Defensive Equity Strategies For Volatile Markets

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As equity markets recover from recent interest rate fears, brokers are centred on strategies to counter either re-emerging inflation or a cyclical slowdown.

-The strongest inflationary environment in more than a decade
-We are already in a quasi-tightening cycle, believes Macquarie
-The case for building exposure to defensive shares
-Stocks for inflation and others for a slowdown

By Mark Woodruff

In equity markets to be forewarned is to be forearmed. Future scenarios such as inflation are potentialities, others such as market slowdowns are an inevitable part of the economic cycle. In both cases, stockbrokers are either adjusting portfolios now or planning new ones in anticipation.

As of the 20th of May, US equities were only -3% off their highs and likewise the Australian equity market was only -2% adrift of recent highs.

The resilience in equity markets to date may be partly attributed to a lack of alternative investment opportunities, with cash rates remaining anchored near zero. US 10-year bond yields, even after a sudden rise this year, are still sitting at a miserly 1.7% and at a very similar rate for Australia.

Additional resilience has stemmed from strong corporate earnings that have provided a key support to stocks and their outlook over the medium term.

The US earnings cycle has underpinned the global corporate revival, and the most recent earnings numbers for the US market remain impressive. After the first quarter reporting season, results for 86% of the constituents making up the S&P500 surprised positively.

High commodity prices, fiscal stimulus and conservative forecasts have all combined to give ASX stocks their strongest earnings upgrade cycle in years. Currently, earnings (per share) are almost back to pre-covid levels.

As earnings upgrades have also been occurring on a broad front, one could argue the easy gains have been made in the recovery and expansion phase, particularly if investors made adjustments along the way from Growth to Value.

Before turning our attention towards new sector allocations to prepare for a slowdown phase and to defend against potential inflation, let’s first examine those inflationary expectations.

Inflation

Commodity prices and shipping costs already signal a stronger inflationary environment than we have seen in more than a decade. These rising input costs are still flowing down supply chains, notes Macquarie.

Covid and border closures have negatively impacted labour supply in a way that may impact wage inflation for 12-18 months.

While peak cyclical inflation could be two years away, such current inflationary pressure could still see a Federal Reserve tapering announcement, as a catalyst for higher real yields.

Macquarie continues to expect US 10-year yields to rise to 2% by the end of 2021, which will steepen the yield curve ahead of any rate hikes.

In a strategy piece on the banking sector, Citi also points out the inflationary impact of wages growth, which has been absent for over a decade in the Australian economy. Closed borders and surging demand could be the catalyst to reverse the trend as employment roles are filled domestically.

On the other hand, stockbroker Wilsons is some short-term cautious, expecting the inflation pulse to ease easing over the second half of this year.

The Outlook 

While the RBA is dovish, rising yields and tapering by other banks suggest we are already in a quasi-tightening cycle, suggests Macquarie.

The broker feels the OECD leading indicator is likely to signal a shift to a slowdown phase in May or June. The US manufacturing PMI may have already peaked as re-opening should drive a shift in spending from goods to services. Additionally, while stimulus is not being withdrawn as quickly as after the GFC, we are past that peak too.

The recent 2021 sell-offs in US special-purpose acquisition companies (SPACs) and bitcoin are considered a sign this quasi-tightening is impacting the highest beta assets. These are assets that exhibit greater sensitivity than the broader market.

As a result, Macquarie suggests cyclical momentum is peaking, and expects lower but positive stock returns.

Wilsons feels the one-way bull market of the last year is likely giving way to a more volatile phase as the tug-of-war between better growth and profits, and higher inflation and interest rates, becomes more intense. 

While retaining an overall constructive view on Australia equities, the broker mounts a case for building exposures to defensive shares. 

With the strong recovery backdrop over the last 12 months, defensive names have not stood a chance against the very strong moves in the share prices of cyclical companies.

Just a mere normalisation of returns from the market or a general pull-back in markets would assist such a swing toward defensives, notes the strategists from Wilsons.

The cycle rolls on and by way of illustration Macquarie observes China experienced covid first, then recovered first, and has already moved to the slowdown phase. There is some offset in the US cycle though with additional fiscal stimulus already occurring.

This is relatively good news for Australian stocks as they have a higher correlation with the US compared to China. This is because the US is still the world’s largest economy and its monetary policy drives global equity markets.

Sector allocations

Australian investors should expect lower, but still positive returns and more volatility in the slowdown phase, according to Macquarie. The shift to defensives is considered the biggest sector allocation change that occurs in a slowdown. Within defensives, the Healthcare and Consumer Staples sectors tend to be the best performing in this phase of the cycle.

Within Healthcare, outperformance tends to be driven by Pharma and Biotechs such as CSL ((CSL)). Next in terms of performance tends to be Staples, driven by Food & Beverage retailing.

The complication in this cycle is to avoid rotating to defensives (such as supermarkets) that were covid-winners, as there will likely be higher uncertainty over post-pandemic earnings. That said, the broker notes ABS data suggest sales have reverted to the pre-pandemic trend.

Consumer Services is another sector with high odds of outperforming in a slowdown and Macquarie believes even more so in this particular slowdown. This is because casinos and travel agents stocks for example were negatively impacted by covid.

However, the broker cautions against becoming overly defensive, as a slowdown may not be immediately followed by another downturn. In recent cycles the first slowdown phase was followed by a second (or third) expansion. This could occur if the re-opening drives strong spending.

Macquarie also expects Value to outperform in a slowdown though on a lesser scale than during the expansion phase. Value would be favoured by upside risk to bond yields and the still high PE dispersion in Australia. Finally, small caps often lose their outperformance relative to large caps in the slowdown phase.

Stocks for inflation and others for a slowdown

Wilsons has compiled a go-to shopping list of a dozen quality defensive names. Should there be increasing concern about growth, inflation or other risk scenarios the list will be on-hand.

In a pre-emptive move for bumpier near-term markets, the broker recently added Telstra ((TLS)) to reduce the beta (market-related, rather than, stock-specific, risk) of the list and dampen the overall potential share price volatility. This is for an overall broker portfolio that still has 65% exposures that will directly benefit from the cyclical recovery.

The other eleven names by sector are as follows: Consumer staples includes Woolworths ((WOW)) and Coles Group ((COL)); Financials include ASX ((ASX)), Insurance Australia Group ((IAG)) and Medibank Private ((MPL)); Within Healthcare are CSL, ResMed ((RMD)) and Ramsay Health Care ((RHC)); Materials includes Amcor ((AMC)) and Northern Star Resources ((NST)); and finally Brambles ((BXB)) comes under Industrials.

Macquarie feels the defensive options for a portfolio are limited by uncertainty over post-pandemic earnings, as does the impact of higher real yields on the valuations of many defensive equities.

While rising yields are a potential valuation risk, earnings for CSL, Cochlear and Ramsay Health Care were all negatively impacted by covid and have the potential to bounce back. Meanwhile, Woolworths has a potential offset from the Endeavour Group spin-off.

Banks

Banks should also be an attractive defensive in a slowdown, according to Macquarie.  They also have the strongest EPS upgrades of any industry group and tend to outperform as bond yields rise. Commonwealth Bank of Australia ((CBA)) is considered a low beta bank.

Citi agrees on the relative attractiveness of banks though with absolute valuations looking stretched, higher revenue growth or cost-outs will be needed to make the case for rising share prices from here. Building inflation bodes well for the cyclical/value sectors, with banks particularly well placed to outperform in a relative sense.

As bank sector performance is highly correlated with inflation, potentially the only way this relationship holds is if other sectors de-rate versus the banks, given the high absolute valuation starting point.

Higher inflation and higher rates have led to proven sector outperformance over many cycles. There are also a few fundamental benefits as well, with ensuing wage inflation generally good for loan serviceability. This will be important as the household sector digests a run-down of excess covid deposits over time and there is a roll-off of cheap fixed rate loans in years to come.

Banks globally are the most leveraged to inflation, while technology is the opposite.

Australian Technology

There has been a stark divergence in performance between the US and Australia for technology equities. Despite rotational pressure as interest rates edge up in the US, the sector is still seeing impressive upgrades from a fundamental perspective, with one year forward estimates 7% higher than three months ago.

Meanwhile, in Australia technology earnings are under significant pressure, with one year forward estimates -6% lower than three months ago.

Emerging Markets

One year forward estimates for emerging markets (EM) are low compared to pre-covid levels, suggesting plenty of scope for additional upgrades. 

EMs have had a very strong recovery last year and early this year but have weakened in the last few months despite ongoing upgrades to estimates.

The recent weakness has largely been due to a weaker trend in Chinese equities, explains Wilsons. This stems from concerns over credit tightening and increased regulation in the technology/e-commerce sector.

Potential Risks to an overall positive outlook

One risk is the Biden administration’s proposal to lift the US corporate tax rate to 28% from 21% though the market seems to believe the hike will be negotiated down in the Senate, probably to 25%.

Another possible scenario is the global re-opening hits a speed bump due to a covid relapse, with the global vaccine program potentially proving less effective than hoped.

Wilsons still sees significant potential for a further strong profit uplift as the world progressively re-opens and pent up demand is released over the coming 12-24 months.

The broker concludes there is upside risk in Australia as earnings expectations for the coming year are still below pre-covid levels, as opposed to the higher US equity markets.

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