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#Investments — 17.10.2018

Sector Strategy: Our Latest Recommendations

Guillaume Duchesne

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Positive outlook  for equities despite uncertainties

Global equities declined sharply on 10-11 October due to a sharp rise in US yields, renewed trade concerns and the IMF’s lower global growth forecasts. For some time now, equities have been under pressure as several risks are in place: 1/ trade tensions are the number one risk for growth. 2/ In Europe, the main risks are political. Downside risks include Italy and Brexit. 3/ A faster-than-expected rise in inflation could prompt central banks to normalise monetary policy more rapidly. This could lead to a sharp fall in bond prices. 4/ A bigger-than-expected fall in Chinese economic growth, resulting from the new import tariffs by the US, is a risk.

This difficult environment has been painful for equities, especially European ones. Nonetheless, we do not believe that it is the end of the cycle. The recent rise in US yields is actually in-line with our long-standing view that US yields would go higher. We still believe that most of the interest rate hikes are behind us as there is no acceleration in inflation and economic growth is set to slow in 2019.  We thus continue to play equities. We see a large gap between good fundamentals (solid companies’ earnings) and cheap valuations.

Sector strategy

We keep a sector strategy in favour of cyclicals and financials. Our central assumptions are still: solid economic growth/EPS, weaker USD and rising bond yields. The yield curve could steepen (especially in Europe). This combination is reflationary. It thus supports cyclicals. We are currently positive on Materials, Industrials, Energy, Financials and Communication equipment in Europe. We believe that in the short term the appetite for defensives – Staples, Utilities and Telecoms – will fade. Our favourite defensive sector remains Health Care where we see better growth profile.

Some subsectors look cheap for time being in Europe, in particular semis, auto, banks and telecom. At the current low valuation levels, some of them offer opportunities, we thus adapt our recommendations:

  • We upgraded global Auto from Negative to Neutral: Car manufacturers are facing a perfect storm. Several headwinds have impacted their activities (additional CO2 regulations, diesel scandal, tariff fears, slowing car sales). The industry is extremely cheap after its sharp underperformance. Most companies have cut their profit outlook. The latest one is BMW confirming that the environment is difficult for all OEMs. The environment will remain challenging for the automotive industry : 1/ Car sales cycle is mature in some countries (UK, US) 2/ CO2 and NOx emissions will be reduced and stricter regulation will be a constraint for car companies 3/ In this environment, companies will need to transform them with rising electric vehicles, declining sedan and diesel volumes. During the summer, Continental issued a profit warning due to a lack of demand for sedan models. 4/ ongoing uncertainties on trade. Nonetheless, we believe that a lot of newsflow has been priced in. Valuations will provide a floor in our view.

  • We upgraded European Semiconductors from Neutral to Positive as there is a divergence between good fundamentals and valuations. The industry (-19% since June high) has been impacted by : 1/ Slowing demand in smartphone (downward pressures on DRAM prices),  2/ Warnings in the automobile industry (EUR semis are highly exposed to Auto), 3/Trade concerns between the US and China, 4/ China industrial automation has slowed in recent months.  

In this environment, the industry de-rated sharply over the summer. EUR semis are now trading below their 2Y average (P/E at 17x.). The industry has probably suffered too much. We see reassuring facts in the industry:  book-to-bill ratios are still encouraging, demand is quite diversified (auto, smartphone, industrials, IA,…) and the industry should continue to expand in the coming 12 months (+15%).

In the Automotive industry, the warning from Continental is company-specific rather than industry-wide. Semi companies continue to see autos’ market strength, especially with its transformation (electric vehicles).

Even if a growth is expected to decelerate in 2019, the momentum still looks solid. We are thus opportunistic and consider that the current level is an attractive entry point, especially if investors’ risk appetite for European equities returns in the coming months. The main risk is an escalation in trade concerns between the US and China (negative impact on semi revenues). 

We have also reduced Commercial Services (a diversified industry within the Industrial sector) from positive to neutral. The industry has performed well over the last few years and now looks expensive (P/E at 24x in the US and 18.4x in Europe). Within Commercial Services, temping companies have reported slowing activity. We thus take profits in this cyclical sector. We however remain positive on capital goods (and thus on Industrials) as companies will continue to benefit from the positive capex momentum in the late cycle phase.