Equity investors can defend against the next downturn

In less than a year this will be the longest US economic expansion on record. Investors know they should have at least one eye on the timing of the next downturn, but are equally aware that Indian summers in the stock market can be balmy.

If you sold your S&P 500 stocks 24 months before the market peaked in either of the past two US downturns then you missed out on returns in excess of 30 per cent. If you sold 12 months too early then you missed in excess of 15 per cent returns.

The tendency of markets to perform very well at the end of a bull run is a longstanding complication for investors torn between wanting to lock in their gains without missing out on more. This time preparations for a downturn are further muddied by the fact if you choose to lock in returns, it’s not terribly obvious where to shift money to.

Historically, bonds have offered a good shelter. Investors begin nudging further up the capital structure towards corporate bonds, such as investment grade, as the economic cycle matures and then into government bonds as fears intensify. Portfolio managers could take comfort from the expectation that government bond prices would rise as central banks slash interest rates, helping to insulate a portfolio from the drag of falling share prices.

The worry is that fixed income might not provide the shelter historically expected of the next downturn.

First, the quality of many of the corporate bond benchmarks has deteriorated notably since the last recession. The proportion of the investment-grade index that is now lower grade (BBB-rated) is now 49 per cent. In 2006 it was roughly 35 per cent, according to the International Monetary Fund.

Second, the leverage of the companies in the US investment grade index has jumped from 1.4 times in 2006, to 2.5 times. While the US economy is still booming, interest coverage looks perfectly manageable. The same may not be true when the fiscal tailwinds fade.

Third, we are not in a tech boom but a disruption boom. The tech behemoths whose shares have risen almost inexorably in recent years are not creating technologies that will feed broad economic growth. Instead, they are disrupting traditional sectors: grabbing bits of the economic pie rather than making it bigger. This leaves even large US companies that are rated “investment grade” — and their investors — vulnerable to innovation in Silicon Valley.

And yet despite this additional risk, the premium investors are demanding to own investment grade bonds over government debt is still near historic lows.

So why not bypass corporate bonds and head straight to government debt? Perhaps for a US investor that is a possibility. Even if the Federal Reserve stopped its raising rates cycle before too long, the 10-year US Treasury yield at 3.2 per cent does offer some protection for portfolio. But when you hedge that back to sterling that yield virtually disappears.

And it’s unconvincing that the sterling government bond market offers any attraction. If, as I expect, Prime Minister Theresa May not only secures a Brexit deal in the coming months but manages to navigate it through the UK parliament, that could lead to a dramatic repricing of the outlook for UK rates that hits bonds. If, by contrast, a Brexit deal proves elusive — either in Brussels or Westminster — then the chance of a general election and a Labour government with less market-friendly policies rises. It seems that in any scenario the outlook for UK government bond prices is fairly bleak.

So where does that leave a more cautious investor who wants to start increasing the resilience of a portfolio? At this stage, the best strategy is to stick with a modest overweight to equities but begin altering the composition of the stocks in your portfolio. Previous downturns offer potential tweaks to the type of equities you want to be owning.

There are more defensive sectors: consumer staples, telecoms, utilities and healthcare tend to fall by less than the cyclical sectors such as industrials, materials and consumer discretionary. Then there is market cap to consider. Particularly in the UK, small-cap stocks tend to underperform the large-caps. The FTSE 250, for example, has had a considerable run, but at some point it will be time to consider some shift back towards the FTSE 100 names. Finally, “quality” stocks — those that have the best current cash flows — tend to fall by less than the broad index.

Rather than jumping out of equities altogether, investors could consider making these small adjustments to help increase the resilience of a portfolio.

Karen Ward is chief market strategist for Emea, JPMorgan Asset Management