4 Ways to Hedge Against the Next Recession

The 2008 financial crisis was caused by a glut of subprime lending, which filtered through defaulting structured products, causing crippling losses for banks. The increase in lending standards and capital adequacy requirements for banks introduced by the Dodd-Frank Act in 2010 has led to a financial crisis and the recession with similar credit catalysts was not likely to happen again.

But while the United States has rebounded strongly from the height of the 2008 financial crisis, a recession in global markets could still be cause for concern.

Key points to remember

  • The Great Recession in the United States triggered a global financial crisis and market crash.
  • Historically speaking, we are due for another recession, but there are ways to protect yourself against this event.
  • Diversification into global markets, safe havens or short positions can help soften the blow of the next recession.

The economic table

Looking at global market GDP levels, emerging market weightings have increased significantly since the era of the financial crisis. China, one of the largest emerging countries, has significantly increased its gross domestic product (GDP) relative to world markets. From 2005 to 2019, China’s GDP, as a percentage of global GDP, grew from 5% to 16%. As a result, US investment in the country has also increased.

A macro event from China triggering large-scale losses in areas invested by the United States could lead to another recession. A recession triggered specifically by China could also have a broadly negative impact on domestic and international real estate, as well as the US stock market. While a recession could be negative for the current economy, it does not specifically mean that a crash could occur. Thus, investors should be cautious and prepared for potential changes in market direction, with liquid assets available for hedging and downside protection.

Liquidation of the domestic market

US investors continue to watch the Chinese economy closely. In 2019, China announced an expected GDP growth of 6.1%. However, GDP growth should be a catalyst to watch closely as it has a high potential for triggering a recession in the United States, especially since GDP growth in the United States has not been particularly robust in the during the last quarters.

The most recent reading of US GDP, as of 2019, shows GDP growing at a seasonally adjusted annualized rate of 2.16%. Other measures of China’s market stability, such as currency valuation and oversupply of real estate, are also recession risk concerns that need to be considered.

The global COVID-19 pandemic

Events can occur at times that simply cannot be predicted, but have a significant impact on governments, individuals and businesses. For example, the global COVID-19 pandemic put tremendous pressure on a global scale, which no one could foresee. As of January 28, 2021, there were over 100.2 million confirmed cases worldwide and approximately 2.16 million deaths.

But that’s not all. The pandemic has also had a huge impact on the economy. Virtually every sector of the economy has been affected, including hospitality, transport, healthcare and manufacturing. Unemployment rates have soared as businesses have been forced to close or curtail operations. Governments enacted stimulus plans and arrangements to keep owners in their homes.

In June 2020, the World Bank estimated that the virus would plunge the global economy into the deepest recession since World War II. The group expected a 7% drop in economic activity in developed countries for 2020, while emerging market economies are expected to see a 2.5% drop.

But the outlook for 2021 remained uncertain. This is because the World Bank noted that growth results would not be uniform throughout the year. The global economy is expected to grow by 4.3% while US GDP growth is expected to increase by 3.5% in 2021.

Hedging for a US market recession

When detecting and hedging a US market recession triggered by a macroeconomic event in emerging markets, investors should closely monitor the key catalysts mentioned above, including GDP, currency valuations and markets. real estate, all of which strongly influence the valuations of emerging market equities. markets.

If negative reports come from the Emerging Marketsand particularly China, which has the highest emerging market GDP, such events could lead to market losses and necessitate a shift of assets to safe havens and hedging strategies.

A potential recession scenario triggered by emerging markets and likely to result in losses can be hedged in the safest and easiest way by moving high-risk assets into safe havens. Safe havens include treasury bills and inflation-protected treasury securities, US government bonds, and corporate bonds of high credit quality US corporations.

A second strategy to protect and potentially benefit from losses incurred by a macroeconomic event in emerging markets is a pair swap that involves buying domestically oriented ETFs, such as the SPDR S&P Mid-Cap 400 ETF (MDY), and country-specific emerging market ETFs, such as the Deutsche X-trackers Harvest CSI 300 China ETF (ASHR).

Other potential strategies include taking a one-sided short position against a specific country or emerging market index. An example of this is the short sale of the iShares Currency Hedged MSCI Emerging Markets ETF (RESIDENCE) to protect against currency risk. Another option could be to short only the index through put options on the iShares MSCI Emerging Markets ETF (EEM).

The essential

Market recessions vary for different reasons and have been caused by many catalysts. The next market downturn is unlikely to be caused by subprime lending. However, developments in the global economy, partly as a result of the 2008 financial crisis, could lead to various factors of recession.

Therefore, investors should be cautiously aware of global markets, and in particular the growing production of emerging markets. Negative catalysts in these countries could lead to another recession and market downturnof which investors should be cautiously aware and prepared, with strategies to mitigate losses.

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