Why investors should consider defensive income stocks in an inflationary market

As central banks across the globe continue to jack up interest rates in response to soaring inflation, the level of uncertainty in the market has reached unprecedented levels.

Record low interest rates aimed at boosting the economy during the lockdown have led to a massive inflationary bubble with too much money chasing too few goods.

The situation has been exacerbated by a move towards de-globalisation on the back of supply-chain issues brought about by the pandemic and rising geopolitical tension between Russia and China and the West, leading to an increase in global sanctions and an energy crisis to boot.

Although debatable whether the US will enter a full-blown recession, although it is officially there after recording two successive quarters of negative growth, there is little doubt the economic indicators are pointing toward a downturn that will impact people’s earnings, which essentially also means lower share prices.

With the current bear market showing little signs of dissipating anytime soon, one option available for investors to protect their portfolio is through defensive income stocks.

“We're telling investors they need to be defensive in the current storm we find ourselves in; with all this uncertainty, you’ve got to invest your money in ‘sleep-at-night’ dependable cashflow businesses,” says ASR Wealth Advisers head of Australian equities research Tim Montague-Jones.

“That's why we've got our income portfolio, where we look to generate dependable cashflow, which may be perfect for someone who's retired or needs to generate income to live off. We invest in infrastructure, all boring stuff, utilities, toll roads, and ports, and our main priority is capital preservation, prudence and income.

“We're looking for regulated and semi-regulated assets, ideally monopoly assets. We don't expect these things to double in price, but our income portfolio is paying roughly 5.5 to 6 per cent yield.”

What is a defensive stock?

With interest rates at historic lows, your money needs to work harder for you.

Defensive stocks can be relied upon to provide consistent returns and can be used to guard an investment portfolio against speculative losses during economic or market uncertainty.

While not offering huge growth potential, defensive stocks can be trusted to perform consistently during periods of economic decline, when other equities are plummeting.

The Income Report from ASR Wealth Advisers is centred on the investment principal of targeting a consistent and reliable dividend while protecting and preserving capital, safeguarding investors from being unintentionally exposed to any sector.

How can investors protect their portfolios with defensive high-yield income stocks?

During an economic downturn, investors might want to strategically shift away from capital growth stocks toward income-generating stocks.

To help protect your wealth against inflation, ASR Wealth Advisers strongly advocates investing money in equities that are expected to generate a sustainable income. Its analysts scan the market for the income stocks that have the potential to provide the greatest opportunities to support your lifestyle.

Some investors worried about rising inflation might think about cashing out their money and placing it into a cash account at the bank.

But, by having your money on the sidelines, Montague-Jones argues that you will lose money if inflation continues to creep higher. Instead, he advises investors to put money into the income portfolio that provides a source of cash.

“The income portfolio has a record of generating strong returns; it provides a diversified portfolio of defensive assets, and the portfolio has outperformed the market by 21.06 per cent for the financial year 2022. It’s where I put my money, and I believe it's a good place to hide in this current uncertainty, as nobody knows the reality of how we will get through the next year,” he says.

“What you will see in this reporting season is that CEOs will be unwilling to provide an earnings outlook for the financial year 2023 because it's so hard to know how businesses are going to operate through all this economic uncertainty.

“We’ve got an inventory problem brought about by lockdown, essentially a lack of products, and this has led to so much money entering the market, which has caused massive inflation. I think you’re navigating a very uncertain future at the moment, and that’s why you’ve just got to be defensive.”

What are the best examples of the best yielding defensive stocks?

ASR Wealth Advisers is looking to target businesses that can weather a recession or even a depression.

It recommends looking at electricity and distribution companies, as people still need to turn on the lights in the morning after they wake up.

Its income portfolio includes Atlas Arteria (ASX: ALX), which owns toll roads predominantly in France. ASR Wealth Advisers is a big fan of toll roads as they have a CPI-linked contract, so as inflation rises, it's passed on to the consumer, meaning you get a higher cash flow come through.

Another excellent industry for defensive stocks is pipelines, and ASR Wealth Advisers likes APA (ASX: APA). In a recession, the volumes going through pipelines might dimmish slightly, but the reality is that they’re monopoly assets and critical infrastructure, meaning no one can take them over.

ASR Wealth Advisers also likes consumer staples, and its income portfolio includes Inghams (ASX: ING), which is a poultry-based business, and Tassal (ASX: TGR), which is a seafood producer although it is currently in the process of being taken over.

Having previously been invested in Sydney Airports and Spark Infrastructure, Montague-Jones is cognisant that Canadian pension funds are also playing in the same space.

The income portfolio also includes Dalrymple Bay Infrastructure (ASX: DBI), a mining port in Queensland’s Mackay region, paying a roughly 10 per cent yield. It’s a monopoly asset that the Queensland Government regulates, and it’s basically a bottleneck where all the coking coal goes through on the way to China.

Where can you find more information about defensive stocks?

ASR Wealth Advisers is an Australian provider of research that is distributed by its partner Australian Stock Report (ASR) via a subscription-based service.

Its Investing Report provides subscribers with capital growth ideas by choosing good businesses with a sustainable competitive advantage and potential to make a solid capital return.

The Income Report is on the other side of the ledger. It is very defensive, which suits people looking to shift focus away from capital growth to more income to help protect their wealth against inflation by providing consistent dividends and quality earnings.

With August through to October typically the period when market volatility remains high, Montague-Jones advises ASR subscribers to be cautious.

“Investors should stay away from the more consumer discretionary and the tech names and try to be defensive until we get some more clarity on where the global economy is going,” he says.

“We're trying to help the battlers, the average Australians. We are retail-focused, and we’re out there helping people to structure portfolios and advise what sort of stocks they should look at.

“We tend to invest in larger businesses with a market capitalisation over $200 million, so we stay away from all the speculative stocks and concentrate on cashflow positive.”

Investors can sign up for a free Income Report from Australian Stock Report through its website.

How important is it for investors to keep up to date with the current trends?

It is prudent to have a diversified portfolio, and ASR Wealth Advisers investment report provides an extensive range of stocks across sectors that help build a balanced portfolio.

ASR’s webinars provide weekly market updates and, due to the current uncertainty, it bodes well to remain attentive.

How is Australia likely to fare in the next 12 months?

As a commodity-based country, much of Australia’s economic growth depends on China.

The Chinese command economy has been targeting 5.5 per cent growth this year, which looks difficult with a quite aggressive COVID-zero policy stifling its economy.

With Xi Jinping up for re-election in November, and although hard to read, Montague-Jones believes China will look to aggressively stimulate its economy over the next nine months.

This would mean an increase in the Chinese housing market, leading to a growing demand for iron ore and Australian commodity stocks.

“I think our commodity stocks will do well, and I believe Australian household balance sheets are pretty solid - people have been saving for the last couple of years. Banks are very well capitalized; I know some construction companies are going into administration, particularly developers, but we don't see that as a bigger issue.

“Due to the changes in banking regulations after the 2008 global financial crisis, banks have so much cash on the balance sheet that they can easily weather an economic downturn. I don’t think we will have a recession over here; we're going to have a bit of a downturn which will see some wage inflation coming through as our economy is relatively small.

“I think we'll muddle through, to be honest, and I think Australia will do better than the US, UK and Europe, where they certainly have a lot of problems with their reliance on Russia, which we don't have to worry about.”