4 Ways to Hedge Against the Next Recession

The 2008 Financial Crisis was brought about by an overabundance of subprime lending, which filtered through structured products with defaults, leading to overwhelming losses for banks. Increased lending standards and capital adequacy requirements at banks ushered in by the Dodd-Frank Act in 2010 meant a subsequent financial crisis and recession with similar credit catalysts was not likely to occur again.

But while the United States strongly rebounded from the height of the 2008 financial crisis, a global markets recession may still be a cause for concern.

Key Takeaways

  • The Great Recession in the United States triggered a global financial crisis and market meltdown.
  • Historically speaking, we are due for another recession, but there are ways you can hedge yourself against this occurrence.
  • Diversifying across global markets, safe-haven securities, or short positions can help blunt the blow of the next recession.

The Economic Picture

When looking at world market GDP levels, emerging market weights significantly increased since the financial crisis era. China, one of the largest emerging market countries, substantially increased its gross domestic product (GDP) in comparison to world markets. From 2005 to 2019, China’s GDP, as a percentage of the world’s GDP, increased from 5% to 16%. As a result, U.S. investments in the country also increased.

A macro event from China triggering large-scale losses in U.S.-invested areas could lead to a new recession. A recession triggered specifically by China could also have broadly negative implications for both domestic and international real estate, as well as the United States equity market. While a recession could be negative for the current economy, it does not specifically mean that a crash might occur. Thus, investors must be cautious and ready for potential changes in market direction, with liquid assets available for hedging and protection against downside risk.

Domestic Market Selloff

American investors continue to watch China’s economy closely. In 2019, China reported expected GDP growth of 6.1%. However, GDP growth should a catalyst to watch closely because it has a high potential for triggering a recession in the U.S., particularly because GDP growth in the United States has not been especially robust in recent quarters.

The most current reading on America's GDP, as of 2019, shows GDP growing at a seasonally adjusted annualized rate of 2.16%. Other measures of China’s market stability, such as currency valuation and real estate oversupply, are also recessionary risk concerns that need to be considered.

The Global COVID-19 Pandemic

Events may arise at certain points that just can't be predicted but have a great impact on governments, individuals, and corporations. For instance, the global COVID-19 pandemic put an enormous amount of pressure on a global scale—something no one could predict. As of Jan. 28, 2021, there were more than 100.2 million confirmed cases across the world and about 2.16 million deaths.

But that's not all. The pandemic has greatly impacted the economy as well. Virtually every sector of the economy was affected, including hospitality, transportation, health care, and manufacturing. Unemployment rates shot up, as companies were forced to shut down or restrict operations. Governments enacted stimulus plans and provisions to keep homeowners in their homes.

In June 2020, the World Bank estimated that the virus would push the global economy into the greatest recession since World War II. The group expected a drop of 7% in economic activity in developed countries for 2020 while emerging market economies were expected to see a drop of 2.5%.

But the outlook for 2021 remained uncertain. That's because the World Bank noted that growth outcomes would not be uniform throughout the year. The global economy was expected to expand by 4.3% while U.S. GDP growth was expected to grow 3.5% in 2021.

Hedging for a United States Market Recession

In detecting and hedging for a United States market recession triggered by an emerging markets macro event, investors should closely watch the leading catalysts noted above, including GDP, currency valuations, and real estate markets, which all highly influence the valuations of the emerging market equity markets.

If negative reports occur from the emerging markets, and most specifically China, which has the highest emerging-market GDP, then such occurrences might lead to market losses and call for a shift in assets to safe havens and hedging strategies.

A potential recessionary scenario triggered by the emerging markets that may lead to losses can be hedged most securely and easily by moving high-risk assets to safe-havens. Safe havens include Treasuries and Treasury Inflation-Protected Securities, U.S. government bonds, and corporate bonds of high-credit-quality American companies.

A second strategy for protecting and potentially benefiting from the losses incurred by an emerging market macro event is a pair trade that involves buying domestically oriented ETFs, such as the SPDR S&P Mid-Cap 400 ETF (MDY), and short selling country-specific emerging market ETFs, such as the Deutsche X-trackers Harvest CSI 300 China ETF (ASHR).

Other potential strategies include taking a one-sided short position against a specific country or emerging markets index. One such example of this is shorting the iShares Currency Hedged MSCI Emerging Markets ETF (HEEM) for protection against currency risk. Another option might include short-selling just the index through put options on the iShares MSCI Emerging Markets ETF (EEM).

The Bottom Line

Market recessions vary for different reasons and have been caused by numerous catalysts. It is not likely that the next market recession will be caused by subprime lending. However, changing global economics, partly a result of the 2008 financial crisis, could lead to different recessionary factors.

Therefore, investors should be cautiously aware of the world markets, and in particular, the growing production in the emerging markets. Negative catalysts in these countries could lead to a new recession and subsequent market downturn, of which investors should be cautiously aware, and prepared for, with strategies to mitigate losses.

Article Sources
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  1. World Bank. "GDP (Current US$) - China, World."

  2. World Bank. "GDP (current US$) - China, World, United States."

  3. World Bank. "GDP growth (annual %) - United States

  4. World Health Organization. "WHO Coronavirus Disease (COVID-19) Dashboard."

  5. The World Bank. "COVID-19 to Plunge Global Economy into Worst Recession since World War II."

  6. The World Bank. "Global Economy to Expand by 4% in 2021; Vaccine Deployment and Investment Key to Sustaining the Recovery."

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