Earlier this month, the Bank of England (BoE) announced some worrying forecasts that have renewed investor fears of a recession and, in turn, a stock market crash.
Inflation is expected to hit 13% by the end of this year before beginning to reverse. Yet it may take until 2024 before things start to normalise again. And with interest rates already being hiked six times this year, with further hikes potentially coming, the risk of recession is undoubtedly getting higher.
Having said that, it’s important to remember that nothing is guaranteed. And there are several methods for investors to prepare and even capitalise on the situation if it does get that bad. Let’s explore.
How does a recession trigger a stock market crash?
As a long-term investor, I’m focused on finding high-quality businesses capable of delivering impressive returns for decades to come. But a recession, while technically a short-term problem, can throw a big spanner in the works. They often end up triggering a stock market crash, and I think that’s unlikely to change this time around.
With consumer spending already declining as the cost of living continues to surge, revenue and profit growth are becoming more challenging. That’s why growth stocks have been hit the hardest so far this year, especially those with no profits to their name.
Equity is no longer a sensible method of raising capital since share prices have already dropped significantly. Meanwhile, rising interest rates make debt more expensive. As such, businesses across the board, including top-tier industry leaders, are looking to cut costs. And sadly, during a recession, that usually means job losses.
Lower household income further exacerbates the financial pressures of inflation on families. This, in turn, further reduces consumer spending, leading to more job losses in a vicious cycle of decline.
Needless to say, that compromises corporate earnings. Dividends are therefore likely to get cut, low financial flexibility means most firms can’t buy back shares, even at cheap valuations, and for the groups with weak balance sheets, a stock market crash could spell the end of the line.
Why investors shouldn’t panic
As horrifying as the situation sounds, let’s put some things in perspective. Firstly, the BoE has a pretty dire track record of accurately predicting recessions and inflation levels. But let’s assume it’s right this time. What can I do to prepare and even profit from the situation?
The first thing I’ve already done is to build a nice chunk of cash in the bank. This eliminates the risk of being forced to sell my shares at the worst possible time to cover living expenses. I’ve also got some extra capital in my Stocks and Shares ISA, ready to take advantage of collapsing shares prices.
The next few years may be bleak with stagnant growth, but that doesn’t mean all companies are heading for bankruptcy. In fact, I think a good majority will likely survive, providing they have strong balance sheets, smart management, and a proven business model capable of delivering long-term returns.
If a stock market crash were to occur, as unpleasant as it will be, it serves as an incredible buying opportunity. And that could help propel my wealth to new heights once the storm is eventually over.
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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.