#Investments — 11.05.2017

Equities: The US and Europe Show Major Disparities in Performance

Guillaume Duchesne

Sector rotations differ in Europe and the US. We explain how and why.

We have noticed in recent months that global economies have been moving in sync. Leading indicators in developed and emerging market countries are mostly in the black. The International Monetary Fund has revised up its World Economic Outlook accordingly. Although economists are quite optimistic, the luck of investors in the stock markets is not always good. A revealing fact is that sector choices are not the same on both sides of the Atlantic. We look at the differences and causes.

Noticeable sector differences

US and European indices have risen over the past three months (+3.5% for the S&P500 and +7.5% for the Stoxx 600) thanks to a combination of positive factors including an upbeat economic climate, reduced political risks in Europe and rising company profits.

However, sector performances are fairly different in the two regions. What conclusions can be drawn?

Greater selectivity around the “reflation” theme

Both regions are benefiting from the buoyant economic environment, and investors like reflation sectors. Indeed, firmer demand is driving sales of companies which are sensitive to cyclical activity. However, this renewed interest is recent (it began in 2016), after the cyclical theme had long been snubbed by investors on the grounds of deflationary fears.  However, investors do not approach all cyclical sectors in the same way.

  1. In the US, consumer stocks are now the main source of performance. Retail and leisure stocks are back in favour with investors in the context of improving GDP, higher consumer confidence and wage increases. Leisure comes top for this month’s performance, spurred by the hotel business. Moreover, this sector is the most sensitive to a rise in disposable income, and in turn, discretionary spending. Company results for the first quarter of 2017 confirmed this trend and valuations for cyclical stocks remain attractive.
  2. In Europe, cyclical stocks are above all underpinned by luxury and industrial stocks. Capital goods might benefit from the pick-up in investment, stimulated by a better economic climate (and the promise of tax cuts), but also by an improved European policy coordination and new projects in the pipeline following the recent decline in populism. The fly in the ointment is that the sector is trading at high PE valuations. The luxury sector has risen from the ashes after suffering strongly in 2016 by the economic slowdown in China, geopolitical uncertainties (terrorist attacks), price pressure and the lack of brand loyalty among generation Y customers for luxury goods. A world economic recovery usually augurs well for this sector.
  3. Regional disparities are also apparent in the financial sector. This sector continues to perform well in Europe, but seems to be struggling in the US where it is already fairly priced. In Europe, price-to-book value ratios are still below 1. European banks should continue to benefit from the improving economic climate and interest among investors wishing to ride the recovery in Europe. In addition to higher valuations in the US, banking regulations are today a top issue with the Basel IV debate, parallel to the potential separation of investment and commercial banking activities (revival of the Glass-Steagall Act), mentioned recently by President Trump.
  4. The Automobile sector is under pressure in the US, as it is in Europe. The sector has performed nicely in recent years, but the auto sales cycle in the US looks very advanced at present (rising stocks, price pressure).  That said, the markets reacted strongly to the downside when US car manufacturers published disappointing April sales. Overall though, the first-quarter results beat expectations.

The economic cycle in the two geographical regions is advancing in different ways, which largely explains the regional differences. The US markets have probably largely priced in the effects of a more favourable economic cycle, boosted by the election of Donald Trump at the end of 2016. Both sectors (banking and infrastructure investments) performed very well at the end of last year.  The European markets participated less in this momentum in 2016 but are back in favour with investors, particularly now that political risks have faded.  No doubt there are still opportunities out there. The reflation trade might continue, albeit in a more selective way in the coming weeks. But that will depend on just how far the already-high valuations will go.

Commodity stocks in difficulty since the beginning of the year

In 2016, sectors linked to commodities largely outperformed. The main reason is the spectacular rise in commodity prices, but also the huge efforts of companies (deleveraging, cost control, etc.). Investing in these sectors is a good way of playing the global economic recovery, particularly following the market consolidation seen at the start of the year. However, the prerequisite is another rise in commodity prices. Investors will continue to focus their attention on the balance of supply and demand of materials. In this regard, the health of the Chinese economy is a source of concern, as the latest figures coming out of the Middle Kingdom show signs of weakness.

To sum up, in Europe, the sectors linked to commodities might benefit from a combination of positive factors, including attractive valuations, the rebound in commodities and the ongoing rally in the markets.

Disinterest in domestic defensive stocks on both sides of the Atlantic

Conversely, domestic defensive stocks (telecoms, utilities, food retailing) are underperforming massively. Investors have shunned these sectors on account of their low correlation to the rise in end demand and their decorrelation to interest rates. Investor appetite for sectors like this might return with new deflationary fears and/or a new risk aversion. But these sectors have fairly solid fundamentals. Whereas telecoms offer satisfactory growth and solid dividends, utilities have long suffered from a sluggish economic environment (thin demand, high stocks).

Do not underestimate global defensive stocks

Although today’s economic climate favours “reflationary” sectors, it is essential to diversify investments. In view of the rally in recent quarters, investors may suddenly lose faith in the economic recovery. In this scenario, some defensive stocks would benefit from new sector rotations.

In 2016, these sectors (consumer staples and health care) largely underperformed. That said, the pharmaceutics sector now looks attractive.
Following protracted concerns about the strong price pressure on drugs (competition, political pressure), investors have shifted their attention to innovation and new product launches. In this vein, the latest quarterly results (albeit not exceptional) have been pretty decent. Moreover, the sector is relatively appealing because it offers solid growth in a still uncertain environment. However, after collapsing in March, the health care reforms in the US are under debate again in the House of Representatives and should be watched closely in the weeks ahead.