Interactive Investor

How to build a defensive portfolio in 2024 as recession risks loom

For investors looking for a more defensive approach, David Prosser highlights several options to consider, both in new asset classes and in different areas of the equity market.

10th January 2024 10:29

by David Prosser from interactive investor

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Are we heading for recession? Figures just published reveal the UK economy began shrinking in October, with analysts fearing that the slowdown has continued since then. And the UK is not alone; eurozone data suggests it has also gone into reverse – Germany, Ireland and Italy are faring worst – while the US is slowing too. At a global level, the International Monetary Fund (IMF) now predicts growth of just 2.9% for 2024, the worst performance since the pandemic arrived in 2020.

In which case, investors may want to consider battening down the hatches for the year ahead. Some areas of the equity market may struggle to retain their lustre amid this darkening economic backdrop.

That’s not to suggest shifting into panic mode. More positively, the shifting landscape may even create new opportunities. Moreover, stock market performance in recent months has been very strong despite anxiety about what lies ahead. Chartered financial planner Scott Gallacher, a director of independent financial adviser Rowley Turton, warns: “Not all recessions have the same impact on returns and investors often overact to these fears.” His advice is to “assess your risk tolerance and investment goals before making any drastic changes to your portfolio” .

Still, for those investors looking for a more defensive approach, there are several options to consider, both in new asset classes and in different areas of the equity market.

A change of asset class?

On the former, fixed-income securities – the bonds issued by governments and companies – are usually regarded as a less-risky option in volatile times. While companies can cut dividends on equities, bonds promise to deliver an agreed amount of income each year – and bondholders rank ahead of shareholders in the pecking order for getting paid.

In addition, there is a positive case to make for bonds during a recession. “The first thing likely to happen is a cut in interest rates,” says Ben Yearsley, investment director at Shore Financial Planning. He adds: “Assuming inflation is at more normal levels – around 3%, say – we’ll get an interest rate reduction of 50 basis points or so,” he predicts. That makes bonds look more attractive than other income-generating assets, boosting market demand and driving up their capital value until the anomaly levels out.

That said, bear in mind that there is a debate about when interest rate rises might arrive, particularly in the UK. The Bank of England’s Monetary Policy Committee made it clear in December’s announcement on rates that it is not minded to ease monetary policy in the short term. Other central banks, for whom persistent inflation is less of an issue, are more optimistic. The US Federal Reserve, for example, is now signalling a move towards interest rate cuts sooner than previously expected.

Equally, not all bonds will do equally well in this new world. Recessions are bad news for corporate earnings – and can drive bankruptcies – so bonds issued by higher-quality borrowers are a safer option. “Investment-grade bonds should be fairly safe; in this scenario, you could see double-digit returns for investment-grade bond funds in 2024,” adds Yearsley. He suggests funds such as Artemis Corporate Bond and Premier Miton Corporate Bond as potential core holdings.

Another possibility, suggests Dzmitry Lipski, head of funds research at interactive investor, could be to think about gold as a safe-haven asset in 2024. The precious metal is traditionally considered a good store of value – although the gold price can be volatile – during troubled times, Lipski points out. He adds: “In the past, gold has performed well relative to equities and other risk assets during periods of extreme economic turbulence, market volatility and high inflation.”

Moreover, says Lipski, it is possible to make a bullish case for gold right now: since the metal is priced in US dollars, a weaker dollar is good news for international holders. “Over the longer term, the outlook is positive for gold because the Federal Reserve is expected to start cutting rates sometime in the second or third quarter of 2024, which will cause the US dollar to weaken,” he explains.

With market analysts also noting increasing demand for gold from countries such as China, Lipski suggests an exchange-traded fund (ETF) as a good option for getting direct exposure to the metal. He picks out iShares Physical Gold ETC (LSE:IGLN) as one to consider.

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A different approach to equities?

For investors minded to stick with the stock market, meanwhile, there are several approaches to consider.

First, adding more exposure to international stock markets may make good sense for those expecting the UK’s economic downturn to be more severe than problems in other major economies. Partly, this is because investors will benefit directly from the stronger performance of companies in those economies. But also, a UK downturn – prompting lower interest rates – will weaken the value of sterling, so when investors turn their overseas earnings into pounds, they’ll do better.

“Look for options with low UK exposure, such as Vanguard FTSE Global All Cap Index, to capitalise on potential gains,” suggests Gallacher.

The second possibility here is to reorient your portfolio away from smaller companies towards larger stocks. This makes sense because smaller businesses often find it tougher to ride out difficult times – they have fewer resources and tend to be less diversified. Also, larger companies are more likely to have earnings from sales in international markets, which may provide insulation against a UK downturn – as well as a play on the falling pound.

One option here is a low-cost ETF or index-tracking fund focused on large-cap UK equities. But Gallacher points out that an active investment approach can have advantages during challenging periods.

“Fund such as Invesco UK Opportunities merit consideration, with the advantage that the fund manager has greater discretion than, say, a pure FTSE 100 tracker,” he argues.

A last thought for equity-focused investors is that some sectors of the market are more recession-proof than others. Businesses such as pharmaceutical companies, food producers and retailers, and utility companies all benefit from the fact consumers have to spend money in these areas. Cyclical stocks – car manufacturers, travel businesses and the leisure sector, for example – are at a disadvantage in tough times because consumer spending in these areas is more discretionary. It is therefore worth understanding the biases of the funds you currently hold to different sectors of the market.

Outsource the decision?

Finally, investors not sure how – or if – to make these shifts for themselves may prefer to pay a professional fund manager to make the decisions on their behalf. Multi-asset funds, including Flexible Investment sector investment trusts, have a mandate to invest across multiple asset classes. Managers decide on their funds’ asset allocation according to their current views about the prospects for markets and economies; investors are effectively outsourcing these choices.

In this category, interactive investor’s Lipski suggests looking at Capital Gearing (LSE:CGT) Trust, which has been run for the past 40 years by the highly regarded Peter Spiller – a manager, in other words, with experience of multiple market cycles.

“The fund has two objectives: to preserve capital over any 12-month period and to deliver returns well in excess of inflation over the longer term,” explains Lipski. “Capital Gearing currently has a big emphasis on index-linked government bonds, which account for around 50% of the portfolio; these offer protection when stock markets fall, as well as providing a shield against inflation.”

Yearsley, meanwhile, is a fan of Personal Assets (LSE:PNL), another investment trust focused on capital preservation. “It currently holds less in equities than it has for many a year, with a correspondingly high holding of index-linked bonds, as well as exposure to gold bullion,” he explains. “If interest rates get cut and inflation remains under control, those bonds should prosper; gold may get a boost too.”

Alternatively, a more aggressive option could be RIT Capital Partners (LSE:RCP). Although its portfolio includes real estate assets, bonds and credit instruments, it has maintained more exposure to equities.

Importantly, this includes private equity – companies not listed on a stock market. Concerns about the valuations of private equity following interest rate rises have been a headwind for both private equity trusts and investment trusts like RIT that have notable exposure. This has contributed to shares in RIT falling to a unusually wide 36% discount to the value of its underlying assets.

“We think the shares offer interest value on such discounts,” says the investment trust team at broker Stifel, which has a positive rating on the fund. “There is scope for a re-rating of at least 10 percentage points if net asset value continues to deliver positive returns as it has over the past three years.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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