In this article:
Balance sheet recession
Probability: 10 per cent
Investment implications: The dramatic downturn of a balance sheet recession would prompt cautiousness across the board, but there would still be opportunities. Fixed-income duration and ‘safe-haven’ currencies would be likely to provide some relief, while investments in solid, defensive sectors that have long term visibility on income - such as healthcare and utilities - could remain attractive.
- A risk-off approach would be needed across most asset classes
- Focus on duration, defensiveness, and sustainable incomes
- ‘Safe-haven’ currencies and gold would be interesting
This is a clear risk-off scenario and one that would be bullish for both the US dollar and Japanese yen (as traditional safe havens), gold, and also bond duration, given the likelihood of sharp pivots from key central banks, with outperformance by companies with strong balance sheets. We would be particularly concerned about the ability of some small-cap companies to weather a deep and prolonged recession, especially those carrying large debt loads. There would be good reason to look at US mid-caps and parts of the S&P 500 where valuations have remained reasonable – but excluding the ‘Magnificent Seven’ stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla). Similarly, we would strongly prefer high-quality credit over the riskier segments of high-yield bonds.
Outside the US, more defensive emerging market equities in places like India and Southeast Asia look best placed for this scenario, as those markets are less tied to the global cycle.
- Henk-Jan Rikkerink, Global Head of Solutions and Multi Asset
A balance sheet recession always puts fear into fixed income investors. But it would be risk off for everyone. Credit and much, if not all, of the equities universe would be knocked off the table - or at least forced to play second fiddle to bets on falling interest rates and the need for capital preservation.
In a real downturn we always buy duration because we would expect the central banks to cut rates, potentially hard, with the possibility that they may even return to quantitative easing. Many clients have been creeping into those positions this year already. Some have been burned for doing so, but in this case it could pay dividends.
We would look for the capital uplift from duration, and would also raise the allocation to cash and buy gold. We would probably want some ‘safe-haven’ currencies as well. We would go up the quality spectrum as high as possible and hedge against some of the downside that equity holdings will inevitably deliver. Assuming we had seen off the threat of big supply-side-driven cost increases, there would be no case for inflation-linked paper.
- Steve Ellis, Global Chief Investment Officer, Fixed Income
Given the associated material correction in asset prices and with corporate valuations under pressure, in a balance sheet recession we would favour moving up the capital structure, with a focus on senior secured exposure. Investment grade tranches of structured credit, specifically collateralised loan obligations (CLOs), also offer defensive properties and high excess returns: in more than 25 years of the European asset class, the market has not seen a single default of tranches rated single-A or above (although past performance does not guarantee how it would perform through a new balance-sheet recession). The yields on these instruments also offer a substantial premium to corporate fixed income assets.
We would also suggest looking at higher-rated senior secured leveraged loans and direct lending where credit valuations should more than compensate for any potentially adverse default scenarios while also providing high single-digit income and above. We favour Europe over the US because of the dominance of defensive industries, higher expected recovery rates, and less leveraged capital structures.
As happened during the global financial crisis, expect fewer deals, although any new issuance in both direct lending or senior secured loans would be likely to have lender-friendly documentation packages and pricing, so there could be attractive opportunities to place new capital further down the line. It is important to note the differences between the market now and how it was heading into the Global Financial Crisis in 2008. There is far less leverage in the system today, and with the growth of private credit, companies have more options to address capital structure issues, meaning that defaults should be contained and recoveries respectable.
- Michael Curtis, Head of Private Credit Strategies
Banks and other financials are well placed to deal with a standard, cyclical recession, but they struggle when faced with this more severe scenario. In a balance sheet recession we would significantly reduce our exposure to financials. Some commodities stocks could also come under pressure as demand falters.
This is the scenario to look for somewhere to hide, and utilities and healthcare firms - those names that act like bond proxies - could be the place to go. The US could also act as a relative safe haven. There would of course be some beneficiaries in the falling rate environment, such as those previously expensive growth names whose discounted cash flows would suddenly look more attractive. For example, subscription model software companies that have strong recurring revenues would be worth investigating.
It would be important to make any defensive moves quickly. No major markets currently reflect this scenario in their valuations, so if a balance sheet recession took hold, prices would correct sharply. You would want to keep your powder dry when it comes to small-cap companies and wait to see how the dust settles. Policymakers would be under enormous pressure to pivot and save the economy. Interest rates would turn sharply, putting growth stocks back in favour towards the end of the year.
- Ilga Haubelt, Head of Equities, Europe; Martin Dropkin, Head of Equities, Asia Pacific
In a balance sheet recession, any growth in the market could prove difficult to find and that naturally leads to more caution. A lot of investors would sell out of the sector altogether, but this might be short-sighted. It would be far better to concentrate on the core of the market and those assets with long leases, collect the income, and wait out the storm. The reliable income from investments such as nursing homes or supermarkets could be particularly attractive in this scenario.
The last time there was a balance sheet recession, during the global financial crisis, there was no concept of a green premium, but that has changed. Now an asset’s sustainability profile could still drive demand even in a difficult recession. This would be down to cost sensitivity - buildings with strong sustainability credentials are more efficient, drastically reducing tenants’ energy bills. Even in this tightened scenario tenants might be happy to pay a rental premium for greener buildings given their overall costs would be cut.
- Neil Cable, Head of European Real Estate Investments
The view on the ground
How our analysts think their sectors would fare in a balance sheet recession:
“Lower rates are helpful for cash flows for food delivery companies. These are somewhat of a special case within the consumer discretionary sector given their immaturity - it’s unclear how their margins will grow as the industry develops, and in many cases they’re only just about to turn free cash flow positive so their value is unusually heavily skewed towards a longer-term view. This makes the interest rate background very important.” - Consumer discretionary equity analyst, Europe
“A deep recession would mean demand gets hit further which implies inventory correction will take longer to finish which in turn implies this downturn gets messier.” - Information technology fixed income analyst, North America
“Defensive sectors, such as grocers within consumer staples, would benefit from the rotation away from cyclicals.” - Consumer staples equity analyst, North America