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Expensive defensives in retreat
Anyone looking for evidence Donald Trump’s election has sparked a ‘dash for trash’ need look no further than the government bond market.
The best performing government debt in the world this week belongs to Greece: the country’s 10 year bonds were one of only a handful of
fixed income securities to gain in value since the US vote.
The price of most countries’ government bonds fell, meaning their yields rose.
Equity investors are making use of the same playbook. Shares in high quality, defensive names like Unilever (ULVR) are down 4.5% since the election while the indebted and highly cyclical UK equipment hire outfit HSS Hire (HSS) is up 4.5%.
Why? The answer is straightforward. In a low growth, low inflation environment investing in a solid company at 20 times earnings, provided it can grow modestly, makes sense. Over time, these kinds of businesses will deliver steady and occasionally spectacular returns to investors, even from high starting valuations.
On the other side of the coin are cyclical stocks. Investing in a business like HSS even at 10 times earnings is risky: its profitability and share price can go into meltdown at the mere sniff of an economic downturn.
Today, investors are betting the risk of a global economic downturn has declined. The downside risk at cyclical stocks, particularly in the US and maybe in other developed countries, is being underwritten by what markets expect to be a free-spending Republican president in the US.
In such an environment, cyclical stocks should deliver stronger earnings per share growth from low starting valuations. This would make them more attractive than more expensive, lower growth defensives. Investors are repositioning their portfolios as a result.
Some commentators expect this trade to continue in the year ahead. Others, including analysts at Bank of America-Merrill Lynch (BAML), say investors may be getting too far ahead of the curve.
A BAML statistical analysis of price movements since Trump’s victory indicates defensives may now be oversold.
Defensive stocks in the utilities sector, including National Grid (NG.), and the utility-like telecoms sector, including Vodafone (VOD), have seen the weakest performance relative to the rest of the market.
Cyclicals like miners, banks and (life) insurers are flagged by BAML equity strategist Tommy Ricketts as ‘overbought’.
In the short term, statistical analysis of price movements can have some value. Longer term it is earnings that will determine the success or failure of any investment and investors should consider the relative growth.
Even BAML’s Ricketts accepts that higher global economic growth would support the rally in cyclicals in the medium term. (WC)