Fx Horizon Blog Ep 3, Recession investing special

I´ m pretty late with this episode of the weekly Blog, but for a good reason!

It is no secret now that we are on the brink of facing a severe recession in most parts (if not all) of the developed world. The question that pop´ s up is how to invest as a retailer during these times of the cycle.
Many of us did never experience a recession as an active trader / investor so it is good to understand theoretically what is going to happen and how we can use that as our advantage to not fall for big losses.

In this episode, I will highlight what a recession means, which assets are performing well during these times and which ones you should try to avoid.

Consider that this is going to be an investing focused post rather than a trading post – the timeframes are substantially higher and the theories have limited effect in daily trading.

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What the hell is a recession?

It is relatively simple:
A sustained period of economic downturn is a recession.

Usually this is measured by the economic output (GDP) of a country / area. Many economists define a recession by two consecutive quarters of declining GDP.

However, there are other definitions out there too, like falling consumer & business confidence, weakening employment, falling real incomes and declining sales & production all combined.

A recession is also highly affected by the debt cycle which is basically the reason why we even get up´ s and down´ s.

There are three general charts to overlay to get the general market cycles. We often only see one full cycle on illustrated charts, like the first one on this episode and it is usually only showing one, smaller cycle which is called the short term debt cycle.

But let´ s start from the beginning.

We have the green line here, which is relatively steady and is going up. This is the productivity increase of a country, caused by techonological advancement and other factors. Imagine a farmer who suddenly has a new fertilizer, due to basic scientific advancement achieved on a university – he is going to have a better harvest the next year if he uses the new fertilizer, with the same amount of land / capital / workforce used – this is productivity growth and / or higher efficiency.
There are small up´ s and down´ s in this line too due to small peaks and ebbs in advancements, but it is rather steady seen on a wider range of different industries and countries.

The second line we want to focus on is the red one. This is the shortterm debt cycle and is usually lasting 5-7 years from each top to the next top (take this with a grain of salt). It is what we usually see on a 1-cycle chart for explanations. This is the reason why we get the typical boom-and-bust cycle in markets. If things are running good, businesses and privates are taking loans to leverage their investments which is – in the shortterm – increasing output and growth. Pretty much like a farmer buying a new tractor on a loan to increase his harvest. The problem here is that the loan is just money that is due to be repaid. It is just higher output taken from the future. As soon as there is a natural peak in the new investments from the lent money, we see a turn in all sectors and the downturn is starting. revenues stall, repayments are growing on higher rates, sentiment changes to a negative outlook and all of a sudden the whole thing is more or less collapsing. Output is slowing down, so are rates declining. With money beeing repaid in a painful process, we see a bottom again and the whole cycle starts again.

The third thing we have to look at is the blue line. Thats the biggest problem we could face pretty soon ourself. It is the so called longterm debt cycle. Same as the smaller brother, it is caused by the principle of lending money for output growth / investments in whatever sector. Just in this case, the loans are longer term in general and thus the boom and bust is taking a long time – usually ~100y from top to top / bottom to bottom. It is marked by ultra low interest rates in the downturn and ultra high interest rates in the peak.
The last time we had such a bottom? 1920´ s, the great depression. Last time we had such a peak? 1980´ s. Can you see the pattern in time? Currently, the world is running at the lowest interest rates we had in history, 0%. In some countries the central banks even run a negative interest rate, meaning you effectively get money for borrowing money which is completely agains the logical function of the whole system.

Does this mark the beginning of the next big cycle low / start of the next big depression? Probably.

This is a bit older chart from 2016, but it pretty nicely shows the cycle of the longterm debt.

The thing is, never before in history we had such circumstances like these days, with longlasting zero rates and QE in an epic scale, so we cannot say 100% that this is the end of the road, but a lot of factors point to it.

We still have a very strong output growth after the covid crisis, a strong labour market and inflation. The problem is that rates are as low as they can be and there are still a lot of bottlenecks around which damps supply. All of this is driving inflation up. Central banks are now forced to go up with rates rather quickly to battle inflation, but the economy is going to suffer from higher rates as commodity prices are through the roof already and demand is about to get crushed on all sides. This is going to lead to a lot of bankruptcies, forcing workforce layoffs, which in turn is decreasing average income, forcing consumers to cut spending, turning down business revenue, forcing more layoffs and so on. Its going to be a spiral from here on, creating the classic recession.
Government´ s debt (thats the budget they always talk about) is on record highs and just ever growing. That is money practically borrowed from central banks and at some point it should be repaid.. But how do you repay money when everything is going even worse as before? You cannot.. We really could be at the brink of the big bust here, so keep and eye on the rest of the Blog.

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As you can imagine, all of this leads to a lot of unloading in riskier assets and flows into  safe haven assets. To identify this assets and put them into the specific categories is key to help investing during these high volatile times.

It is not all bad though. A recession may mark the low of a cycle, but it is also the best time to invest with a lot of discounted prices in the market you cannot find at any other times.

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Timing the recession

This is really the hardest part of it all. The good thing is that we don´ t have to be selling at the very top and buying at the very bottom. Getting a rough feeling and overview of what is happening and what could be a catalyst to change it all is the most important thing.

So, what could be such a catalyst for the start of the big downturn / recession?

We already see a lot of factors pointing towards it and are feeling quite some selling in the market too. All of this is still a bit foggy due to the covid rebounce, QE still running and especially right now with the RUS-UKR issue.

Too high interest rates dampening the demand too far getting us started with the “death spiral” is likely the key factor getting us into it. Where is that threshold? One can only guess.. Generally saying, as long as output is steadily growing, labour market is tight and wages are growing too, along with slowly decreasing inflation, we should not get a problem. I think a 1,0-1,5% interest rate (speaking of the US here now) is likely not a problem for the economy. In Europe, the whole situation is a lot worse though. Get to 1,0% and we eventually see a lot of problems arising already. The reason for this are the relatively unstable economies of certain countries, like Italy, Spain, France and Greece just to name a few.
Rememeber 2008 and Greece? Yeh, just like that.

Central banks will acknowledge that higher rates WILL cause problems, but they cannot stay at zero due to inflation, so they will go up slowly, and then stop pretty early in my opinion at a certain level, like 1,25% and see what is happening there.
The problem here is that the inflation problem is only getting worse then if the central banks are not hiking aggressively enough. This is called beeing “behind the curve”. The central bank is simply not hiking/cutting fast enough to what the current market cycle situation is calling it for.

They are already behind the curve, a lot.
They will fall further behind the curve.

This is not good of course and just worsening the problem, but it is probably delaying the recession by a few months – depending on their reaction (cutting rates, introducing QE again anyone?) probably even delaying by years, again.

So a key thing to look out for is still output growth, inflation numbers, wage increase and the employment levels as well as consumer / business confidence:

Low interest rates –> delaying recession (but also increasing inflation)
Too high interest rates –> key factor for recession (but decreasing inflation)

QE –> delaying recession (but also increasing inflation)
QT –> get us there faster (but decreasing inflation)

Output growing constantly –> delaying recession
Output decreasing –> key factor for a recession

Inflation cooling off due to supply fixing –> delaying recession
Inflation cooling off due to demand going down –> key factor for a recession
Inflation steady on supply issues –> BIG key factor for recession
Inlfation steady on high demand –> delaying inflation

Wages increase rapidly –> delaying inflation (but also key for higher inflation)
Wages decrease –> BIG key factor for recession

Steady / falling unemployment –> delaying recession
Rising unemployment –> key factor for recession

Steady / rising confidence –> delaying recession
Falling confidence –> key factor for recession

Watch out for any of these key indicators to turn around in the next couple months to get and overview of where we stand at the moment and where we are heading to.

As soon as the only thing we hear about is firms going bankrupt, loans and whole countries defaulting, its likely close to the end of the downturn.

“The darkest hour is just before the dawn” – T. Fuller

As soon as the outlook of all economic projections is as low as possible, it is likely the best time to invest big time again.

Key indicators too look at, are again the ones above, just in reverse.
Falling unemployment, rising wages, rising confidence, rising output and also rising inflation (again) along rising rates (if we ever get that again..).

 

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Stocks

In the beginning it is important to understand what exactly the situation for the consumer in a recession is to understand which stocks are performing the best and which one the worst.

As we said above, there are a lot of layoffs in a recession, unemployment is higher, spending is going down as income is decreasing. 

The first thing you cut your spending on, is luxury goods such as yachts, wine, watches, jewelry, high quality clothes, personal services, art, and everything holiday. The stuff you do not necessarily need – you name it.

The last thing you cut your spending on, is everyday goods, such as groceries, consumer staples, alcohol, cosmetics and funeral services. It is really all you need for basic life in our society. Also consider defense stocks as basic needs.

This, basically, is all you need to know to be able to invest into stocks during a recession..

Into the recession, we want to be invested in the so called counter-cyclical stocks in recession proofed industries. Those industries are the ones we do not cut spending on if money is tight. These industries usually perform very well during those times.

A good example for this could be Wallmart as a big and long lasting grocery player in the US. People NEED food, cosmetics and other goods for their every day life, they cannot cut spending on this.

On the other hand, we don´ t want to be invested in the cyclical stocks in high-growth or speculative and / or luxury industries.

A good example for this could be Royal Caribbean Cruises as a big cruise ship service company. People DO NOT NEED a luxury holiday on a cruise ship, they are going to cut on this.

We also want and need to consider the financial strength of a company. Looking a the balance sheet tells you more about the current situation of the company.
We WANT to see high cash reserves, low debt and high cashflows. Same, but reversed is true for companies we want to avoid.
We DON´ T WANT to see low cash reserves, high debt and low cashflow.
The so called dept-to-equity ratio can give a good overview of this, which is basically the leverage a company is running at.

The higher the leverage, the higher the risk of a financial default in bad times.

Out of the recession, so at the bottom, we want to switch again from the counter-cyclical stocks into the high growth, speculative, cyclical stocks.
I´ am likely going to write another Blog post about that anyway, when it is time.

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Commodities

Usually, with cut spending, demand is going down. This also means the need for supply is going down, which also means that the price for commodities is going down too.

Currently though, we are probably running into the beginning of a commodity super cycle as supply for certain commodities is limited and demand is steady of even growing on new techonological advancement and / or a change in thinking / lifestyle.

Take climate change.
We need a change. And it is eventually (slowly) coming.
The “green energy” production is in need of certain materials that are sometimes really scarce, like copper, silicon, lithium, cobalt, rare earths and silver.

Other commodities, like wheat and corn are also really hard to get down, even in a downturn. As spending on high price foods like steak, chocolate and others is likely to go down, the need for basic foods is likely going to increase rather than fall.

Another aspect of commodities is the physical property which is sort of a safe haven property.
As money flows from risk assets into safe havens, that includes all physical and trust “proofed” objects, such as gold.

Oil and gas – energy generally speaking – are going to be a pricy commodity too, as demand is only going down marginally, but supply is going to cripple (even more) on financial problems at the providers (not the suppliers itself)

200$ on oil someone?

In the meanwhile, commodities used for construction could take a hit, like iron, steel, lumber and others. Keep an eye on big infrastructure spending plans from governments to curb up the economy though – that could change things again.

So in short: into the recession – buy gold, wheat and other essential commodities, such as copper, silver and energy. Sell / or stay out of construction materials / jewelry.

Out of the recession – buy construction materials / jewelry and sell gold, but also keep an eye on energy and the green energy materials to buy.

Overall I don´ t think we see big declines in a lot of commodities during this recession.

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Forex

For me, one of the most clear trades, probably.

The flows are pretty clear into a recession:

Get out of risky assets, get into safe havens.

In fx it is pretty clear what risk assets are and what not.

The most likely flow is going to be into the JPY as the ultimate safe haven.
Second is going to be flows into the Franc, but also the USD as the world reserve currency is going to get nice inflows.

Those three are my take to bet on the risk trade.

Include the current and likely outlook on interest rates and the USD should be the easy winner of them all, with the FED going to hike at least 4x 25bps in 2022 alone, whereas the BoJ is not going to do a lot, same as the SNB.

The riskier currencies are a bit harder to find though, for different reasons.

Usually, the AUD, NZD and CAD are going to suffer the most on the risk aversion trade, along the GBP in the major 8, BUT we also have to include the commodity prices, which are going to support that exact currencies, excluding the GBP.

Another thing to watch, is the uneven severity of the recession that is going to come.
In other words, some regions of the world are (likely) going to fall deeper and faster, whereas other are going to (probably) hold a bit better.

Regions listed by the severity of the recession, from worst at the top to best at the bottom

• Eurozone
• Japan
• Asia
• US / Oceania
• Canada

I dont include Africa and South America here as there will be a lot of other economic dynamics effecting their economy.
Also, take this with big caution, it is my own take and is not even close to a 99% forecast and also relying on the current forecast of mine, which can also change every minute with any decision made by a single politician, central bank or others.

With the assumption above, we can take our winners and losers in the Fx space.

Clear winner: USD, then JPY and CHF
Clear loser(s): EUR, then Asian exotics, like SGD, HKD, TWD, THB,…

Out of the recession, we want to get invested into the riskier stuff again, so selling the safe havens and going for the risky stuff.

Which economic region is going out on top of the recession, is hard to tell, but that is likely the currency you should buy at that point.

In the end, we will have plenty of time to decide until it is time though and a trade then only takes a few seconds to be placed.

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I hope you enjoyed this special Blog post and it is helping you with your investment decisions in this rough times ahead!

Dont forget to join our community for daily market struggles and help wherever and whenever it is needed 😉

See ya´ all next time!
Dom