When Defensive Stocks Are No Longer Defensive

by on November 26, 2014

A confluence of factors helped U.S. equities rebound more than 12% from their October low, pushing valuations to their highest level since 2009. Besides extraordinary foreign central bank monetary stimulus (with the latest shot of adrenaline coming from China) and a fresh wave of mergers and acquisitions, I discuss in my new weekly commentary how low and stable U.S. interest rates are another significant driver of the rally. Income-oriented stocks have appreciated considerably and now appear overvalued as investors continue their reach for income in this low yield environment.

Reasons why U.S. rates are so low

Despite the two best back-to-back quarters of economic growth since 2003, U.S. long-term yields refuse to budge. Declining inflation expectations are one reason yields are remaining so low, and another reason is yields in other developed countries are even lower. With German and Japanese bond yields well below 1%, a 2.35% yield on a 10-year U.S. Treasury seems attractive in comparison. This entices investors to buy Treasuries, supporting their prices and keeping yields low.Defensive Stocks

Yield Seekers Pushing Up Prices for REITs, Defensive Stocks

Thus, investors in need of income continue to look for alternatives. One manifestation of this is a strong bid for so-called “defensive” equities, or stocks with low volatility and a high dividend yield. Real Estate Investment Trusts (REITs) are one example of this trend. The thirst for yield has pushed the Dow Jones Select REIT Index up about 20% year-to-date, roughly twice the return of the S&P 500.

We see a similar appetite for income with other yield oriented sectors of the stock market, notably utilities and consumer staples. While the thirst for yield is understandable, it may be leading investors to overpay and take on hidden risks.

The defensive sectors all sport aggressive valuations and carry hidden duration, or interest rate sensitivity. If interest rates rise even modestly in 2015––as we expect they will––these sectors are likely to perform poorly, as their valuations are particularly sensitive to rate rises.

Instead of taking on more exposure to these parts of the market, we would prefer to source our yield from other places, including U.S. high yield bonds and more cyclical sectors of the equity market, which could be poised to benefit from an improving economy.

Source: Bloomberg.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog.

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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

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