Defensive equities – a safe haven amid global woes

Strange times in the financial world

If asset class valuations are anything to go by, we’re living in fairly uncertain times across the globe. For one thing, both sovereign and corporate bond yields are negative, and some yield curves are even inverted. These relatively rare events are a strong sign the global economy is slowing down.

After a decade of record-low interest rates, down to zero per cent in some countries, and more debt being thrown on to fix the debt crisis, it begs the question of whether this ends deflation - as bond prices suggest, or inflation - as high growth equities suggest. It doesn’t appear they both can occur at the same time.

This low to no-yield environment means investors must look elsewhere for income to meet their goals. There is now more than A$15 trillion¹ of sovereign and corporate bonds at negative yields. While they have been very profitable in the past, Australian investors now need to find yield and medium-term capital growth elsewhere.

Where to hunt for yield

Imagine there was an asset class where the low growth part of that universe was trading very close to historic valuation levels, a third of the universe was net cash and it was in a country that a decade after the global financial crisis still had stimulus options?

Well, there is. And it’s defensive Australian equities. Outside of banks and infrastructure, which are highly geared, we’re currently seeing about 20 per cent of stocks in the market – about a third of the ASX300 - that have net cash balance sheets, giving a great selection of defensive stocks to choose from. Net cash is generally a good measure for investors to determine whether an investment in a particular stock is suitable or safe in these uncertain times.

What does this mean for investors?

This is good news for investors, and essentially it offers them the opportunity to invest at the top of the capital structure - as many of our holdings are in net cash or lowly geared - yet still have all the upside of equities. Due to their relative high demand, defensive equities tend to remain solvent through the cycle, so they can provide several benefits to investors.

For starters, due to their strong balance sheet, they are very robust and flexible. So, if times get tough, or even if times are particularly good, they have money to invest. They may do this through buying competitors on the downside or investing for growth on the upside.

In addition to this, they will also pay dividends, which will lessen the effect of falling stock prices in market declines. With Labor’s recent defeat it looks like franking credit refunds will likely continue and there is a bonanza of franking, which we think will reach new records in 2019.

This is a niche that is often overlooked by investors, but an area we believe investors have the potential to see good returns. For any investors looking to protect their portfolios in weak economic conditions, such as we are seeing now, they are a good option to consider.

In the AMP Capital Equity Income Generator fund, we have a robust portfolio of stocks that have reasonable or low levels of debt, are on reasonable multiples, and have high free cash flow. There is also an attractive 6.3 per cent yield, paid monthly.

As with any fund of this type, there are inherent risks with investing and investors should review the offer documents before deciding to do so.  

¹ https://www.ft.com/content/a1899c76-92a8-11e9-aea1-2b1d33ac3271