Defensive Sector Strategy: Telcos and Pharma - Telco Offers a Hedge to the Risk-on Trade

In our PSA Japan Perspective 2017, we outline a risk-on scenario. As things stand, we are in something of a Goldilocks situation, with the economy growing just enough for investors to be confident, while not fast enough to hurt the bond market and risk changing BoJ policy. If we hold this position and factor in the time value created in equities over the past 18 months, we have room for reasonable upside. However, it is important that the economy not start to run away. This is something that holds true not just for Japan, but also for the US and some other markets, like the UK. 
Having started 2016 at 19,000, the Nikkei 225 was below 15,000 by mid-February. The year low was registered as late as June, when the yen went down through ¥/$100 for the first time since 2013. That was probably at the height of the negative interest rate debate. 10yr JGB yields fell to -0.3%, and in June alone, Japan’s banking sector lost one-sixth of its stock market value, to take its then year-to-date losses to 40%. That the financial industry itself was so worried that interest rates might go deeper into negative territory essentially forced the Bank of Japan’s hand and it became evident over the summer that such a policy would not be pursued.  
This was not only positive for the stock market / negative for the JGB market, but it caused a massive U-turn in sector strategy for equities: away from risk-off sectors like foods and pharma and towards risk-on sectors such as financials and basic materials. By the end of the year, not only was the Nikkei back to where it had begun, but so were sectors like banking and steel. 
While in the current risk-on environment an underweight position in defensives seems sensible, we remain on the look-out for attractively-priced exposure to the defensive sectors. The flip-flop story of 2016 underlines the need to remain alert to changes in outlook.  
Within Pharma, we struggle to find names which either offer value or, at least, offer a fair prospect of delivering the returns the stock price premiums indicate are justified. Indeed, there are now fresh political reasons to be concerned about the sector, which may precipitate some mean reversion.
With regard to Telcos, valuation support plus the likelihood of positive earnings surprises for the final set of figures for FY16 make these names in our view an attractive area for investors to gain exposure to defensives.