Expensive defensives to feel US rates pressure

Warnings of a pullback in ‘expensive defensive’ sectors of the sharemarket are getting louder.

Trading on the ASX finished slightly higher with banks and miners leading the way.

Warnings of a pullback in “expensive defensive” sectors of the sharemarket are getting louder.

A rise in the market on Tuesday was underpinned by banks and resource companies that have underperformed in the past year, while market darlings in the property trust, utilities, infrastructure and healthcare sectors lagged.

Transurban, Sydney Airport, AGL Energy, Westfield, Stockland, Resmed, Cochlear, TPG Telecom and Sonic Healthcare were flat to weaker, while the benchmark S&P/ASX 200 index rose 0.2 per cent to 5478.3 points.

Ahead of US non-farm payrolls data that could trigger an interest rate rise from the Federal Reserve next month, strategists are cautious about stocks that have benefited the most from record low interest rates.

While Australia is expected to cut interest rates again in the year ahead alongside further stimulus in Japan and Europe, US officials are signalling their intention to raise rates, a move that could cause at least a temporary sell-off in benchmark US Treasury bonds against which so-called “bond proxies” in the equity market are normally priced.

“For the most part bond proxies are expensive, they have delivered solid outperformance for almost five years and recent share price gains are disconnected from current earnings growth forecasts,” Morgan Stanley equity strategists Ewa Turek and Nathan Lim say.

“In an environment of falling bond yields and anaemic global growth, seeking out ‘boring’ equities with stable dividend streams was a sensible strategy … the question is whether it is still sensible today.

“While we don’t expect the Federal Reserve to raise rates anytime soon, there are other factors that could put bond proxies under pressure.”

After initially flagging four interest rate increases this year, the Fed dialled its “dot plot” projections back to two hikes after global financial ructions at the start of the year. The Brexit vote and patchy US economic data then saw financial markets all but give up on a US rate rise this year, but with US data picking up and Fed chairwoman Janet Yellen saying the case for an increase has strengthened, the market is again warming to such a move.

Apart from the risk of a US rate rise, Morgan Stanley sees three other scenarios with the potential to disrupt the bull run in bond proxies: co-ordinated global fiscal stimulus, disillusionment with the efficacy of quantitative easing and negative interest rate policies, and rotation out of defensive into cyclical equities. In their view, the final scenario has the highest ­potential of playing out.

“In fact, if we assess equity market performance over the past quarter there are signs that a ­rotation trade may already be in the making,” they say.

“Despite ongoing declines in bond yields, bond proxy performance has been lagging. Returns have been particularly weak over the past month, which is notable in the context of an interest-rate cut by the RBA in early August.”

Australian utilities are particularly expensive as the sector trades on a 75 per cent premium to its 10-year average 12-month forward PE ratio. Property trusts also stand out, having delivered a total return of 28.4 per cent in the past year, while the consensus earnings growth estimate for next year has shrunk to minus 3.4 per cent.

While resources might also seem expensive based on consensus earnings estimates, Morgan Stanley expects a rise in commodity prices next year amid supplier rationalisation, as well as improvements for resources companies thanks to cost cutting.

Macquarie equity strategists also warn that investors should expect more profit-taking in bond proxies as another rise in US interest rates is likely to push up the “risk free rate”. And given an 8 per cent rise in the sharemarket since July, with the S&P/ASX 200 ex-­financials trading at 20 times forward earnings, “it is difficult to argue for more multiple expansion particularly given the wide skew of earnings performance seen in the reporting season”.

But they don’t think recent hawkish comments from Fed officials change the hunt for yield. In their view, banks are the cheapest yield plays that are not considered straight bond proxies and could outperform property trusts, infrastructure and utilities in a bond-driven sell-off.

“We also don’t think it means the market will need to go through a severe multiple adjustment despite price optics — this is a time to dial back risk, not abandon equities,” they say.