Last month, for the first time since the GFC, the US yield curve inverted. This was significant because since 1956, the stock market has peaked after an inverted yield curve before falling into a recession. The time between inversion of the yield curve and recession has been 7-24 months. Normal yield curves are where long-term yields are higher than short-term yields. An inverted yield curve is the opposite: short-term yields are higher than long-term yields.

Avoid the banks

Inverted yield curves are particularly painful for banks. Banks borrow at short-term rates and lend at long-term ones. A flattening of the yield curve means margins are squeezed and inversion of the yield curve hurts margins. In March, the US financial sector was the worst performing sector in the US stock market, down 3.4%. Here in Australia, Australia and New Zealand Banking Group (ANZ) was down 7% and Commonwealth Bank of Australia (CBA) down 4.5% for the month of March.

Which sectors perform better in recessions?

High beta sectors such as energy, material, industrial and consumer discretionary usually perform well when the global economy is doing well. These sectors are cyclical sectors.

When the market turns down, it’s the low beta sectors such as utilities, property, staples and telecom that usually outperform. These companies usually have a stable cashflow, despite economic conditions which is why they’re considered defensive sectors. The dividend yields or distribution yields are relatively high and act as a buffer against the fall in share price.

My asset allocation & strategy tips 

1. Reduce your domestic cyclical exposure. Focus more on global. Global leaders will benefit from a lower $A. Avoid domestically focused.
2. US: underweight. Upcoming quarterly reporting season is key. Watch to see whether there’s a contraction in growth of earnings, which would be a negative for markets
3. Diversify geographically into markets in an earlier part of the cycle. China: overweight. Stimulus plan should start to have impact. It’s one of the best markets in 2019 so far, off a low base and moves in a different cycle to the US.
4. Overall: overweight defensive, quality. Screen more heavily on earnings quality and predictability. Step up exposure to dividend growth areas in economically unsensitive areas.
5. Underweight: momentum, growth

$A exposure

The $A is seen as commodities based and hence growth currency. When downturns hit, people look to the safety of currencies, such as the US dollar, Japanese yen or Swiss franc. It means that the $A is usually weaker. The weaker $A benefits exporters listed on the Australian market.

• Material stocks: BHP Group Ltd (BHP), Rio Tinto Limited (RIO), Fortescue Metals Group Limited (FMG)
• High quality $A fall winners: Amcor Limited (AMC), CSL Limited (CSL), ResMed (RMD)
• Market linked: Janus Henderson Group (JHG), Magellan Financial Group (MFG), Macquarie Group Ltd (MQG) 

The stuff that glitters

With added market volatility comes demand for gold. Aussie gold miners receive a double boost in this environment from the higher gold price, which is traded in US dollar terms and then from the weaker $A, which means costs in US dollar terms fall. This means higher margins for Aussie gold miners with assets in Australia selling gold in US dollars.

Prefer: Newcrest Mining Limited (NCM), Gold Road Resources Ltd (GOR)

My conclusion

When downturns hit, there is a premium put on stable cashflows and dividend yields. In terms of sectors, this is property, utilities, staples and telecom. In terms of strategy, quality and defensive usually fare better than growth and momentum. Look for companies that benefit from the weaker $A.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.