Recession or Rebound? Three Strategies for Three Scenarios

The power of planning

As the old adage goes: failing to plan is planning to fail. Managing a portfolio through the rearview mirror is a recipe for disaster, which means that Advisors can best serve their clients by planning for multiple scenarios in advance. The way that’s accomplished is through diversification.

Depending on a client’s time horizon and risk tolerance, a portfolio can be tilted more or less aggressively. But the scope of diversification—the breadth of assets within the portfolio—should remain fairly similar. To put it in simpler terms: a conservative client and an aggressive client should have the same types of assets in their portfolio more or less, just in a different mix. The mindset is the basis for the traditional 60% equities/40% bonds portfolio. Balanced accounts got a bad rap in 2022, but statistically speaking, that’s unlikely to repeat in 2023 and the strategy remains viable for the long term. To quote my colleague Fred Demers, “the death of the balanced portfolio has been greatly exaggerated.”¹

Three scenarios, three strategies

Setting aside the probability of each scenario—hard landing, soft landing, and perfect landing—we’re left with a key question: how should portfolios be positioned, and what information can Advisors impart to their clients, if and when any of them comes to pass? Let’s take each scenario one by one:

Soft landing

If the U.S. Federal Reserve (Fed) and other central banks successfully thread the needle and we only see a mild recession, equity markets can be expected to react strongly. In fact, markets began the year acting like kids hopped up on sugar to a certain extent—they had gotten what they’ve wanted out of the Fed (i.e., indications of an end to rate increases, evidenced by their smaller 25 bp increase) and reacted optimistically. The concern is that if they’re given any more dovish indications, they might get out of control, which is why the Fed has attempted to temper expectations. In effect, they’re telling the market to not count their chickens before they hatch—that inflation may take a while to be tamed. At any rate, in a soft-landing scenario, we can expect both equities and bonds to rebound to some degree, with equities likely rebounding a bit more forcefully. The lingering question is the duration of central banks’ interest rate pause—the sooner they stop raising rates, the longer the pause is likely to be, and vice versa. As a result, in a soft landing, you probably want to be modestly overweight equities, and stay in fixed income rather than cash given that rates are likely to come down eventually.

Hard landing

A hard landing would be an ‘oops!’ moment for the Fed—a realization that they went too hard and fast with rate increases and did too much damage to the economy as a result. In this case, they’d likely be forced to react by moving to cut rates much sooner, as a longer and deeper recession will quickly bring down inflation but cause too much pain to labour markets and the consumer. A key takeaway here is that investors can’t have it both ways—they can’t have a soft landing and also expect central banks to lower rates quicky, because the Fed’s first goal is to avoid a double-dip recession like we experienced in the 1980s. Inflation is kind of like a campfire: you can’t just splash a bit of water on it and expect it to be out for good; you need to really douse it and make sure that every last ember has stopped burning. In a hard landing, being positioned in fixed income will likely prove profitable, particularly given the higher yields we’ve seen in the last year versus the prior decade. With the acceleration of rate cuts, it may also be wise to be a bit further out on the duration curve and lean toward conservative exposures among equities, with a focus on Quality and Value.

Perfect landing

Unsurprisingly, an end to inflation with little additional loss of jobs and a reasonable terminal interest rate will likely result in a surge in all risk asset markets. Oddly enough, this may not be the preferred outcome, as it could result in inflation rebounding faster than desired by the Fed, leading to a premature return to higher interest rates—to return to the campfire analogy, in this scenario, inflation may not have been completely ‘put out,’ so there’s a risk of it flaring up again. Be sure to watch excessive risk rallies and take profits accordingly, to add to downside hedges along the way. One way we’ve been hedging risk is with the selective use of covered calls, which can also be accomplished with allocations to covered call ETFs.

Signals in the noise

Finding meaning in the sea of data available to investors nowadays can be challenging, especially when to comes to weighing the chances of a recession. Here are a few indicators to keep an eye on—including both obvious and lesser-known bellwethers:

• Interest rates: Central banks’ commentary—especially around whether they intend to pause or continue their rate increases—is a sign of how they see the economic picture unfolding. It’s also important to note that monetary policy is a slow moving, lagging mechanism, so a single month’s economic data is not necessarily a good indication of a turning point.
• Inflation: Looking at the three-month rolling month-over-month inflation rate is one way of gauging the trajectory of inflation—it gives a run rate that one can simplistically use to project the decline of inflation. Diving deeper, looking at core inflation vs. headline inflation is also useful. While headline numbers may be dropping based on volatile energy prices, core inflation remains stickier due to the integration of wage and housing costs into the overall measure.
• Employment: Beyond absolute employment figures, a good historical indicator has been the four-week rolling average of U.S. initial unemployment claims. Historically, they get up to about 300,000-400,000 claims per week before you can conclude the labour market—and the economy—is really in trouble. Recent numbers haven’t been anywhere near that, hovering in the 200,000 range.²
• Housing: There are a few ways to look at the Canadian housing market. From a homeowner standpoint, watching resale prices go down is never fun. But looking at the broader market, newly constructed home prices were still 3.9% higher year-over-year on a national basis.³ What is more concerning is the deterioration of housing affordability, which is a function of sticky prices with higher mortgage rates. In 2017, it took about 45% of the average paycheck to afford a detached bungalow—that was close to 60% by the second quarter of last year, with regional stories being even more extreme. And of course, rent has also skyrocketed in major urban centres.⁴ This, of course, impacts disposable income, reducing spending and potentially contributing to a downturn.
• Consumer credit: Recently, credit card, mortgage, and auto loan defaults have picked up, but not to levels that would signal a hard recession. Those numbers are worth monitoring, with a major uptick potentially indicating a longer and more painful economic downturn.

Where things stand – and where they might be going

BMO GAM’s Multi-Asset Solutions Team (MAST) extensively researches the possibility of a recession, and right now, our base case scenario is for a ‘soft landing’—a relatively short and not particularly painful recession. Personally, I’d peg the probability of that at around 70%. What has shifted materially is the timing of said recession, now being pushed to the back half of 2023, or even to 2024.

There are a lot of indications that this downturn may be different from historical ones, including the fact that high inflation has been driven partially by the supply side rather than purely being the function of an overheated economy. That could mean a less painful recession.

I’d put a 20% probability on a ‘hard landing’—a longer and more painful recession—which could be the result of excessively restrictive policies or an unanticipated downside shock. And finally, under the heading of “never say never,” I’d estimate a 10% chance of a ‘perfect landing’ in which there is no recession at all.

Please contact your BMO Global Asset Management wholesaler for any support and guidance.

¹ Fred Demers, “10 Big Investment Trends for 2023,” BMO GAM’s Monthly House View: Special Edition, January 2023.

² “U.S. Initial Jobless Claims,”, February 16, 2023.

³ StatsCan, New Housing Price Index YoY%, to December 31, 2022, via Bloomberg.

⁴ StatsCan, Teranet-National Bank, CREA.