4 ways to hedge against the next recession

The 2008 financial crisis was triggered by too many subprime loans, which were filtered through defaulted structured products, causing banks to suffer huge losses. The increase in bank lending standards and capital adequacy requirements brought about by the 2010 Dodd-Frank Act means that subsequent financial crises and recessions with similar credit catalysts are unlikely to happen again.

However, despite the strong rebound from the peak of the 2008 financial crisis in the United States, the global market recession may still be a cause for concern.

Key points

  • The Great Recession in the United States triggered the global financial crisis and market collapse.
  • Historically, we will face another recession, but you can hedge this situation in many ways.
  • Diversification in global markets, safe-haven securities, or short positions can help mitigate the blow of the next recession.

Economic picture

From the perspective of world market GDP levels, the weight of emerging markets has increased significantly since the era of the financial crisis. China is one of the largest emerging market countries, and its gross domestic product (GDP) has increased significantly compared with the world market. From 2005 to 2019, China’s GDP as a proportion of the world’s GDP rose from 5% to 16%. As a result, US investment in the country has also increased.

Macro events from China have triggered large-scale losses in the US investment sector and may lead to a new recession. The economic recession triggered by China may also have a wide range of negative effects on domestic and foreign real estate and the U.S. stock market. Although a recession may be bad for the current economy, it does not mean that a crash may occur. Therefore, investors must remain cautious and be prepared for potential changes in the direction of the market. Liquid assets can be used to hedge and resist downside risks.

Domestic market sell-off

American investors continue to pay close attention to the Chinese economy. In 2019, China is expected to increase its GDP by 6.1%. However, GDP growth should be a catalyst to watch closely because it is likely to trigger a recession in the US economy, especially since the US GDP growth has not been particularly strong in recent quarters.

As of 2019, the latest data on US GDP shows that the seasonally adjusted annual growth rate of GDP is 2.16%.Other indicators that measure the stability of the Chinese market, such as currency valuation and real estate oversupply, are also recession risks that need to be considered.

Global COVID-19 pandemic

Certain events may occur at moments that are unpredictable but have a significant impact on the government, individuals, and companies. For example, the global COVID-19 pandemic has brought immense pressure on a global scale-which no one can predict. As of January 28, 2021, there were more than 100.2 million confirmed cases worldwide and approximately 2.16 million deaths.

But this is not all. The epidemic also has a great impact on the economy. Almost all sectors of the economy are affected, including hotels, transportation, healthcare, and manufacturing. As companies were forced to close or restrict operations, the unemployment rate soared. The government has formulated stimulus plans and regulations to keep homeowners at home.

In June 2020, the World Bank estimated that the virus will push the global economy into the worst recession since World War II. The organization predicts that economic activity in developed countries will decline by 7% in 2020, while emerging market economies are expected to decline by 2.5%.

But the outlook for 2021 is still uncertain. This is because the World Bank pointed out that the growth results throughout the year will not be consistent. The global economy is expected to grow by 4.3% in 2021, while the US GDP growth is expected to grow by 3.5%.

Hedging the U.S. market recession

When discovering and hedging the US market recession triggered by emerging market macro events, investors should pay close attention to the above-mentioned main catalysts, including GDP, currency valuations, and the real estate market, which all have a great impact on the valuation of emerging market stocks.

If there are negative reports in emerging markets, especially in China, which has the highest GDP in emerging markets, such events may cause market losses and call for assets to be shifted to hedging and hedging strategies.

By transferring high-risk assets to safe havens, it is the safest and easiest to hedge against potential recession scenarios triggered by emerging markets that may lead to losses. Safe havens include U.S. Treasury bonds and Treasury inflation-protected securities, U.S. government bonds, and corporate bonds of high-credit-quality U.S. companies.

The second strategy that protects the losses caused by emerging market macro events and may benefit from it is paired trading, which involves buying domestic-oriented ETFs, such as SPDR S&P Mid-Cap 400 ETF (MDY), and short selling emerging market ETFs in specific countries. , Such as Deutsche X-trackers Harvest CSI 300 China ETF (ASHR).

Other potential strategies include unilateral short positions in specific country or emerging market indexes. One example is shorting iShares Currency Hedged MSCI Emerging Markets ETF (HEEM) to prevent currency risks. Another option might include short selling the index only through put options on the iShares MSCI Emerging Markets ETF (EEM).

Bottom line

The reasons for the market decline vary and are caused by multiple catalysts. The next market recession is unlikely to be caused by subprime loans. However, the changes in the global economy that were partly due to the 2008 financial crisis may lead to different recession factors.

Therefore, investors should carefully watch the world market, especially the growing output in emerging markets. Negative catalysts in these countries may lead to a new recession and subsequent market downturn. Investors should be cautious about this, and be prepared for it, and develop strategies to mitigate losses.

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