As we begin 2023, the question of where the economy is headed continues to dominate the financial news: Will economies be pushed into recession?
Regardless of the differing views – whether a “soft” or “hard” landing is imminent – there is little doubt that we are facing slower economic times. Since the start of last year, the central banks have aggressively raised interest rates, with the intention of slowing economies to try to reel in persistently high inflation.
Recessions occur when there is a prolonged decline in economic output after a period of growth, often characterized by decreasing gross domestic product (GDP), rising unemployment, slowing industrial production and declining wholesale-retail sales. Recessions can occur for various reasons, commonly due to imbalances that build up in the economy and sometimes as a result of rising interest rates, inflation or commodities prices. Events leading to declines in corporate profitability may also be a trigger, as corporations reduce spending and investing, cut wages and lay off workers. When unemployment rises, this leads to lower consumer spending and puts further downward pressure on economic growth.
It’s no wonder, then, that talk of a potential recession has created particular gloom in the financial markets. However, let’s not forget that recessions are a normal part of the business cycle and they won’t last forever. Over the past 50 years, Canada has been in official recession for only around 10% of all months.1
Of course, recessions can put substantial pressure on individuals. For investors, portfolios can experience temporary periods of volatility due to downward pressure on earnings and growth during slower economic times. For individuals who are working, there may be a greater risk of job loss as labour markets weaken. Recessions can force those approaching retirement to retire earlier than planned due to job loss. And, for retirees, there may be concerns about tapping into retirement accounts when investment values are temporarily under pressure. Adding to these challenges, we are all facing rising costs of living due to persistently high inflation.
While we will never be able to control the timing of a potential recession, what we can control is how we prepare for tougher financial times. Are there actions that can help to strengthen our finances and create greater resilience in the event of a recession? Here are some personal finance ideas – not just for difficult economic times, but regardless of the prevailing economic circumstances:
1. Maintain an Emergency Fund – An emergency fund helps protect individuals in the event of an unforeseen financial situation. It typically consists of the equivalent of three to six months of living expenses set aside for unexpected life events such as job loss, illness or damage to your home. While the obvious benefit is to help buffer against any financial hardship, it can also help to avoid holding debt and provide peace of mind knowing that a contingency exists in the event that life throws an unexpected curve ball. For high-net-worth individuals, a common notion has been that having significant assets negates the need for an emergency fund. Yet, don’t overlook one of the benefits of maintaining an emergency fund: preventing the need to liquidate investments on short notice.
2. Take Stock of Your Cash Flows – Having good visibility over your funds’ inflows and outflows can help better plan your finances. Creating a personal cash flow statement can be a valuable exercise, regardless of your stage of life or income level. In a basic sense, this is a snapshot of your sources of income, as well as what you’re spending and saving. Many of us have good visibility over our income, but we may not have as clear a picture of where our funds are going. Do you know how much you spent in 2022? Or, how much was spent on each type of expenditure, even at a high level such as “essential” and “non-essential” items? When our clients undertake this exercise, many discover their expenses aren’t exactly what they thought. Once you determine how much you are spending, you can then incorporate different rules for managing your money. As an example, if you have funds available after all expenditures are covered, some investors consider setting goals like the “50/30/20 Rule,” which focuses on budgeting 50% of inflows for needs, 30% for wants and 20% for savings and investing.
3. Prioritize Your Spending – Knowing where your funds are going can help to balance spending priorities. The prospect of a recession often prompts many to consider increasing savings, and cutting back on non-essential spending may be the first step. Debt-relief experts suggest that there are common ways to reduce expenditures, such as focusing on unnecessary insurance, unused memberships or subscriptions and “unconscious spending.”2 For instance, many of us pay for excess insurance, such as travel or rental car insurance. We may hold credit cards that provide trip cancellation and lost luggage coverage, or have existing car insurance policies with coverage that extends to rentals. There may be an opportunity to revisit insurance coverage (such as life, home and automobile) to negotiate better rates through bundling (home and auto), raising a deductible or dropping certain non-essential add-ons. Or, you may be paying for subscriptions that you do not use, especially if you signed up for a free trial that you have since forgotten to cancel. In our increasingly cashless world, there may be areas to reduce unconscious spending: thoughtless purchases made out of convenience, such as one-click online purchases. Even daily expenses such as expensive coffees, convenience food store snacks or food delivery may appear small in the moment, but can quickly add up over time.
4. Pay Down Debt – Over the past decade, we have become accustomed to historically low interest rates which may have made it easy and affordable to assume debt. However, this can complicate a financial situation if income declines during recessionary times. With rising rates, the cost of debt has substantially increased. If you hold debt, it may be beneficial to focus on paying it down. Consider prioritizing debt subject to the highest interest rates first, such as credit card debt, to reduce the interest paid and allow the principal to be paid down. If you hold a mortgage that will soon be renewing, consider shopping around for competitive alternatives to get the best rate possible.
5. Review Your Goals – One way to help keep on track is to review your financial plan and revisit it when changes may occur. A financial plan acts as a personalized roadmap that helps our clients reach their financial goals. It considers an investor’s needs and priorities and provides a longer-term strategy to achieve those objectives. A comprehensive plan can consist of many elements – in addition to investing – such as tax strategies, insurance planning, risk management and contingency planning, retirement planning, business succession planning and estate planning.
6. Think Longer-Term About Your Portfolio – While recessionary times can affect equity markets as corporate revenues and earnings often decline, trying to time the markets can be difficult, if not impossible. Consider also that economic and earnings recessions can vary in magnitude. Not all sectors respond the same during more challenging economic times. And, even during recessionary periods, many companies remain profitable.
Worth repeating: building wealth takes time. We may have become accustomed to the rapid gains of many asset classes over recent years; however, this seemingly uninterrupted climb was largely driven by artificially low interest rates and the stimulus actions of policymakers. While we all embrace extended periods of market appreciation, we should also remember that markets go through cycles; in order to progress to another up-cycle, the markets need to reset. As we return to normal, this is when thoughtful analysis, prudent investment selection and careful portfolio construction, with a view for the longer-term, continue to benefit investors.
As advisors, we remain focused on maintaining portfolios that are resilient and balanced, making adjustments where necessary. However, it’s important not to act too hastily; the problem with chasing the short-term narrative is that things may often turn out differently than many predict. We review portfolio allocations on an ongoing basis and rebalance them, when needed. Over time, individual securities can change in relative attractiveness and value. This can change the asset mix of your portfolio – the optimal mix depends on each individual’s circumstances and goals. Sometimes the rise of one particular security can distort a portfolio’s balance, and it may be necessary to make adjustments to ensure that a portfolio is adequately diversified, spreading investments across asset classes and sectors so that your exposure – and risk – to any particular one is limited.
We remain selective about the types of securities we invest in, with each component of your portfolio intended to achieve a specific purpose, such as providing dividend yield or income or achieving a specific capital gain or yield to maturity. During more difficult times, we continue to be critical of investments, both public and private, that have high levels of debt. This is because of the risk of default if companies cannot service their debt due to lower revenues and earnings.
Moreover, we remember that equity markets are forward-looking mechanisms: they can often begin their upward climb well before the economy’s recovery is evident. It isn’t uncommon to see some of the strongest returns occurring in the late stages of an economic cycle. This is why staying invested remains important.
It may be difficult not to focus on the current narrative, but try and look beyond today. Inflation will eventually be reined in, though it has taken more patience than many have expected. Recoveries have always followed slower economic growth and recessions – economies will continue to move forward, just as they have turned from previous setbacks. Many underlying factors continue to support future growth – a growing population especially driven by immigration here at home, the incredible pace of technological innovation, including future developments in artificial intelligence and machine learning, the investment in infrastructure and innovation to support greener economies, to name just a handful. Continue looking forward.
If you need assistance with these personal finance ideas, or have questions about any other investing matters, we would be pleased to help.
1. https://www.cdhowe.org/sites/default/files/attachments/research_papers/mixed/Commentary_366_0.pdf; Recessions are typically defined as two successive quarters of declining Gross Domestic Product. However, in August 2021, CD Howe declared that the recession that was prompted by the COVID-19 pandemic was only two months in length. In Canada, the CD Howe Institute’s Business Cycle Council is the main “arbiter of business cycle dates.”; https://www.cdhowe.org/council-reports/cd-howe-institute-business-cycle-council-declares-end-covid-19-recession