Sector Strategy: Be Patient!

Cyclicals versus defensives have suffered from the largest underperformance in recent years. This suggests that the markets have already priced in a sharp slowdown in growth. We see a large gap between fundamentals and valuations. As we do not believe we are at the end of the cycle, we stick to our positive view on pro-cyclical sectors (Materials, Industrials), Financials and an atypical sector, Energy. We are also positive on Pharma (see below).

Energy stocks have suffered from the recent downturn in oil prices. After a strong performance in 1H18, the sector has underperformed by 6% in Europe since the beginning of October. The expected rebound in oil prices should continue to sustain oil stocks. Capex discipline remains a positive factor for the sector. It should help generate cash flows while valuations appear attractive. Since the recent sell-off, the sector has de-rated significantly, returning to attractive levels. The dividend is not at risk in our view, as it is backed by significant free cash flows at the current level of oil prices. We thus remain confident in the sector and favour oil majors in Europe and in the US. We are however neutral on oil services due to their riskier profile.

We remain selective within defensive sectors. Based on our scenario of robust economic growth, a gradual hike in interest rates and, ultimately, a rebound in stock markets, we remain cautious on most other defensive sectors that are big winners of present market concerns: Consumer Staples (negative view), Utilities (negative), Real Estate (neutral) and Telecoms (neutral). The telecommunication services sector has benefited from a sudden burst of interest among investors, who are attracted by the high dividends and the domestic nature of the sector (i.e. less sensitive to trade tensions and concerns over global growth). The Telecommunications sector in Europe, however, is suffering from weak revenues and price pressure in a still fierce competitive environment. In addition, most defensive sectors are expensive. As defensive names are resilient in case of recession, investors are ready to pay them with a high premium.

We turned positive on pharma stocks in the autumnWe remain positive on global equities over the medium term. The combination of an attractive valuation and strong fundamentals suggests that stock markets still have upside potential in the medium term. That said, the market has been affected by a negative sentiment amid a challenging political environment (trade tensions, Italian budget, Brexit negotiations, etc.) since October 2018. As investors have begun to anticipate a sharp economic downturn, strong earnings visibility has become a key criterion in their stock-picking. This is a clear strategy in the US. In this context, the market correction in the autumn gave us an opportunity to rebalance our recommendations in favour of slightly less risky themes.  The Pharmaceutical industry provides good earnings visibility and its valuation is not too overstretched.

The industry boasts inherent strengths:

1.     Encouraging fundamentals
The relative earnings momentum of pharma stocks has recently stabilised in the US and Europe (after a period of negative revisions). Earnings forecasts in the industry are decent (7% in Europe and 6% in the United States) and return on equity (ROE) is solid.
The third quarter 2018 reporting season was encouraging. Sector players published sales in line with (or above) expectations. New key products were launched in immunology, oncology, rheumatology, antidepressants, etc. and beat analysts' expectations. As a result, scepticism about the potential of new products has faded. Finally, the end of patents in the United States is weighing less than the sector compared with previous years. After a peak in 2011-2013, patents falling in the public domain are indeed less numerous. This backdrop is supporting revenue (one-digit growth) but also sector margins.

2.     A less negative sentiment on the industry in recent months
Recent market events have brought the sector back in the spotlight. The pharmaceutical industry appears to be immune from trade tensions and is less sensitive to macroeconomic uncertainties. This context is obviously reviving interest in the industry.
Apart from this relative aspect, investors are focusing once again on the industry's fundamentals, and less on drug prices. For several years, the focus on greater price transparency has been perceived as a risk factor for the industry. The Trump administration has been applying huge pressure. The American president has made several announcements since the beginning of his mandate. His efforts culminated in a lacklustre reform of Obamacare and a complex project on drug price control, to  be finalised in 2025. After the mid-term elections in the US, the debate of prices may obviously reopen. In Congress, Democrats and Republicans are still likely to find a compromise in this area, but we remain very sceptical about this issue in view of the political stakes. In our opinion, a price regulation is still very difficult to implement. 
In the meantime, pharmaceutical groups have compensated for the impact of price risk by reining in costs. In addition, they have reassured the markets that any price changes are fully manageable.

3.     Fair valuations
While the sector is close to its 2-year average in the US (15.1x), the P/E ratio is attractive in Europe (14.7x). The fall in share prices in the autumn was primarily due to challenging market conditions rather than sector-specific fundamentals.

4.     Mergers and acquisitions, share buybacks and dividends
In terms of mergers and acquisitions (M&A), the consolidation has been (above all) concentrated in the US health insurance sector (CVS/Aetna, Cigna/Express Scripts). This was indeed necessary amid fears of growing competition from Amazon. Its repercussions on pharmaceutical companies are fairly limited.
In the pharmaceutical industry, M&A activity has been quite calm. In the US, however, companies have been able to repatriate cash thanks to the tax reform implemented by President Trump.  What should be done with this liquidity?  We do not expect any mega-mergers, but rather more targeted acquisitions.  Nevertheless, share buybacks and dividend yields of 3% are more supportive factors within the sector (see chart below).

Guillaume DUCHESNE, Equity Strategist