Cycling on a tightrope
Matthew Hudson reviews the current position in the economic cycle and recommends a defensive approach to equity holdings
KEY POINTS
- The global balancing act looks unstable
- Equities have recovered well from low points
- Know your cyclicals from your defensives
- Defensives are a good strategy at the moment
It might sound like a new act for ‘Britain’s got talent’ but the competing dynamics of economic activity and the hangover from the financial crisis makes investing in equities as difficult as cycling on a tightrope. Investors could be forgiven for wondering where economies and, more importantly, markets are heading next. In China the authorities are desperately trying to slow economic growth from the supernormal levels reached in 2010. While in the US, economic activity has finally picked up but the rate of unemployment has remained stubbornly high, restraining consumer demand which traditionally accounts for over 60 per cent of US GDP.
In addition, for major economic blocs such as Europe and the UK, economic activity is expanding but it is still well below the levels reached in 2008. Already inflationary pressures are squeezing consumer incomes and pushing central banks to start thinking about raising interest rates, with the European Central Bank leading the way with the 0.25 per cent rise. Contrast this with the situation in the US, where the central bank (the FED) is still effectively printing money as part of its economic support package most commonly known as quantitative easing (the second stage).1 If we throw in the political and social unrest in North Africa and the Middle East, the tragic situation in Japan and the fundamental imbalance in exchange rates between the economic superpowers of China and America, then the global balancing act looks increasingly unstable.
Meanwhile, back home…
Despite the challenging economic backdrop, equity markets – including the UK equity market – have risen very significantly from the low point reached at the time of the financial crisis. Globally equities have staged one of the most impressive recoveries ever.
Of course, as one might expect, not all stocks have performed the same in the rally. Since early 2009 the equity market has favoured those companies which are exposed to developing and especially Asian markets. China has been one of the key drivers of the global economic recovery. These companies have included industrial manufacturers, such as engineers, but also commodity producers such as mining companies. Mining companies in particular have benefited from the real increase in demand from China for their products such as iron ore, copper, coal or aluminium. However, the share prices of mining companies have also reflected the rise in commodity prices generally as speculative activity, propelled by ultra-loose monetary policies and near zero interest rates in the US financial system, the price both of basic raw materials and food stuffs has been driven up. Having experienced a huge recovery in equity markets over the last two years, investors are becoming more concerned about the fundamental imbalances in the global economy, so how should they progress in these conditions?
Cylicals and defensives
Cyclical stocks
One way of thinking about the equity market is to differentiate between those companies that are heavily influenced by the stage of the economic cycle – let’s call them cyclicals and those that are less influenced by the cycle – let’s call them defensives. For example, imagine a manufacturer of cars. When economic conditions are challenging, volumes fall (as fewer cars are demanded by consumers). Profits fall by a greater extent than the decline in volumes because much of the car manufacturers costs are fixed. In addition, not only do profits fall but the value the market ascribed to these falling profits also diminishes. In contrast, when conditions improve, volumes pick up but the fixed costs do not go up, so profit improves very quickly and usually share prices anticipate this change. This means that cyclical stocks tend to outperform the market when an economic recovery begins. This was very much in evidence in 2009 when traditional cyclical sectors like engineers and autos did very well.
Defensive stocks
Defensive stocks however, do not have as much linkage with the economic cycle. Imagine a utility company which supplies homes with water – demand for water is pretty much constant through the economic cycle. Defensive assets should be attractive to investors as the rate of economic growth slows or actually reverses as it does in a recession. In these periods a defensive water stock with stable and consistent profits should be much more attractive to investors than the car marker where profits are falling as volume growth turns negative. Therefore an investor may favour cyclical companies when economic conditions are improving but wish to have a more significant allocation to defensives as the economic or business cycle matures and risks to growth rise.
The right allocation
Cyclicals and defensives come in all different shapes and sizes and this allows investors to differentiate further between companies. For example, within cyclicals there are commodity cyclicals like the mining company BHP Billiton; consumer cyclicals like the retailer Marks & Spencer; and industrial cyclicals such as the autoparts maker GKN or the engineering company IMI. Of course, what is of utmost importance for an investor in determining the right allocation within a portfolio between cyclicals and defensives, is where we are in the economic or business cycle and in what direction we are headed.
Application to the current market
Applying these principles to the current market, a starting point for many investors is that since 2009 the global economy has reacted to the massive interventions of governments around the world. We have seen quantitative easing and near zero interest rates in the US and UK, direct infrastructure pump priming in countries such as Australia and most importantly China, and in Europe bail outs for those countries most impacted by the 2008 crisis. Unsurprisingly, from the low point in activity at the end of 2008 company profitability has recovered to record levels helped by the programmes mentioned above and so too have equity markets which in the UK have risen by over 33 per cent since December 2008.2 From this position two points stand out.
Commodity prices
First, one of the key effects of supercharged government interventions has been to drive commodity prices to record highs. This is pushing up inflation across the globe but its impact is felt most acutely in the developing world where basic commodities such as foodstuffs or oil are a very high percentage of overall consumer spending. A population which is struggling to feed and clothe itself is more likely to welcome a change in government, as we are currently witnessing in certain Middle Eastern and North African countries. Usually inflationary pressures are a result of economic growth coming through too quickly but in many parts of the global economy, despite the massive government interventions, economic activity is well below peak levels.
Government debt
Second, and perhaps more importantly, a side effect of these interventions is that government debt as well as consumer debt in many developed countries is unsustainably high and the cost of this debt, for governments in particular, is starting to rise. The rising cost of sovereign debt is often in those countries with the slowest rate of economic growth, which in turn is partly due to the pressures of too much debt and the need for fiscal austerity (although at the same time in the UK and US extreme monetary looseness!). So while China recorded GDP growth of 10.3 per cent in 2010, Japan grew by four per cent, the US by 2.8 per cent and UK grew by only 1.3 per cent.3 Economic growth is therefore uneven, poorly distributed and volatile. Many countries including the UK are caught between the pressure of inflation on one side and the weight of debt on the other – truly walking along a tightrope.
Current responses
In order to address these issues and given the very strong recovery in equity values, it seems logical for investors to prefer defensive assets over more cyclical assets at this stage in the cycle. Defensives are not only attractive in a relative sense but also in an absolute sense with low price earnings ratios and high and growing dividend yields. An example of an attractive defensive asset might be the pharmaceutical company GlaxoSmithKline, which (according to Reuters at the time of writing) is trading on a forecast price earnings ratio of ten in 2011 with a prospective yield of 5.9 per cent.
They should also look for those few companies that can grow in a low growth environment where specific opportunities exist. For example, in the telecoms market the proliferation of mobile devices is pushing up the demand for data and consequently the price that can be charged for this traffic by telecoms operators. Other examples include those companies with pricing power which can maintain margins, even as cost pressures (inflation) increase. Companies that have some of these attributes include those in the beverages, pharmaceuticals and telecoms sectors, which combine defensive qualities, attractive yields and growth.
These types of companies are traditionally seen as businesses with dull profits growth, few positive earnings surprises and less exposed to exciting developing market growth, than other sectors such as the miners. However, low valuation in absolute and relative terms, stable business models and high and growing yields may become much more exciting and enticing than previously thought as the economic cycle matures. Old fashioned perhaps, potentially much better value.
Dividends
A key focus for many investors since 2008 has been dividends, which suffered very heavily in the financial crisis and last year from the suspension of the distributions from BP which previously had been one of the biggest payers of income in the UK market. It has been a very difficult period but the outlook is now much more positive with strong dividend growth expected by the market.
Although the distribution of income in the market is still concentrated in a small number of big stocks, underlying dividend growth is robust and yields attractive on a relative and absolute basis.
Bolt on the stabilisers
See Figure 1 for a summary of how share indices around the world have rallied from major low points from 1970 to the present day. With the twin dangers of high levels of debt requiring fiscal austerity and rising inflation pressures, an inclination toward more defensive assets and especially higher yield assets appears a good option for riding the current cycle.
1. www.charitiesdirect.com/caritas-magazine/all-aboard-qe2-846.html
2. Datastream
3. Ibid
Author: Matthew Hudson
Matthew Hudson is a fund manager and a member of the pan-European equity team at Cazenove Capital Management Ltd.
He joined from AIB Govett Investment Management where he was a UK equity fund manager and prior this was a chartered accountant at PriceWaterhouseCoopers in the financial services division.
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