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Talk of a possible recession, both here in Australia and globally, refuses to go away.
The 2023–24 financial year continues to be dominated by talk of high interest rates dampening economic growth to the brink of, if not into, recession.
Global central banks have complex mandates and simple tools to achieve them. Our own Reserve Bank of Australia (RBA) aims to contribute to the stability of the currency, full employment and the economic prosperity and welfare of the Australian people. To achieve this, the main tool at its disposal is the interest rate lever.
The RBA decided decades ago that economic prosperity can best be achieved within an inflation range of 2–3%. Yet Australia remains significantly above this inflation target despite aggressive rate hikes. The RBA has lifted the cash rate 12 times in the current rate cycle – from a low of 0.1% to 4.1% at the time of writing – in an effort to bring us back to its target inflation range.
Higher interest rates apply the brakes to the economy to reduce demand, slow the growth in wages and prices of goods and services and lower inflation. That’s the theory.
Despite evidence inflation is falling, RBA press releases are still full of language warning that even higher rates may be necessary. It’s little wonder talk of recession continues to make headlines.
Recessions and the market indicators to keep an eye on
A recession is defined by two consecutive quarters of negative economic growth.
Lower industrial output, falling consumer confidence, increasing unemployment and household consumption are the key indicators to keep an eye on.
It should be remembered that Australia’s exports minus imports also make a significant contribution to economic growth rates.
Prices for commodities, our largest exports by far, are still quite high by historical standards. This is due in part to war in Ukraine and supply shortages.
If global demand eases and commodity prices fall, this may contribute to a technical recession. On the other hand, if they move the other way…
It’s worth remembering we didn’t have a technical recession in the GFC because of China’s insatiable demand for our mineral resources and high commodity prices. But with China’s economic growth faltering, Australia cannot count on a China-led recovery.
Which assets and sectors could be vulnerable to a downturn?
Downturns bring with them the spectre of lower profits and investment valuations. In the brutal recessions of the past, before central banks were actively trying to tame inflation, very few businesses were spared from falling valuations.
Any sectors that depend on consumer spending, such as retail, are most at risk. While financial stocks like banks that rely on consumers paying their mortgage and other debts can be at risk as well.
Defensive stocks that generate consistent income whatever the economic conditions tend to perform better during recessionary periods. However, please be aware they too can still suffer from falling valuations.
Defensive stocks provide essential products or services that consumers can’t do without in sectors such as utilities, healthcare and consumer staples.
Considerations for SMSF trustees
Headlines proclaiming recession can certainly set off the ‘fight or flight’ response in investors. While it may be tempting to react to market volatility by selling off assets, remember that investing in an SMSF is a long-term endeavour.
History has shown that markets recover from recessions. We would also note that recessions generally tend to be brief. Selling during a downturn could lead to substantial losses that may be difficult to recover.
Rather than selling off shares when prices are low, ensure that a portion of your SMSF assets can be easily liquidated, such as cash and bank term deposits with staggered expiry dates. Liquidity provides flexibility during uncertain times. It also allows you to take advantage of investment opportunities when markets are down or cover immediate financial needs without selling long-term investments at a loss.
That said, if your portfolio is overweight in assets or sectors vulnerable to recession, it could be a good time to rebalance.
All SMSFs can benefit from the following factors, and not just during recessions:
- Professional assistance
- Long term planning, and
- Regular review
Seek the guidance of financial advisers, tax professionals and SMSF specialists. They can help you with the other three factors to ensure you are on track and hold an asset mix in keeping with your objectives. Using professionals to stay informed remains an essential component of managing your SMSF successfully and making sure you remain compliant with regulatory obligations.
One of the cardinal rules of recession-proofing your SMSF and enhancing long-term returns is diversification. By spreading your investments across different asset classes, industries and geographical regions you reduce the risk of your portfolio taking a significant hit when one sector faces a downturn. Diversification can be achieved by including shares, bonds, real assets such as property, and cash.
Failing to plan is akin to planning to fail. Expenditure, income, savings, investments and protection are the five areas that are critical to shaping your long-term financial success. Once you have plans for these five areas set down, then it’s important to stick to them!
You must also regularly review and rebalance your SMSF portfolio. Your risk tolerance can change over time due to various factors like age, financial goals and personal circumstances.
It’s essential to periodically reassess your risk tolerance and adjust your SMSF investments accordingly. Asset allocation that was appropriate during a bull market may become unbalanced during a recession.
Rebalancing involves selling overperforming assets and buying undervalued ones to bring your portfolio back in line with your target allocation.
During a recession, you may want to adopt a more conservative investment strategy to protect your capital. This needs to be balanced against achieving your long-term goals. It’s important to highlight that the best performance for growth assets tends to happen just after recessionary periods, so investors who sell in a downturn risk missing out on the market rebound.
Recession-proofing your SMSF requires a combination of prudent financial strategies, diversified investments and proactive management.
By using the guidelines above, you can enhance the resilience of your SMSF and ensure that it remains a reliable vehicle for achieving your retirement and wealth-building goals, even in the face of economic downturns.