Amid the market volatility of the last several years, many investors have flocked to the perceived safety of defensive sectors. Among such sectors, I’ve long been advocating that investors underweight expensive US utilities and last August, I warned that global telecom stocks looked overvalued as well.
Now, investors may also want to consider lowering their exposure to another defensive sector – global consumer staples. Here are three reasons why I’m downgrading my view of this sector from neutral to underweight:
- Valuations: As people generally need to buy household items like toothpaste and soap even when the economy is weak, consumer staples stocks typically trade at a premium due to the stability of their earnings streams. But today’s premium looks extreme.
Consumer staples is now the most expensive sector globally, trading at 3.4x price to book, nearly double the level of the global benchmark. And this is starting to weigh on the stocks. While consumer staples did quite well for much of 2012, they have been trailing the broader market since November.
- Earnings growth: Despite their rich valuation, earnings growth estimates for the sector are the third lowest of the 10 economic sectors. While the US housing market is on the mend and we have seen some job creation, US unemployment is still stubbornly high and personal consumption remains muted. Meanwhile, in the eurozone, unemployment has recently hit another record high and consumer sentiment is low.
- Taxes: Finally, though consumer staple companies, by their nature, are much less exposed to changes in income and confidence than consumer discretionary companies, they are still impacted when consumer confidence drops or income growth decelerates. People will still buy staples when their income is falling, but they tend to buy cheaper brands, hurting the profitability of the sector.
The recent deal to avert (or at least delay) the fiscal cliff will mean higher taxes for many Americans and we’ve already seen this start to hurt US consumer confidence and it won’t be long before income is impacted as well. As a result, consumer stocks’ current hefty valuations could come under pressure.
So what sectors do I like? I believe the valuations of global technology stocks look compelling and I like the global energy sector given long-term supply-demand trends, attractive valuations and an anticipated pickup in emerging market demand. I continue to advocate overweighting these two sectors through instruments such as the iShares S&P Global Technology Sector Index Fund (IXN) and the iShares S&P Global Energy Sector Index Fund (IXC).
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.