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#Investments — 12.07.2018

Sector View for the summer : We turn positive again on the energy sector

Guillaume Duchesne

Global equity markets have been rather nervous in recent weeks due to higher macroeconomic risks (a peak in growth, rising inflation, normalising monetary conditions).

The recent exacerbation of trade tensions between the US, China and Europe is an additional stumbling block. Consequently, a significant rotation into defensive stocks, particularly Consumer Staples, has occurred in a short space of time.

 

“We have adapted our sector strategy:  We upgrade oil stocks to positive in the US and Europe. We like large diversified oil companies ("majors")”

 

Guillaume Duchesne

Chief Investment Advisor in Equities

We turn positive again on the energy sector

In this difficult context, we have adapted our sector strategy. Although we maintain a positive view on cyclical stocks, we have decided to rebalance our recommendations by favouring a sector with a less pro-cyclical profile:  We upgrade oil stocks to positive in the US and Europe.

Concerns about the OPEC meeting in June led to a temporary decline in oil prices and oil stocks after reaching a peak in May. We took profits in the sector in early May. Recently, we have identified (again) some positive factors for oil stocks:

  • In relative terms, the sector will benefit from a challenging environment over the summer. We believe that energy remains a good protection against current uncertainties linked to trade tensions. Of course, the sector could be hurt by a marked slowdown in the global economy in the event of a protectionist escalation, but this is not our base scenario. Compared with other sectors, oil stocks offer visible and solid growth in a context in which investors are essentially looking for growth. According to analysts' forecasts, Energy will be the largest contributor to earnings growth in 2018/2019 in Europe and the US. As a result, our strategy for this sector has become more balanced and better suited to the potential summer volatility.

  • But also specific advantages of its industry: The sector has strong free cash flows, high, secure dividend yields and attractive valuations. Its dividends are not at risk because they are backed by significant free cash flows. Amidst a still difficult geopolitical environment, oil prices are likely to remain at high levels, well above the profitability level of oil companies. The barrel of Brent is currently $77-78 per barrel. Although our forecasts remain at $65-75/bbl, the risks are rising in the short term. Strong global demand (seasonal effects), lower production in Venezuela, US economic sanctions against Iran and limited production capacity in the US will support oil prices during the summer.
     

We like large diversified oil companies ("majors") for their good combination of high dividends, improving earnings and reasonable valuations. However, we are more cautious on Oil Services, given the less favourable earnings momentum and unattractive valuations. Investment spending in the oil sector remains low at this stage. Moreover, oil services are not only highly sensitive to oil prices but are also a high beta (*) industry on the markets.  Their risk profile is therefore less suitable for our strategy.
 

Positive view on financials and cyclicals

Despite the clear scepticism of investors, we remain positive on Financials, particularly European banks. Our interest rate expectations and the steepening of the yield curve, essential for the profitability of the sector, remain at the heart of our conviction. At this stage, we believe that Banks have an upward potential in the context of an economic recovery, and thus, rising interest rates. The sector is expected to benefit from rising net interest margins and solid credit growth. Costs in the sector remain under control. Within the banking sector, we favour high-quality European names. 
 

We also remain positive on materials and industrials. Whereas the recent slowdown in certain activity data and the intensification of the trade war have dampened the outlook, growth should remain strong. The threat of a trade war is not likely to disappear before the mid-term elections in America, but to date only a small amount of import duties have actually been implemented.  Global economic fundamentals remain strong, as reflected in the latest business surveys. Companies’ earnings are also on a good trend.
 

However, we are still negative on the automobile industry, which is currently on the front line of President Trump's attacks. Albeit cheap, carmakers’ stocks are facing numerous challenges: the maturing US sales cycle, stricter environmental regulations, NAFTA negotiations at a standstill, and now, concerns about the implementation of import duties.
 

It is too early to buy defensive stocks

We remain negative on certain defensive sectors: Utilities, Consumer Staples (except Food Retail) and UK Real Estate. With rising volatility and falling interest rates, it is tempting to rotate into some of them. These sectors have underperformed in recent years and are often cheap. We believe it is too early to adapt a Buy recommendation. These sectors will continue to suffer from weak earnings growth and should continue to underperform during the final phase of the economic and financial cycle.
 

Among defensive stocks, the pharmaceutical industry is our favourite (solid growth despite price pressures, cash repatriation to the US, M&A). We remain neutral, however, as this sector is characterised by strong differences between companies, favouring essentially stock picking.
 

In conclusion, we adopt a positive opinion on energy, and despite risk factors, maintain our positive view on pro-cyclical sectors.

 

(*) beta measures the sensitivity of the sector to market movements.