GLOBAL EQUITY OUTLOOK

Building the right defense in equities

Apr 17, 2018
By Kate Moore, Yanni Angelakos

High-yielding “bond proxies” earned their stripes as equity safe havens as bond yields were slow to revert to pre-crisis levels. We look at what may constitute the new defense in equities as interest rates transition from “lower for longer” to higher at long last.

Equity highlights

  • Traditional high-dividend stocks could do more harm than good in an environment of higher rates and inflation. They have underperformed broad indexes year-to-date and are vulnerable to rate moves. Minimum-volatility (min-vol) strategies suffered a similar fate, suggesting a good defense is a multi-faceted one.
  • The “why” behind rate rises is important. Different sectors tend to play better defense depending on the impetus for rising rates. When yields are rising faster than inflation expectations, as they are today, cyclical (rather than defensive) rate-sensitive sectors can lead. U.S. banks, in particular, appear well positioned.
  • Defense in stocks today is less about high yield and more about quality and the ability to outrun inflation, in our view. Companies with the free cash flow to boost dividends also tend to sport attractive valuations versus the highly bid high yielders.

Snapshot

High-yielding bond proxies did not offer downside protection in the February stock rout. It’s a role they historically have played well in drawdowns caused by economic deterioration and other risk-off periods. But this sell-off came amid a steady global expansion. The impetus this time, aside from a technical matter of investors exiting strategies betting on low volatility, was fears over rising rates and inflation.

Strong growth provides a solid foundation for stocks, we believe, but this experience makes it worth considering whether bond proxies can provide the same downside protection they have historically. They may even face competition from bonds for the first time in nearly 10 years.

We analyzed S&P 500 sector performance from 2000 to present to isolate vulnerabilities. The findings: Traditional defensive sectors such as utilities, telecommunications, real estate and consumer staples provided minimal protection when nominal yields moved higher. Our analysis reveals this relationship has held outside the U.S. as well. See the Yields up, defensive stocks down chart.

Sector performance when nominal yields rise, 2000-2018
Kate Moore
Chief Equity Strategist
Kate Moore, Managing Director, is Chief Equity Strategist for BlackRock and a member of the BlackRock Investment Institute.