Duck and cover: How to play defence on share markets in volatile times

With war raging in Gaza and the Ukraine, the US economy slowing and oil prices rising, global recession is looking inevitable in the coming months.

Investors are worried about the repercussions on their portfolios and asking which sectors of the share market could provide the greatest protection.

Since the war started in Gaza, stock markets have become much more volatile, with those sectors most adversely effected including airline companies such as Boeing and Deutsche Lufthansa and companies listed in Israel or with connections to the country. Those include technology companies such computer chipmakers — think US giants Nvidia and Intel, which have production plants in Israel.

In contrast, given the surge in oil prices, energy companies have jumped, as have the prices of global defence companies.

With the prospect of global recession in 2024 growing, investors’ portfolios could benefit from defensive investment strategies to reduce overall volatility and enhance risk-adjusted returns.

It is important for investors to know that within global asset markets there are a few important factors that drive returns across asset classes. These factors are driven by different economic rationales and tend to outperform at different times.

“Low volatility” is characterised by being a defensive factor, meaning it tends to benefit during periods of economic contraction. This strategy is more concerned with the management of the volatility of returns from the share market than with maximising gains.

“Value” stocks are those that have low prices relative to their financial fundamentals such as earnings.

“Quality” involves investing in companies with healthy balance sheets including strong earnings and low debt.

A “growth” strategy involves investment in high-growth stocks, such as technology companies.

Companies with low volatility typically enjoy defensive earnings and are the most likely to outperform the overall share market when economies are contracting. In contrast, companies with earnings that are more sensitive to economic growth — such as growth or technology companies — are likely to underperform during recessionary periods.

Low volatility investment strategies have, on average, been the most resilient throughout six US recessions between 1963 and 2019. That is because low volatility strategies tend to include more defensive sectors such as utilities and consumer staples and healthcare companies.

Research from US finance company MSCI has also examined how different equity factors have performed in different inflationary and growth environments since the 1970s. MSCI has found that minimum volatility investing will outperform the overall share market during periods of economic contraction, as well as 70s stagflation. That is, when inflation is rising and economic growth is minimal, a situation the world potentially faces today given high levels of inflation, rising energy prices and interest rates.

One reason for the outperformance of low volatility companies is that investors tend to pay too much for higher-risk or growth stocks. You can see this with the strong run towards technology stocks in the US this year; investors have been paying sky-high prices for the mega-cap technology companies such as Nvidia, which has been riding the artificial intelligence boom.

The US share market rally has been highly concentrated in the so-called “Magnificent 7” largest technology companies in the US — Tesla, Apple, Amazon, Nvidia, Microsoft, Meta (Facebook) and Google’s owner Alphabet.

Given that low volatility strategies have proven to be a protector of capital in most recessions, and with a potential drawdown looming, it may be appropriate for investors to allocate more to defensive sectors in their portfolios, especially with valuations being around fair value.

Low volatility investing can diversify risk and returns and complement other investment strategies such as an allocation to value or growth shares.

John Bilsel is an investment analyst at Innova Asset Management