Investors are falling into a major trap if they buy defensive bond-like equities such as consumer goods, regulated utilities and large-cap pharmaceuticals, according to Invesco Perpetual’s Martin Walker, who warns that while they may seem like safe investments the outlook for those overvalued sectors is now very poor.
While equity markets have surged so far in 2015, there have been growing concerns within the investment community about the underlying macroeconomic backdrop as worries of deflation and unevenly spread economic growth have increased.
Performance of indices in 2015
Source: FE Analytics
On top of that, more short-term fears such as the ongoing Greek debt negotiations and the upcoming UK general election are also weighing on investors’ minds.
However, with bonds offering very little in terms of their yields, defensive dividend-paying mega-caps have become increasingly popular with investors due to the fixed income-like nature of their shares.
Though there seems little to stop this trend given general concerns within the market, FE Alpha Manager Martin Walker – manager of the Invesco Perpetual UK Growth and UK Aggressive funds – says investors are making a big mistake if they were to buy sectors for their perceived safety.
Indeed, speaking at the FE UK Growth event this week, he went as far as saying it is the worst mistake investors can make.
“It has really been those bond-like equities which have really been driving the market over the last few years and in terms of sectors I would include FMCG [fast-moving consumer goods], regulated utilities but also large-cap pharmaceuticals,” Walker said.
“Fund managers’ Pavlovian reaction to a market that he or she is getting twitchy about is to run to defensive shares, that’s the instinct in all of us. However, I think that is the worst thing you can now do – in fact I think it is a trap.”
“It has been defensive shares which have been driving the market valuation up. Investors, in my view, should look to take shelter from any kind of bond market rotation by looking at value areas of the market – now more so than ever.”
He added: “Particularly value areas that have exposure to global growth.”
While a number of leading industry experts have voiced similar concerns to Walker, his thoughts are still very much anti-consensus compared to the wider market.
Thanks to years of extraordinary monetary policy from the world’s central banks along with deflationary impulses such as high debt levels and falling commodity prices – like the huge drop in the oil price – yields on fixed income assets have been forced down to ultra-low levels.
Performance of index since January 2014
Source: FE Analytics
Ten year-gilts, for example, currently yield 1.6 per cent – meaning that average IA UK Gilt fund is up close to 15 per cent over 12 months – while their German and Japanese equivalents yield just 0.31 per cent and 0.08 per cent respectively.
While some have suggested bonds are now in bubble territory, others say it is only natural they are so highly valued given that inflation in the UK is 0 per cent and the eurozone recently moved into deflation.
“It is fair to say that there is quite a lot for fund managers to fret about at the moment,” Walker said.
“Some of those are short duration in nature, like the general election, and some are longer term like Russia’s actions towards Ukraine, overcapacity in the Chinese economy and the global deflationary death spiral argument that seems to have gripped bond markets and which bears seem very attached to.”
“Also, to some extent, valuation levels within the market.”
However, he warns investors are putting their long-term returns at risk by over-paying for safety both within the bond and equity markets.
Walker added: “But the risk that I think could have the most profound effect on markets is a growth surprise on the upside – and I think that is quite likely over the next year to 18 months.”
“I think, primarily, we will see this coming out of Europe and improved growth data out of China towards the end of the year. I think this will partly challenge the global deflation story.”
“The other challenge will be inflation. It is very hard to push back against deflation when CPI is flat or negative, but I would expect UK and US CPIs to start picking up towards the end of the year and into next year.”
The major reason why the FE Alpha Manager expects inflation to start trending higher is that inflation, as measured by consumer prices indices (CPIs), will soon start to “anniversary out” last year’s falling commodity prices. He thinks that due the lower prices, supply will start to fall which will in turn lead to greater demand over the medium term.
As a result, he expects the oil price to hit a new high over the next five years.
However, a more important factor, according to Walker, is signs of wage growth in developed economies.
“We are seeing wage growth pick up in the UK, US, Germany and even Japan. This, combined with stable or improving GDP forecasts, will really challenge this really bearish defensive mentality which has gripped markets over the past few years,” he said.
“Clearly, if we did see this deflationary consensus ebb away then you would expect some downside in bond markets. If you are seeing some downside action in the bond market, then you clearly don’t want bonds but nor would you like to own bond-like equities.”
Walker notes that investors should be wary of consumer goods, regulated utilities and large-cap pharmaceuticals – which have all delivered stellar returns over recent years due to reliable nature of their earnings and therefore well-protected dividends.
The likes of FE Alpha Manager Nick Train has been one of the prime beneficiaries of this trend, as his very high weighting to the likes of Unilever, Diageo and Heineken has helped his five crown-rated CF Lindsell Train UK Equity fund beat the FTSE All Share and IA UK All Companies sector in each of the last seven calendar years.
There are also a number of high-profile managers who are long-standing advocates of the pharmaceutical sector.
One of the best examples is FE Alpha Manager Neil Woodford, who formerly headed-up Invesco Perpetual’s UK equity desk. He has 17.23 per cent of his £5.5bn CF Woodford UK Equity Income fund across GlaxoSmithKline, AstraZeneca and Roche.
Though to a lesser extent, Walker’s current head of UK equities Mark Barnett is also a fan of large-cap pharma across his income funds.
Walker, instead, says investors should rotate out of those defensive areas and into more value stocks. In an article next week, FE Trustnet will take a closer look at the three sectors the FE Alpha Manager thinks offer the best opportunities.
The FE Alpha Manager has headed up his five crown-rated Invesco Perpetual UK Growth fund since June 2008, over which time his £1.4bn portfolio has beaten both the IA UK All Companies sector and FTSE All Share.
Performance of fund versus sector and index over 5yrs
Source: FE Analytics
The fund has also been a top quartile performer over three and five years and is outperforming both the sector and its benchmark over 12 months.
Walker’s focus on value means his fund has been top decile for its alpha generation relative to its benchmark, risk-adjusted returns and maximum drawdown – which measures the most an investor would have lost if they bought and sold at the worst possible times – over five years.
Invesco Perpetual UK Growth has a clean ongoing charges figure of 0.91 per cent.