Global Equity Sectors: Not The Time To Be Defensive
Despite the turmoil in global financial markets over the summer, there have been some important divergences and leadership changes that did not occur in previous “risk-off” phases in recent years. Notably, this bout of weakness has mostly been driven by Fed “tapering” concerns, and changes at the BoE, rather than policy indifference in the face of deteriorating economic activity (which was the source of market woes in 2010-2012). One important change, which we expect to persist in the coming year, has been the loss of equity market leadership by defensive equity sectors.
Paralleling the rotation in investment flows out of bonds into stocks, global equity markets have seen a relative fading in defensive sectors’ performance. Initially this shift was focused in the high-dividend, “bond-proxies” parts of the stock market. Relative underperformance in defensives has recently broadened somewhat, as more cyclical sectors have started to attract investor interest, especially industrials and select technology sectors.
The chart shows that rising bond yields have coincided with periods of poor relative performance in defensives. Such periods develop when economic activity is sufficiently robust to push up yields. Relatively expensive defensive sectors have only slightly underperformed recently as yields have moved up. This has likely occurred because investors are still wary of embracing a more upbeat view on global growth, after repeated disappointments in recent years. This wariness should fade over time.
Aside from being underweight most defensive sectors, MRB favors the financial sector which tends to perform better in a rising bond yield environment. Typically, such periods witness an improvement in bank asset values (and lower loan loss reserves), a steeper yield curve (positive for net interest margins) and, later on, a better lending backdrop. Rising bond yields are also positive for insurers.
The recent spike in bond yields is a slight overreaction to perceived changes in central bank policy (especially with regards to the Fed and BoE), and yields should calm this autumn. However, beyond any short-term stability, MRB expects global economic growth to gradually improve and bond yields to grind higher in the coming 12 months. This will favor most early- and mid-cycle equity sectors, and financials, to the detriment of defensives.
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Salvatore Ruscitti, MRB – The Macro Research Board