J.P. Morgan’s Dan Morris says defensives rally may have been driven by fixed income investors

15th April 2013

J.P. Morgan says that equity markets performed well in the first quarter, but in an unusual way because defensive stocks are rising. This has seen healthcare and consumer staples rise in the recent rally.

In a note, global strategist Dan Morris says: “When equities markets are rising, they are generally lead by the growth or cyclical sectors, such as information technology or energy, and when declining by defensive sectors such as consumer staples. The 9.2% first quarter gain in the MSCI AC World, however, was driven by a 15.2% rise in the health care sector and a 14.4% rise for consumer staples Index (price in local currency terms).

“Health care is a leading sector (in the top two) only 10.5% of the time, and consumer staples just 5.8% when markets are rising, well below the percentages for the typical leaders. Returns since the end of March show much the same pattern. The explanation for the anomalous result is that low interest rates are driving investors towards higher yielding assets.”

Morris says that the ‘Great Rotation’ from fixed income to equities has played out this year, disillusioned fixed income investors may be allocating to the more fixed-income-like equity sectors.

Morris asks if this behaviour likely to be rewarded over the medium term? He says: “To some degree it depends on the expectations of the investor. A fixed income investor who is now earning a 4.2% dividend yield (based on the MSCI World High Dividend Yield Index) may well be quite satisfied when the alternative is just 2.5% in investment grade corporate bonds or 5.6% for the risk of high yield. But the strategy is not without dangers. Unlike holding a bond to maturity and recuperating the initially invested capital (except for defaults), an equity investor may find that the price of the stock has not moved in their favour over time. Valuations for high dividend yielding stocks suggest that risk is elevated today.”

The note continues: “Defensive/high dividend sectors typically trade at a discount to those sectors with lower payouts and higher earnings growth expectations (see Figure 2). Over the last few years that relationship has broken down. While valuations have increased this year for the equity market as a whole, they remain below average for stocks that provide either little or no dividend yield or even an average dividend yield, while those for the most generous segment are now at the highest level since at least 1994.

“For the privilege of obtaining that yield, investors are giving up potential price appreciation. Companies in the low-to-no dividend yield quartile are expected to grow their earnings by 13% on average over the long-term versus less than half that rate for the high dividend yielding stocks. The dividend yield compensates for some of that gap, and is more reliable than earnings growth. But over time the gap in return can become significant. In addition, growth sectors may lose some of the current valuation discount and the high yielding sectors give up some of their premium. Investors targeting equities for high dividend yields need to think clearly about their exit strategy.”



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