How to invest for a recession

If you've been reading my weekly and monthly newsletters you will be aware that recession fears have risen sharply in the last month. Investment markets have reacted accordingly, with bond yields falling alongside commodity prices. We've also seen some rotation within equity markets, where money has flowed out of company shares in certain economic sectors into others in the hope that they may fare better in a recessionary environment.

It raises the question of how should you invest for an impending recession?

How to invest for a recession

The first and most obvious asset class that should in theory benefit from the market pricing in a recession is bonds. If economies around the globe begin to contract, central banks will cease their monetary tightening plans and possibly begin loosening policy again. That would mean that they stop increasing interest rates and instead start to reduce them to avoid a severe recession. This in turn would inevitably make the fixed income generated by bonds more attractive causing yields to fall and bond prices to rise.

So it would be worth looking at my recent research piece Funds for a bond market rebound for bond fund ideas.

Elsewhere, in a recession commodities are likely to fare badly as demand is closely linked to economic growth. See my newsletter Call the Dr... the economy looks sick.

But what about equities? Corporate profits are usually closely linked to economic growth so a potential drop in profits should in theory make equities less appealing. However, different equity sectors fare better or worse than others during each phase of the economic cycle. During a period of rapid expansion cyclical stocks tend to fare better as we saw during the post-pandemic economic recovery. Conversely during periods of economic contraction cyclical sectors tend to lag defensive sectors.

Below is a list of the sectors that cover the companies within the S&P 500. Most global stock markets have similar sector make-ups.

• Communication services
• Consumer discretionary
• Consumer staples
• Energy
• Financials
• Health care
• Industrials
• Information technology
• Materials
• Real estate
• Utilities

Those sectors highlighted in red are widely regarded as defensive sectors while those in green tend to be cyclical. So if you want to invest in equities for a recession then you might prefer to invest in companies from the Health Care, Utilities or Consumer Staples sectors.

This makes sense because in times of recession consumers and companies pare back unnecessary spending. But during a recession consumers will still spend money on food, drink, tobacco and certain household items such as cleaning products. Companies that sell these products are categorised as being in the Consumer Staples sector. During a recession consumers still need medicines (sold by companies in the Health Care sector) as well as water and electricity (provided by Utility companies).

But this likely outperformance of defensive sectors goes beyond just theory. Fidelity International produced the chart below following research into how different equity sectors have tended to perform across past economic cycles in history (click image to expand).

The sectors coloured green tend to outperform during the stated part of the economic cycle and the scale of that outperformance is represented by the + and ++, with the latter representing the strongest outperformance. Conversely the red sectors have underperformed during the stated economic cycles, with those marked -- underperforming the most.

Right now it is likely that we are somewhere between the late cycle and possibly the recessionary cycle on the right of the chart. If you look at the sectors that tend to outperform during both of these periods then it is utilities, health care and consumer staples that lead the way.

Funds with defensive equity exposure

So as an investor you might decide to rotate your equity exposure within your portfolio towards those three key sectors. Now this is relatively straightforward with ETFs, as there are a host of them that track the performance of individual sectors, particularly in the US. You can simply search the sector names within your platform's ETF search function.

But if your platform doesn't offer them, or you don't want to take such a direct and significant bet on the economic cycle you could instead opt for a diversified equity fund that has higher exposure, than its peers, to utilities, health care and consumer staples. However it's not easy to screen for funds with higher than average exposure to these sectors using tools available on mainstream platforms or research sites such as morningstar.

So I have analysed over 1,700 unit trust and investment trusts to produce a shortlist of funds that have significant exposure to utilities, health care and consumer staples sectors.

The criteria that each fund had to meet were:

• at least 5% exposure to each of the three defensive sectors (utilities, health care and consumer staples)
• at least approximately 30% total exposure across all three defensive sectors

This produced the two lists below. You may need to scroll to the right on each table to see the final columns.

However, there is no guarantee that the funds selected will necessarily outperform if a recession hits. It is also worth bearing in mind that no two recessions are quite the same. For example, right now we have an overlay of surging energy prices and by way of example, there was no such surge in the pandemic-induced recession of 2022. So to give an overlay of the current market environment to the tables I have highlighted in green the funds that outperformed the average of their peers during two recent bouts of recession fear which coincided with a drop in the 10 year US treasury yield as shown by the red arrow in the chart below. The two periods were 14th-23rd June and 21st-23rd June, when there were two aggressive sell-offs as recession fears gripped markets.

 

Unit trusts for a recession

Fund	ISIN	Sector	Health Care % exposure	Consumer Staples % exposure	Utilities exposure %	Total defensive exposure %
ASI European Equity Enhanced Index	GB00BGHW1T66	Europe Excluding UK	18.18	10.4	5.04	33.62
Aviva Inv Continental European Equity	GB0004457973	Europe Excluding UK	18.52	10.52	5.69	34.73
BlackRock Continental European Income	GB00B3S9LG25	Europe Excluding UK	19.34	5.13	7.02	31.49
Fidelity Sustainable European Equity	GB00B8287518	Europe Excluding UK	17.7	9.7	5.5	32.9
Jupiter Merian European Equity (ex UK)	GB00B1XG8D08	Europe Excluding UK	19.5	8.4	9	36.9
AXA Framlington Global Thematics	GB00BRJZVP64	Global	20.57	5.65	7.09	33.31
JOHCM Global Opportunities	GB00BJ5JMC04	Global	14.68	7.96	13.3	35.94
FP Carmignac Emerging Discovery	GB00BJHPHX25	Global Emerging Markets	9.29	11.05	11.53	31.87
BNY Mellon Global Income	GB00B7XK5M25	Global Equity Income	16.88	11.74	7.07	35.69
Fidelity Global Dividend	GB00B7778087	Global Equity Income	14.7	13.2	6.4	34.3
Sarasin Global Dividend	GB00BGDF8F44	Global Equity Income	17.1	8.4	5.7	31.2
Sarasin Global Higher Dividend	GB00B84ZSV39	Global Equity Income	17.6	9.8	6.3	33.7
Aviva Inv US Equity Income	GB00B44GRT93	North America	13.65	11.65	11.28	36.58
T. Rowe Price US Equity	GB00BD8G5832	North America	20.06	9.82	5.25	35.13
T. Rowe Price US Large Cap Value Equity	GB00BD446M25	North America	20.19	8.6	8.74	37.53
VT Tyndall North American	GB00BYPZY050	North America	27.19	13.58	9.33	50.1
FTF Franklin UK Opportunities	GB00B76GK996	UK All Companies	12.67	21.58	5.08	39.33
Invesco Income & Growth (UK)	GB00B3RS9443	UK All Companies	7.12	8.12	14.91	30.15
Invesco Sustainable UK Companies (UK)	GB0033031047	UK All Companies	8.37	15.29	15.78	39.44
Invesco UK Equity High Income (UK)	GB00B1W7HH10	UK All Companies	6.82	12.25	13.78	32.85
Jupiter Responsible Income	GB0008337569	UK All Companies	14.5	14.7	19.3	48.5
Schroder Sustainable UK Equity	GB0032312729	UK All Companies	15.66	10.13	11.54	37.33
Scottish Widows Environmental Investor	GB0031632010	UK All Companies	11.6	13.96	9.9	35.46
Scottish Widows Ethical	GB0032200213	UK All Companies	18.1	10.01	11.26	39.37
VT Vanneck Equity	GB00BJ4G2665	UK All Companies	10.63	19.33	5.29	35.25
BMO UK Equity Income	GB0033146340	UK Equity Income	14	15.8	5.3	35.1
ES R&M UK Equity Income	GB00B3KQG447	UK Equity Income	16.79	21.65	5.43	43.87
Fidelity Enhanced Income	GB00B87HPZ94	UK Equity Income	9.5	22.4	9.2	41.1
Fidelity Moneybuilder Dividend	GB00B3LNGT95	UK Equity Income	11.2	24.4	10.5	46.1
Premier Miton Income	GB0003884722	UK Equity Income	11.5	14.1	6.1	31.7
Premier Miton Monthly Income	GB0003886875	UK Equity Income	11.6	14.2	6.1	31.9
Premier Miton Optimum Income	GB00B3DDDX03	UK Equity Income	11.7	15.3	6.1	33.1
Threadneedle UK Equity Alpha Income	GB00B12WJY78	UK Equity Income	16.2	15.5	5.04	36.74

 

Investment trusts for a recession

Fund	ISIN	Sector	CITI	Health Care % exposure	Consumer Staples % exposure	Utilities exposure %	Total defensive exposure %
Aberdeen Standard Fund Managers Ltd - Dunedin Income Growth Investment Trust PLC	GB0003406096	IT UK Equity Income	DU37	10.1	5.4	13.8	29.3
Aberdeen Standard Fund Managers Ltd - Murray Income Trust PLC	GB0006111123	IT UK Equity Income	A783	11.7	7.8	12.4	31.9
Allianz - Merchants Trust PLC	GB0005800072	IT UK Equity Income	BJ25	15.9	7	6.4	29.3
BlackRock Investment Management (UK) Ltd - BlackRock Sustainable American Income Tru	GB00B7W0XJ61	IT North America	GWOO	5.1	5.1	19.5	29.7
Invesco - UK Equity Share Portfolio	GB00B1DPVL60	IT UK Equity Income	J689	6.1	13.9	6.3	26.3
Janus Henderson - Henderson High Income Trust	GB0009580571	IT UK Equity & Bond Income	HE23	25.17	7.86	7.31	40.34
Janus Henderson - The City of London Investment Trust	GB0001990497	IT UK Equity Income	HJ01	20.99	7.37	9.58	37.94
Schroder Investment Management Ltd - Schroder Income Growth	GB0007915860	IT UK Equity Income	QA24	5.8	7.1	16.4	29.3

 

Final thoughts

Aside from investing in bonds and defensive sectors one strategy is to invest in companies that pay reliable dividends. Defensive sectors tend to be among those companies that do provide reliable dividends. It is therefore no coincidence that the shortlist of funds above have a disproportionate number from equity income sectors. Or in other words funds that aim to produce reliable income payouts over time. During a recession, you want to focus on those that have a history of maintaining and growing their payouts over time. That is precisely what our UK income fund heatmap, Global income fund heatmap and Investment trust income heatmap do and it is, therefore, no surprise that the likes of Janus Henderson The City of London Investment Trust , which has grown its dividend payout for the last 55 years in a row, makes the list above.