Equities: Abandoning our Short-Term Neutral Stance in View of the Better Risk-Reward Ratio
From now on, we only have one stance: positive. Investors should take advantage of volatility to invest in pro-cyclical markets and cyclical sectors.
Based on our conviction that short-term downside risks are limited and the medium-term outlook remains positive, we abandon our short-term neutral stance. Going forward, our investment stance on equities is positive. The upward path is likely to prove bumpy. Our preference for pro-cyclical markets remains intact (euro area, Japan, Asia ex-Japan). In terms of sector opinions, we make several changes. We upgrade our rating on materials and industrials to positive.
On 2 February, the release in the US of average hourly wage growth of 2.9% year-on-year led to a rise in the 10-year US Treasury bond yield to 2.84% and a general selloff in equity markets. Investors suddenly became concerned that inflationary pressures might prompt the Federal Reserve to raise interest rates more often and by larger amounts than expected.
Forced disposals by investors using strategies based on low volatility (among other) aggravated the selloff movement. However, safe-haven assets did not really take advantage of these circumstances. Gains by the Japanese yen and the Swiss franc were marginal, gold even lost ground and the rise in High Yield bond spreads was not commensurate with the drop in stock markets.
At this stage we can conclude that equity investors were on the lookout for a catalyst to generate a consolidation. Prior to the selloff, sentiment had reached extremes, technical conditions had become extremely overbought, weekly fund flows towards equities had reached record levels and the analysis of investor positioning showed that investors were most overweight on equities relative to government bonds since August 2014. In other words, a consolidation or a correction was long overdue. The trigger was the rise in hourly wages. Investors neglected that this reflects a decline in hours effectively worked.
A corrective phase but not the beginning of a bear market
With important support lines and the 200-day moving average fast-approaching, on both the MSCI World index and the S&P 500, downside risks are now very limited. Consolidation and corrective periods usually last between one and three months. We would expect the norm to be respected; it will take some time to clear the overbought conditions and excessive optimism.
The main reason why we believe that we are not currently facing a bear market but rather a period of consolidation is that economic conditions remain strong. The world economy is firing on all cylinders, and particularly encouraging is the recovery in capital expenditure, which points to a continuation in the current economic expansion for some time. The earnings outlook is therefore promising, for 2018 but also for 2019. The main constraint on equities is valuations, particularly as bond yields are rising. Still, 2018 should be a year of positive returns compared with 2017, which we forecast at approximately 10%.
Beyond the current phase of consolidation, equity markets are facing important headwinds and the question is how fast they can recover. These headwinds are the likelihood that PMI indices and economic surprise indices will slip lower in the coming three to six months, because they currently stand at historically high levels. The rate of change of equity markets is closely correlated to movements in these indices. Hence, we would expect the curve of price gains to be much flatter than in 2017.
The upward path in the medium term is also likely to prove much bumpier as volatility is here to stay. Growing inflationary pressure, rising bond yields and shifts in central bank policies towards less accommodation will be the main causes of higher volatility in the future.
An attractive risk-reward relationship prompts us to abandon our short-term stance
Based on our conviction that short-term downside risks are limited and the medium-term outlook remains positive, we abandon our short-term neutral stance. Going forward, our investment stance on equities is positive. We emphasise though that we see equities in a late stage of the bull market and the price to pay for participating in the upside is accepting higher levels of volatility.
Our country preferences remain unchanged. We favour pro-cyclical markets: the euro area, Japan, Asia ex-Japan.
A major sector rotation
During the recent few days of stress, the sectors most affected by the sudden stock market downturn were cyclicals and Energy stocks. Conversely, Utilities and Telecoms outperformed. This sector rotation is actually not surprising and is coherent in view of the uncertain environment. Investors are trying to protect themselves by reducing their positions in the most cyclical sectors and returning to defensive sectors. Nonetheless, we believe that it is therefore too early to envisage the end of the bullish economic cycle and to adopt a definitely more defensive sector strategy.
We play late cyclicals
The change of macro environment—towards an acceleration in more inflation and solid economic growth—is creating volatility in the very short term, but should at last incite investors to reposition themselves on very specific sectors, primarily on financials, commodity-related stocks and industrials. Financials will benefit from the rise in long rates and strong credit growth in developed economies, commodity stocks will rise on solid raw material prices in a context of strong demand, and Industrials will ride the wave of higher capital expenditure at the end of this cycle. At the same time, Consumer Staples (negative stance) will continue to suffer. We thus continue to recommend a positive stance on Financials versus Consumer Staples.
As we are convinced that equity markets still have a bright future ahead of them, we thus adjust our sector recommendation accordingly:
- We upgrade (global) Materials to positive from neutral. In the recent sell-off, the sector is back at its 200-day moving average in the US and in Europe. The good macro data in China, re-synchronisation of global economic growth, weaker USD and relative attractive valuations (P/E below its 3-year average) will lift investor sentiment. In Mining, free cash flow has improved thanks to capital discipline and a rosier global environment. We also favour Construction & Infrastructure (positive demand). Chemicals will benefit from positive drivers (M&A, pricing power, solid demand) despite rising input prices (higher oil prices).
- We upgrade (global) Industrials to positive from neutral. The current rebound in corporate profits in developed economies is expected to support Capex. In most countries, leading indicators of Capex point to a pick-up in spending activity. There is a growing interest in infrastructure spending. Capital goods will benefit from this major shift. Previously we were positive on two sub-sectors in Industrials, i.e. Commercial Services and Infrastructure (a subsector of capital goods). We are now positive on Industrials overall
- We keep a neutral stance on Technology, but play European Communication Equipment (upgraded to positive). Tech stocks are back at their November levels, but are not yet at their 200-day moving average. As the market correction has been modest, valuations still look relatively high (P/E at 19.5x in the US) and rising bond yields may represent a headwind for the sector. Although we remain confident in the sector’s structural drivers (solid demand and secular growth, i.e. strong product cycle, new markets), we prefer being selective within the IT sector. We see opportunities in the Communication Equipment: relatively more attractive valuations and improving revenues (deploying 5G spending).
Some defensive sectors have suffered over the last few months and are oversold for the time being. We will downgrade them in the event of a market rebound:
- We downgrade European Utilities to negative. The sector is not really exciting and has limited organic growth. Rising bond yields might penalise regulated Utilities that are rather expensive in Europe. Regulated Utilities are considered as bond proxies and have outperformed in recent years. We are thus cautious on these utility stocks. Integrated Utilities should have more potential thanks to an earnings inflection from low levels.
- We downgrade European Telecom services to neutral from positive. The sector should benefit from likely M&A, cheap valuations and high dividends (the pay-out ratio of major companies remains reasonable). Nonetheless, Telecoms have suffered as investors see the sector as a bond proxy. Our positive stance has not worked, so far (pressure on FCF, poor earnings reports, reflation trade, and disappointing inflation data in the sector). There is no reason to believe that the sector will outperform in the short term. Any technical rebound in the sector will be an opportunity to reduce exposure.
- We downgraded global Health Care to neutral in October 2017, but unfortunately kept a positive stance on European Health Care. Over the past few months, the sector has been hit by poor earnings reports, disappointments surrounding some products, rising pressure on drug prices and a weaker dollar. Due to these waning fundamentals, a neutral stance in Europe makes sense. Nonetheless, as the sector is currently oversold, we will reduce the European Health Care sector to neutral on the next rebound.