Asset owners should prepare now for the next recession

The Great Recession of 2007-2009 and the bear market that attended it caused great damage to most parts of the U.S. and world economy, and to pension funds, defined contribution plans, endowments and foundations.

While a number of economic commentators warned that a housing bubble was growing, none foresaw the damage the bursting of that bubble would do to the financial markets and the economy. As a result, few investors took action to protect their portfolios against the possibility of even a mild bear market.

Had they seen it coming, investors could have cut the stock allocations in their portfolios and increased their long-term bond exposures; and had capital gains in the bond portfolios, as interest rates tumbled, to offset the losses in their stock portfolios caused by the stock market crash. At the very least, they could have increased their funds' cash positions.

Given the near impossibility of correctly anticipating the next recession and attendant bear market, fund executives should be taking steps now to minimize the damage to their portfolios when those events do occur.

Why should executives be worried now? No recession or bear market is in sight. The U.S. economy, in particular, is stronger than it has been for many years with strong GDP growth, low unemployment and low inflation.

Analysts see no obvious trigger for a recession and bear market, though the stock market is at record highs, the Federal Reserve is tightening the money supply and pushing up interest rates, and a trade war is brewing between the U.S. and China. The economy seems so strong that analysts and investors are shrugging off these issues. Congress and regulators also have strengthened the banking system and oversight of Wall Street. What could go wrong?

Congress and regulators have been working to prevent the last recession and bear market, like generals preparing to fight the last war, but the next recession will almost certainly be different. For example, given the new bank regulations and their higher required asset levels, it is unlikely to originate with banks and mortgages, and banks likely will withstand any new recession.

Congress should be thinking about what might cause the next recession and bear market and take steps to prevent both. Investors should be thinking about what might trigger a new recession and bear market and how to protect their funds if they occur.

There are several possible suspects as likely triggers. First, the informal banking system, or non-bank sources of loans to companies. These sources are largely unregulated and companies have turned to them as bank loans have become harder to get.

Also, companies have become more highly leveraged, taking the opportunity to borrow at relatively low interest rates even as corporate profits soar, and their debt now totals more than $6.1 trillion, up from $5.1 trillion in 2014, according to the Federal Reserve of St. Louis.

Investors, seeking higher fixed-income returns than available from government debt and highly rated corporates, have moved further out on the yield curve and have been willing to buy lower-quality bonds, thus taking more risk. Assets managed globally in private debt strategies totaled $638 billion as of June 30, 2017, Pensions & Investments reported.

The looming trade war with China, which Alibaba Chairman Jack Ma fears could last 20 years, could do more damage to the U.S. economy than analysts now predict. That could cause a recession.

The Federal Reserve is targeting a 2% inflation rate. If it should lose control and inflation begin to surge the result would be higher interest rates and a rapid decline in investor and consumer confidence.

While the low interest rates now available discourage investors from taking significant positions in high-quality bonds, given that an increase in rates would result in capital losses, fund executives should be considering what other steps they could take to prepare their portfolios to minimize damage from another bear market. Perhaps it is time to reduce the positions in lower-quality debt.

They should have a plan in place to make sure the barn doors are locked before the horses escape.