How Can Investors Financially Prepare For A Recession?

The sell-off after the Fed June meeting has been indiscriminate, and with several major monetary authorities in the world making the decision to raise rates few markets have been safe, especially globalised markets like commodities. While we all expected some rate increases, seeing red in your accounts may lead you to totally rethink the economic reality, and perhaps to panic sell in the expectation of economic doom. Make no mistake, the economy is not in a good spot, but with inflation on the one hand and economic decline on the other, it’s hard to say whether cash is necessarily the way to go either. The best thing to do is shift money from one sold-off stock to another, except where the latter is better positioned for the possible eventualities: in other words rebalancing. We provide in broad strokes our economic view below and what you can do to prepare for the oncoming economic turbulence.

Economic Hurt Coming One Way or Another

Some monetary authorities are raising rates because they want to reduce demand by increasing unemployment to reduce inflation. It will work but at great cost to economic growth, albeit not likely a total deleveraging like some believe. These monetary authorities think, or are currently pretending to think, it will be possible to reduce inflation just a tad at the expense of a bit of unemployment to control the situation, but it won’t work. They are aiming for a goldilocks zone, except the forces they are putting into motion by raising rates and unemployment will accelerate and overshoot that zone by a lot. If you create a bit of unemployment, you start a vicious cycle where unemployment reduces consumption which causes companies to lay people off creating more unemployment and reducing consumption further.

We are going back to effective austerity, the thing everyone hated from 2008 in European countries like Italy that took that route. If the central banks decide to reverse course and turn back on their decision to take a strong stance against inflation, they will still overshoot the goldilocks zone to arrive at our current situation where more consumption causes less unemployment and spirals inflation through the wage price mechanisms. Inflation is bad, it’s true, because it damages people’s real wealth, but so do rate increases by increasing debt service costs and reducing disposable income.

Real Economy

What is the problem and why do we have to accept that real wealth will be damaged and cause a recession? The problem is the productive capacity of the economy, i.e. the real economy. How productive are we? Raising the value of our economies nominally through inflation or decreasing them through deflation both have nothing to do with real increases in productivity. The dotcom bubble burst because the tech companies weren’t actually doing anything productive. If there was economic value-add there wouldn’t have been a bubble. When we got real innovation in the late 2000s we had real productivity growth and that’s why the economy has gone on so long without inflation despite growing wealth. Some critics complained that it was because of inflation in asset prices as opposed to consumer prices, hiding the effects of the last decade of low rates, but opportunities with earnings power were becoming more abundant in the markets and justified the growth. Now because of regressions brought on by value destruction from supply chain and east-west economic disintegration, the consumption that had been financed by another surge of money printing during the pandemic has us extended beyond what the productive frontier can support.

While logistics tie-ups and difficulties in catching up dwindled 2020 inventories with consumption are part of it, another problem is more transitory and that is energy prices, as shown by the Ukraine situation. We don’t have enough energy to produce what people want to consume. Opposition to nuclear energy has been fervent with governments refusing to renew concessions of major utility operators, and believe it or not nuclear plants have been closing during this period of high energy prices with coal plants instead being recommissioned to deal with the energy shortages. Renewable energy has not been able to make up for the shortfall and limit cost push inflation.

Energy Concretely Scarce

The green lobby has taken a big hit as the politically assured stranded asset risk has meant millions in barrels per day of refining capacity being decommissioned since the early 2010s, some of it being converted to renewable diesel and the rest falling into disrepair. Ultimately, we have been only more reliant on oil since the moving forward of the green agenda, with our products as well as the dirty energy that helps create them all occurring offshore where constituents won’t pay much attention to them. Indeed, peak oil has not come from a demand perspective, but supply has lagged in growth. OPEC says that they are at their limit and they are. We can only expand production by about 7%, 3.5% from Saudi Arabia which Biden is working with, and it is not such a big number. Russia This doesn’t cover at all the situation in which we are moving towards the loss of Russian supply to the western bloc, which accounts for 20% of overall run-rate oil streams.

Why Rates Increases Weren’t Inevitable

Japan has realised this. They’re not raising rates and it is causing the value of the Yen to crater. They know that they need to keep the economy consuming, because Japanese people are such savers that if they don’t they’ll probably get deflation which is way worse than inflation, because people stop spending altogether in anticipation of lower prices which destroys the economy. Basically, they are choosing for wealth to be destroyed by inflation and a devaluing currency and terms of trade rather than falling growth.

Where To Invest From Here

Since we can never hit the goldilocks zone, we are either going to have inflation or economic decline that will hurt our wealth. This means we can only invest in things that can resist inflation and have resilient markets that won’t fall in the case of economic decline, or are otherwise so undervalued that it doesn’t matter how bad things get because it’s all been priced in. Thankfully, just as exposed stocks have sold off, resilient gems can be bought for cheap as well.

• DDH1 (OTCPK:DDHLF) – DDH1 is recession resistant and isn’t heavily commodity exposed because it operates within the mining drilling contracting sector. Drilling activity didn’t decline much during the 2008 financial crisis for example, and miners will CAPEX as usual for mines as long as it’s economical in order to sustain volumes at economical prices. With commodity prices being so high, there’s a large margin before it becomes uneconomical to explore. Moreover, expenditure on drilling for exploration and developing mining assets has actually declined in ratio with the value of commodities, meaning that the CAPEXing hasn’t gotten exuberant over the last year with miners being disciplined in the face of the commodity boom. Moreover, the DDH1 revenue mostly comes after mines are opened with projects to expand or monitor mining deposits with drilling sample analyses and through longer term contracts to deploy DDH1 drilling rigs and continue the development of mining assets, providing cash flow visibility for DDH1. To the extent that it is commodity exposed, most of its customers are gold miners. Gold reserves are falling fast, and with growing demand of gold there’ll need to be a lot more exploration in order to keep up the production that will otherwise go off a cliff in a couple of years. Finally, the DDH1 price has fallen precipitously over the last few months, by almost 40%. This is in contrast to the Canadian company Major Drilling (OTCPK:MJDLF), which has rocketed in price and trades at a 14x PE ratio on LTM net income vs DDH1 at less than 5x. Oaktree Capital Management has a ~20% share of the company.
• Rubis (OTCPK:RBSFY) – Rubis is not commodity exposed as they are owners and operators of pipelines, regulated refineries and retail gas stations. In retail they charge a unit markup that will usually be unaffected by commodity prices (some price caps in Africa are affecting margins a little bit now), their refinery is regulated and works on a constant crack spread that doesn’t change with market conditions in the French Antilles, and their pipeline and terminal infrastructure doesn’t take on commodity price risk. They own some of the best terminal assets in the world located at premier locations like Rotterdam. They’ve already seen the worst they ever will with COVID-19 decimating their Caribbean exposure which is dependent on tourism and accounts for about 20% of EBIT on a normalised basis. With governments in the west mostly coming to terms with COVID-19, reopening will mean that even with a recession Caribbean volumes should stay above 2020 levels. Retail volumes are supported by countercyclical forces, as if the price of gasoline declines people will be able to move more. Finally bitumen exposures in Africa are market agnostic since they’re connected to essential infrastructure projects that have to happen.
• Japan Petroleum Exploration (OTC:JPTXF) – JAPEX owns shares in several oil rigs in different geographies including Iraq and off the coast of Japan. It has oil price exposure through these assets which could turn in a recession. In 2008, the prices went from $100 to $38 per barrel with the reduced demand that was a consequence of the financial crash. However, they also run the Japanese gas pipelines which is commodity price independent, and this accounts for half of their profits. Again, another toll-road economics stock with limited commodity cycle exposure. Moreover, the market cap is equal to the company’s cash and stock in the bank, so even if oil were $10 per barrel, there’d still be upside on the scrap from the rig, with the gas assets in Japan being complimentary. It’s free hard assets, a ridiculously cheap company.

Bottom Line

The majority of the market’s gains are made on only a handful of the days in a year. It’s too risky to possibly miss those days while trying to time the market. Cash will also get eroded by inflation, which would come back quickly if rates fell again, if it gets under any sort of control anyway. Moreover, fixed income, until rates settle, are still subject to duration risk and aren’t so attractive yet. With stocks on the market that have earnings yields still miles away from risk free treasury yields, there are plenty of options where a margin of safety is provided. But move slow, because the spread between the S&P earnings yield and current rates are now at decade lows, meaning a bad bargain for that extra risk just when things are in fact the most uncertain. Markets could come down quite a bit more. But looking broadly and globally you can avoid getting exposed to markets like the US that people are overweight to and buy things that are in no rush to rebound in what would be a premature rally, as we’ve just seen in the US, where interest rates are sure to rise in response to calls from populists amongst others. The ideas above do just that and address the issue in the real economy as directly as possible.