Should Long Term Investors Worry About Recession and Inflation?

Investors and traders in the stock market are bullish these days.

The belief that the worst is over is dominant. Almost everyone in the market thinks stocks will now go up and a new bull market will begin.

Yet the naysayers are not ready to give up so easily. The bears in the market claim the underlying reasons behind the market not going up, until recently, have not gone away.

These reasons are well known and still very much around. A recession in the US, sticky inflation, debt crises in emerging markets, and geopolitical tensions. You can't say any of these are not a threat to the market or that they are not a concern anymore.

Now it's not that the bulls are not aware of these risks. Of course they are. The people running big global funds, with billions of dollars at their disposal, are not ignorant.

Yet, the sentiment in financial markets around the world is clearly bullish. Even retail investors can sense it. They are back investing in the broader market of midcaps and smallcaps.

The BSE midcap index went from 23,500 to 28,500 in less than three months. The smallcap index, in the same period, went from around 26,000 to 32,500. These gains are significant. But the gains in individual stocks are much higher.

So what does this mean? Should investors ignore the concerns about recession and inflation?

No, they shouldn't. That would be unwise. But at the same time, they also shouldn't lose sleep over these concerns.

Let's address these concerns and find the best way to tackle them. Here we will discuss concerns of recession and inflation from the point of view of long term investors.

Recession

It makes sense to take the threat of a global recession seriously. After all, foreign investors sell Indian stocks as well as stocks in all other emerging markets for this very reason.

In fact, the fear of a global recession can take on a life of its own. Fearful investors might sell their stocks in anticipation, well before the actual recession hits.

Economists are of the opinion that a recession could occur in 2023. This is more likely if the US Fed's interest rate hikes stifle demand too much from individuals and businesses.

At Equitymaster, we believe you should not get too influenced by these predictions. If a global recession hits, we will see a stock market crash. But that's not really a bad thing.

The crash will bring down prices of the best stocks to reasonable levels. In other words, a global recession will be a great time to buy stocks.

Make a watchlist of fundamentally strong stocks. Keep track of their stock prices. You can consider buying them in the global recession when everyone else is selling.

Or you could consider recession proof stocks. These are listed companies whose chare prices are not badly affected during a recession.

In a recession the economy contracts. GDP growth is negative. Businesses lose revenue and thus profits. Many businesses shut down. A significant percentage of the working population either lose their jobs, have to take a pay cut, or see their salaries stagnate.

But in this scenario some companies remain relatively unaffected.

In a recession, the fundamentally strongest companies in every sector will emerge stronger. Once the dust settles, many of their weaker competitors will be either out of business or may be willing to be acquired.

Thus, it's a good practice to look for the industry leaders in every sector. These stocks will be the most resilient during a recession. They may fall along with the rest of the market but they are also the most likely to rise again strongly when the market turns back up.

These are the most likely candidates to become multibagger stocks in India.

So don't worry too much about a recession in the US or the rest of the developed world. Recessions come and go.

The benefits of long term investing are permanent.

Inflation

Investing in a period of high inflation is more confusing than in a recession.

In a recession, you can rest assured that the bad times will end and the good times will return. So if you buy fundamentally strong stocks during a recession, when the stock market is down, you will do well in the long term after the market recovers.

But inflation is a different beast. It can happen at any time. It can last for any length of time. It can be severe or mild. It's intensity can even vary with time.

This can be confusing to long term investors. And that's understandable. Even the great Warren Buffet, the best long term investor in the world, struggled to handle the high inflation of the 1970s. In fact he considered it an investor's main enemy.

Buffett emphasised the need for investors to achieve a 15% annualised return in the long term largely because he knew that inflation will silently eat away a huge chunk of the value of an investment portfolio over an investor's life.

After all, the whole point of long term investing is to build a big corpus for a comfortable retirement.

If you don't achieve a good inflation adjusted return in the long term, then forget about getting rich, even your retirement corpus may prove to be insufficient.

But there are ways to protect your hard-earned wealth from inflation's negative effects.

Not all investments are negatively impacted by inflation. All you need to do is find the right strategies to mitigate the effects of inflation on your investments.

So how can you inflation proof your portfolio?

Well, you can consider non-equity investments like REITs, InvITs, precious metals (either physical or ETF), commodities (if you're willing to get into futures trading), floating rate bonds, etc. They all have their pros and cons.

However, you also have equity investments that can help you beat inflation.

You see, the impact of inflation on earnings will vary by sector and the ability of companies to pass on higher input costs to consumers.

Choosing the right companies to invest in is the key in times of high inflation. In general, businesses that gain from inflation are those that enjoy pricing power.

It would make sense to invest in companies that are able to raise the prices of their products along with the rate of inflation (like FMCG & energy stocks). This can help them potentially maintain their profits, which can benefit investors.

Interest rates are generally increased to beat high inflation. In such times it makes sense to buy and hold value stocks which have strong current cash flows instead of growth stocks which have little or no immediate cash flow.

These value stocks are usually of mature, well-established companies with strong current free cash flows.

Growth stocks don't offer immediate returns or dividends, but they demonstrate the potential to outperform the market in the future. The promise of future returns becomes less attractive when inflation reduces the value of those returns.

In times of high inflation, dividend paying stocks could also underperform. This is because they pay regular and stable dividends which may not keep up with high inflation in the short term. But they should do fine in the long term.

Hence, it's prudent to consider how inflation fits into the larger economic picture.

As inflation fears ease, investors may reallocate funds to growth stocks. These stocks tend to outperform in a strong economy.

Thus if inflation does not persist for long, in which case it could severely harm consumption patterns, then growth stocks will do well when the market realises that inflation is on the way down. This is why tech stocks in the US have begun to rally.

Conclusion

Long term investors should not worry about recession or inflation too much.

As long as you're aware of what you need to do in these scenarios, you can stay calm and remain invested in the market.

During good times, investors tend to have at least some junk stocks in their portfolios. This is because these stocks tend to go up like a rocket in bull markets.

But as soon as the market becomes fearful of a recession, long term investors would do well to dump all these stocks and shift their funds to the fundamentally strongest stocks.

Also keep some cash on hand in this scenario. You can make clever decisions with this cash. You can deploy it when the market has bottomed out and has begun to recover.

As far as inflation is concerned, you can shift to value stocks when the market begins to fear high inflation. You can then shift to growth stocks once this fear abates.

We hope this article put your fears of recession and inflation to rest and provides you with a template for thinking about these concerns.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...