people to stretch their money further.

Read more: What is inflation and how does it impact financial markets?

Global supply chain problems have also added to inflation as this also raises the cost of doing business and lifts the chance that this will have to be passed on to consumers. China’s determination to enforce its zero-tolerance approach toward Covid-19 has contributed to the widely reported supply chain challenges, while Russia’s invasion of Ukraine has also been a factor and sent the price of commodities such as oil and grain higher.

Read more: What should you trade when inflation is rising?

The tough environment has prompted countries around the world to scale back their growth forecasts, and that has prompted fears that inflation will turn to what is known as stagflation, which is when an economy suffers from soaring prices and low growth, and this is often accompanied by high unemployment.

Read more: What is stagflation?

Central banks are therefore having to aggressively hike interest rates in an effort to curtail inflation back toward desired levels. Interest rates are the primary weapon wielded when they want to accelerate or put the brakes on the economy. Typically, the inverse relationship between the two means low interest rates leads to higher inflation and high rates leads to lower inflation. The idea of raising interest rates to increase the cost of borrowing and make it more worthwhile for people to save money, which results in less spending to weaken demand and alleviate the pressure on supply to bring prices back down. However, with inflation running well ahead of central bank targets, this could remain such a big problem that they could have limited firepower to respond to any other economic shocks that it leads to going forward.

Read more: Stocks that perform well when interest rates rise

Overall, the weaker and highly uncertain economic outlook has knocked sentiment and confidence and the threat of a recession has increased markedly since the start of the year. This has, in part, been reflected by the heavy selloff that has hit stock markets this year. The current consensus among economists and institutions appears to be that we could be heading for a recession sometime in 2023, although there are some that think one could hit in 2022 and others that believe it could wait until 2024 to erupt.

 

How to invest during a recession

Recessions can pose both challenges and opportunities for investors and traders. The single biggest change experienced by the markets when there are fears of a recession is a change in appetite toward risk.

When the economy is powering ahead, markets have a greater appetite for risk and there is a greater pursuit for stocks that are underpinned by rapid growth and the focus is on future potential rather than what is being delivered today.

Read more: What cyclical stocks could suffer in a recession?

The opposite is true when a recession hits and markets shun high-growth stocks and turn to value as they seek safer and more reliable options. They turn to those that have the most inelastic demand, the most stable margins and cashflow, little debt, plenty of cash and the ability to continue to make profit, while avoiding loss-making companies or those saddled with large amounts of debt. Dividend-paying stocks also become more attractive in a downturn, but tread carefully and pick those with sensible payout ratios to ensure the stock can maintain dividends when things get tough.

Diversification is also more important when a recession is on the horizon. In fact, the reason diversification is such a widely recommended tactic is to help minimise the damage from any sudden shocks or downturns. This means having a broad range of assets (think gold and cash) and stocks within your portfolio to ensure you are not overly exposed to one area. While a recession often spreads to almost every area of the economy, investors can try to shield themselves, at least partially, by including safe haven assets like gold and rebalancing their stock portfolios to include more defensive stocks that are in a better position to deliver during a downturn.

Read more: What are defensive stocks?

Longer-term investors focused on future decades rather than the coming weeks, months and years can feel the urge to jump into action as their portfolio takes a hit during a recession, but should remain confident so long as the long-term fundamentals are strong and the stock can survive the turmoil. In fact, recessions can offer some rare opportunities for investors looking to snap-up quality stocks at low prices in the hope of booking long-term gains.

With this in mind, it is also worth highlighting the importance of drip-feeding any money being ploughed into the markets during a recession. By buying shares at regular intervals, one can benefit from a lower average price by continually benefiting from lower share prices without having to second-guess where the bottom is. The same tactic could be used when selling. As we have seen, stock markets have already suffered a huge selloff before there was even talk of a recession this year, showing how hard it is to guess where the top and bottoms are.

 

Recession stocks to watch

The majority of stocks will suffer during a recession and, although there aren’t any that are guaranteed to rise during a downturn, there are some sensible bets that are more likely to outperform the wider market.

Read more: How to trade during a recession

Below is a selection of sectors and stocks that could perform better than the wider market during a recession.

 

Consumer staple stocks

One of the consequences of a recession is that many consumers will tighten their purse-strings and cutback on spending as they grapple with the tough economic environment. Non-essential items and discretionary spending are often the first types of expenditure to see a pullback. However, they still need to buy consumer staples such as food, everyday household goods and hygiene products, so demand tends to hold up better compared to other areas of the economy.

Stocks to consider: Major food producers such as Kraft Heinz, Tyson Foods, Kelloggs, and JM Smucker, as well as major agricultural firms that focus on the raw materials to make food like Bunge and Archer-Daniels Midland. There are also producers of personal care and household products like Unilever and Reckitt Benckiser in the UK or Colgate-Palmolive and Procter & Gamble in the US. All of these stocks either suffered a smaller decline than other areas of the stock market during the 2008 financial crash, and most of them bottomed-out months before the wider market did.

 

Supermarket stocks

Many of these consumer staples will continue to be purchased in supermarkets during a recession, placing them in a better position to maintain sales during a recession compared to other stores. The scale and buying power of the largest firms will prove crucial amid rampant inflation and the need to keep prices low for consumers, and those with large portfolios of own-brand products stand to benefit the most as cost-conscious shoppers turn to cheaper alternatives.

Stocks to consider: Tesco is a standout performer in the UK as the only member of the so-called Big Four to have successfully defended itself from German discounters Aldi and Lidl in recent years, and some of its rivals can only dream of boasting its scale and buying power. The biggest players in the US to consider are the likes of Kroger, Albertsons, Costco and Walmart.

 

Discount retail stocks

Discount retailers tend to shine during a recession, and the inflationary environment driving the cost-of-living crisis will only further encourage shoppers to visit cheaper outlets in the search for savings. Although people may buy less during a downturn, they still need to buy staple items and are more likely to treat themselves to a cheaper discretionary item at a discount store.

Stocks to consider: Notably, Dollar Tree was the best performer in the S&P 500 during the 2008 financial crisis and gained significant ground that year while the wider market collapsed. Other US discount chains include Dollar General, Big Lots and Five Below. With this in mind, some also believe larger retailers like Walmart and Target can benefit as they can wield their scale over the discount-end of the market. Over the pond, there is the likes of B&M European Retail Value.

 

Alcohol and tobacco stocks

Alcohol and tobacco have some of the most inelastic demand around. The addictive nature of nicotine means smokers are still likely to buy cigarettes or tobacco during a recession, even if it means shifting to cheaper alternatives, and alcohol sales barely nudged down during the 2008 financial crash.

Stocks to consider: The biggest tobacco companies include British American Tobacco, Imperial Brands, Altria and Philip Morris, while the leaders in the alcohol space are the likes of Constellation Brands, Diageo, Brown Forman, Ambev, Molson Coors, AB InBev and Pernod Ricard.

 

Healthcare stocks

Healthcare is a resilient sector during a recession. Whether its producing drugs, developing medical devices or providing medical care, companies in the healthcare sector are providing vital life-saving medicines, equipment and services that are still needed even if the economy is in bad shape. It is worth noting that those with established portfolios and businesses tend to outperform smaller startups that are still burning through money researching potential new drugs during a recession, so it is better to opt for more established players with cashflow over loss-making firms.

Stocks to consider: Some of the largest pharmaceutical players are AstraZeneca, GlakoSmithKline, Novartis, Sanofi, Pfizer and Eli Lilly. There are also companies like Smith & Nephew or Medtronic that supply medical devices to consider, as well as those providing critical services like insurance such as UnitedHealth, Anthem and Centene.

 

Utility stocks

Utility stocks are renowned for being one of the most stable of markets to invest in, but this often means they don’t look that attractive when the economy is growing and better returns are on offer elsewhere. But stability is what is needed during a recession and utility stocks, providing vital power and water in highly regulated markets, can offer this. However, with energy being one of the biggest components driving rampant inflation, investors should tread carefully about which stocks they pick and consider where they operate and how a rise in bad debts or a reduction in consumption could impact the business.

Stocks to consider: NextEra Energy, Duke Energy and Dominion Energy are among the largest energy utility companies in the US. In the UK, investors may prefer to consider the operator of the core infrastructure, National Grid, over energy suppliers like Centrica. Water companies like Pennon Group in the UK or American Water Works in the US may look a safer option given the volatile nature of energy markets this year.

 

Defence stocks

Defence stocks largely operate under long-term contracts with governments, which are less likely to alter their long-term spending on defending their country because of a temporary recession. In 2022, the likelihood that defence stocks will outperform is even greater considering the war in Ukraine has put the world on heightened alert and increased demand for weapons and defence systems. It is worth noting that some defence stocks are also big players in the aerospace and aviation markets, which cater more to commercial markets like airlines which can be more exposed to any downturn. This may cause some distortion in terms of how individual stocks perform this year and next.

Stocks to consider: Lockheed Martin and Northrop Grumman were both standout performers back in 2008, while Raytheon is also one to watch after hitting fresh highs back in February. BAE Systems has already stood out in the UK this year after soaring to new all-time highs, while Meggitt has also outperformed the likes of Babcock International and Rolls Royce.

 

How to trade recession stocks

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