For investors, the start of this decade marked a very different environment to the prior one. The prior decade saw monetary policy remaining loose as economic shocks seemed to hit the demand side of the economy. The labour market took a substantial time to recover in the aftermath of the financial crisis of 2008 and the largest problem seemed to be generating inflation.
Turning back to the present, economic shocks seem to stem from the supply side of the economy. The tight labour market is seeing stickier wage pressures, keeping inflation elevated. This has driven central banks to not only raise interest rates aggressively but threaten to hold them there for an extended period of time. In terms of fiscal stance, long gone are the days of austerity with federal budgets operating large deficits. Geopolitically, regional conflicts have broken out and concerns are mounting that more actors could get involved.
Taking this altogether, one would assume that equity investors would have been right to pivot their portfolio towards the so-called defensive sectors.
These sectors tend to focus on expenditure that are less discretionary in nature and fulfil a need, rather than a want. The industries that make this broad category include Utilities, Consumer Staples and Healthcare. In an environment where the cost of borrowing is increasing and consumers have been squeezed in real terms, one would assume that the safety of these industries would be desirable. So far this year, the bellwether S&P 500 (market weighted) index has returned 14.8%* versus a decline of 5.1%, 6.5% and 12.9% for Consumer staples, Healthcare and Utilities subsectors respectively. Clearly adopting a strategy on focussing equity exposure on expenditure that is not cyclical has not paid off so far. So why have these lagged the index by such a large quantum?
It is important to note the overall breadth of the market has been narrow. Headlines focus on the equities dubbed the magnificent seven. These have been darlings of the equity market as the buzz around AI seems to have captured everyone’s imagination, as well their savings. These companies are Meta (parent of Facebook and Instagram), Microsoft, Apple, Amazon, Alphabet (parent of Google and YouTube), Tesla and Nvidia. The basket of these seven stocks on an equally weighted basis has returned a staggering 91% year to date (YTD). By contrast, the equally weight S&P 500 index has delivered flat returns year to date. To illustrate this point further, the Consumer Discretionary sector, a sector one would expect to be most affected by consumers pairing back expenditure, is up 26.2% YTD, thus outperforming the market index. Digging deeper into this subsector, we note that Tesla and Amazon combined, make up 50% of this category and were up 70.5% and 67.4% respectively YTD. Stripping those two stocks out, we can see the names most associated with this type of spending like Home Depot and Nike are down for the year.
The other important headwinds affecting this basket of stocks is the cost of debt.
While the predictability of the defensive sectors are highly desirable, Utilities tend to run their businesses with sizeable debt. In fact, a lot of the defensive sectors engaged in financial engineering over the prior decade. This involved increasing their level of debt relative to earnings as interest costs declined. This enabled them to give shareholders larger rewards without materially changing their earnings. As interest rates have risen substantially, on a forward-looking basis, they will need to use more of their earnings to service the increased interest costs. This could potentially dent the prospects of rising dividends. Another side effect of rising interest rates is the price to earnings multiple, better known as P/E ratios, that investors are willing to pay for these businesses. When interest rates were low, the cost of debt was below earnings yield. Currently with longer dated utility bonds yielding between 6 and 7%, this equates to a rough P/E multiple of 15 and is below the average 18 level that investors were willing to pay over the past ten years.
With government bonds yielding close to 5% and higher quality investment grade corporate bonds yielding in excess of 6%, the defensive sectors are competing with the alternatives available in bonds. Should we see a clearer sign that central bank policy is slowing down the economy and reducing inflation pressures, then investors may well see the attractiveness of these sectors again.
*up to the close at the 9th of November 2023
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