IN A WORD:
· This summer, the economic recovery turned out to be stronger than expected. Some stock market indices, driven by technology, reached new all-time highs. Despite the resurgence of Covid-19 at the moment, the economic recovery is likely to continue. The sharp rise in contamination in the Western world, however, continues to hamper travel and mobility, one of the reasons why we suggest short term prudence with energy (sector recommendation cut to neutral, except for European oil majors which remain in ‘+’ for the long term).
· Cyclical/value stocks still appear, in our view, to have the most potential. This month, we have upgraded industrials to positive, a good vehicle for playing the ongoing and future improvement in the manufacturing sector. We remain positive on materials and insurance globally and we are positive too on technology at the European level. We also upgraded pharma to ‘positive' after its underperformance in recent months.
· Conversely, we continue to avoid consumer staples (-) which have traditionally underperformed during recovery periods. And we suggest delaying new purchases (‘buy on dip’) on medical equipment makers and techno in health care (reco from + to =) after their good run this year.
· Finally, we look at which sectors would benefit from a victory for Mr Trump or for Mr Biden in the US presidential election.
Despite the resurgence of Covid-19 in the West, we believe the health situation will remain under control and should not jeopardise the economic recovery.
Leading indicators of manufacturing confidence such as Purchasing Managers Indices (PMIs) continue to improve, while the same indicators are capped in the services sectors.
On the other hand, new lockdowns at the local level, are being implemented (‘stay at home’ is back in some cities). This is hampering the recovery in travel, transportation and it is also weighing on oil demand.
We adjust our sector views accordingly:
1. We upgrade our recommendation on Industrials from neutral to positive.
2. We lower our recommendation on Energy from positive to neutral (but we remain positive on the European oil majors for the long term because they are too cheap).
3. After recent good performances from Medical Equipment and Health care technology in general, we would delay new purchases in these segments (down + to =). On the other hand, we increase Pharma from = to + as it is too cheap now after its underperformance in recent months.
We also include in this report a review of which sectors would benefit most from a victory for Mr Biden in the US presidential election and who would benefit from Mr Trump's victory.
Explanation of changes
1. First of all, we have taken advantage of the correction in equities in September to become positive on the industrial sector, a sector which is highly correlated to the manufacturing PMI and China. At the global level, we can see that freight and transport activities continue to improve. Companies in general have not invested much in recent months and, with the stronger-than-expected economic recovery, they need to reinforce production capacity. In many cases, they also need to invest more in their supply chains (many disruptions occurred in the spring) and they need to replenish their stocks, sometimes at higher levels than before to avoid disruptions.
This is why, although the industrial sector is not so cheap (price-to-earnings ratios slightly above 20), it is likely to continue its momentum, supported by expectations of increased infrastructure spending, “Green deals” and other stimulus plans expected or underway in various countries. Profound changes in the way industrial companies are run (e-commerce, Industry 4.0 or the 'Internet of Things', etc) are also creating new opportunities.
2. On the other hand, due to the resurgence of Covid-19 and related fears, the recovery in travel and the entertainment sector appears to be running out of steam and, as a result, demand for oil is slowing right now. Elsewhere, OPEC increased its supply in September and Libya is also increasing its production. Therefore, in the short term, the environment has become less favourable in the oil and gas market. In another segment, renewable energy companies have seen a very strong run on the stock market this year and probably need a pause in their surge. Therefore, we would delay further purchases in the energy sector in general (we consider there are more attractive sectors to play at the moment, with much better momentum). We tactically reduce our recommendation from positive to neutral. However, we are maintaining our positive bias on European oil majors for the long term, as they are very cheap.
3. In the health care sector (+), after the excellent performance of health care technology and medical equipment makers, we would delay further purchases and tactically cut our recommendation to neutral in these segments. With regards to medical equipment suppliers, their business could suffer again, as in the spring, if patients no longer dare to go to hospital in view of the increase in cases of Covid-19.
Pharmaceuticals, on the other hand, have underperformed since our downgrade from + to = at the end of May (the sector has remained stable since then) in favour of materials (+15% since then). Pharmaceutical stocks are now very cheap, and we find value there, just like in biotechnology. We are therefore upgrading the pharmaceutical sector to positive and we are maintaining the biotech sector to positive.
This year, growth sectors have outperformed, at least technology and health care. In these sectors, since the beginning of the year, we have been highlighting 5G, e-commerce and innovation in health care globally as well as European technology which all performed very well.
The still very low interest rates are a key supporting factor for these growth sectors. As long as inflation does not rise sharply, and central bank action keeps yields at very low levels - and with the support of the stimulus packages voted in many countries - we do not believe that a major correction will affect these themes and sectors.
In fact, the health crisis has amplified the rise in technology stocks because many individuals and businesses have had to equip themselves better. It was preferable to stay at home/work from home if feasible. Similarly, consumers became accustomed to ordering more and more goods and services online because many stores were closed, and they could not leave their homes or only for a limited period.
Valuations are now expensive, especially the 'FAANGs' (Facebook, Amazon, Apple, Netflix, Google, etc.), but momentum remains strong. It seems too early to take massive profits on this sector. Several segments still have potential, including 5G related stocks, Artificial Intelligence, and European techs.
Finally, the results in the health care sector were often better than expected in 2020, a scarcity in the context of the Covid-19 crisis. And of course, this sector is currently receiving exceptional support from political authorities and the people.
It should be noted that the recent resurgence of Covid-19 cases in the West once again provides support to the technology sector, which had corrected sharply in early September.
We think the valuation gap between so called ‘value’ and 'growth' stocks is now too wide (in fact, the valuation gap is at an all-time high!) And we argue for a rebalancing of portfolios in favour of cyclical/value stocks. Overall, we remain positive on the materials sector, which is sensitive to the strong recovery in many countries, particularly China. And gold mines (+) are a good diversification in these uncertain times, or even a protection against a future resurgence of inflation that some fear. The visibility and outlook of many industrial companies has improved well in recent months, hence our upgrade to positive this month (see above).
For other cyclical sectors, notably financials, energy and consumer discretionary (neutral on these three sectors), the situation remains highly disparate from one segment to the next or from one company to the next. Selectivity is still relevant.
Among financials, our preference is for insurance (+), a relatively strong sector, which is not expensive. As far as consumer discretionary is concerned, we still find ‘value' in the automotive sector, where some selectivity is also recommended, however.
Summary of our sector views:
Materials (positive): We believe this sector is ideal to play our repositioning towards quality cyclical stocks. There is indeed a great deal of discipline in the management of balance sheets and investments in recent years. Balance sheets are generally strong and, in comparison with other cyclical sectors, cash flows and dividends look relatively better insured. Even if the sector has already recovered well along with the rest of the equity markets, we believe there is still potential. Economic indicators are likely to continue to improve, and this sector is highly correlated to these, as is China, which is a major importer of raw materials and other materials. The economic recovery there is obvious and is arguably the prelude to what is going to happen in Europe and North America. Giant government stimulus plans should also directly and indirectly support materials (needed for construction, housing, glass and steel for automobiles, etc.). Finally, with the return of risk appetite on the financial markets and the dollar having begun a downward trend (it seems less necessary to favour this 'safe-haven' currency), raw materials prices should continue to rise, as should the materials sector.
Health Care (Positive)
Sectors on which we are neutral:
Financials: In early March, we became more cautious in general on financials (=) due to the looming economic crisis. US banks are facing corporate bankruptcies and many consumers will also not be able to repay their loans or credit cards. Generally-speaking, interest rates remain very low.
Before turning more positive on banks, we would like to see a more confirmed economic recovery leading to a rise in inflation and higher yields and interest rates, which would provide a much more favourable backdrop for the banking sector.
Dividends are under pressure on both sides of the Atlantic. While this is likely to be temporary, banks are losing one of their main attractions: visibility on dividends has deteriorated and some banks may indeed be tempted to 'reset' their dividends structurally at a lower level. Finally, events in Hong Kong and Brexit are making the UK financials less attractive.
Therefore, we still recommend selectivity by favouring the strongest banks in the US and the core eurozone countries.
Among financials, we prefer the insurance sector (+). Solvency remains very good (around 200% on average). P/E 2021 ratios in Europe are now around 8.4x for insurance against 15.7x for the market and in the US it is 10.7x versus 21.4x. Dividend yields in Europe look relatively secure there at around 5.2% (although many dividends are likely to be paid only at the end of the year).
There is indeed some doubt about potential compensation of businesses hurt by the crisis. But we believe these claims should not significantly penalise insurers' profits and certainly not their strong balance sheets. In addition, these disputes could take years before they are settled. On the other hand, new opportunities have arisen to raise prices in view of the new risks involved. Some insurers are even creating new 'Covid' or 'pandemic' insurance.
Technology: in the sector, we continue to favour Europe as well as 5G and Artificial Intelligence themes. European technology remains discounted relative to the US. In addition, some debates and disputes regularly reappear in the United States about the power and unsocial attitude of some 'Mega Techs'. More controls and regulations could emerge in the coming years to counter abuse and allow for a healthier competition.
Lockdowns have shown some benefits of teleworking and have also led to an accelerated development of online leisure and shopping. All this requires better connections to the Internet and many other IT developments. Moreover, in the treatment of new diseases, medical and pharmaceutical research requires much more powerful and faster data exchange and treatment capabilities. This is another supporting factor for these technologies.
Energy: see above
The consumer discretionary sector (neutral opinion) is also suffering, but the impact of current crises on final consumption remains difficult to estimate. As mentioned several times, this is a very heterogeneous sector. It also offers several 'big winners' from new consumer trends. In the short term, we continue to recommend caution on traditional leisure related names (restaurants, cinemas, hotels, etc.) and on travel in general. At the moment, we prefer the automobile sub-sector, which is too discounted. In general, it is important to be selective and we favour a rather thematic approach to this sector.
Similarly, for communication services, utilities and real estate (broadly neutral opinions), we recommend selectivity and/or a thematic approach.
Sector on which we are negative
Consumer staples (-): Following its rebound with the rest of the market in March-April and following the end of the lockdowns, the sector looks fairly valued (price to earnings ratios of around 20 on average) and is likely to underperform in the current context of an economic recovery. This sector would most likely underperform if Mr Biden were to win the US election in November.
WINNING SECTORS - LOSERS IN THE EVENT OF A VICTORY FOR MR TRUMP OR FOR MR BIDEN
Sectors that would continue to benefit from a victory by Mr Trump in the US Presidential election:
o Mr Trump has implemented a far-reaching tax reform, in particular reducing the higher corporate tax rate from 35% to 21%. He has also taken a whole series of deregulation measures. These reforms benefited many companies and sectors, especially financials, telecoms, basic goods and pharmaceuticals.
o Other sectors typically favoured by Republicans: fossil/traditional energy and defence.
o The more domestic companies (‘US centric’) would also continue to be favoured by ‘America first’ policies.
o On the other hand, sectors that would suffer from a victory by Mr Trump (in addition to some companies he regularly attacks, such as Amazon or AT&T Time Warner): renewable energy, some technology hardware companies. The latter would still find it difficult to source from China or may have to relocate production capacity, etc.
Sectors that would benefit from a victory by Mr Biden in the US Presidential election:
o Mr Biden would be less favourable to (large) companies/institutions and instead favour workers and individuals. For example, he wants to increase the minimum wage to $15 per hour and increase the corporate tax rate from 21% to 28%. This would have a direct and negative impact on the earnings of many companies. Moreover, Democrats generally prefer a higher level of control and regulation that would hit financials, telecoms, the consumer staples sector and pharmaceuticals.
o But these policies to offer better wages to low skilled workers would support consumption and be reflationary. These are seen as positive for the economy in general, and therefore even indirectly for banks. Especially in the event of a full democratic victory (so, victory also in the Senate), the yield curve would steepen - a positive for financials - pending large public spending (and the opposite in the event that Democrats do not win the Senate).
o Since Mrs Clinton's defeat in 2016, it has been clear that the Democrats are not happy with social networks (Alphabet, Facebook, etc.) and will want these companies to control much more what is published there, with increasing costs for them. Other ‘MegaTechs’ are now very powerful and, compared with Mr Trump, it is likely that Mr Biden and the Democrats would do more against these quasi-monopolistic technology companies. For example, more competition or a possible division of some companies could be imposed.
o Mr Biden and the Democrats also have clear plans for large-scale infrastructure spending, particularly ‘green’. This is positive for some public and industrial utilities, renewable energy, some automobiles but also for cyclicals and materials in general. By contrast, traditional/fossil fuels would continue to suffer.