Do you know the difference between the economy and a human pyramid?
Nothing much except that one has a physical appearance while the other exists intangibly. Both structures have one thing in common few entities at the base holding the entire structure together. For an economy, banks and regulating agencies form the base. And, if one of these at the bottom sneezes, the entire system shakes.
Recently we have seen two banks calling it quits in the USA one after the other, and, we see a flashback of 2008. Does that mean we are heading for a recession?
Recent Changes in the Indian Economy
Everything in an economy is dependent on everything else. For example, businesses need access to cheap credit to invest money in growth projects. New projects generate new employment, and new employees receive salaries.
Now, more money enters the market leading to inflation. Inflation causes RBI to raise interest rates. High-interest rate is good for investors, and they start to save more and spend less.
But borrowing becomes expensive for businesses, and new projects are postponed or scaled down. New salaries do not put as much money in the market, and inflation comes down. But so will economic growth.
However, a recession is something out of the ordinary.
What’s a Recession?
The slowdown above was a controlled reaction, whereas recession is the same trend but is an uncontrolled reaction of the market forces.
A recession is not a great time for the economy. Economic activities slow down, people lose jobs, inflation is high, businesses have a hard time borrowing money, and stock markets keep declining. That is what a recession looks like.
Is it Possible to Predict a Recession?
Over the years, many have claimed to identify the leading indicators of recession. However, there’s always an element of uncertainty to all predictions, as in, they hold at the moment, but scenarios can change quickly.
The following few factors together can point to an impending recession:
- Inflation Rate
- Interest Rate
- Crude Oil Prices
- GDP Growth
However, these are not the only factors to have an impact on the economy. Also, different economies can have a variety of other factors for judging recession or economic situation. For a country dependent on crude oil imports like India, crude oil rates play an important role in economic activity.
Historically, after a long streak of high economic growth, high inflation, interest rates, and crude oil prices, have led to an economic slowdown.
For instance, in 2008, all three conditions aligned one after the other. The market had just made a new peak, with BSE Sensex looming over 20,000 points. That was after continuous GDP growth of almost 8% p.a. for the last three years.
In the same year, the inflation rate went up to 10% p.a., while global crude oil prices touched a new peak at $ 177 per barrel. High inflation led to high-interest rates. Repo rates ranged between 8 to 9% in the year.
The economy also received pushback from Western economic trends, where markets had crashed altogether, registering an economic slump. The result was the BSE Sensex ending below 10,000 by the year’s end.
What About the Current Indian Economic Scenario?
The present economic scenario in India resembles the times in 2008 only to some extent. For a better understanding here’s a step-by-step progression:
Signs Supporting Recession Movement:
- We have had two good growth years
- Inflation has been rising
- RBI has to increase the repo rate to contain the inflation
- Global markets have also been slowing down, with reports of an impending recession
Signs Not Supporting Recession Movement:
- Crude oil prices are far below the peaks of 2008. Even 2011 was worse for crude oil rates.
- Repo rate changes have been quite effective in breaking the pace of the economy and reigning in inflation
- Despite global cues, Indian businesses have been posting good results
So, to sum it up, we can happily fail to arrive at a doomsday prediction for the markets. The recent downward trend is simply a result of the control measures, and the economy remains on track to a better tomorrow.
How to Invest in a Recession?
You can build a portfolio to counter the impact of a recession. However, first, you should understand the effect of a recession on investments:
- Stock markets slump, stock prices fall, and you will have capital losses, at least in the short term
- Riskier corporate bonds may default on coupon payments:
- Some firms may declare bankruptcy
- Others may borrow more to remain operational, increasing leverage
- Sovereign bonds will become costlier due to higher demand
- Precious metals like gold may rise to new heights
- Real estate prices may fall, causing capital losses and loss of rental value
These possible trends should enlighten you to allocate your investments to multiple assets, including gold, equity shares, bonds and even real estate if possible.
These trends may also entice you to sit on a cash reserve and wait for such a time. However, investing during a recession is fraught with risk. You will find it difficult to identify the right assets if you try to time your investments.
The best strategy is to build a diversified portfolio with ample allocation to fixed-income assets (bonds and FDs).