The UK is facing a long recession, and an unusual one given high inflation and rising interest rates. In the first of a series looking at how to invest during an economic downturn, we speak to AJ Bell’s head of investment analysis, Laith Khalaf, to understand why spreading your cash across different investing styles could be a smart approach.
We are facing a long recession in the UK. The Bank of England expects it will begin at the end of this year and last for most of 2023. And yet we mustn’t forget that the stock markets look forward, and much of this doom-laden economic forecasting is already in the price. That’s not to say further falls won’t happen: the economy could get even worse, affecting company profits more than anticipated. But if things get a little brighter and markets accelerate, investing at times when stock values are depressed can be a stroke of genius for our long-term returns.
But this is an unusual recession that requires an unusual approach to investing. In this series, we look at some strategies and fund ideas that might be appropriate for these unusual times.
Strategy one: invest across different investing ‘styles’
In investing, companies are often grouped under a set of defining characteristics which fund managers will target as part of their investing ‘style’. Different styles will come in and out of favour at different points in the economic cycle.
But as Laith describes, this is an unusual recession: “Unemployment is expected to stay low, energy prices are expected to remain elevated, and interest rates are continuing to climb, despite the weak economic outlook.”
As a result, received wisdom is being somewhat turned on its head regarding where the investing opportunities and pitfalls might be. As a result, Laith suggest blending styles as a smart strategy for your portfolio.
1. High-quality growth investments
High quality growth stocks are companies that are growing their revenues and earnings at high rates relative to peers or the wider market, but also deemed to be of exceptional ‘quality’ too, perhaps sitting in market leading positions, with strong profit margins, low debt, and pricing power.
These can be a good place to hide during recessions, as Laith explains: “Investors will likely be familiar with the idea that high quality growth stocks are good places to be in a recession, as the strength of their balance sheet and earnings will prove an attractive port in a storm.”
But he explains the unusual economic environment is slightly challenging this rationale: “Central banks are increasing interest rates despite deteriorating conditions, in order to fight off inflation. Given the gloomy economic forecast by the Bank of England, one would normally expect them to be cutting rates to stimulate growth.”
This presents a problem for anything classed as ‘growth’ as it lowers the value of their future profits, which is for many of these companies where a lot of their value lies. It also sends investors who traditionally seek bonds but have found solace in quality growth companies in recent years amid low interest rates, back into their natural habitat.”
“It’s difficult to predict how these factors will play out against the fundamental attraction of high quality growth companies, especially in a recessionary environment where balance sheets come under scrutiny, and the resilience of these stocks should stand them in good stead.”
Laith gives Evenlode Global Income fund as an example. The fund management team seek out companies with strong finances that offer predictable earnings growth they can hold for the long term.
2. Value investments
Value stocks are those deemed to be cheap or good value, with financial characteristics such as low share prices relative to their profits, revenues or dividends. Traditionally, these sorts of stocks tend to be associated with cyclical industries, such as banking or energy.
While value strategies would normally be avoided during recessions, Laith recommends balancing quality growth strategies with some value funds too:
“[An] economic downturn would normally be seen as a headwind for the cyclical stocks that usually fill the value bucket.”
However, at the moment “higher energy prices are driving the profits of oil and gas companies, and higher interest rates are boosting the bottom line of banks. A low valuation also acts as a bit of a margin of safety because it means there’s less room on the downside for a stock to fall. Value stocks also tend to have dividends attached (see below).”
One idea he points to is Jupiter UK Special Situations. The fund manager, Ben Whitmore, has a strict value discipline, but he also only invests in companies that have robust balance sheets, which is clearly important in an economic downturn.
Darius McDermott, Managing Director at Chelsea Financial Services, also points to Ninety One Global Special Situations Fund as a good value strategy.
3. Income investments
Income stocks are those paying strong levels of dividends. These companies tend to be at a more mature stage of the life and established in their markets, and therefore producing a lot of cash today. These stocks are particularly attractive in an environment of high inflation, given the uncertainties regarding the future and their ability to raise prices and therefore dividends in lockstep.
Laith also think the pandemic was far worse for company dividends, and suggests income focused investment strategies as a third style to consider too.
“The current economic malaise threatens to squeeze company profits by reducing revenues at the same time as increasing costs. That will undoubtedly put pressure on dividend payments, but these have very recently been through a trial by fire at the hands of the pandemic. To put some perspective on this, the Bank of England now reckons the UK economy will shrink by just over 2% in 2023. That compares to a 20% decline in economic activity during the pandemic.”
“So, what we’re facing is much more of a slow burn than the blistering economic inferno of the pandemic. The result is that dividend payments are generally more resilient than they were prior to COVID-19, because companies were forced to cut them to more affordable levels.”
“Dividends can also be attractive in times of economic turmoil, because one in the hand tends to be valued more than two in the bush when uncertainty is heightened. Dividends can also act as buoyancy aid for share prices, because if a company is paying investors a 50p dividend every year, there comes a share price below which this income stream looks irresistible.”
Both Laith and Darius points to City of London Investment Trust, run by Job Curtis for over 30 years. For a global approach, Laith points to Trojan Global Income, Darius to Fidelity Global Dividend Fund.