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Economy, Investments

Recessionary times make diversification key

Investment portfolio diversification

As financial markets enter an uncertain economic period, the level of diversification contained within investment portfolios is more critical.

The level of diversification present in investment portfolios will be very important as a protection mechanism to combat the likelihood of recessionary times, according to an investment manager.

Zenith Investment Partners head of asset allocation Damien Hennessy outlined the possibility of four potential contraction scenarios for the Australian economy in the short term, ranging from a soft landing with lower inflation and a shallow recession, as well as the worst-case scenario of stagflation risk.

Hennessy stipulated though market activity over the past three months may favour a soft-landing scenario.

“Equity markets have held up reasonably well, while credit spreads have tightened a little bit. Markets are starting to price in a soft landing, with inflation returning to the 2 to 3 per cent range in 2024/25,” he noted.

“Another scenario is that the US Federal Reserve, and indeed our own Reserve Bank of Australia, fixate on cutting inflation and tightening monetary policy too aggressively, which increases the chance of a recession occurring over the next 12 months.

“The Federal Reserve absolutely doesn’t want to be the central bank that lets inflation get out of control, so they’re prepared to go so far in tightening monetary policy. Ultimately, it’s good for bonds and probably good for cash, but risk assets would struggle.”

He indicated the most probable market scenario is a prolonged period of higher cash rates, leading to ongoing risks of a mild recession. In this situation, inflation will decrease but remain higher than the central bank’s target and he identified the more favourable asset classes.

“In this scenario, bond yields at least provide yield and recession diversification. Investors need to be selective within equities, underweighting those priced for soft landing while seeking to overweight those assets and sectors already factoring in pessimistic outcomes,” he said.

He acknowledged certain market analysts are predicting a period of stagflation where high inflation is combined with stagnant economic growth.

“In this scenario, the Fed and other central banks feel they can’t do anything about a slowing economy because they’re still fighting the inflationary war. The probability of this happening is low but it’s certainly one that needs consideration,” he said.

Regardless of which outcome eventuates, he reiterated the value of holding bonds and cash.

“Bonds have a place in portfolios, perhaps more so than they have for quite a few years now. Yields are in the 3 to 4 per cent range, not exciting, but they provide a bit of protection to investors for those more pessimistic scenarios,” he said.

“Cash and other short-dated investments that provide returns in that 4 to 5 per cent range can also provide a bit of flexibility for investors.

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