Uncertainty is the watch word for 2017 and it appears to be increasing by the minute. Aside from the political risks to the global economy posed by the new Trump administration and the round of elections in Europe, the policies pursued by the major central banks are likely to prove pivotal. Clearly, the Federal Reserve (Fed) is on a divergent path in the sense that it has already embarked on its tightening cycle, but there is still a clear tendency for ‘imminent’ rate hikes to be repeatedly delayed. In contrast, bond yields have priced in hikes since mid-2016.
Investors often interpret rising interest rates as the precursor of an economic recovery. This raises the question of whether it is an appropriate time to abandon defensive stocks, sometimes referred to as ‘bond proxies’, in favour of those that are more sensitive to economic momentum (‘cyclicals’).
A glance at the historical relative development of these two market segments since 1 January 1990 in comparison to the return on a global bond index is helpful (graph below). For this purpose, it is first necessary to define how the shares of a company are allocated to the corresponding segment, especially since no globally clear definition is available.
Global interest rates versus the relative performance of cyclical and defensive stocks
For the purposes of comparison, each of the 24 industrial groups (or companies included) was classified as either cyclical or defensive in the global industry classification standard of MSCI and Standard & Poor's. The advantage of this method is that the composition of the two global portfolios remains relatively stable over time. The global cyclical portfolio is made up of 15 industrial groups with currently just over 1070 shares, while the remaining 9 industrial groups collectively form the defensive portfolio (around 550 positions). The defensive portfolio performed 2.2 times as well as the cyclical portfolio (blue line, left scale) between 31 December 1989 and 28 February 2017.
It is interesting to compare the interest rate trend with the changes in the yield to maturity on the Bloomberg Barclays Global Aggregate Index (brown line, right scale). The table below shows the data on the 11 largest interest rate increases since the end of 1989.
Table: Periods of rising interest rates
The most marked increase in yields during this period, which occurred in 1994, did not result in any substantial performance differentials between cyclical and defensive stocks. Although interest rate increases tend to be positive for cyclical investment strategies, the excess return generated over defensives has been subject to substantial fluctuations, with five of the eleven phases lasting more than six months. In only four cases, the margin difference was more than 10%.
A further important point besides the interest rate movements is the profitability of the companies. Defensive companies, on average, are 3% more profitable there cyclical peers on a global average. The graph below illustrates the return on equity ratios of the two global equity market segments over time. A switch to cyclical stocks therefore makes sense only if the difference is very large. This is indeed the case currently – the difference is around 5.7%.
Return on Equity of Cyclical and Defensive Stocks
So should investors now turn their back on defensives and switch to cyclical stocks? We would suggest that the answer is no, not just on the basis that historical return patterns have not always supported such a move, but also because of the timing issue. The phases of the outperformance of cyclical companies are typically relatively short, as described above. We are now already almost eight months into the new rising rate cycle (as measured by the Barclays Global Aggregate Index yield), which we believe will not last long: the prospective economic conditions in the coming years simply do not provide much room for sustainable interest rate increases, both in view of the high national debt levels seen in the US and large parts of Europe, and the relatively low real growth rates.
One factor that could potentially undermine this thesis, and result in an extended period of outperformance by cyclical stocks, is the economic policy pursued by the newly elected US president. The proposed fiscal stimulus is especially pertinent, given that the financial sector accounts for about 18% of the corresponding world index, while the consumer discretionary segment constitutes around 12% and the industrials sector almost 11%. Additionally, the planned reform of the Affordable Care Act might negatively impact the healthcare sector, which represents approximately 12% of the world index and 28% of the world defensive portfolio.
Nevertheless, on the basis of historical comparisons, the case for investing in cyclicals is, at best, a tactical and selective one. Indeed, it makes sense for income-oriented investors to remain largely positioned in defensive sectors. Long-term outperformance, as clearly demonstrated by our analysis, is primarily achieved through positioning in defensive stocks. This is unlikely to change regardless of recent, or forthcoming, election results.
However, we would not necessarily advocate an indiscriminate exposure to defensive sectors since we believe that a discretionary overlay based on fundamental analysis can add significant value. In this respect, we particularly favour companies that can generate high levels of free cash flow and those that are able to cover their cost of equity on a sustainable basis.