The market may have lurched lower in recent weeks, but investors are still talking about a two-speed market. On the one hand are the high quality global companies that have led markets almost without pause since the global economic crisis started. On the other are cyclicals, which have been widely unloved because there has been precious little economic growth around. The question for investors is whether to use the weakness in markets to stock up on high quality companies, or whether cyclical exposure makes more sense.
Over the shorter term and during the recent rally, cyclicals have had a stronger run. Over the past year, among the best performing sectors have been the FTSE 350 Technology Hardware & Equipment sector, up 53.5%, with general retailers (50.2%), banks (44.8%) and travel & leisure (43.2%) all standing their ground. However, some cyclical sectors—notably mining and industrial metals (down 6.3% and 48.2% respectively) have lagged. Equally, over the longer term, high quality defensives have a significant edge. The life insurance sector is up 97.4% over three years, beverages by 89.4% and household goods by 84%.
Unquestionably, cyclicals still have the edge on valuation. Value managers Nick Kirrage and Kevin Murphy, managers of the Schroder Recovery fund (rated Bronze) point out that although some cyclical areas—housebuilders, selective retail, banks—have performed well, they are far from being widely loved by investors. Kirrage says: "The reality is they started from extremely depressed valuations and so it is not as if either sector has become the darling of the market again. A lot of that has to do with the fact that, while most investors have just about come to terms with the idea the world is not ending, there is still a lot of uncertainty."
Equally, Robin McDonald, deputy head of multi-manager at Cazenove, points out that higher valuations for quality global companies only make sense if they can sustain their current high earnings. If they can't, their high multiples will start to look unsustainable: "We believe this makes equities in aggregate look deceptively cheap. The most expensive parts of the market are those considered 'safe', but it is possible to buy businesses that don't have this problem of high margins and high volatility." He has moved to more cyclical funds where, he believes, the risks are lower.
Cyclicals also have the edge for the contrarians. Gavin Haynes, investment director at Whitechurch Securities, says: "Defensive higher quality companies have certainly been the area to be, but it is now such a consensus play and the valuation gap between quality, non-cyclical companies and cyclicals in itself makes a compelling argument to be rotating into more cyclical value driven areas."
However, he points out that much depends on the global economic recovery remaining on track. He believes that the current strength in the US economy suggests that the economic recovery has momentum, but admits that this is not assured. Even so, Haynes believes that the high quality global companies are 'priced for perfection', leaving plenty of potential risks should their growth stumble.
However, there is a valid argument that in the long-term investors should aim to be in the best companies. It is certainly an argument made by managers such as Nick Train, manager of the Finsbury Growth & Income trust (FGT). Ideally, he likes to hold a company 'forever' and as such is more interested in the quality of the company itself rather than the valuation level at any given point.
There are also those who make a cogent argument that economic growth is likely to disappoint and therefore cyclicals will not work well, no matter how cheap they are. Caspar Rock, chief investment officer at Architas, is maintaining an overweight position in risk assets, but says that those leading indicators not swayed by the impact of quantitative easing still show anaemic growth. There are certainly plenty of headwinds: there seems little likelihood of an improvement in the eurozone economy as a whole and its future remains dicey. At the same time, China's growth is slowing and the US economy can only prop up the global economy for so long.
In this more difficult environment, investors will need to seek out companies that can grow their earnings in all weather. Equally, the weakness of China is likely to put continued pressure on certain cyclical companies, notably mining and industrials as the commodity super-cycle draws to a close. This would seem to favour renewed outperformance by higher quality companies, particularly those with a consistent dividend stream.
Higher quality companies may also have the weight of money argument in their favour. If the 'great rotation' out of bonds and into equities ever becomes a reality, then investors may feel uncomfortable moving wholesale from fixed income into cyclical equities. In this case, higher quality companies are likely to be preferred, whatever their valuation.
Investors will need to decide where they sit on the global recovery. Another lurch down in global growth expectations is unlikely to favour cyclicals as fear grows in markets, but if US growth can counterbalance the weakness in China and the eurozone, they may see significantly stronger returns.
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