Consensus is for no major intervention in North Korea. But if it happens, a more defensive equity exposure would be a prudent strategy. We examine the past seven corrections since 1995 and offer our insights into which sectors provide the best protection if volatility returns.
Classical defensive sectors
Based on the seven major corrections since 1995 in global equities, we find that the "bread and butter" of defensive equity portfolios are: utilities, telecommunication, healthcare, and consumer staples. Those four sectors have offered consistent outperformance relative to global equities in all corrections.
As a side note, these four sectors generally have low realised volatility and therefore are over-represented in low-volatility strategies, which tend to perform well during stressful times. One key observation is that investors should cut down dramatically on their exposure to financials and industrials to tilt the portfolio in a defensive direction.
Potential defensive sectors
In addition to the usual classical defensive sectors, a few other sectors have offered protection from time to time. Energy was one of the most defensive sectors during the three corrections (1998, 2000-02 and 2007-09) before the period following the global financial crisis. Recently the energy sector has become high-beta and sensitive to the macroeconomic outlook. Given the current outlook for oil prices, we do not believe that energy will be a defensive sector in the next correction.
iShares Global Energy ETF (IXC, monthly):
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Source: Saxo Bank
Real estate is another sector that has many times offered alpha during corrections, although the 2007-09 correction was a terrible period for real estate. The steady cash flow from renters and rare nation-wide declines in house prices have historically made real estate steady during corrections despite interest rates spiking through those periods.
In the post-GFC period, real estate stocks have done well during corrections. Assuming that the current inflation outlook dampens interest-rate normalisation, we believe real estate is a potential candidate for a defensive sector during the next correction.
The last potential defensive sector is surprisingly IT. Historically, the IT sector has been sensitive to the business cycle as semiconductors and hardware producers have had the largest weight in the sector index. This is quite evident in the 1998 and 2007-09 corrections. In the 2000-02 correction, the IT sector was the epicentre of the correction, and so it delivered the worst returns.
In the 2011 correction and the last one in 2015-16, the IT sector delivered alpha, and the key driver is an increasing sector weight on software and services companies. Today the software and services industry group has a 60% weight in the sector index. Software companies have more monopolistic characteristics and more stable cash flows that are less sensitive to the business cycle, so in our view the IT sector may very likely outperform in the next correction.
In a deep correction (around 40-50% decline), IT stocks would likely perform on par with global equities due to current high valuations.
Russian financial crisis of 1998
This correction had its epicentre in Russia, and was related to government debt and the rouble causing great damage to financials as the Russian government defaulted on its debt and the central bank devalued the rouble on August 17, 1998. The utilities sector was a strong performer, delivering positive returns during those weeks.
The equity market crash after the dot-com bubble burst was prolonged and severe. The epicentre of the bubble was IT and telecommunication stocks that were part of the "new economy". In this correction, the best performers were energy and consumer staples stocks. At that point in time, the energy sector had low debt-to-equity ratios and the outlook was stable.
Global financial crisis
The crash in global equities from late 2007 to early 2009 was extremely severe, with correlations going towards one. The epicentre was financials and real estate, which produced the worst returns, while healthcare and consumer staples cruised through the period with strong alpha generation. As the performance plot shows, there was no place to hide. Everything fell, with the best performance being consumer staples, down only 34% relative to global equities, which dropped 56%
This correction started in the second quarter of 2010 when the Greek government asked for a bailout as the GFC and recessions had pulled the rug out from under the government's finances. Financials were again vulnerable, together with miners (materials sector) and energy. The consumer staples and telecommunication sectors were the best performers, but all sectors delivered negative returns, highlighting the synchronised equity market in the GFC period.
European sovereign debt crisis - part 1
The correction was severe and started in August 2011 as investors got increasingly worried about the credit quality of the Spanish and Italian governments. Those fears sent the euro area on a roller-coaster ride and rattled global financial markets. The financial and materials sectors were severely hit, while consumer staples and healthcare were the best performers. All sectors once again delivered negative returns.
European sovereign debt crisis - part 2
In 2012, the euro area crisis reignited, but was quickly dampened over the summer months, with the help of European Central Bank president Mario Draghi's famous "whatever it takes" pledge. Financials, materials and energy sectors were all hit hard, while consumer staples and telecommunication did well again. As further evidence of new synchronised financial markets, all sectors were down.
The explosion in oil supply from US shale oil fields caused an oil glut in 2015, triggering a severe correction with energy and materials sectors as the epicentre. The utilities and consumer staples sectors were again the best sectors, but again all sectors were down.
Given that global equity markets have become highly correlated across sectors, the only way to get a positive return in equities during corrections is to create a long-short position, which is short the cyclical sectors and long the defensive sectors. Another idea is to be long the defensive sectors and long puts on the general equity market.