It's often brightest before the downturn

I’ve been warning against the risk of a recession for over a year. And I admit it: so far I’ve been wrong. The economy’s shown surprising resilience, thanks to a few factors I underestimated: households built up huge saving buffers during Covid, companies secured long-term financing at very cheap rates, a generative AI boom sparked new investment optimism, financial conditions that mostly withstood rising interest rates, and governments pumped more money into the real economy through stimulus programs. And many of these elements continue to keep the US economy looking healthy – which is indeed reassuring. Yet here I find myself again cautioning against underestimating the possibility of a more severe economic downturn.

Now, sure, I may be experiencing confirmation bias – a tough trap to avoid, even when you're conscious of it. Still, certain facts and data points raise concern. A significant one is that, like now, investors were expecting a gentle economic slowdown just before the crises of 2000 and 2008.

That’s because the biggest downturns tend to happen slowly and gradually at first, and then all of a sudden. In the “slowly and gradually” phase, economic indicators send mixed signals – they’re imperfect, and have lags, after all. That seeming resilience can lull investors into a false sense of security. For example, despite early signs of distress in 1999 and 2007, the economy seemed to be resilient, which led experts to expect a soft landing and led stocks to continue doing well. But after a while – and this period can be lengthy: in 2008, it took two full years for the recession to begin after the initial yield-curve-inversion warning – the downturn arrived and caught everyone off guard.

There are several reasons for this. For starters, pinpointing the root cause of weaknesses and vulnerabilities can be challenging. When interest rates rise aggressively, issues can pop up unexpectedly – just like we’ve seen during last year’s mini-banking crisis and the UK’s mini-bond crisis. Then feedback loops – and reflexivity – can make things go from bad to worse extremely quickly.

Now, I’m not saying a difficult recession is inevitable (in fact, I’m more optimistic now about our chances of avoiding one). And I’m not suggesting that investors wait for a completely risk-free market environment (that will never happen). However, when weighing probabilities and considering current market expectations, I’d say you shouldn’t underestimate the risk of a harsh recession.

For long-term, conservative, buy-and-hold investors, this may not be a major concern – as long as you can stay the course during tough times. Time in the market tends to outperform timing the market, after all. But investors who are invested heavily in riskier assets could face major losses if a sharp downturn prompts them to exit their positions at the worst moments.

So even if you’re bullish on the economy and are happy with the risks associated with going all-in on more speculative stocks, I’d just recommend three things: make sure your portfolio can survive a bad scenario, make sure that you have a game plan in case that scenario materializes, and make sure you have ways to force yourself to actually implement it. Let’s hope it won’t come to that, but it’s always better to be safe than sorry.

-

Capital at risk. Our analyst insights are for information purposes only.