How fund managers are preparing for an all-but-nailed-on recession

The drag of operating with heightened cash is an important consideration, says one fixed income manager

Fraser Lundie, head of fixed income, public markets, at Federated Hermes

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The Bank of England forecast a second consecutive 0.1% GDP contraction in the third quarter of the financial year, as it enacted its latest rate hike to 2.25% on 22 September, meaning the UK economy is already in a recession.

As near-record inflation and rising rates hammer consumer spending, activity in manufacturing and construction has been consistently slumping. And that was before the pound plumbed new depths.

Risk appetite

Managers have been reducing their overall risk appetite for some time now, turning to mid-risk assets and alternative allocations as equity markets faced headwinds.

“Our infrastructure book, including across renewable energy, has been particularly resilient, as well as some of the hedge and commodity trading adviser strategies we hold. Our cash level has been moderately elevated and is an outcome of other asset-class-specific decisions elsewhere in the portfolio,” says Tihana Ibrahimpasic, multi-asset portfolio manager at Janus Henderson.

Ibrahimpasic explains that regardless of the “type” of recession the UK economy faced, the firm would favour resilient balance sheets and cash flow-rich businesses boasting robust debt positions and liquidity profiles.

Axa Investment Managers has similarly reduced its equity exposure in this context, skewing to regions such as Japan over areas more vulnerable to geopolitical risk and rate rises, such as the eurozone.

Mathieu L’Hoir, head of institutional multi-asset, says he too now considers cash an “investable asset class”, adding that a significant portion of Axa’s portfolios are now in-money market instruments.

Within fixed income, L’Hoir says he has implemented a flattener trade on bonds – going short on two-year bonds and long on 10-year bonds to take advantage of the rate curve.

“The short end is under pressure as faster hiking is priced in, while the long end should pay off as recession risk rises,” he says. “The speed of the recent correction across almost all asset classes means value is beginning to appear notably at the long end of the eurozone curve.”

Sectors

Other managers are shunning at-risk sectors, such as those reliant on discretionary spending, in favour of less cyclical areas of the market expected to be better served through a downturn.

But according to Fraser Lundie (pictured), head of fixed income, public markets, at Federated Hermes, valuations in credit markets had already priced such concerns “to a large degree”.

“Deploying capital toward companies with the pricing power and balance sheet health to manage through these harder times is now appropriate,” he says.

Lundie explains he had identified attractive opportunities in the European Telecoms sector where M&A would be a likely tailwind and valuations were currently attractive, compared to previous years. Energy stands out as expensive, he adds, and offers little in the way of compensation despite market stress.

“We also expect increasing scrutiny on company’s decarbonisation strategies to become more intense and the degradation of the buyer-base to affect valuations negatively,” says Lundie.

Drag?

For Lundie and income investors like him, the “drag” of operating with heightened cash is an important consideration, particularly now as yields on short-dated government bonds are elevated, compared to recent history.

“That said, with the environment so uncertain, the ability to be nimble and flexible is particularly important and highly liquid securities are used extensively in our portfolios,” he says.

Indeed, half of Shard Capital portfolios are now allocated to uncorrelated or alternative investments. The firm’s head of research, Ernst Knacke, explains that as geopolitics had exacerbated market uncertainty, risk-reward for traditional financial assets has been rendered unattractive.

The firm’s short positions in high-yield bonds and long volatility hedge in equities remains, he says, adding the firm is watching the space as the Federal Reserve’s pace has thrown up attractive yields while providing some protection against a ‘deflationary-bust.’

“From a timing perspective, it might perhaps be a little early, but we have started dipping a toe into long-term US treasury bonds, while retaining exposure to short-dated, inflation-linked treasuries and gilts alongside our short high-yield position,” he says.

Knacke concludes: “The biggest risk, in our opinion, is the extent to which market liquidity could impact capital markets. While we’ve seen some tightening in financial conditions, it could get significantly worse given the direction of travel and broadly hawkish intentions of central bankers around the world. What one might describe as a ‘not-too-unusual recession’ could turn into a depression for some nations if weak currencies exacerbate stagnation.”

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