Credit vs Equities in a Slowdown: Who Loses First?

There must be something about the 20s. Just like the 1920s, the 2020s have been turbulent and full of contradictions, though hopefully the 2020s won’t end the same way. As investors watch economic and geopolitical risks increase, alongside an uptick in inflation forcing the hand of the RBA, some may wonder if a slowdown is in the future.

It’s also been a tough reporting season so far, with large tech stocks underperforming the markets, despite large-scale profit announcements as investors show concern over capital expenditure on AI and cloud infrastructure.

Whether a market slowdown is sooner or later, if you are planning for the longevity of your portfolio, you may wonder what this means for the underlying assets in your portfolio, particularly credit and equities.

After all, a diversified portfolio holds both – the aim is to have a variety of assets with differing correlations to buffer you from market volatility.

Here’s what you need to know about how these assets perform in a slowdown.

The Correlation Between Equities and Credit

Traditionally, credit has been viewed as having a negative correlation to equities, but the truth is that the relationship fluctuates, and can have short periods where there is positive correlation. This means that the two assets will experience similar returns, rising or falling together.

For example, the two experienced a brief positive correlation in 2021-2022 and had also experienced a positive correlation during the GFC. However, the correlation was negative in the dot-com bubble.

In normal times, credit will tend to fluctuate less than equities and therefore move back to a slightly negative correlation. This is why investors typically use both assets to diversify their returns and offer a buffer in periods of volatility.

Some of the key drivers include persistent high inflation, and supply-side shocks, like natural disasters and geopolitical activity.

Learning from the Past: Credit Loses First

In past slowdowns, credit generally both sells off and recovers earlier than equities.

Research from Schroders indicates that, on average, investment grade corporate bonds start to recover in a recession three months before equities do. The research suggests that the recovery may be bolstered by central banks cutting rates during a recession.

Markets are cyclical, and a slowdown often follows a typical pattern that explains why credit sells off first.

A very simple explanation of this pattern is that in a period of growth, asset prices increase and there can be an expansion in credit and accumulation of debt. Over time, this expansion leads businesses and households to cut back on expenses and investments to manage their debts, and this takes a toll on economic activity, leading to a slowdown.

It’s worth noting that the business and household cutbacks can also be linked to rate rises – that is, where central banks try to control inflation (asset price growth) through interest rates.

Across the process, lending standards tighten and it becomes more difficult to borrow money or roll over debts into new loans – as a result, credit markets contract and sell off. This can eventually have a flow-on effect on stock markets, as there is less money to invest and grow. Investors may also be forced to sell their assets to cover their debts, which can push the market down.

As credit markets start to slowly recover, liquidity increases and stock markets start to recover too as opportunities to invest and availability of credit increases.

The Global Financial Crisis is a key example of this, starting with a credit crunch in the housing market and poor quality subprime lending in the US which spilled into banking collapses and affected global financial markets. Central banks cut global interest rates to lows and new regulation improved the quality of available credit which supported recovery in credit markets and, in turn, stock markets.

Not All Assets Are Equal

While broad trends show credit sells off first and recovers first, investors should remember that not all underlying assets are equal. Factors like quality and duration will influence what happens to your investments, and the extent of any losses.

From a credit perspective, some options that typically perform better in a slowdown, according to Aberdeen Investments, include:

• Higher quality credit options tend to be less volatile; aim for BBB+ or higher to reduce the risk of defaults.
• Investment-grade short-dated credit: a shorter maturity date can be protective of value so less volatile and may offer attractive risk-adjusted returns.
• Private credit, which typically offers higher yields and may offer broader protection (but also tends to be less liquid compared to public options).

Government bonds in higher rated countries, such as Australia, are also considered ‘safer’ investments to hold, with a better chance of recovery in a slowdown.

From an equities perspective, quality is still important, but take a close look at the sector too to determine which options will better withstand a slowdown.

For example, sectors that depend on consumption and demand activities are likely to be harder hit – think consumer discretionary, real estate and financials. Businesses and consumers can choose to reduce their spending to cope with a slowdown and accordingly, these stocks will experience greater challenges.

The sectors that are less likely to experience big losses (or will recover faster) are typically more essential, such as consumer staples, utilities and healthcare. These days, some types of telecommunications are considered essential and this can fall into this bracket as well. You need groceries, you need internet and phones while turning off electricity or water is one of the last decisions you’d want to make in a crisis.

Plan for Losses and Recovery

In planning a portfolio, it’s important to consider both the possibility of loss and recovery – after all, your portfolio will experience many cycles across your lifetime. It’s unavoidable.

Knowing that credit is more likely to sell off first in a slowdown doesn’t mean you should avoid it. Diversification is important. Understanding what types of credit (and equities) will sell off and how quickly they might recover can help you build a more resilient portfolio for the longer term. You may look at funds that offer diverse, higher quality portfolios, be it credit or equities, to help with resilience, alongside other asset classes that might be less subject to movement in market downturns.

It can also be helpful to remember that it’s only when you sell that a loss becomes real. If you can stay the course through volatility and downturns, your assets may recover from falls in value and continue to grow. Speak to an expert for help planning for different market scenarios and for resilience. After all, preparation can make the difference in a downturn and also better set you up for the next bull market.

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.