- Falling yields and the slowdown in GDP growth have lowered the discount rate for equities; the declining equity risk premium has more than offset the lower growth profile.
- Defensive sector outperformance primarily reflects the hunt for yield.
Recently disappointing PMIs have renewed market concerns about the prospect of recession in the US, or at least a more significant slowdown, and the decline in the 10-year Treasury yield has been seen to send exactly that message. One could argue that Treasury yields have fallen in line with declining PMIs over the last year, merely reflecting the slowdown, not anticipating it.
What are equity markets paying attention to when it is obviously not the falling PMIs given equities’ strength this year?
We believe it is not rising earnings expectations (read: economic growth), but rather a sharp fall in the equity risk premium (ERP) and declining interest rates.
What about the view that the relatively poor performance this year of cyclical sectors, and the outperformance of defensive sectors, shows a rotation into safer parts of the market ahead of a downturn?
The cyclical sectors that most often outperform in rising markets are information technology (TEC), financials (FIN), consumer discretionary (C-D), and industrials (IND). The sectors that typically underperform are consumer staples (C-S), utilities (UTY), and telecom services (TEL).
Technology is the only one of these cyclical sectors to have clearly beaten the index this year, while of the defensives, two have outperformed instead of underperforming (see Exhibit 1).
Exhibit 1: US equity sector year-to-date returns
Data as at 4 October 2019. TEC = Information Technology, RST = Real Estate, UTY = Utilities, MED = Media & Entertainment, C-S = Consumer Staples, C-D = Consumer Discretionary, SPX = S&P 500, IND = Industrials, TEL = Telecommunication Services, FIN = Financials, MAT = Materials, HLT = Health Care, EGY = EGY. Source: FactSet, MSCI
The strong showing of real estate (RST), and lagging returns for financials, suggest that it may be more interest rates than defensiveness that are driving sector returns. Real estate and utilities are currently both offering a 3% dividend yield and consumer staples 2.7% (vs. 2% for the broad S&P 500 index), while the typically cyclical banking sector has clearly been suffering from low interest rates.
One important consequence of the current hunt for yield, however, is that some sectors have become expensive. The price/earnings ratio (P/E) of the S&P 500 is currently 15% above the average since 1985, but the P/E of utilities is 53% above the average and that of real estate 43% (the real estate ratio is based on price to funds from operations).
Do defensive sectors necessarily outperform ahead of turns in the market?
Over the life of the bull market, we have found no notable increase in the frequency of outperformance as the market neared its peak.
We conclude that there may not be a contradiction between declining PMIs, falling bond yields, and (modestly) rising equity markets. Current yields do not necessarily reflect imminent recession, and it is exactly those falling yields that have given life to the equity market.
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