Defensive funds are for life, not just for recession

Danielle Levy speaks to professional investors who buy funds to find out how they are positioning their portfolios ahead of the UK entering a recession later this year.

Investors find themselves in a tricky situation today: inflation in the UK is running at 10.1%, continuing to squeeze household finances, the Bank of England has warned that the UK will fall into recession at the end of this year, while the war between Russia and Ukraine continues with no resolution in sight.

Unfortunately, the UK isn’t the only economy moving towards a downturn. The US is already technically in recession after two quarters of negative growth, while many economists suspect the eurozone could be headed the same way as energy shortages created by the war in Ukraine risk driving record inflation even higher.

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“Economic growth has been slowing this year, with leading economic indicators pointing downwards and reasonably consistently so,” points out David Lewis, co-head of strategy for Jupiter’s multi-manager Merlin fund range.

He adds: “Over the last few cycles, central banks have been able to loosen policy and stimulate the economy because inflation hasn’t been a problem. But this time around inflation is a problem.”

While Lewis believes it is a good thing that central banks, such as the Federal Reserve, have hiked interest rates in a bid to keep inflation under control, he says there are also challenges associated with raising interest rates when economic growth is slowing.

“This has the potential to push us into some form of recession,” he added.

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Nathan Sweeney, deputy chief investment officer for multi-asset at Marlborough, believes the UK may well be heading towards recession but he is encouraged to see that recent economic growth data has remained resilient, up 0.8% during the second quarter.

“This leads us to believe it will likely only be a mild recession, should it occur. I think the timing is less critical as markets already expect it to happen and the good news is inflation always declines in or after a recession,” he explained.

So, how are investment managers preparing their portfolios for a potential recession?

Stock markets are forward-looking, which means that if bad news is forecast for the economy, it is generally already reflected in share prices.

Daniel Lockyer, a senior fund manager at Hawksmoor Investment Management, says the starting point for investors should always be valuations and what they are indicating. Right now, he believes the valuations of UK small and mid-caps – which tend to have greater economic sensitivity – have already priced in recession. This means investors may be positively surprised if the economic news is not as bad as anticipated, but of course things can also negatively surprise if the recession proves to be harsher or more prolonged than the market anticipates.

Defensive ballast needed at all times

Lockyer also warns against trying to forecast events and positioning portfolios with a specific outcome in mind. “You can end up having a portfolio that is stacked on one outcome which then turns out to be wrong,” he added.

Lockyer says it is important to hold defensive funds or investment trusts in your portfolio at all times to protect you from whatever lies ahead. These should sit alongside “midfielders and attackers”, as he puts it.

One example of a defensive investment trust he currently holds is Impact Healthcare REIT (LSE:IHR), which owns a portfolio of healthcare-related properties, predominantly residential care homes.

“It offers investors a steady yield and inflation-linked revenues, which means the income is going to move in line with inflation. And you have got an asset class that is not really affected by economic situations, whether there is recession or not, as you are still going to have old people going into care homes year after year,” he said.

Sweeney, meanwhile, started preparing the portfolios he manages for the possibility of a recession six months ago by adding to several equity income funds. These can play a defensive role in portfolios because they invest in companies that typically perform better during times of stock market volatility. He cites Allianz UK Income fund as a prime example.

“They have an experienced team with a strong track record. Importantly, they are delivering now when it matters,” he said.

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Peter Lowman, chief investment officer at financial advice firm Investment Quorum, agrees that equity income funds deserve a place in portfolios right now on account of their defensive qualities. He favours the GAM UK Equity Income fund, which he believes has the potential to deliver in spite of a challenging economic backdrop.

“A good investment strategy for recession is to look for fund managers who are backing companies with strong balance sheets and cash flow. Companies, which through being in the right sectors, are increasing their dividends as well,” he said.

The ability to pass on rising costs to customers, known as pricing power, is essential at a time of high inflation, Lowman added, which means sectors such as consumer staples should be on the radar.

Lowman also cites the JPM Global Macro Opportunities fund as one to consider in challenging market conditions. The investment team has the ability to take both ‘long’ and ‘short’ positions via derivatives across shares, bonds, commodity and currency markets.

Taking a long-term view

Lewis agrees with Lockyer that timing markets is tricky, so it is better to simply focus on the medium to long term. With this in mind, he has made very few changes to his portfolios this year.

“It is critical at all times to be invested in fund managers who you believe you can hold through a market cycle, through a downturn and an upturn. Those with a strong enough process, philosophy and team to get you through whatever comes down the line,” he explained.

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Whether these fund managers invest in so-called growth or value stocks, Lewis favours those who focus on quality businesses with solid balance sheets.

“We have tried to not make a big call on where markets are going and to stay balanced between ‘growth’ and ‘value’. This has been of great benefit so far. Fundamentally, we are focusing on managers with a quality underpinning to what they do,” he added.

When it comes to those with a “quality growth” style among the funds he favours is M&G Global Dividend, run by Stuart Rhodes.

On the “quality value” side of the equation, he likes Jupiter Global Value, managed by Ben Whitmore and Dermot Murphy.

Navigating previous cycles

If we are heading towards recession, how important is fund manager experience?

Lowman believes it is of paramount importance. However, he points out that while many managers are likely to have invested through previous recessions, only a small number will have experienced a ‘stagflationary’ environment of slower economic growth and high inflation, which last occurred in the UK in the 1970s.

“It is difficult if you have not been through this type of cycle – and not many fund managers have,” he said.

Lowman favours fund managers who have run money for many years, if not decades, and highlights Adrian Gosden, manager of the GAM UK Equity Income fund, as a good example.

Nevertheless, he adds that fund managers have multiple challenges to consider at this point in time: high inflation, interest rate hikes, the ongoing war between Russia and Ukraine, as well as the potential implications of a recessionary and/or stagflationary environment.

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Jupiter’s Lewis likes to hold a mix of veteran fund managers, with a wealth of experience behind them, as well as younger investors. He says there is much to be said for younger managers who have worked with experienced professionals.

“Hopefully, they have learnt some of the tools that will help them to navigate this downturn or recession, even if they have not been through lots of these things in the past,” he said.

While experience is helpful, he says it is not the be-all and end-all. “Experience is of great benefit, but it is only useful when combined with people who have a rigorous process and philosophy that they continually apply over time, which helps them to navigate these challenging times.”

Sweeney, meanwhile, believes experience is not essential, as some fund managers may not make the right calls the second time around. “Experience does not guarantee good outcomes,” he concluded.