In a market with heightened volatility and increasing correlations, investors should be looking to the most defensive sectors. That’s the view of John Stephenson, president and CEO of Stephenson & Company Capital Management Inc. in Toronto. Says Mr. Stephenson: “Nothing is more defensive and has less exposure to China than electric utilities.” He names his top 3 U.S. stocks to buy in this most defensive sector.
Global stock markets have been selling off with a vengeance lately as concerns about the outlook for global growth once again bubbled to the surface. In recent weeks, stocks, currencies and commodities have swung dramatically on signs of a slowdown in Chinese growth. Disappointing economic data out of the world’s second-largest economy, as well as Beijing’s decision to devalue its currency, have exacerbated concerns. The catalyst for the current round of selling was data that showed that China’s manufacturing sector shrank at the fastest pace in three years, while the services sector also cooled.
Worries about China have been battering stocks all over the world. Stock indexes suffered their biggest monthly losses in years in August. The Stoxx Europe 600 Index had its largest one-month percentage decline since August 2011. The Dow Jones Industrial Average of top U.S. stocks fell 6.6 per cent, representing its biggest monthly percentage decline since May 2010, while the Shanghai Stock Exchange Composite Index fell 12.5 per cent, notching its third straight month of decline.
U.S. Stocks: The calm within a global storm
The global uncertainty is complicating the U.S. Federal Reserve’s plan for raising short-term interest rates for the first time since 2006. Data released in recent weeks show the U.S. economy holding up and continuing to be a bright spot in the sluggish world economy. In late August, the U.S. Commerce Department reported that gross domestic product expanded in July at a 3.7 per cent annualized pace. Fed officials signalled a rate increase remains on the table for its September 16-17 policy meeting.
China’s worries ripple out across global markets
The selloff in global stocks that ushered in the start of September came on the heels of heightened volatility in global markets as the Shanghai composite index saw its largest two-day selloff in more than two decades in the last week of August, but then rallied more than 10 per cent to end the month.
Beijing’s ‘fix-it’ efforts confirm there are problems
That rebound followed Beijing’s decision to cut interest rates and inject cash into the banking system by cutting the reserve requirement ratio—the portion of deposits banks must hold in reserve with the central bank. Volatility in China spilled over into global markets as investors questioned the competence of Chinese policymakers and the true extent of the current slowdown in China.
The latest selloff
What triggered the most recent round of selling was China’s official manufacturing purchasing managers’ index for August, which fell to 49.7, from 50.0 in July, marking its lowest level since August 2012. A number below 50 implies contraction. This new piece of evidence of China’s slumping economy was widely expected, but still sent investors once more into retreat. Another metric, the Caixin General Manufacturing Purchasing Managers’ Index, a gauge of nationwide manufacturing activity, told a similar story, falling to more than a six-year low in August, according to Caixin Media Co. and research firm Markit Economics.
Oil—moving like a late summer fairground ride
Oil prices have been on a roller coaster over the last week few weeks—a casualty of shifting market sentiment on global growth. Following a sharp slump in August, a breathless three-day rally drove oil prices up by more than 27 per cent. Underscoring the volatility, the price of West Texas Intermediate (WTI) crude oil (the American benchmark) has fallen or risen by at least six per cent for four straight trading days, the first time since January, 1991.
More like ‘submerging’? China’s impact on emerging markets
A slowdown in China is bad news for emerging market countries whose stock markets picked up where they left off in August, sliding by 2.4 per cent on September 1. A slowdown in China has repercussions for countries from Brazil to Russia and South Africa, which rely on demand for the world’s second-largest economy for exports of goods. The prospect of the U.S. Federal Reserve raising interest rates as soon as this month is also weighing on sentiment.
Christine Lagarde, the International Monetary Fund’s managing director, recently said that the global expansion outlook is worse than the lender anticipated less than two months ago. “This reflects two forces: a weaker than expected recovery in advanced economies, and a further slowdown in emerging economies, especially in Latin America,” Ms. Lagarde said in a speech in Jakarta.
The early arrival of challenges: ‘Tomorrow’s problems’ today
China’s growth was blistering for decades as the country rose to become a major economic powerhouse posting double-digit economic growth. But in the last few years, global investors have become increasingly skeptical of China’s true level of economic growth with Chinese authorities scrambling to convince markets that growth will pick up in the months ahead.
Investors have long realized that the world faces a potential Chinese problem when the eventual slowdown occurs, but it was long felt that this would be tomorrow’s problem. Now, however, there is a dawning realization that it is a current problem and it is spooking markets.
It’s becoming increasingly hard for investors to envision what new driver can keep Chinese gross domestic product growing at Beijing’s targeted annual rate of seven per cent a year, at least absent the kind of deregulation that the government is retreating from rather than moving towards. A retreat back to state pump-priming and spending on infrastructure and real estate only worsens debt issues while generating less bang for each buck.
What some key ‘economic tea leaves’ indicate
A host of Chinese economic statistics that cannot be easily massaged by government officials seems to be indicating that growth in the Middle Kingdom is modest at best and may even be turning negative. China’s freight traffic when measured on a year-on-year basis has been declining for the last three and half years. Electricity consumption has essentially flat lined over the last three years, suggesting the economy may not be growing at all. Import data for major industrial commodities has also plunged, sounding another dire warning on Chinese economic growth.
What I Recommend
The markets have become increasingly volatile with the lingering worries about the health of the Chinese economy. As investors get more stressed they become less discerning, causing stocks to move together in a swaying motion. In August, correlations amongst European equities hit a record high, and correlations amongst the constituents of the S&P 500 Composite Index touched a four-year peak, according to S&P Dow Jones Indices. In a market with heightened volatility and increasing correlations, investors should be looking toward the most defensive sectors of the market with the least exposure to China.
Given that I believe that there is still another shoe to drop on the Chinese growth story, investors should consider raising cash levels and working on a shopping list for when we see eventual bottoming in the stock market.
NextEra Energy: Top U.S. stock pick in the most defensive sector
Nothing is more defensive and has less exposure to China than electric utilities. One top U.S. stock that I really like is NextEra Energy, Inc. (NYSE─NEE), which is an electric utility and parent company of Florida Power & Light Company.
The company continues to invest in its subsidiaries, which should power earnings growth at a 6.3 per cent clip through 2018. The company should outperform the sector due to above-average earnings and dividend growth. As well, NextEra has little significant exposure to “merchant energy” power markets, nuclear risk, or regulatory filings in the near-term, and should be a core holding for utility investors.
I have a buy recommendation on the stock and a 12-month target price on the shares of $122 a share.
Duke Energy: Lower risk with above-average EPS growth
Another top U.S. stock that fits the bill is Duke Energy Corp. (NYSE─DUK), an electric utility headquartered in Charlotte, North Carolina. With 90 per cent of its earnings derived from regulated subsidiaries and limited need to invest in new generation technology or significant exposure to market power prices, Duke is a lower-risk regulated utility with above-average earnings growth in a constructive regulatory environment.
I have a buy recommendation on the stock and a 12-month target price on the shares of $91 a share.
CMS Energy: A ‘best in class’ defensive name
Another name that I like is CMS Energy Corp. (NYSE─CMS) an electric utility company operating primarily in Michigan. Ongoing cost-management should help generate earnings growth of six to seven per cent annually until 2017. CMS’s growth is primarily driven by its utility investments and positive rate-case outcomes. As well, constructive changes in Michigan’s energy policy should lead to upside potential for CMS’s merchant energy plants. CMS is a “best in class” defensive pick among these top U.S. electric utilities stocks.
I have a buy recommendation on the stock and a 12-month target price on the shares of $38 a share.
Solid defence: The winning plan for the near-term
The global economy can probably manage a soft-landing. However, it is increasingly starting to look like a hard-landing for China, which would pose a significant risk to global growth and global equities. Markets typically overshoot on both the upside and downside. This makes solid defence the winning plan for the months ahead. While there’s always the potential of a quick market snapback I believe that it’s better for investors to be safe rather than sorry.
The MoneyLetter, MPL Communications Inc.
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