The UK recently fell into a technical recession after the domestic economy contracted in two consecutive quarters.
Japan also slipped into a technical recession and Germany’s Bundesbank warned that Europe’s largest economy is poised to follow suit.
The classic recession playbook suggests investors should lean towards a defensive allocation, consisting of investment grade bonds, plus companies and sectors deemed to be resilient, and currencies benefiting from safe haven status.
However, such cautiousness may not sit well against the backdrop of all-time highs in the US, Japanese and European stock markets.
Indeed, Kevin Thozet, a member of Carmignac’s investment committee, believes it might be short-sighted to adopt a defensive approach at this point in time.
He explained: “Given the starting point of the economy, the tightness of the job market, the concerns over the stickiness of inflation and all eyes being on when bond yields or policy rates will finally recede, the most likely sequence is that the ‘bad news is good news’ mantra plays out before it is all doom and gloom on financial markets.”
Therefore, Thozet suggested investors should hold growth stocks rather than defensives. He stressed, however, that healthcare is the exception among defensives, as the sector boasts embedded long-term growth.
Thozet also encouraged investors to stay geographically diversified because regional economic cycles are desynchronising. For instance, the US economy has been more resilient so far, while Europe has been stagnating and China is waiting for a recovery.
Like Carmignac, Insight Investments is hedging its bets. The firm has adopted a barbell approach in the equity portion of its multi-asset portfolios, acknowledging the potential for further upside, as well as the risks on the horizon.
Matthew Merritt, head of Insight Investment’s multi-asset strategy group, has been adding to tactical upside exposures where stock markets have the potential to move higher, alongside defensive positions.
He said: “Our equity weighting is above average, and we are mindful that a further lurch up in rates could trigger a larger bout of equity market turbulence. Nevertheless, we are mindful to look for opportunities in such periods with a focus on markets with specific catalysts such as Japan (corporate reform) or laggard markets where we see attractive entry points.”
In the fixed-income sleeve, Merritt has kept low levels of government bond exposure and prefers slightly riskier bonds.
“In a mid-cycle slowdown scenario, spreads may tighten modestly further. Should growth risks come to the fore, the duration component may provide a cushion,” he explained.
Thozet also suggested holding some level of spread assets, that is bonds offering a yield above the risk-free rate.
In the alternatives space, Merritt has been cutting his exposure to infrastructure holdings in recent months, as the move in interest rates this year has impacted the asset class.
He has also kept his exposure to commodities below average, as he does not currently need them as an inflation hedge, while it is still too early in the cycle to see improving demand as a driver of performance.
Preparing for an inflationary rebound
Besides an economic downturn, another concern for fund managers is whether inflation will rebound.
Thozet believes that resurgent inflation is a credible scenario to which investors are not paying enough attention.
He said: “The persistence of inflation, inflation uncertainty and the risk to inflationary pressures mounting again as we approach the turn of the year, appear to be among the most ignored risks out there (when looking at long-term inflation expectations for instance).”
For investors who want to mitigate against these risks, Thozet recommended inflation-linked bonds, alongside some steepening positions.
He also suggested looking into emerging markets assets, including debt, equities and currencies.
Finally, cyclical equities – which have been left “unfairly” aside for so long – would be helpful in this environment, according to Thozet.