Today’s defensives may not be fit for tomorrow

As we reach nine consecutive years of global economic growth, investors are not planning celebrations. 

Instead, they are becoming increasingly preoccupied with when the next downturn will take place, and in what form. With many eyes tracking the inverting yield curve, concerns over a possible recession naturally put investors on the defensive. But this time, defensive shares are considerably more expensive than their more cyclically sensitive counterparts.

Everywhere but the US, the economic recovery since the global financial crisis has been more muted and fitful than in the past. This fragile recovery made investors cautious, so when they started shifting from safe assets into riskier ones, many chose lower volatility equities, or ‘bond proxies’ (figure 3).

As central banks cut interest rates to ultra-low levels, bond prices rose, as did the price of bond-like assets. This meant that lower-risk equities, or defensives, were re-rated by investors and performed broadly in line with cyclicals, despite the latter being more highly geared to improving economic conditions.

Figure 3: Defensives versus cyclicals

As this chart of total returns shows, consumer staples (a key defensive sector) have performed broadly in line with industrials (a key cyclical sector) since the financial crisis.

Source: Datastream and Rathbones. 

Cause for concern

We have concerns about the welfare of several traditionally defensive sectors. Consumer staples face change as lowered barriers to entry give rise to challenger brands who use social media to target audiences cheaply and effectively. Younger generations have different consumer behaviour and tastes to their predecessors and consumer staples have to keep up. Social responsibility is becoming increasingly important as millennials scrutinise company ethics before purchase.

Shopping online has become the norm but that isn’t good news for supermarkets, which are traditionally a defensive safe haven. The sector faces stiff competition from Amazon Fresh on one side and German discounters Aldi and Lidl on the other. Tobacco companies are facing challenge as their regulators try to shift smokers to ‘reduced harm’ smoking products, such as e-cigarettes and heated tobacco, while also ensuring that these newer products do not appeal to children.

Healthcare and pharmaceuticals usually enjoy relatively stable demand throughout the economic cycle but are currently facing increased scrutiny over drug pricing in the US, where rising healthcare costs are a major political issue. They also face increased competition for established biopharmaceutical products from generic-like ‘biosimilars’. Aerospace and defence are beset by political concerns around supplying Saudi Arabia, following the killing of journalist Jamal Khashoggi.

In the UK, utilities are facing a more punitive regulatory outlook and possible nationalisation if Jeremy Corbyn’s Labour Party comes to power. Quasi-utilities, such as telecoms, have disappointed because of their weak revenue progression and a failure to earn decent returns on capital invested in 4G networks.

Thinking more creatively

Given the challenges traditional defensives face, investors have to cast their net more widely to find safe havens. There are some defensive plays in more traditionally cyclical sectors if you know where to look. For example, media is generally cyclical because of advertising, but actually, there are elements within it, such as academic publishing and business analytics, which should prove more resilient.

In technology, software has traditionally been quite cyclical as software licence sales have relied on notoriously cyclical corporate capital spending budgets. However, more recently, software companies have shifted to a cloud-hosted Software as a Service rental model, which not only means they have annually recurring revenues, but also that they can increase their addressable market as more customers can afford to rent rather than pay an upfront licence fee.

The key to any safe haven is resilience in demand and cashflow, and sensible levels of financial gearing. Investors need to keep an open mind when scouring the market for defensives.

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