Updated: Nov 14, 2022
There has been a lot of talk about soaring inflation, the upcoming stock market crash, the housing bubble, crypto sell-offs, and ultimately, the looming recession. Not to mention the war in Ukraine. Basically, this all means is that there is great uncertainty in the market right now and the rosy days from 2020 and 2021, where everything just went up and up, are snow over.
The government stopped printing money, which it did in trillions of dollars during the Pandemic, and is now serious about reducing the deficit, most likely through taxes. The economy is slowly reopening and the damage from the Pandemic is starting to rear its ugly head. While all of this may sound scary, times of economic uncertainty can also be a source of opportunity, as more millionaires are made during a recession. If you want to learn how to best prepare in times of an economic downturn and profit from it, make sure to read until the very end!
I have a full post here about inflation that goes into depth about inflation 101, its effects on the economy, and how to hedge against it through specific investments, so feel free to check it out. But in a nutshell, inflation is the highest in 3 decades here in Canada. The latest CPI or Consumer Price Index results from March 2022 is 6.7%, compared to the target rate of 2% which has been set by the Bank of Canada for the past few years.
To curb inflation, the Bank of Canada has been raising interest rates from 0.25% all the way to 1% in the span of two months and is expected to raise the rates a couple more times this year. Interest rate spikes are designed to cool demand by increasing the cost of borrowing, thus discouraging individuals and businesses from consuming and investing. You can see the following effects of higher interest rates:
Rising interest rates also impact the price of the stock market but it affects certain sectors differently. You may have noticed that growth stocks and tech start-ups have taken a hard hit recently, as investors tend to look for more stable companies. This is because growth stocks tend to be unprofitable and burn through cash to reinvest back into the company, so high borrowing costs can clip their wings. On the other hand, financial stocks may benefit from the rate hike as their margins increase. Also, blue-chip companies might not take as big of a hit as they tend to have healthier financial statements, with extra cash and the ability to pay down debt comfortably.
However, according to Forbes, there isn't a correlation between rising rates and falling markets as people tend to think. In fact, Dow Jones Market Data analyzed the five most recent rate hike cycles to see how the stock market did in the past. Out of the five long-term periods, the three leading stock market indexes (DJIA, S&P500, and NASDAQ) only declined once during a rate hike cycle.
Not to mention, the stock market had been generally overvalued in the past with people flooding the market with stimulus money and cheap borrowed money. I've mentioned in my past post on Growth ETFs (link here) that I believed the stock market was generally overvalued with the Price to earnings ratio being significantly higher than in the past. It was time for a correction.
With rising interest rates, for homeowners out there on variable interest rate mortgages, you would have felt the effects of higher interest payments. We are coming from crazy home prices here in Canada as well as the US during the past two years, but are now seeing a slowdown in the real estate market.
The higher interest rates are making it more difficult for current homebuyers to afford homes. Those who bought homes in the past few years at all-time high prices might have stretched themselves too thin and may have difficulties trying to afford their monthly mortgage payments going forward.
For example, say you purchased an apartment for $500,000 in which you put down a 10% deposit of $50,000, with an amortization period of 25 years. You managed to lock in a variable 5-year closed interest rate of 1.75%, resulting in an annual interest of $4,543. However, after the 75 basis point rate hike, your variable interest rate is now 2.5%, which increases annual interest payments to $6,494. That is a 43% increase in interest payments.
1.75% interest rate
2.5% interest rate
You may have seen on the news that we are currently in a housing bubble and that the price of real estate will be dropping. In Canada, signs of the housing market cooling. According to the Canadian Real Estate Association, national home sales fell back 5.4% on a month-over-month basis in March 2022 and 16.5% below the all-time sales record set compared to March 2021, one year ago.
Bitcoin has dropped by almost 50% from its all-time peak in November 2021, and it's been a rocky roller coaster since. As the digital gold, Bitcoin also influences the price of other altcoins, which also haven't been performing so well.
According to Forbes, $200 Billion from the price of Bitcoin, Ethereum, BNB, XRP, Luna, Solana, Cardano and Avalanche had been wiped out, as investors share an "extreme fear" sentiment. Who is to say that this bear sentiment will linger around for a few months to a few years before jumping back up. Though, I do crypto is the future, there are still ways to go before its full potential is realized and before crypto becomes more integrated with our current financial system.
So when is the Recession Happening?
I wish I had a crystal ball to tell you the exact timing. However, all the signs seem to be pointing to an economic downturn. In the past, a recession had occurred every 10 years or so. While we had a major crash in March of 2020, it was short-lived. Since then, much damage has been accumulating as a result of the Pandemic, in which the government had put a temporary bandage on by printing money. As Morgan Stanley's chief economist claimed" The ingredients for a global recession are on the table."
A bear market is signaled by a drop of 20% or more from recent highs. As you can see in the following chart and article by Forbes, Nasdaq and Russell are currently in the Bear territory with a drop of almost 25%. S&P is in the correction stage by being down almost 15%.
While things don't look too good right now, it's not quite ripe for a recession. According to Forbes, "Recessions usually come from demand weakness, but supply problems can also trigger a downturn. In 2022 demand for goods and services will be strong. Consumers have plenty of money, thanks to past earnings, stimulus payments and extra unemployment insurance." Businesses also have cash from positive past earnings and cheap debt they were able to take on before the rate hikes started.
While 2022 is seen as unlikely to host a recession as money is still in the markets and reopenings are creating strong demand, 2023 and 2024 are "extremely risky," according to Forbes. This is when money is going to start running out and the full rate hikes will be in place. We will start to see the full impact of the Pandemic on the economy, since the economy usually reacts with a time lag of one year, give or take a few months.
While the following poll is specific to the US recession prediction, Canada and the rest of the World are also experiencing the same economic issues, with the major concern being inflation. The World Bank put out a report saying that the world is facing the largest inflation shock in the last 50 years.
While all signs seem to point to a recession, economists have been wrong in the past. If the government can properly put in place the right monetary policies, we may be able to avoid a recession. Nobody can say for sure, but it's better to be safe than sorry. So here are the following ways to prepare and profit from a potential recession.
How to Prepare & Profit from a Recession
Tip #1: Save Up an Emergency Fund
The first thing is first, save up an emergency fund of 3 to 6 months minimum. In times as uncertain as now, having some cash to your name will give you peace of mind and the chance to get back on your feet if anything unexpected happens.
Tip #2: Pay Down Debt with High-Interest Rates
After you save up some emergency funds, make sure to start tackling debt with the highest interest rates first such as your credit card debt or a line of credit. The interest on these high-interest rate loans can snowball in a relatively short period and you don't want to find yourself in a position where the interest alone becomes more than the principal you borrowed.
If possible, don't take out additional debt and start budgeting to reign in your spending. Taking on new debt during good times might not be a problem, but when the economy takes a turn for the worst, risk increases. Your income might decrease or, worst, be laid off from your job, and not being able to pay your debt has a significant impact on your credit score for future borrowings that matter, such as buying a home.
Tip #3: Invest in the Stock Market
While it may seem contradictory to be investing in stocks when the market is down, it can be seen as an opportunity to buy when prices are "cheap." If you are a long-term investor and planning to invest for your retirement, short-term price fluctuations shouldn't be a major concern. Indexes such as the S&P500 have historically resulted in average positive returns of 7 to 8% since 1928. There are going to be years of negative returns, but they have been seen to smooth over 5 to 10 years.
Instead of trying to time the market, dollar-cost averaging is a strategic way of investing that reduces the risk of overpaying for a stock. It removes the emotional aspect of investing that can result in buying high and selling low - the opposite of what you want to be doing. However, as a novice investor, you don't necessarily want to be put up with the pros. By dollar-cost averaging, you simply need to determine a fixed amount of money, such as $100, that you want to invest in regular intervals, such as every month, regardless of whether the price is high or low.
Buying an index fund ETF, which is a basket of stocks that also provide diversification, such as that of the S&P500 can be an ideal way to dollar-cost average. While trading fees can be a disadvantage to this strategy, there are brokerages out there such as Questrade or Wealthsimple that have no trading fees when it comes to buying ETFs. Check out my link below for free stocks if you sign up using my link.
Tip #4: Save Extra Cash for Good Buying Opportunities
While holding cash during inflationary times might seem counterintuitive, investments during a recession go for bargain prices that you want to take advantage of. Take the housing market crash of 2008 for example, when prices of homes in the US fell by almost 33% and in Canada by almost 10%. Those who had some cash and were able to buy homes by putting down a modest deposit would have seen that investment kick-start their wealth. Over the years, the value of their properties in Canada grew to double or even triple the original value. Those investors were able to take out a home equity line of credit on the appreciated value to invest in other investments, such as other real estate properties or stocks.
Tip #5: Invest in Yourself
During a recession, jobs become uncertain. Companies can enter financial hardship and you might have your salary reduced or get laid off altogether. One of the best investments you can make during inflationary times and even during a recession is to invest in yourself.
This is emphasized by the legendary investor, Warren Buffet, who at the 2022 Berkshire Hathaway annual shareholders meeting repeated his long-held advice that one of the strongest protections against inflation is sharpening your skills and working to be at the top of your field.
He said, “Whatever abilities you have can’t be taken away from you. They can’t be inflated away from you. The best investment by far is anything that develops yourself, and it’s not taxed at all.”
He also shared similar advice from 2009, at the tail end of the Great Recession, when Buffet said "the best thing to do is invest in yourself."
I hope you enjoyed today's post and got some insight out of it. In the meantime, what are you doing to prepare for the upcoming Recession? Leave a comment down below!