Investors need to protect themselves against the unwinding of the current “yield-orientated bubble”, according to David Eiswert, who has been upping his exposure to more economically sensitive areas of the market within his T. Rowe Price Global Focused Growth Equity fund in preparation.
A number of leading industry experts have warned about the outlook for more defensive areas of the equity market, as valuations on mega-cap dividend-paying companies with reliable earnings have been driven up by yield-seeking investors who have been forced out of the bond market due to central bank intervention.
Many now warn that if interest rates do rise and, though anti-consensus, if inflation and economic growth surprise on the upside then there could be a major correction in fixed income, which in turn would drive down the prices of so-called ‘bond proxies’ like utilities and consumer staples stocks.
Eiswert is one such manager. He says investors have to realise that the rally in equities, which has gone from strength to strength since the market bottomed in March 2009 after the global financial crisis, has been far from normal.
Performance of indices since March 2009
Source: FE Analytics
“Unprecedented monetary stimulus and historically low interest rates have been major catalysts for the resurgence in equity markets over the past six years,” Eiswert said.
“However, the magnitude of the accommodation by central banks, amid a persistently sluggish economic environment, has dramatically affected investor psychology and capital allocation decisions by businesses. Market participants have responded to this stimulus with a deep pessimism for the global economy.”
“One manifestation of this paradigm has been a market rally led decisively by defensive sectors. Investors have flocked to less volatile and higher-yielding equities, believing they would deliver bond-like volatility with equity-like returns.”
He added: “We believe this has given rise to a yield-oriented market bubble that is still unwinding today.”
The manager points out that company management teams have added to this phenomenon as, instead of investing for growth, they have been using excess cash to repurchase shares or to increase their dividend payments in order to satisfy investors and boost their share prices.
However, Eiswert says this trend is beginning to change as not only has M&A activity picked up substantially in 2014/05 but companies which are either being bought or are acquiring other businesses are being rewarded on the stock market.
He says that this, along with his belief that economic growth will catch many market participants out, means investors need to start re-positioning their portfolios.
“To be sure, moving beyond a deflationary, defensive mind-set to an inflationary mind-set takes time, but it is already underway,” Eiswert said.
“One reason companies are acquiring each other at a record pace is precisely because the price of acquisition will be higher tomorrow and the quality of the target company likely less attractive. The more investors and companies become concerned with prices rising in the future, the more economic activity is pulled into the present.”
There are many who disagree with the view that inflation and economic growth will surprise on the upside. This argument seems to have legitimacy as well given that CPIs are near zero, there is still huge amounts of debt in the system and Q1 GDP figures in the US and UK were far less superior than first expected.
Nevertheless, economic bulls point to improving wage inflation and recent the boost in US non-farm pay roll figures as signs that the current high prices of safe assets are unfounded.
The likes of Mark Harris recently told FE Trustnet that the bond market “rout” in 2015 is a warning shot of a more brutal sell-off later in the year and therefore he has been selling down his defensive equity income exposure as a result.
As the graph below shows, the fortunes of the likes of the MSCI AC World Consumer Staples and Utilities indices have been tightly linked to those of UK gilts and US treasuries so far this year.
Performance of indices in 2015
Source: FE Analytics
In order to protect his investors, Eiswert is upping his exposure to more cyclical areas of the market.
“As we go through this transition, investors should consider how they want to be positioned for the next two or three years. We focus on businesses with improving economic returns over time – driven by innovation, changing industry structure, regulation, and other forces – and we try to be there early.”
“As the regime of excessive accommodation comes to an end, we want exposure to companies that see profits and margins rise along with interest rates, so we find large US financials attractive.”
“This sector has faced stiff headwinds, but it is one of the few in the US market where valuations are historically low. While financial companies have been constrained in the amount of capital they can pay out, the tough regulatory environment should start to improve or at least stabilise.”
“Leading banks will benefit from rising rates and volatility during the transition to a more inflationary economy. The returns of those businesses should improve.”
This focus on financials has been echoed by the likes of Old Mutual’s Stephen Message and JPM’s Talib Sheikh, who have been buying the sector on the back of attractive valuations and the belief that they will perform well in a rising interest rate environment.
“One can make the case that, as interest rates start to rise, that will probably have a detrimental effect on things like high yield, certainly in the short term. But, you could argue that financials will probably do quite well in that kind of environment,” Sheik said.
It’s not just financials Eiswert has been upping his exposure to, though.
“Given our expectation that we are likely to see a healthier global economy than many investors expect, we have also increased our focus on companies that will benefit from tight supply conditions after years of underinvestment, industry consolidation and capacity retrenchment.”
“These include industrials, such as aerospace, transportation, non-residential construction and home building materials firms.
He added: “We are also overweight technology and consumer discretionary stocks – areas where there is significant change, where industry structures and pricing can improve quickly.”
Eiswert has managed the $127m T. Rowe Price Global Focused Growth Equity fund since January 2012.
Performance of fund versus sector and index since Jan 2012
Source: FE Analytics
According to FE Analytics, it has been a top quartile performer in the IA Global sector over that time with returns of 70.11 per cent, beating its benchmark – the MSCI AC World index – by 15 percentage points in the process.
While it narrowly underperformed in 2012, it was top quartile and beat the index in 2013 and 2014 and is outperforming once again in 2015. T. Rowe Price Global Focused Growth Equity has an ongoing charges figure of 1.77 per cent.
