How to invest through an unusual recession

Laith Khalaf is head of investment analysis at AJ Bell.

The UK economy is heading for recession, but investors can take some consolation from the fact that the Bank of England’s recent doom-laden forecast barely caused a ripple on the stock market.

That’s because the market is already anticipating poor economic performance, and so prices have already adjusted.

This is not to say stocks won’t suffer any setbacks during the downturn, if it looks like getting worse, or if the shock to corporate earnings is greater than currently anticipated.

But a lot of bad news is already reflected in valuations, and when sentiment turns more positive, markets can accelerate sharply, leaving the uninvested behind.

It’s also important to bear in mind that the UK only makes up around 3 per cent of the global economy.

Other countries are going through the ringer too, but international economic forecasters are predicting a particularly hard landing for the UK.

The silver lining for investors is that that much of the stock market, even in the UK, derives its earnings from a variety of international sources.

Global growth as a whole is expected to slow next year, but recession for the UK economy doesn’t necessarily spell poor returns from investing.

Investing strategies to consider in the coming recession

We should be mindful that we’re facing an unusual recession, where unemployment is expected to remain relatively low, energy prices are expected to remain elevated, and interest rates are continuing to climb, despite the weak economic outlook.

As a result, some of the strategies investors might employ, such as investing in value funds, dividend stocks and smaller companies, may run against the grain of the orthodox approach of simply battening down the hatches.

But unconventional times call for unconventional methods.

There are also some more familiar strategies investors should consider, especially those with a cautious disposition, such as using multi-asset funds to spread risk.

As ever it’s important for investors to maintain balance in their portfolio in terms of the stocks, sectors and countries they have exposure to.

This is especially relevant in turbulent times, because you never know where economic problems are going to rear their head next.

Investors should also consider drip feeding any fresh funds into the market gradually, in case there are any further steep downdrafts along the way.

As ever, it also makes sense to use Sipps (self-invested personal pensions) and Isas to reduce any unnecessary tax leakage, which could diminish hard-won returns.

1. Invest in value as well as growth

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.

That is absolutely true, but this is a bit of a strange economic downturn, because 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.

Higher interest rates do present a problem for growth stocks for two reasons. First, higher rates, and indeed elevated inflation, diminish the current value of future cash flows, which will be a key input into the pricing of growth companies.

Second, in recent times many investors who have been driven out of bonds by low yields have found sanctuary in solid, reliable growth companies, driving up their valuations.

As bond yields rise, these investors may be tempted back to 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.

However, the nuanced picture suggests that investors should balance growth exposure with value funds, despite the fact that an economic downturn would normally be seen as a headwind for the cyclical stocks that usually fill the value bucket.

That’s particularly the case because higher energy prices are driving the profits of oil and gas companies, and higher interest rates are boosting the bottom lines of banks.

A low valuation 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.

Investors looking for a value fund might consider Jupiter UK Special Situations. (ongoing charge: 0.76 per cent) 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.

Investors looking for a growth fund might consider the Evenlode Global Income fund (ongoing charge: 0.55 per cent). The fund management team seek out companies with strong finances that offer predictable earnings growth they can hold for the long term.

2. Seek out dividends

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 per cent in 2023.

That compares to a 20 per cent decline in economic activity during the pandemic. What we’re facing is much more of a slow burn than a blistering inferno.

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.

Dividend cover for the FTSE 100 is forecast to be over 2.16 times earnings in 2023, the highest level since 2012.

This figure is an average of analyst estimates, so it already includes their expectations for how a weakening economy will hit corporate earnings.

Of course, those predictions might be wrong, but that is still a fairly healthy buffer for FTSE 100 companies to have, which will go some way to protecting dividends.

Dividends can also be attractive in times of economic turmoil, because one in the hand tends to be valued at more than two in the bush when uncertainty is heightened.

They can also act as a 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.

Investors looking for dividend-paying funds might consider City of London investment trust (ongoing charge: 0.45 per cent) or Trojan Global Income (ongoing charge: 0.91 per cent).

3. Consider multi-asset funds

Multi-asset funds invest across a range of different markets and asset classes, so you don’t have to. Typically they have exposure to equities, bonds, cash, commodities and property.

Such a diversified approach means you have irons in lots of fires, which is particularly appealing when tomorrow’s winners and losers are so hard to predict.

A number of these funds will also appeal to more cautious investors because they focus on capital preservation.

While they’ll never shoot the lights out if markets are roaring away, they offer downside protection when things take a turn for the worse.

They can and do fall in value, but the manager builds a portfolio that is constructed to minimise losses. Such funds include Personal Assets Trust (ongoing charge: 0.67 per cent), Ruffer Investment Trust (ongoing charge: 1.08 per cent) and Rathbone Strategic Growth (ongoing charge: 1.61 per cent).

4. Look at smaller companies

The average UK smaller companies fund has fallen by over 20 per cent so far this year, which suggests a lot of bad news is already in the price of the minnows of the stock market.

Economic downturns can be particularly challenging for smaller companies, but more adventurous investors might find now a good time to start building a position.

While in the short term the share prices of smaller companies may trend lower, over the long run this area of the market has been an exceptional source of returns, especially when allied with a skilful active manager who can sort the wheat from the chaff.

Over 10 years the average UK smaller companies fund has returned 169 per cent, compared to 95 per cent from a UK index tracker.

While poor economic conditions are clearly not good for smaller companies, they can also be an opportunity for stronger businesses to prove their worth, and potentially find themselves the beneficiary of weaker competition going to the wall.

Smaller companies may also enjoy secular growth – a fundamental, long-lasting trend – which is less reliant on the broader economic picture.

Funds to consider in this area include Abrdn UK Smaller Companies Growth investment trust (ongoing charge: 0.88 per cent) and TB Amati UK Smaller Companies (ongoing charge: 0.89 per cent).

5. Focus on fundamentals

In boom times, a rising tide lifts all vessels, so investors can find themselves on the receiving end of healthy returns, even if they haven’t been particularly discerning in their stock picks.

Until this year, the previous decade had also been dominated by long running trends, in particular low inflation and ultra-loose monetary policy.

The duration, and indeed deepening, of these trends favoured a performance-chasing approach. In other words, one of the best ways to pick an investment that performed well in future was to plump for one that had performed well in the past.

Now the tectonic plates of geopolitics, monetary policy and inflation are shifting, that may no longer be a successful approach.

It therefore makes sense to go out fishing for good companies with a line and rod, rather than a trawling net.