Rotating to non-discretionary stocks

There’s no doubt that the market focus is quickly shifting from the pandemic and lockdowns to inflation and interest rates.

With the Omicron variant less harmful than its predecessors and life returning to normal, the focus is now on what’s happening to the economy and how central-bank policy will unfold in the near future.

After three decades of relatively flat prices, inflation is threatening again, which may force central banks to revisit their ultra-dovish stance. The financials sector in general and banks in particular are feeling relieved, as near-zero interest rates are bad for business, making it very difficult to make a profit from lend/borrow spreads.

Rising rates help banks normalise business and profits. Bond issuers, like the government, are also happier. If the central bank keeps moving beyond the curve, real rates will erode and make it easier to pay coupons over time. However, if price rises take us all by surprise, disposable income will reduce.

As a consequence, consumer purchasing power would decline over time. And if that happens, the first thing consumers will cut back on is spending on discretionary items. This includes all online purchases related to entertainment and non-essential goods and services.

PayPal says it all

Last week, shares of PayPal suffered a 24% loss, erasing $50bn in market value in a single day. The accumulated loss since a peak on 23 July 2021 is now 50%. There may be several reasons for this loss. These certainly include an expected loss of part of the eBay business and a shift in focus from attracting new clients to better retain the existing ones.

However, it is becoming clear that growth rates expected for e-commerce and e-payment businesses are fading, as they’re no longer expected to benefit from the effect the pandemic and lockdowns had in boosting their businesses. Many customers are returning to the high street, and while the global economy will continue its shift to a more digital version, the pace will soften this year.

PayPal is just one example. There are many digital businesses that are (or have been until recently) trading at triple-digit price ratios, as investors were expecting stratospheric growth rates.

Moderna, for example, has benefited from the pandemic, and I’m certain that the Covid vaccines it developed will have many use cases in the future. Its stock price rose from below $20 to above $450 over a period of one year and a half. This has already corrected to $160, which is in line with a more conservative valuation. But many Nasdaq stocks are still at the $450 point.

The assumptions that make for triple-digit price ratios are changing, as growth rates are being revised down. This exposes growth stocks to a correction. The situation is further complicated by rising bond yields and expected hikes in interest rates.

Future cash flows, in the form of profits and dividends are worth less today when interest rates are higher. If these cash flows are expected far in the future, which is usually the case with growth stocks, the impact on price, of changing interest rates, is greater. Thus, the potential end of the pandemic, along with rising interest rates is an explosive mix for growth stocks, in particular those related to e-commerce and e-payments.

But, returning to PayPal’s profit statement, I would say the company is being hit not only by changing consumer habits and rising interest rates but also by the impact inflation may have on purchasing power. If the central bank doesn’t move fast enough, inflation will continue rising and dent purchasing power. PayPal is a perfect example of a service that the typical consumer would cut back on when facing rising costs, as the e-payments company is mostly used to pay for discretionary items. These are exactly the kind of items people stop buying when money is tight.

It may therefore be time to tilt portfolios towards larger, conservatively valued companies with a proven track record of profits, high return on equity, stable profit growth and low financial leverage. These are quality stocks, which are in general less vulnerable to changing economic conditions. Most of them are non-cyclical stocks. These include companies that sell essential (inelastic) goods and services. Cyclical stocks are much more volatile and exposed to economic downturns.

If inflation hits consumers severely, stocks in the consumer-staples sector will do better than others. If the economy slows down, these stocks are also favoured. Taking this into consideration, I’m looking at three ETFs that target this sector. Two invest in US companies while the third invests half of its funds outside the US. To cope with interest-rate rises and the concept of duration, I’m also suggesting two ETFs featuring high-quality dividend-payers.

Investing in consumer staples

Vanguard Consumer Staples ETF (NYSEARCA:VDC)
In my opinion, Vanguard offers the most cost-efficient choices in almost any ETF category. In general, investors have access to broad-themed portfolios, at a low cost. In this particular case, ongoing charges are just 0.10%, which equates to $10 for each $10,000 invested, per year.

VDC holds 99 US stocks from companies that provide direct-to-consumer products that, based on consumer-spending habits, are considered non-discretionary. Top holdings include behemoth companies like Procter & Gamble, Costco Wholesale, Coca-Cola, PepsiCo and Walmart. Some of these stocks suffered during the pandemic and are expected to underperform the broad market under favourable economic conditions. However, in volatile times, and in particular when consumers lose purchasing power, these stocks may do better than the broad market. This ETF is averaging 10.2% per year in returns since its inception in 2004.

iShares US Consumer Staples ETF (NYSEARCA:IYK)
BlackRock ETFs are almost always more expensive than Vanguard’s ETFs. But it is worth considering the iShares US Consumer Staples ETF due to its performance. Since the start of 2020, this ETF has risen 50%, clearly outperforming not only VDC but also the broad market. In this case, it seems worth paying the higher ongoing charges of 0.41%. However, there’s always a catch. While the top holdings are not much different from Vanguard’s, this fund is more concentrated and may therefore come with more risk.
[insert vdc iyk chart]

iShares Global Consumer Staples ETF (NYSEARCA:KXI)
If you want an international exposure to the consumer-staples sector, then KXI is a good option. This ETF invests half in the US market and the other half in the rest of the world, with the top exposures being the UK (12.8%), Switzerland (9.5%) and Japan (6.0%). The fund also allocates funds to France, Canada, the Netherlands, Australia, Belgium and Germany.

Investors gain exposure to 91 stocks from the consumer non-discretionary sector, from the developed world. However, there are a few key points to consider. Top holdings still include companies like Procter & Gamble, Coca-Cola, PepsiCo, Walmart and Costco Wholesale, which are present in the top holdings of both IYK and KXI. Therefore, if you invest in this ETF, avoid the others, otherwise you’re duplicating your holdings. Another important point is that the top-five holdings amount to one third of the portfolio. In terms of risk, this may be undesirable for some investors. Ongoing charges are 0.43% − almost the same as BlackRock charges on IYK. For the global exposure it provides, this level of fees is reasonable.

Investing in dividend-payers

iShares Select Dividend ETF (NASDAQ:DVY)
At times of rising interest rates, managing duration is key. Many of the cash flows from deploying money into a stock or bond today come in the far future − when interest rates rise, these future cash flows are more heavily discounted. The nearer to the present these cash flows are, the better.

So, when translating the concept of duration to stock investing, it means looking for large value stocks paying robust dividends over time. The iShares Select Dividend ETF is a very good option. It invests in US value stocks that are reasonably priced and pay high dividends. Top holdings include Oneok, Exxon Mobil, Altria, Pfizer and Philip Morris. A quarter of its holdings are in the utilities sector, making it a defensive non-cyclical investment and thus a good fit for the theory unfolded above about the near future. The ongoing charges amount to 0.38%.

Vanguard High Dividend Yield Index ETF (NYSEARCA:VYM)
For a much cheaper way to build a portfolio with a high dividend yield, there’s the Vanguard VYM, with ongoing charges of just 0.06%. Top holdings include JP Morgan Chase, Johnson & Johnson, Home Depot, Procter & Gamble and Pfizer, which are all big US caps.

The performance of VYM and DVY has been similar over the years, with VYM gaining a slight edge during the recovery from the pandemic. However, I believe DVY is more defensive, as it targets many more companies in the utilities sector and thus is a better option for the time being. Given the high correlation between DVY and VYM, investors should either invest in one of these or reduce the exposure if investing in both at the same time.