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. Thanks to the 2010 Dodd-Frank Act, which has increased lending standards and capital adequacy requirements at banks, a subsequent financial crisis and recession with similar credit catalysts is not likely to occur again. However, while the United States has strongly rebounded from the height of the 2008 financial crisis, a world markets recession could still be a cause for concern.
When looking at current world market GDP levels, emerging market weights have significantly increased since the financial crisis era. China, one of the largest emerging market countries, has substantially increased its GDP in comparison to world markets. Since 2005, China’s GDP, as a percentage of the world’s GDP, has increased from 5% to 17%, and as a result, U.S. investments in the country have increased. Thus, 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
In the United States, investors have been watching China’s economy closely. Most recently, in June 2016, the country reported expected GDP growth of 6.8%; however, GDP growth should be closely watched as a catalyst, with high potential for triggering a United States recession, 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 first quarter 2016, shows GDP growing at a seasonally adjusted annualized rate of 0.8%. Other measures of China’s market stability, such as currency valuation and real estate oversupply, are also recessionary risk concerns.
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, United States government bonds and United States corporate bonds of high-credit-quality 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 (NYSEARCA: MDY), and short selling country-specific emerging market ETFs, such as the Deutsche X-trackers Harvest CSI 300 China ETF (NYSEARCA: 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 (NYSEARCA: 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 (NYSEARCA: EEM).
Overall, 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.