With a recession potentially approaching, adopting a multi-asset trading strategy could be prudent – but not only to offset risk. Asset classes tend to perform differently in different phases along the business cycle, illustrating the upside of tactical asset allocation. Meanwhile, stock markets are statistically down 35-55% during a recession, where short-selling can be an efficient way to capitalise on falling markets.
The state of the economy
The question of whether or not we are moving towards a recession is on the minds of traders and investors around the globe. While no expert can accurately predict future developments, most recession indicators are pointing towards a slowdown.
The inverted yield curve is one of the most reliable recession indicators, having correctly predicted the last nine recessions in the United States with a slowdown generally occurring about 22 months after the emergence of a yield curve inversion.
Two other major recession indicators are the prices of copper and gold. The former is regarded as a good indicator of the economic state given its use in the construction industry, with a high demand for copper usually suggesting a booming economy. However, copper was down 14% from April to August. Gold, regarded as a safe haven investment in times of economic uncertainty on the other hand, has meanwhile soared more than 20% since the US-China trade war heated up in May.
Tactical asset allocation in turning markets
The basis behind tactical asset allocation is the assumption that certain asset classes, sectors or geographies perform better during different stages of the macro-economic cycle. In contracting markets, for example, investors can benefit from rebalancing their portfolios towards securities that tend to outperform in these conditions. Our analysis suggests that the worst performing sectors during a recession include financials, energy, industrials and materials, while the best performing sectors include health care, communications services and information technology.
With recession signals starting to turn orange, investors need to consider tactical asset allocation as a viable tool to expand the relative performance of their portfolios. This applies especially to long-only investors who feel most comfortable with non-derivatives such as stocks, Exchange Traded Funds, bonds and mutual funds as part of their investment mix.
Short-selling in economic slowdowns
Traders and investors who are open to derivatives have another alternative to merely rebalancing their portfolios during changing business cycles. With equity markets statistically down 35-55% in a contracting economic environment, short-selling becomes an interesting strategy not only to hedge a long exposure, but also to earn potential returns in bearish markets.
A vast variety of derivatives can be used to short securities across industries and geographies. The most popular ones, however, are futures, options and Contracts for Difference or CFDs. While futures and options might be more appealing to the experienced trader, CFDs are considered most versatile as they are offered on a wide range of underlying asset classes including stocks, indices, bonds, commodities and currencies.
You need a broker that gives you the complete toolbox
In light of the above strategies, it is important for traders and investors to select a broker that does not limit their opportunities during difficult market conditions. Tactical asset allocation relies on the availability of a wide range of cash products that is not limited to certain geographies or few large cap stocks from selected exchanges. Likewise, short-selling can only be a suitable strategy if the right instruments and scope of underlying securities are made available to the short-seller.