Renewed turbulence in financial markets means investors should be considering allocating more to defensive and higher-yielding stocks, according to Securities Trust of Scotland manager Mark Whitehead. 
After several years characterised by a relatively calm market backdrop, 2018 has seen the return of volatility and the year has already witnessed two significant sell-offs – the most recent of which started in October and is still flaring up at the moment.
Whitehead, who has managed the £169.3m global equity income trust since May 2016, noted that the synchronised recovery in global growth that was in play for much of 2017 appears to have “broken down”, leading to renewed investor nervousness.
Performance of indices during 2018
Source: FE Analytics
The US remains the best performing G10 economy and its growth is expected to continue into 2019, supported by robust consumer and corporate spending. The picture is different in other parts of the globe, however.
In Europe, for example, the outlook has been impacted by the decision of Italy’s hard left- and right-wing politicians to form a coalition government while the UK’s looming departure from the EU is casting a shadow over both sides of the Channel. Eurozone GDP growth has been decelerating in 2018.
When it comes to emerging and frontier markets, the strong US dollar, poor budgetary and liquidity conditions, large levels of US dollar-denominated debt and weakening commodities have all been highlighted as causes of a slowdown. This came to a head in Argentina and Turkey, where central banks hiked rates aggressively because of slowing growth and higher inflation.
“Because of the more turbulent backdrop, it is therefore not surprising that some subtle shifts in equity market leadership have developed recently. Defensives have begun to work better than the higher-risk, more cyclical areas of the market,” Whitehead said.
“Higher-yielding stocks have fared marginally better recently, reflecting the strength of more defensive areas of the market relative to some of the more cyclical areas. Some growth and momentum stocks continued to produce strong returns but they are waning a little, as ‘FAANG’ [Facebook, Amazon, Apple, Netflix and Google-parent Alphabet] stocks falter.
“We believe defensive, higher-yielding stocks should continue to perform more consistently over the short-to-medium term after years of meaningful underperformance, particularly as volatility is rising and as we near the end of the economic cycle.”
This shift in market leadership has buoyed Securities Trust of Scotland. Over the past six months, it has fallen less than its average peer. As the chart below suggests, the trust’s 2.49 per cent fall puts it in the top quartile of the IT Global Equity Income sector, where the average member lost 4.55 per cent over the same period.
Performance of trust vs sector over six months
Source: FE Analytics
In the trust’s financial report for the six months to 30 September 2018 (so before the October sell-off), the manager highlighted several areas that have performed well for the portfolio.
The trust’s information technology holdings were the “standout performer” over the period under review. While the so-called FAANG stocks have come under intense pressure more recently, Securities Trust of Scotland holding Microsoft (the portfolio’s largest position) has posted double-digit share price returns.
Whitehead also noted that healthcare stocks – to which the portfolio has a weighting of around 10 per cent – have performed strongly in 2018. Healthcare is traditionally a defensive sector but the manager is cautious because of issues such as long-term pricing erosion.
However, he prefers to take larger positions in healthcare names that he has a high conviction in. Securities Trust of Scotland’s second largest holding, for example, is German multi-national pharmaceutical, chemical and life sciences company Merck, which held up well during October’s sell-off.
For 2019, the manager expects markets to be hit with further bouts of volatility.
“We believe we will continue to see spikes in volatility and sharp sell-offs in equities. There is an expectation of further fiscal and monetary tightening well into 2019, which could well be enforced to slow the US economy down and keep inflation in check,” Whitehead said.
“This poses a major conundrum, as too much monetary tightening could choke off activity too quickly, plunging the economy into recession; while this is not our central forecast, it is a risk we remain acutely aware of.”
He added: “As trade wars, geopolitical tensions and market volatility escalate, we remind ourselves that high-quality, structural dividend growth stocks should offer protection and opportunity as a style, during the last stages of expansion in the economic cycle.
“Dividend growth has been strong year to date and many out of favour stocks not only offer defensive attributes but also look better value than they did earlier in the year.”
Performance of trust vs sector under Whitehead
Source: FE Analytics
Whitehead, who also runs the £155.4m Legg Mason IF Martin Currie Global Equity Income fund, has managed Securities Trust of Scotland since 11 May 2016. Over this period, it has made a 30.79 per cent total return and underperformed its average IT Global Equity Income peer.
Securities Trust of Scotland has ongoing charges of 0.88 per cent, is trading at a 6.69 per cent discount to net asset value (NAV) and yields 3.8 per cent, according to the Association of Investment Companies. It is 11 per cent geared.