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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved

Saturday, June 01, 2019

3 Recession Strategies

By Century Financial in Off The Wall

3 Recession Strategies

The roller coaster of an economic cycle takes us through many phases like peak, trough, expansion, and recession. And the one word which instills a lot of fear and panic amongst all economies and businesses is “Recession”.

During a recession phase, the economic activity of any country goes through a decline leading to the trough. A key measure of economic activity is the GDP and hence a declining GDP number is a clear indication of a recessionary phase. The technical definition of a recession is two consecutive quarters of negative economic growth as measured by a country’s gross domestic product (GDP). We try to highlight below a few leading indicators as well as strategies that perform well during any recessionary phase.

Early indicators of recession:

  1. Yield Curve inversion

A leading indicator of past recessions has been an inversion in the 10 year and 2 year US treasury bond yield curves, wherein the yield of 10 year T-bills goes lower than the 2 year yields. The yield curve is the difference between the yields on longer-term and shorter-term Treasuries. A yield curve inversion happens when long-term yields fall below short-term yields. An inverted yield curve is an indicator of recession in the next 12-18 months.

Investors would be expecting the short-term interest rates to fall in the next 1-2 years as the Federal Reserve would react to an economic slowdown, due to these expectations investors prefer buying the long term bonds and sell the short term bonds causing the yields to invert.

  1. Gold Crude Ratio

An early indicator of global recessionary pressures is the ratio of Gold price to the price of Crude oil. Gold is considered as a safe haven asset where demand increases in times of uncertainty and recession vis a vis crude oil that is the lifeline of all industrial activity, slow down in which translates into lower demand for the Crude oil. We make use of the historical gold/oil ratio prices & related statistics to find out where the ratio is currently vis-a-vis the growth/recession cycle. Historically, the mean for the ratio is 16.70.

It is also worth considering that whenever the ratio has spiked up, we have seen major risk-off events /precursor to crisis e.g. ratio high of 30 during 1992 European ERM Crisis, ratio high of 24 during 2008 Lehman Fiasco/Advent of Recession.

Recession Proof investment Ideas:

  1. Put options

Yields inversion has shown in the past that the recession hits after the bond yield inversion happens and currently similar kind of situation is coming so we are starting to think about how to leverage this in our favor. And the best way to go will be to buy the put options which are out of the money.

A put option gives the buyer of that option the right to sell an instrument at a pre-determined price known as the option strike price. Buyers of put options are making bearish bets against the underlying instrument. The price you would pay for that put option will be determined, among other things, by the length of time you want the option to last. The longer the time, the more you pay.

The main reason currently for us to go bearish on the market is because of

  • Inversion in bond yields
  • Slow growth in Europe and China
  • China-US trade war
  • Lower Earnings guidance from the US companies for the current year

One of the ideal strategies for a bearish market will be buying put options at the start of every month which is 4 to 5 % out of the money from the current market price. Historically in 2008 recession, SPX had given Approx. 17% downside movement in a month so for example, if we are  buying Put option of SPX 500 cash at start of every month for next 12 months by paying a fixed premium every month when market crashes in as the start of recession, if one month market gives Around 17% fall which happened in 2008 at time of recession that will be enough to cover up the cost of 12 month put options and will give profit.

  1. Agricultural Commodities

During the recession, most of the asset classes suffer due to less investor confidence in the overall global economy. While other asset classes suffer one clear outperformer has been the agriculture commodities. Food is one of the necessities for living and the demand is relatively less elastic to recessionary market conditions, which means the demand for Agricultural commodities like grains doesn’t reduce due to factors like a recession. As the consumption of food does not reduce to recession as it is one of the essentials for living.

Hence most of these Agricultural commodities are said to be recession proof. When compared to the historical recession periods, not only have these commodities avoided depreciation but have given good gains during recessionary periods. The below table highlights the performance of a few commodities during past recessions.

  1. Safe-haven Currencies

Safe-haven currencies are currencies where investors prefer investing during times of uncertainty and recessionary pressures.

Japan has always been a large exporter and has continually exported significantly more goods and services than it imports. The result has been decades of current account surpluses that have positioned Japan as a net creditor to the world. Due to the above reason and negative interest rates, Japanese Yen has been the go to currency during periods of recession.

This is a distinction also shared by the Swiss franc, often considered another haven currency.

In addition to blazing the trail in terms of debt-to-GDP ratios, Japan has also been a leader in terms of low-interest rates. Attempting to stave off deflation and spur economic growth, Japan has held interest rates at rock-bottom levels for nearly 20 years.

In what’s known as a carry trade, investors will borrow money in a low-interest rate environment and then invest that money in higher yielding assets from other countries. Japan’s long-standing policy of near-zero interest rates has caused it to become a major source of capital for these types of trades