IN A WORD:
· Since early June we have seen a slowdown in the improvement in economic news and Western equity markets have been consolidating. We are closely monitoring the resurgence of the pandemic in some parts of the world, particularly in the South and West of the US as its resurgence could fuel new doubt, and affect our current positioning.
· Given that the economic recovery is set to continue (our base-case scenario) on the basis of very strong support from the political and monetary authorities, we recommend a bias towards cyclical/value stocks. We remain positive on materials, health care (excluding pharma) and insurance globally as well as energy and IT at the European level (the latter sector, however, is under review following excellent recent performances). Gold mines (+) provide good diversification and portfolio protection in these uncertain times.
· Conversely, we continue to avoid consumer staples (-) which have traditionally underperformed during recovery periods.
· There is relatively little visibility on some very volatile sectors. This prompts us to maintain a degree of caution, for example on banks and industrials (we are neutral on both and selectivity is still relevant). We think there are opportunities in the automobile sector that we deem a cheap industry.
The economic improvement is benefiting cyclical and 'value' stocks. But we recommend sticking with the strongest companies as they are more likely to withstand the crisis.
In the first half of the year, growth sectors 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. Several European technology leaders have just announced much better-than-expected results for the first half of 2020 and/or a positive outlook.
The still very low interest rates are another 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/ 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.
European technology stocks have performed very well since the beginning of June (+13.5% from 31/5 till 23/7). They were relatively cheaper than the US tech when their prospects were also good, something we have stressed repeatedly. After the sharp rallies in recent weeks, we are now putting this sector ‘under review’ for potential downgrade from positive to neutral.
Finally, the results in the health care sector were often better than expected in 2020, a rare occurrence in the context of the Covid-19 crisis. And of course, this sector is currently receiving exceptional support from the political authorities and the people.
When Covid-19 hit Europe and the United States, many countries had to stop numerous economic activities and widely restrain social contact and travel in a bid to stem the pandemic. As a result, activity in sectors related to aeronautics, travel and more generally traditional leisure (restaurants, cinemas, hotels, etc.) collapsed. The situation remains challenging for these sectors on which we remain cautious. Fixed costs are very high there and profitability will take time to return.
On the other hand, some cyclical sectors had corrected excessively and they still carry 'value'. This is particularly the case for energy (positive recommendation, especially for European energy). Supply has been drastically reduced by the OPEC + and the United States, while demand is gradually rising all over the world. Although air travel will take several years to return to its 2019 level, it appears that car travel will be favoured in the short term (at least that is what is happening in China). As a result, demand for oil (and cars) should continue to rise in the coming months, as should the oil price.
We also selectively like the automobile sector but it still seems a bit early to turn positive on the sector as a whole given the many challenges in this industry, particularly the transition to less polluting technologies. We will see when the 1H20 results are released how different groups fare, and the guidance they give.
The fall in the USD is another supporting factor for commodities, i.e. oil, mining and minerals, gold and gold mines. This is another reason why we remain positive on investments in commodity-related stocks. Their trends remain positive and will remain so unless there is a major uptick in cases of Covid-19 and second lockdowns on a massive scale.
In general, 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. Most gold mining stocks are far off 2011 levels whereas gold has hit new highs ; these companies are better managed today than they have ever been. Furthermore, balance sheets are strong.
For other cyclical sectors, notably financials, industrials and consumer discretionary (we remain neutral on these three sectors), the situation remains highly disparate from one segment to another, 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. Among the industrial/consumer discretionary sectors, as explained above, we still find ‘value' in the automotive sector, where some selectivity is recommended, however.
Here is an update of our sector views (no changes in July):
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, compared with other cyclical sectors, cash flows and dividends look relatively better secured. Even if this small sector has already recovered along with the rest of the equity markets, we believe there remains some 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 basic materials. The economic recovery there is very apparent 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 should continue to rise, as should the materials sector.
Health care (positive): as a reminder, our preference is for innovative companies in biotechs, med-techs and other ‘health care technology’ segments (one of our favourite investment themes for 2020). We are, however, more cautious in the short term on traditional pharmaceutical companies (neutral recommendation on this segment) following the good performances at the beginning of the year. Our short-term bias is towards cyclical stocks which are likely to outperform in our scenario of an economic improvement. Some pharmaceuticals hit new highs in April-May, in view of their good fundamentals and the need to support the sector in order to stem the health crisis and be able to respond more quickly when new diseases emerge. But a pause is needed for pharmaceuticals, especially as the classic debate about the very high cost of health care in the US could return during the presidential election campaigns. Price pressure will impact older drugs and intermediation services more than the much needed new therapies right now.
Energy (positive): energy sector remains cheap despite the recent rise, mainly European oil majors (+) especially as we expect oil prices to continue to rise by the end of 2020 to a range of USD 45 - USD 55. Few measures were taken to support the US oil and gas industry following the double black swan (Covid-19 & political tensions between Russia and Saudi Arabia leading to a collapse in oil prices) at the beginning of the year. As a result, many derricks and platforms stopped production, thereby reducing supply in an accelerated manner. The shale oil and gas industry is suffering particularly badly (note for example, the case of the bankrupt US company Chesapeake).
On the other hand, demand is recovering rapidly with eased lockdowns and resumed economic activity. As a result, oil has quickly come back to USD 40 at the beginning of June before consolidating. Even though many challenges persist for the sector - especially the ecological transition - we believe that the many restructurings underway will support it. Our preference is for the strongest players, given the still highly uncertain environment. The European oil "Majors" (+) have little exposure to shale oil and gas and have stronger balance sheets.
Sectors on which we are neutral:
Financials: In early March, we turned more cautious in general on financials (=) due to the looming economic crisis. While, as explained, US banks will face bankruptcies in the energy sector (e.g. Chesapeake in the US) and other sectors, many consumers will also be unable 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 be 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 at around 8.8x for insurance versus 15.4x for the market, and in the US they are at 10.4x versus 20.1x. Dividend yields in Europe look relatively secure there at around 5% (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: we continue to favour Europe ('+' on this continent but 'under review' for potential downgrade to '=' after +13.5% from 31/5 till 23/7) as well as 5G and Artificial Intelligence themes. European technology was 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.
However, 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.
Industrials: the health crisis seems relatively under control in Europe and the North-East American states, although at present, serious doubts have re-emerged about lockdown that was arguably lifted too soon in some Southern and Western states. However, leading trend indicators are improving and industrials are obviously correlated to them. We believe this strong recovery should support the sector. China's experience has shown that most industries have resumed activity fairly quickly and we believe the same will be true for Europe and the US. However, we recommend selectivity for this sector as visibility remains low and the risk is high is many segments, particularly aerospace. It is also better to remain positioned on the strongest companies because many restructurings, recapitalisations and even bankruptcies are expected there.
The consumer discretionary sector (neutral opinion) is also suffering, but the impact of the today’s 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 overly discounted auto sub-sector, while the e-commerce sector should consolidate somewhat after the recent good performances. 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 along with the rest of the market in March-April and following the end of lockdowns, this sector is once again fully priced (est. 2021 price-to-earnings ratios close to 19 on average) and it is likely to underperform in the current context of an economic recovery.