The defensive trusts tipped to shine in the macro gloom

For investors cautious on the prospects for stock markets, these are the defensive strategies to consider. 

What’s the investment prognosis for 2023? After the grief of 2022, it’s a question to which we’d all like an upbeat answer. However, some experts predict little cheer in that respect.

As Investec’s investment director Alan Brierley explains, the impressive market returns achieved over the past 10 years were underpinned by “a highly supportive macroeconomic backdrop and unprecedented actions by the authorities”. Investors could buy into bad news, confident that governments would step in with cheap money to bolster the economy and the markets.

But 2022 saw a dramatic and painful end to all that, as inflation bit hard and central banks, led by the US Federal Reserve, embarked on a series of interest rate rises. The S&P 500 lost almost 20% over the year; the MSCI All Country World Index was down 15.7% in local currency.

Stocks were not alone in their suffering: bonds were hit by the surge in inflation. Indeed, as Investec points out “most asset classes recorded heavy losses”.

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The equity rally that lifted markets at the end of 2022 was fuelled by hopes that the situation will be resolved as inflation peaks and further rate rises are dialled down. However, Brierley sees little indication that anything like ‘normal service’ will be resumed any time soon.

Crucially, he argues, “an increasingly hawkish Federal Reserve is clearly focused on bringing inflation under control, even if this results in a recession (or maybe it sees a recession as the only way of bringing sticky inflation under control?)”.

At wealth manager Sparrows Capital, investment director Mark Northway agrees that the Federal Reserve’s “myopic” focus on controlling inflation through rate rises and tightening monetary policy is set to continue, despite the fact that US inflation actually peaked at 9.1% year-on-year in June 2022 and has since dropped back to 6.5%.

He also concurs that this carries with it a real risk of a US recession: “Many of the current inflationary pressures have little to do with an overheated economy, being more about short-term supply chain and resource issues stemming from Covid-19 lockdown and from geopolitical events.”

Yet rate rises as an inflation-control tool are effective principally against demand-driven price rises, rather than supply-side issues. In the current climate, the risk is that they further stifle declining demand and cripple already struggling businesses.

What does this “obsession with inflation”, in Northway’s words, mean for markets?

Brierley sees little joy in the months ahead. Although equity valuations fell last year, he does not believe they yet reflect the prospect of an earnings recession - so there may be further market declines ahead.

At the same time, continuing increases in quantitative tightening by central banks globally will further reduce the money supply, drain liquidity and increase volatility.

The newly published minutes from the Federal Open Market Committee (FOMC) meeting in mid-December make clear that the US central bank does not expect interest rates to be cut this year. Says Brierley: “Today the Federal Reserve is telling investors that it wants asset prices to be lower. Investors should listen.”

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Further volatility is very much on the cards, agrees Northway. Central banks in the US, UK and Europe are in uncharted territory, with the possible exception of the 1970s.

“They are using very blunt tools to manage an incredibly complex situation. The likelihood of over-control – referred to in aviation as a PIO (pilot-induced oscillation) - is extremely high. Investors would be well advised to keep some powder dry.”

In such a febrile economic environment, Brierley highlights the defensive qualities of members of the Association of Investment Companies (AIC) Flexible Investment sector. These trusts invest freely across a wide range of assets, and can adjust portfolio exposures tactically as circumstances change.

Historically, he says, their defensive characteristics have “resulted in very low participations with falling equity markets, with many delivering absolute returns”.

He picks out BH Macro (LSE:BHMG) and Ruffer Investment Company (LSE:RICA) as two that have delivered exceptional recent performance (to 5 January). “While the total return from the MSCI ACWI index since [its 2022 peak at the start of January] peak is -15.7%, BH Macro and Ruffer have delivered net asset value total returns of 21.9% and 7.2% respectively,” he comments.

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Ruffer comfortably outperformed its two closest peers, Capital Gearing (LSE:CGT) and Personal Assets (LSE:PNL). “We believe that its use of derivatives represents a greater toolkit, which is a competitive advantage, particularly in this environment,” observes Brierley.

He also likes JPMorgan Global Core Real Assets (LSE:JARA), up 12.6% over the year to 30 November, “with sterling weakness making a healthy contribution to this gain”.

RIT Capital Partners (LSE:RCP) is something of an outlier, having notably underperformed as a result of its increasing exposure to private equity. Investec has downgraded the trust, on the grounds that the extent of its privately owned assets make it much more risky in reality than its core objective of capital preservation implies.