The Federal Reserve’s decision to hold interest rates was met with applause by investors, who warned that rates of 5%, with hikes at the fastest pace for four decades, have created “the risk of a real economic accident”. 
The US central bank made clear that this is a ‘pause’ or ‘skip’ in hikes and that, given persistent inflationary pressures, further increases are on the horizon. However, there have been calls for the Fed to call time on its hiking programme, or even consider rate cuts, to stave off a recession.
These warnings are unlikely to change the bank’s strategy. As the BlackRock Investment Institute has spent the past year or so trying to convince investors, the Federal Reserve is now in the business of manufacturing recessions in order to crush inflation rather than preventing them.
At the start of the month, BlackRock put out a note foreshadowing the Fed’s break from hikes: “We see the Fed nearing a pause in rate hikes and living with some inflation to avoid the deep recession needed to get inflation near its target.
“But we don’t see the Fed coming to the rescue of a faltering economy with rate cuts later this year due to the sharp trade-off between inflation and growth. Markets are coming around to our long-held view after having until recently priced in repeated rate cuts in 2023.”
To put it another way, the Fed’s officials are not sat around a table trying to work out how high rates can go without causing a recession. Instead, they are figuring out the minimal effective dose of slowdown that can purge persistent inflation; if they can avoid recession, great – but it’s not the priority.
With this in mind, it’s probably better to spend more time thinking about how to prepare portfolios for a recession – hopefully a shallow one – than rate cuts.
Of course, the most sensible option might be to do nothing. If you’re already running a diversified and balanced portfolio, then ignoring the short-term noise – and recessions do tend to be over relatively quickly – and continuing to drip-feed money in is usually the best strategy.
But those who feel their portfolio isn’t in tip-top condition to start with (for example, being overly invested in yesterday’s winners) can look to history for some kind of playbook.
Unsurprisingly, stocks tend to perform worst in a recession. Sectors such as technology, media and financials have often been the hardest hit, while consumer staples, healthcare and utilities – which sell the goods and services that people need to buy regardless of how the economy is doing – have held up best.
Dividend-paying stocks are another classic play in a recession, especially those companies that have been able to maintain a stable or growing dividend in all economic circumstances (the so-called dividend aristocrats). Analysis of research behaviour by Trustnet readers suggests they have been paying more attention to equity income strategies this year.
Bonds are another place to hide. Research by Fidelity found bonds have delivered higher returns than stocks and cash in every recession since 1950. It also said investors wanting to move from stocks to bonds should do this before recession strikes, in the period when central banks are lifting interest rates.
The type of bond also matters – investment-grade and government bonds have made better returns in recessions than their high-yield counterparts. However, the greater risk of high-yield bonds means they often outperform once the recession comes to an end.
Finally, a short-term allocation to cash can often help to insulate portfolios from volatility in risk assets, may earn a decent yield if interest rates are high enough and will provide the dry powder to invest when the situation improves.
That’s the theory anyway. Bearing in mind that the market and the economy are two different things, doing nothing drastic seems like the best course of action to me. At the start of the year I bought Janus Henderson Strategic Bond to add some recession protection. That move might have been a little early, but I’ll be keeping this fund in my diversified portfolio for some time to come.