Defensives versus cyclicals

Where's the clever money heading?

This year has been one to forget for most investors. Growth stocks on high valuations were sold off heavily early in the year, as inflation bit and interest rates started to rise; since then, growing fears of recession mean cyclical stocks considered more susceptible to an economic downturn have also seen valuations plummet, as worried investors have taken refuge in defensive sectors such as consumer staples and utilities.

Over the year to end September, the MSCI UK Value index is up over 4%, while UK Growth is down 11%; defensive sectors are up almost 9%, cyclicals down over 10%.¹

Nor is there much sign of sentiment improving any time soon. True, inflation – currently hovering just over 10% – is likely to be brought to heel for a while by the government’s very expensive energy price guarantee, which has now been extended to support non-domestic users as well as households.²

But former Chancellor Kwasi Kwarteng’s tax-cutting expansionist mini-budget spooked the markets, and there is now much talk of interest rates rising to as high as 6% in the coming year, as the Bank of England attempts to steady the economic ship.³

What should investors do, as they face up to the prospect of further tough and likely recessionary times ahead? Should they shelter their cash in resilient but relatively expensive defensive holdings? Or is there an argument that the threat of recession has been overdone, and this is a good opportunity to buy and hold dirt-cheap cyclical businesses that will come into their own sooner than markets expect?

MoneyWeek journalist Max King suggested in a recent newsletter that apocalyptic gloom is an over-reaction.⁴ He expects only mild recessions globally, plus peaking inflation and interest rates. “Ten-year bond yields of 3.8% in the US, 4% in the UK, and 2% in Germany reflect confidence in central banks achieving their targets,” he says.

Certainly, those who might have been contemplating a switch from cyclicals into defensive stocks at this late stage have probably missed the boat, argues Joachim Klement, investment strategist at investment bank Liberum. “We don’t think cyclical stocks will do well in the immediate future because markets are in the process of pricing in a recession,” he says. However, he believes that could change. “In September, our early warning indicators for cyclical stocks stabilised for the first time in 2022. If this continues for three months or so, we could have a strong signal to buy at the turn of the year.”

Klement thinks that inflation will start to decline after the October hike in the energy price cap, and that cost pressures will then start to ease for companies and consumers. That should enable cyclical companies to start to outperform. But again, he cautions, “that is not a story for the next couple of months but for the turn of the year and into 2023.”

He picks out companies such as hospitality chain Whitbread, car marketing business AutoTrader and corporate outsourcing company Mitie, as examples of cyclicals that could see their fortunes improve in the months to come.

Of course, at a time of extreme uncertainty such as we’re in at the moment, it’s possible to argue for numerous potential outcomes to current economic pressures. For many investors, the issue is therefore more about hedging bets by adjusting allocations to different types of stock or fund within a balanced portfolio, rather than wholesale rotations. 

As far as individual value-focused fund managers are concerned, it’s a similar story in many cases. Andrew McHattie, publisher of the Investment Trust Newsletter, explains, “Investors usually want to back a particular style, and are not seeking too much deviation from the manager.”

As a consequence, although the market falls have enabled some contrarian managers to pick up cheap cyclical stocks, these are likely to sit alongside more defensive holdings in their portfolios. “Few managers will swing meaningfully from one investment style to another as market conditions dictate,” adds McHattie.

Stuart Gray of Willis Towers Watson, who runs Alliance Trust’s multi-manager portfolio, is highly circumspect about the idea of trying to make significant market calls around cyclicals, defensive, or any other type of stock. “The current market is very interesting, but for us as long-term investors, time horizons are what’s really important,” he says.

“If you’re genuinely thinking long-term about a company and its cash flows over the next ten years or so, you’ll expect to price the ups and downs of an entire economic cycle – including a likely recession or downturn – into today’s valuation. Whether that recession comes this year, next year, or in five or ten years’ time, doesn’t necessarily matter that much, and it certainly shouldn’t be a shock in terms of your investment strategy.”

That perspective is in sharp contrast to the short-term market response to economic events over recent weeks and months: when investors are really worried about the outlook, many simply jump on the bandwagon, sell out of holdings they perceive to be vulnerable, and move their money into more-resilient, lower-risk alternatives or assets.

Such a response in turn raises interesting questions about what really constitutes a cyclical, economically vulnerable stock. Is the market selling down businesses, that on a longer time horizon are not particularly risky propositions?

Gray gives the example of a US alternative asset manager called KKR in the portfolio of value-focused sub-manager Vulcan, which aims to buy high-quality businesses when they are unloved and discounted.

“KKR should be a relatively stable company because its business models involve long periods of locked-in, committed capital with reliable fees,” he says. “Vulcan takes that view of the stock, but the market is treating it as though it’s very cyclical, perhaps because it views KKR as a leveraged play on volatile capital markets. Anyway, the share price is down around 35% this year, which is a lot considering its earnings have remained flat during that time.”

In contrast, a defensive consumer staples business such as PepsiCo can provide obviously stable cash flow and earnings. The Vulcan view is that PepsiCo is achieving only low single-digit growth, and it’s quite expensive on a valuation of about 25 times earnings, whereas KKR has a growth rate in the mid-teens and is on a price/earnings ratio of about ten.⁵

“Vulcan owns KKR even though there is perceived cyclicality in there, because it sees it as a much better long-term investment,” explains Gray. “The market, on the other hand, has a short time horizon and just wants stability, so it is buying PepsiCo.”

It’s hard to ignore major market reactions completely, but the Alliance Trust approach, like that of other long-term asset managers, is to adjust allocations marginally rather than overhauling them radically. Thus, as overseer of a stable of best-in-class managers with widely divergent styles, Gray’s job is to make risk-related adjustments to managers’ portfolio allocations.

“We do take account of these issues to some extent, but we’re tweaking rather than making wholesale changes, and that’s partly because getting such calls right is really, really hard,” he says. It’s also because we definitely want to take long views on businesses, so we put up with market volatility to capture those long-term opportunities.”

Diversification is central to this strategy, however. A broad mix of investment approaches, styles and focuses inherent in the range of sub-managers running the different chunks of Alliance Trust portfolio, plays a crucial role in mitigating the ups and downs of the market.

“We do have some defensive holdings in consumer staples; we have some cyclicals and we have some growth exposure, so as a combined portfolio you get long-term opportunity without so much of the volatility experienced by some more focused managers, because some parts of the portfolio will always be performing relatively strongly,” Gray adds.

The bottom line, when turbulence rules the roost, is that it’s not worth even attempting to make macro calls. A balanced approach involves retaining exposure to cyclical and growth businesses as well as defensives; canny investors will also be keeping an eye on oversold good-quality cyclical and growth stocks as potential additions over the coming months.

Faith Glasgow, freelance journalist and former Editor of Money Observer

1. Rathbones, MSCI UK Value index in GBP Total, 31 Dec 2021 to 30 September 2022

The views expressed are the opinion of the Manager and are not intended as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell any securities. The views expressed were current as at September 2022 and are subject to change. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. TWIM is the appointed Alternative Investment Fund Manager of Alliance Trust plc. Alliance Trust plc is a listed UK investment trust and is not authorised and regulated by the Financial Conduct Authority.