UK recession: How to protect your portfolio

The UK economy officially entered recession at the end of 2023, the Office for National Statistics  (ONS) has confirmed.

Preliminary date from the ONS in February suggested UK GDP shrank 0.3% over the final quarter of 2023.

These figures were subsequently confirmed at the end of March without any revisions.

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Following a 0.1% contraction in the third quarter of 2023, the country's economy is therefore officially in reverse.

High interest rates are one of the factors that's weighed on GDP. The central bank recently held rates at a near-16-year high of 5.25% as part of its attempt to bring down inflation, which dropped to a two-year low of 3.4% in February.

However, it is the shallowest start to a technical recession since the 1970s and more recent data suggests the UK economy has been growing since the start of the year.

Even so, the R word may rattle investors.

While investing in a recession can be frightening, it doesn’t have to be unnerving — if you know what to look for.

"Recessions are tricky times for investors, creating a minefield of business failures that cause bond defaults and declining occupancy rates at properties, cost cutting triggering rising unemployment that squeezes consumption and deteriorating earnings hitting equities," Jason Hollands, managing director of Bestinvest, tells MoneyWeek.

"In other words, stay away from property, consumer discretionary stocks and high yield bonds." 

So, what should you do to shield your investments from a possible recession?

How to protect your portfolio

An ideal portfolio contains a mix of asset classes. As the old saying goes, ‘buy stocks so you can dream, buy bonds so you can sleep'.

“You might want to think about investing in bonds. These tend to move in the opposite direction to equities, so they are good for portfolio diversification, and they tend to do better in tough economic climes,” says Laith Khalaf, head of investment analysis at AJ Bell.

“Rising interest rates have also made bond yields much more attractive, and so you can actually get a decent return from these safer investments nowadays. If you don’t want to manage an allocation to bonds yourself you might consider investing in a multi-asset fund which holds a combination of shares, bonds and cash, and sometimes property, commodities and currencies too,” he adds.

These funds come in a range of risk profiles ranging from conservative to more adventurous, so everyone should be able to find one that meets their needs.

Play defensive?

Another thing to remember is even defensive shares are likely to decline in a recession.

“As such, investors might be positioned in those companies that have the ability to pass on price rises to consumers, even if volumes are declining. This also applies to a portfolio which might be considered inflation-proof to an extent,” Richard Hunter, head of markets at Interactive Investor, tells MoneyWeek.

“Companies which have tended to display these characteristics have been the likes of the tobacco companies (where inelastic demand feeds through to continued consumer purchasing), high-end drinks companies such as Diageo, high-end retailers such as Burberry (where the average consumer may be less affected by the recession) and utility companies where generally higher (and more secure) yields can ease the pain of some share price losses,” he adds.

Another key tip to managing your portfolio in the midst of a recession is not to panic. When you see your investment portfolio going down in value by the day, it’s going to be tempting to consider selling everything to liquidate. The problem with this is that you're likely selling at a loss.

From a sector perspective, investors should consider avoiding or exiting sectors that will suffer in a recessionary environment, such as retailers, big-ticket/white goods providers and leisure companies. 

"The key attributes to look for in shares if you think a recession is looming are companies with strong pricing power, that can sustain their margins and won’t be easily undercut by cheaper rivals because their product commands strong loyalty, as well as businesses with a high degree of recurring income rather than ones reliant on transaction volumes," says Hollands.

"An example of the latter would be Sage, the payroll and accounting software giant. Its systems are highly embedded in the operations of companies that pay licence fees. These are difficult to replace at short notice, making this a very defensive business model," he adds.

Funds that invest heavily in these types of companies include Liontrust UK Growth and TB Evenlode Income.

Cash is an underappreciated asset class but that long-held belief has come into question recently, with plenty of investors changing their tune amid higher saving rates. “Cash is an option now that interest rates are [fairly high],” Hunter says.

The perceived wisdom is to hold between 5% and 10% of the value of your portfolio in cash at any given time.

IN THE FACE OF UNCERTAINTY, DIVERSIFY

In normal times, the 60% equity and 40% bond split should to an extent provide some protection, whatever the economic weather. 

This split is not as consensual as it once was but regardless of the percentages, investors should make sure they don’t have too many eggs in one basket in their equity portfolios.

“Recessions can be punishing for individual stocks and sectors, and you don’t want to be over-exposed to an area that falls through the cracks. Make sure you have a balance of regions and sectors within your portfolio, and also a mix of fund manager styles so your investments aren’t all pointing in the same direction,” Khalaf says.

When picking income stocks, investors should also give some consideration to the dividend track record and dividend cover of the companies they’re investing in. Dividend cover is a measure of how big a company’s profits are compared to its dividends.

“The higher the number, the more secure the dividend as it means the company can suffer a fall in earnings without having to cut the dividend,” the AJ Bell expert explains.

A simple way to boost future returns would be to reinvest all dividends. When the market’s declining, the effect of pound/cost averaging makes the new shares ‘cheaper’, while the underlying holding can then begin to benefit from the wonders of compounding returns, according to Hunter.

Investors also need to think about geographic diversification as economies move in different cycles and at different speeds.

“For example, coming out the other side of a recession, it is likely that the rate and rapidity of recovery will show itself more plainly in the US than the UK, such that investors might consider some extra exposure to the world’s largest economy,” Hunter says.

Finally, make sure your portfolio is invested as tax efficiently as possible using ISAs and self-invested personal pensions (Sipps), so you retain as much of your dividends and gains as possible. 

“If your portfolio is about to encounter rough seas, you’ll be glad you patched up the tax leaks,” Khalaf says.

Longer-term investors should remember that portfolios have been positioned with the expectation that economies and financial markets will experience both ups and downs – this is a normal part of the investing journey.