Investors might be wondering whether defensive ASX shares are good investments in this environment considering volatility is picking up and the possibility of a recession is rising.
In a typical recession, defensive shares can demonstrate resilient earnings and this could mean a more robust share price.
But, in this period of high inflation and rising interest rates, things may be a bit different.
Profit and the performance of the share price can sometimes vary quite dramatically. In a higher interest rate environment, investors may not value the defensive earnings of some ASX shares as much as they used to. Inflation could also hurt their earnings.
Emma Fisher from Airlie Funds Management discusses which ASX shares could be opportunities in the Australian Financial Review (AFR).
For starters, she said that investors have a better chance of making good money when markets are down. This is because it gives more potential to buy mispriced assets.
She said: "Even though it doesn't feel as good and it doesn't feel as comfortable as when markets are making new highs, it's actually a better environment for stock picking."
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Time to look at defensive ASX shares?
Airlie's Fisher is not convinced that defensive shares are an easy pick. Companies like Telstra Corporation Ltd (ASX: TLS) and Brambles Limited (ASX: BXB) were two of the names considered.
Fisher said:
If we are in a more inflationary environment than we have been historically, you want to look at the capital intensity of the business model.
So, a lot of those businesses like Telstra or Brambles, they're spending billions of dollars a year on maintenance capex and that's going to cost even more each year in an inflationary environment.
They're sort of running harder to stand still and you're paying more for them now than you did a year ago. That, to us, doesn't scream good value.
However, the Airlie fund does have some ASX shares in the portfolio that are seen as defensive. They include Woolworths Group Ltd (ASX: WOW), Wesfarmers Ltd (ASX: WES) and CSL Limited (ASX: CSL).
The tricky thing about this investment environment is that both valuations and earnings outlooks have changed for different areas of the market.
Fisher said:
It can be tempting when you're worried about where the cycle is going to want to hide in defensives.
The challenge you've got is the defensive, safe, boring part of the market has re-rated. So, you're now facing this choice between, in some instances, eye-wateringly expensive, defensive companies and bombed-out consumer-facing businesses that look tantalisingly cheap, but where you recognise that the earnings are probably too high.
You've got to have a playbook for how you navigate both sides of the market.
Why do interest rates matter?
The market may view defensive ASX shares as worth a bit less right now. This is because asset values are pulled lower by higher interest rates.
Warren Buffett once described why this is the case:
The value of every business, the value of a farm, the value of an apartment house, the value of any economic asset, is 100% sensitive to interest rates because all you are doing in investing is transferring some money to somebody now in exchange for what you expect the stream of money to be, to come in over a period of time, and the higher interest rates are the less that present value is going to be. So every business by its nature … its intrinsic valuation is 100% sensitive to interest rates.
The Reserve Bank of Australia (RBA) increased interest rates by another 50 basis points today. The RBA "expects to increase interest rates further over the months ahead". So it could continue to be a bumpy ride for ASX shares.
