Benefits of diversification in a recessionary environment

Recession underway

While we are currently seeing a shallow recession thus far - with inflation starting to slow down and potentially reach a peak - there is still high uncertainty within global markets, and specifically within the U.S. in regard to inflation, Russia’s invasion of Ukraine, and rising interest rates.

There are several factors that may contribute to this recession running longer and deeper than initially anticipated and this stems from the following:

First, U.S. banks, which are important to the economy given their integral nature in the financial system, adopted a more cautionary tone during their last earnings release - a leading signal that the economy may be slowing down further. 

Second, inflation has continued to persist. Many would not have expected these high inflation rates to continue into the end of 2022 and in September we continue to see high inflation prints.

Lastly, the Federal Reserve has hiked interest rates very aggressively in response to the high and persistent inflation. The monetary policy actions that the Fed is taking will certainly increase the risk of a greater recession.

Benefits of diversification

Many investors have viewed a balanced portfolio between stocks and bonds as a sufficient diversification model in the past. However, the current environment has eroded the relationship between them, and so far in 2022 we have seen both stocks and bonds perform poorly.

Fortunately, enhanced diversification can be achieved on a number of levels including via different factors, asset classes and geographies. And so, working on the basis that some of these investments may outperform in a less-than-ideal economic environment, a well-diversified portfolio may help reduce the overall negative impact of a recession. 

Role of ETFs in diversification

ETFs are known for providing strong diversification benefits. By pooling together funds from many investors, ETFs are able to gain broad exposure to different asset classes, factors, sectors and geographies. Furthermore, ETFs are able to achieve this diversification in a cost-efficient manner and with greater liquidity in most cases.

Examples of ETFs which automatically have diversified holdings include:

• FirstTrust Preferred Securities and Income ETF (FPE) – provides exposure to Mixed Ratings Corporate Equities and Bonds
• RPAR Risk Parity ETF (RPAR) – provides exposure to Global Equities, Bonds, and Commodities
• Cabana Target Drawdown 10 ETF (TDSC) – provides exposure to Equities, Bonds, Currencies, and Commodities

Data for this article is as of September 7, 2022.

Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.