Nation after nation in the west is slipping into recession. This raises the obvious question for investors: which market sectors should be invested in or avoided?
All times of change provide opportunities for the nimble. Recessions are part of the normal economic cycle. Recessions serve a purpose. They are necessary because they remove inefficient practice, and they clear the way for new ideas, new technologies, new ways of doing things, and new industries. These principles are fundamental to our innovative mercantile economy.
The first area which springs to mind which would benefit would be receivers, administrators and liquidators. But we need to penetrate more deeply and think further than that. I shall set out here how I would go about thinking about how best to make investment decisions in a recession. I always try to form a framework to guide my thoughts in a structured manner.
A recession means less spending in some or most but not all areas. The US is a consumer economy. Eighty percent of US economic activity is consumption. It is useful to determine which industries will reliably expand and which will reliably contract, and then identify the best or the worst stocks within those groups, depending upon the trading or investment strategies you seek to employ.
A recession means that much spending will shift from wants to needs; and from luxuries to necessities. When less is available we make more use of what we have. Therefore a recession will tend to bring about:-
- lower capital expenditure, both at a personal level and at a corporate level;
- deferral of equipment purchases;
- the prolongation of asset life;
- reduction in the size of inventory, both personal and corporate;
- the reduction of or elimination of regular services; and
- a reduction in the quality of inventory – replenishing the pantry with cheaper substitutes as it were.
It is also important to determine who decides how much is to be spent, and how expenditure is to be reduced. The budget decision makers can be classified into four levels. Decisions to reduce expenditure will be made:-
- at a personal level;
- at a corporate level;
- at a national level; and
- at a global level;
We can now think how belt tightening might affect ourselves at a personal level before we work outwards to the broader economy. I start by asking myself how I would respond to a reduction in my income, or the potential loss of employment.
In thinking about how I might regress in a financial sense, Maslow’s hierarchy of needs springs to mind. Maslow’s Hierarchy
(Acknowledgements: http://en.wikipedia.org/wiki/Maslow’s_hierarchy_of_needs)
Clearly self-actualisation and the higher developments are largely independent of financial affairs, so if we are to apply Maslow’s hierarchy to the selection of industries and market sectors, we are confined to only the lower layers. A more superficial hierarchy is required, reflecting only the financial aspects of life. The following matrix provides such a framework by listing a hierarchy of spending.
The Hierarchy of Spending
The human needs and wants are arranged vertically in a similar fashion to Maslow’s hierarchy. The bare necessities and lesser needs are at the bottom with higher level needs arranged in sequence upwards to luxuries at the top. Not all needs and wants are shown. The reader can add further rows to conduct the investigation as desired. One column is provided for each class of budget decision maker.
At each intersection in the matrix, we can now think about how each sector of the market would be affected. This approach will help provide a broad overview of how a recession will affect stock market fundamentals.
Spending will be pushed down to the lower layers, in a sense parallel with economic regression, as less money is available. There will be greater pressure to push spending patterns back into the past, into times when societies were less economically developed. Instead of progressing towards advancement, some economies will be shifted ever so slightly backwards in the direction towards barter and subsistence. Others will be thrust more robustly in that direction, like Zimbabwe.
Let’s now take the example of energy to see how the matrix might guide our thoughts.
In commercial terms, and at a personal or corporate level, renewable and clean energies are a luxury which can be deferred, at least in the short term. But in political terms, and at the global level, this might not be so. A recession increases the pressure to go back to the past instead of forwards to new more expensive and commercially risky sources of energy. A recession will increase demands for cheaper energy, both for corporations and for individuals. Therefore the transition to more costly clean and renewable sources may be delayed.
That would mean that purchases of windmills, solar panels, batteries and inverters, and investment into geothermal, carbon sequestration and other alternative energy related industries and projects would be deferred. I’m not suggesting these industries will suffer, rather I’m suggesting that the odds and the risk have now shifted a little more against those industries. Those industries probably will not reach the heights of commercial success as soon as might have been forecast a year ago.
At a personal level it means delaying the purchase of double glazing, insulation and other energy saving devices which incur a cost premium. It is possible that, as occurred during the oil crisis of the nineteen seventies in the US and Europe, people will turn down their thermostats and wear more jumpers. There might be a shift to the more basic end of the clothing and fashion market which might benefit.
There might be a shift in food consumption from value added five star and processed foods (and note that these are opposites) to basic staples. Consider the seed, fertilizer and food chain industries. Such a shift would echo the reversion from advanced economic activity to more basic lesser developed categories of economic activity. In Iceland that may well be a matter of discarding the financial dealers’ suits and donning the oilskins in order to go back to fishing and whaling.
Does poverty cause theft? My personal opinion, from experience, is that it does not. I reject that notion and I find it insulting to poor people. A failure of character and a lack of principle is the primary cause of theft, however I acknowledge that in some cases desperation might lead to theft. But shoplifting and theft does increase in recessions, and I think we are already starting to observe those effects. Therefore some security related industries might benefit from a recession: industries related to alarms, surveillance and associated electronics; fences, screens, grills, and locks; and also guards and other security personnel. In my opinion some of the increase in theft due to a recession probably results more from a lack of will or knowledge about how to live frugally rather than desperation. The western economies have enough food surplus to provide a buffer against widespread starvation.
Fewer car purchases means squeezing longer life from an aging global car fleet. That will require more gaskets, fan belts, radiator hoses, and other spare parts. If oil prices resume their upward trend, and as the relative cost of people’s time falls, it will mean more walking and cycling. That would result in an increased demand for shoes and bicycle tyres. It is interesting to note that many of the products which will be purchased as a result of reductions in spending are made in China.
The effects of the global recession upon China, and the effect of China upon the global recession, is the subject of a separate discussion, which we will have to leave for some other time.
At a national level, the recession, combined with quantitative easing anti-deflation policy, might encourage some national infrastructure spending decisions to direct more funds to public transport. Where time is not critical, and subject to the future oil price, more transport might shift from the road to railways and ships.
And recessions make time cheaper. People accept more delay because they have less money to purchase acceleration. The US and continental Europe have inland shipping and railway systems which are well developed and efficient.
In summary a recession will bring about a “depletion of the pantry”, the aging of assets, and a shift to more basic needs; at a personal level, a corporate level, a national level and the global level.
The reader can construct such a matrix and explore further by dividing the global economy into geographic, cultural, national or other sectors. Different cultures will respond in different ways.
But there is more to the economy than so called “rational” financial behaviour. We are all real people, not algorithms. So what might seem logical in terms of money will be distorted by human behaviour, at all decision making levels. We are already seeing major government decisions being distorted away from hollow economic rationalism. It is not finance alone which determines which businesses gain or lose. Decisions are skewed by political and social considerations. Governments will do all sorts of things to preserve jobs, for example by allowing accelerated depreciation and other tax concessions, by constructing infrastructure to encourage new industries in places of high unemployment; and by turning away from global free trade to protectionism.
The recession might foster specialised import replacement industries, especially where current large export suppliers cease production. Most countries will respond differently. Therefore the recession might contribute to a fundamental change in global trade. Many will put their own interests before global interests. Some inefficient industries will be supported. The BRIC countries may well account for 100% of global GDP expansion while only the west contracts. So make sure you keep your forecasts in perspective.
In considering the western economies I would be guided by the idea of economic regression and a temporary retreat from wasteful consumerism. Remember your family’s spending habits when you were a child. Importantly: remember what you did not need money for. These are the industries which might come under some pressure.
Thank-you very much. See you next time.
Copyright © 2008 Nils Marchant.
This is an edited transcript of a talk delivered at the Options21 Market Briefings during the 26th – 30th of November, 2008.