How the cost-of-living crisis is changing the way pros invest

Fund managers are making tactical adjustments to portfolios as they seek shelter from economic headwinds, writes David Prosser. 

Britons have gone off going out, cut back their spending on food and started wearing old clothes for longer. That’s the conclusion of new research from the Office of National Statistics (ONS), which looks at how spending is changing in the wake of the Covid-19 crisis and amid a dramatic rise in the cost of living.

Almost two-thirds of Britons have reduced spending on non-essential items, the ONS concludes – and they’re not alone. Inflation is spiking around the world, prompting people everywhere to tighten their belts. The response of central banks is adding to the squeeze, as interest rate rises drive household costs even higher.

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The impacts of the cost-of-living crisis are inevitably flowing through the economy and into stock markets. Blue-chip UK stocks were broadly flat in the first half of the year – and with US shares down 20%, that might be considered a good result. Still, while the spectre of stagflation is very real – as inflation remains stubbornly high because of pressures such as the war in Ukraine and growth slows as policymakers try to tackle it – not all sectors and industries are affected in the same way.

“There has been a general switch from growth to value stocks in this inflationary environment,” says Richard Hunter, head of markets at interactive investor. “And defensive shares – where the underlying products remain in demand whatever the economic weather, or where companies have the pricing power to pass on costs to consumers – have come back into focus.”

How fund managers are responding

Fund managers are rethinking their portfolio positioning accordingly. “If the global economy slows, then many commodities may have seen the best of this run – we’ve already seen a 10% drop in the price of Brent oil in the past couple of weeks,” warns Simon Edelsten, co-manager of the Artemis Global Select fund and the Mid Wynd International Investment Trust (LSE:MWY).

He added: “Some of the value stocks may struggle: we are wary of retailers, housebuilders and banks - these rarely experience much joy in a recession.”

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Looking solely at equity markets, one useful screen that many fund managers apply is the “market beta” of particular sectors. This is a measure of how a sector tends to perform relative to the rest of the market when the market as a whole is falling.

In the current environment, it is significant that utilities, consumer staples, real estate and healthcare all have market betas of less than 1, signalling that they tend to outperform when the market falls. By contrast, energy, consumer discretionary, industrials, financials and technology all have a market beta above 1, suggesting the opposite is true.

Are defensive shares set to prosper?

Does this mean fund managers should jump into the first group of sectors – the defensives - while avoiding the second – the cyclicals? Not necessarily – as ever, the realities of investment are more nuanced.

For example, Artemis’s Edelsten certainly sees the case for defensive stocks – he picks out pet food as one interesting area. “Many people would sooner switch to own-brand food essentials than face the wrath of their moggie or mongrel.”

But Edelsten also thinks there are opportunities in cyclical sectors. “We have been revisiting the shares of technology companies that have suffered collateral damage from the market reappraisal of tech stocks,” he says.

“There are plenty of technology companies caught in the crossfire that are extremely profitable. The best of these have relatively low input costs – they don’t employ as many people and they are not making things that rely on parts and materials being shipped around the world, which makes them resilient in the face of inflation. And their funding models may offer protection in a recession too.”

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Similarly, Nick Brind, co-manager of Polar Capital Global Financials (LSE:PCFT), says that while conventional wisdom is that financial stocks are best-avoided during tough times – cash-strapped consumers struggle to repay loans, for example – this is not always the case.

“Financials, in particular banks, are the most sensitive sector to rising inflation to the extent it leads to higher bond yields and interest rates,” he points out. “The earnings of banks, all things being equal, are very sensitive to rising interest rates but also bond yields which would result in their earnings rising sharply, as loans are repriced, and as net interest margins widen.”

That sounds like a case for buying bank stocks. However, interactive investor’s Hunter flags up the need to dig a little deeper rather than relying only on received wisdom.

Defensive shares have outperformed, he points out, with tobacco giant British American Tobacco (LSE:BATS) and drinks group Diageo (LSE:DGE) up 22.8% and 7.8% over the past year (to 8 August) against a rise of 0.8% for the FTSE All-Share index. But there have been other winners too, including in sectors with high market betas. “Centrica (LSE:CNA) has added 69.4%,” Hunter says. “And while the oil companies are arguably a partial cause of the cost-of-living crisis, they are certainly beneficiaries: oil stocks have also mirrored a strong surge in the oil price, with Shell (LSE:SHEL) and BP (LSE:BP.) up 46.3% and 35.6% respectively.”

Looking for shares with inflation protection

Stephen Anness, manager of the Invesco Select Trust global equity income portfolio, also argues that traditional sector definitions may need redefining in the modern world. In particular, he points to the utilities sector, where people’s views of what count as an essential service are evolving. “We’ve been focusing recently on companies that have utility-like characteristics to build some inflation protection within the portfolio,” he says.

That led the fund to invest in American Tower (NYSE:AMT), a technology company that manages mobile phone cell sites in 200,000 sites around the world. Anness has also bought a stake in media group Universal Music Group (EURONEXT:UMG), which at first sight seems like a classic cyclical play given that music purchases are discretionary.

“Streaming services such as Spotify (NYSE:SPOT) are the equivalent of toll roads for music consumption in a world where few of us buy CDs anymore,” explains Anness. “We think it’s difficult to see subscriber levels falling too drastically and UMG owns the music rights of many of the world’s best artists, past and present; it clips royalties every time its artists are streamed.”

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Another nuance is to think about where you invest. Analysis from fund management group Schroders suggests that while the UK, Europe, the US and Japan are all suffering their own versions of a cost-of-living crisis, stock markets in the first two of these economies provide more protection.

This is a reflection of the respective importance of defensive and cyclical sectors in each country, explains Schroders’ head of strategic research, Duncan Lamont. “Around 50% of the MSCI UK index is made up of energy and defensive stocks, while the equivalent figure for Europe is 36%,” he points out. “But the US and Japan are significantly overweight sectors that would be expected to underperform – such as IT and consumer discretionary respectively.”

On this basis, Schroders calculates that in the event of historical returns during previous periods of stagflation repeating, UK and European equities would outperform the global market by 4% and 1% per year respectively. The US and Japan, by contrast, would both lag by 0.5%; emerging markets, at 0.6% behind, would do even worse.

None of which is to suggest investors should be making wholesale changes to their portfolios right now. Stock market investment is, after all, a long-term pursuit and there are costs to chopping and changing in the short term.

Nevertheless, many fund managers are making tactical adjustments to asset allocations as they seek shelter from economic headwinds. An embrace of more defensive sectors (and regions) – and defensive stocks in sectors that might otherwise be considered cyclical – is continuing. So too is a shift into other asset classes for those managers whose mandates allow such flexibility.

David Prosseris a freelance contributor and not a direct employee of interactive investor.