How equity investors could dodge a recession

THERE is a general belief that if we are not careful, we could easily talk ourselves into recession.

There is a grain of truth in that assertion. After all, consumer spending can, in some countries, account for as much as two-thirds of economic growth.

Consequently, if households keep their wallets and purses firmly shut out of fear, then a huge driver of economic growth could quickly evaporate.

But it is also hard to get away from economic reality. There is growing evidence that consumers are becoming more cautious for good reason.

Following the massive surge in spending after the pandemic, which has been aptly labelled “revenge spending”, many households now appear to have run out of ammunition.

In the US, consumer spending, which is the country’s main growth driver, has come off the boil. There is a silver lining to that, though.

The good news is that falling demand could be helping to keep a check on rising prices. But the bad news is that a slowdown in household spending could have unintended consequences on private sector investments and international trade.

Why would companies want to invest if they should believe that demand for their good and services could be on the decline?

On the back foot

It is not just the US that has found its economy on the back foot. There were high hopes that post-Covid consumer spending in China would help to pull up global growth by the bootstraps.

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But Chinese consumers are behaving no differently from anyone else. They can’t help but worry if their next pay cheque will be their last. And with youth unemployment hovering at around 20 per cent, they have every right to be concerned.

What’s more, the once powerful wealth effect that arose from rising Chinese property prices has since turned into a weighty millstone around their necks, as asset prices fall.

Additionally, declining profits at industrial firms in China could weigh on business sentiment, which could remove yet another lever of growth – namely, corporate investments.

So, the world has good reason to worry. After all, when the world’s two largest economies are stalling, it is hard to see how other countries would be able to escape a downturn.

Throw in the eurozone, which is also sputtering, into the mix, and we definitely have a problem.

Higher for longer

Additionally, the fact that central banks intend to keep interest higher for longer to tamp down on inflation will only exacerbate the problem.

They might say that their intentions are not to bring about economic recession. But they probably have no choice. It is not possible to make an omelette without breaking eggs.

There is yet another more worrying issue, namely, quantitative tightening (QT). This will slowly strangle the supply of credit. The QT tourniquet is already in place, and banks will only become more circumspect about whom they choose to lend to.

To that point, a recent Business Times article reported that an embattled boutique hotel in Tiong Bahru was only able to avert a forced sale after accepting a S$51 million loan at an eye-watering interest rate of 11 per cent. That is nearly twice the fed funds rate.

Point is, it is not central bank interest rates that we should focus attention on but the availability of cash. There is no one-size-fits-all interest rate. Loans are priced according to who is borrowing, who is lending and who has the available cash.

The fittest survive

Investors should take note. This economic downturn cannot be easily resolved by Friedman-like easy monetary policy of the past. Nor will Keynesian economics be able to help with many heavily indebted governments paralysed into inaction.

Instead, the law of the jungle is likely that only the fittest will be able to survive.

The fittest are likely to be companies that can continually generate free cash under all conditions.

In an economic downturn, certain categories of companies can generally do well. They make things that people can easily afford or things that they can’t easily do without.

Pharmaceutical and healthcare companies fall neatly into that category. We can’t easily stop taking our medications just because the economy is in the doldrums. Look also at the makers of consumer goods that we use on a regular basis. And, of course, food, especially low-cost foods.

Peter Lynch, who is one of the greatest investors of our time, said that companies that sell soft drinks, hamburgers and medicine should be able to sail through recession unscathed.

He could be right. But we should still keep a close eye on the finances of these companies. Even their balance sheets could deteriorate quickly in an economic downturn. And we should never invest in a business without first looking at their cash flow – the stronger the cash flow the better.

The writer is co-founder of The Smart Investor