Lofthouse (pictured), who manages the Henderson Global Equity Income fund, says that higher bond yields and an eventual upward movement in interest rates should be good news for equity investors as it will likely signal sustained economic growth.
However, the manager says that while equity income returns should be positive in that sort of environment, some of the more traditional – often defensive – sectors will underperform or, even worse, lose investors’ money. Lofthouse, along with his co-manager Andrew Jones, have compiled a study using data from Credit Suisse to see which equity income sectors performed the best between 1999 and May 2013 when treasury yields have risen and the yield curve has steepened.
The research showed that cyclical sectors have been an income investors best bet, something Lofthouse says is particularly prevalent at the moment as treasury yields have gradually trended higher since Ben Bernanke first alerted the market to the possible reduction of QE in May last year.
“The gradual withdrawing of QE will push long bond yields higher and what has generally happened in the past is that stock markets have reacted quite well because it means the outlook for growth is improving,” Lofthouse said.
“On average, the sectors which have had a positive correlation have outperformed and the ones with a negative correlation have underperformed, but have not necessarily lost you money.”
“It is the more cyclical sectors that have outperformed because growth has improved. That has also tended to be the case since yields have risen since May last year. If you look at Autos, for instance, they have been up 30 per cent while the market has been up 13 per cent,” he added.
The manager uses the performance of the S&P 500 index against the S&P 500’s automobiles sub sector during the period between May and mid-December last year. As the graph below shows, the latter outperformed substantially over that time.
Performance of indices between May 2013 and December 2013
Source: FE Analytics
History shows, according to Lofthouse’s study, that other more economically sensitive industries such as banks and technology should also perform well as bond yields trend higher. However, the manager says that the traditional defensive sectors, which have performed very well since the period after the financial crash as investors have not wanted to take too much risk, could start to struggle on a relative basis.
Lofthouse points to the fact that utilities have underperformed since the Fed’s initial tapering talks in May, with a lot of the stocks within those sectors actually delivering a negative return.
Performance of indices between May 2013 and December 2013
Source: FE Analytics
According to the study, some of the other defensive sectors that tend to lag during a period of rising bond yields and steepening yield curves have been the likes of tobacco, food retail, beverages and telecoms.
That’s not to say there haven’t been some anomalies recently, however.
“This is a sort of top down playbook to help us build a portfolio,” Lofthouse said. “When long bond yields go up, equities tend to go up as well. Some of the sectors have performed as expected since May but some haven’t.”
The manager says that one example of this are pharmaceutical companies, which have been some of the worst hit by rising bond yields in the past.
“Pharmas have bucked the trend recently. However, that is because they were fairly out of favour and quite cheap in the first place. That is the main reason why they have performed so well as they were coming from a low starting valuation,” he said.
Lofthouse also points to REITs (Real Estate Investment Trusts) as a sector where returns since May have also been surprising.
However, they have actually underperformed – and in places lost you money – when in the past it has been an area of the market which has delivered decent returns when bond yields have risen.
According to FE Analytics, the S&P 500 REIT index has lost more than 12 per cent since May last year.
Lofthouse says that the major reason for this, however, is because investors have been desperately buying up income generating assets. Therefore, the sector has fallen quickly out of favour – despite its cyclical nature – has it was already very highly valued.
Mining & metals along with energy stocks have also struggled over the past year or so.
Lofthouse says that, even though they are two sectors that should become more profitable when economic growth reappears, they have underperformed due to external factors such as falling demand in the emerging markets.
As a result, however, Lofthouse says that he will be looking to increase his exposure to the likes of mining stocks over coming year or two.
“From here, if the recovery carries on, then metal and mining stocks along with energy stocks could be the areas to invest as they are two sectors that have so far been left behind,” he said.
The manager says that all these factors are helping him to build his fund.
“As stock pickers we are not just building a portfolio because of past performance, but you don’t want to be invested in expensive sectors which might underperform when bond yields rise,” Lofthouse said.
“It helps us get some perspective to what is actually happens when yields rise. It can be dangerous to say it might be different this time, which of course could be the case, but it doesn’t have a very good track record,” he added.
Lofthouse joined Jones as manager of the £676m Henderson Global Equity Income fund in May 2012.
According to FE Analytics, over that time the fund has been the fifth best performing portfolio in the IMA Global Equity Income sector with returns of 48.48 per cent, beating its benchmark – the MSCI World index – by around 5 percentage points.
Performance of fund versus sector and index since May 2012
Source: FE Analytics
It also boasts top quartile returns over the last 12 months.
Henderson Global Equity Income has a yield of 3.4 per cent and pays out its dividend quarterly. Pharmaceuticals and biotech are the managers largest sector weighting, however Lofthouse describes the fund has being more cyclically biased.
That is shown by the fact that the fund has a decent position in banks and media stocks, and has next no exposure to utilities or tobacco.
The fund has an ongoing charges figure (OCF) of 1.8 per cent and requires a minimum investment of £1,000.