AT A GLANCE:
· Newsflow on both the pandemic and the economy recovery has improved. Leading indicators are clearly on the rise and some normalisation is taking place in China. The same could happen quite soon in Europe. Eased lockdowns and renewed confidence among many economic players have continued to fuel the market rise, thus favouring a repositioning towards more cyclicality and towards laggard/'Value' style sectors.
· In our sector allocation, we recommend returning to cyclical/Value stocks by taking some profits on relatively expensive defensive growth stocks: we upgrade the materials sector from = to + and industrials from - to =. We still like insurers overall (+) because they are very cheap, as well as energy (European in particular) and certain technology segments (5G, AI, Europe).
· On the other hand we have downgraded the pharmaceutical sector from + to = (health care, however, remains positive) and we have also downgraded consumer staples from = to - following the recent rebound.
Visibility is relatively low on some cyclical sectors showing high volatility. This prompts us to maintain a degree of caution, for example on banks and industrials (both on which we have neutral opinions; selectivity is still important here).
The improving economy is encouraging us to return to cyclical and ‘Value' stocks. But we recommend sticking with the strongest companies as they are more likely to withstand the crisis. This month (June):
· We upgrade
o Materials from neutral to positive
o Industrials from negative to neutral
· On the other hand, we downgrade
o Pharmaceuticals from positive to neutral
o Consumer Staples from neutral to negative
These recommendation changes are part of the sector rotation we advocate at the moment: we favour quality Value and Cyclicals by reducing, if necessary, and/or taking some profits on defensive and growth stocks. Cyclical/Value sectors are real laggards this year.
1. Materials upgraded from Neutral to Positive: we believe that 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. These are strong and, compared with other cyclical sectors, cash flows and dividends generally look relatively better covered. The sector has already recovered nicely along with the rest of the equity markets, and we believe there is still some potential. Economic indicators are likely to continue to improve, and this sector is highly correlated to these, as to China, which is a major importer of raw materials and other basic materials. The economic recovery in China is very apparent and arguably, the prelude to what is going to happen in Europe and North America. Gigantic government stimulus plans should also directly, and indirectly, support materials (used in construction, housing, glass and steel for automobiles, etc.). Finally, with the return of risk appetite on the financial markets and the US 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.
2. Industrials upgraded from negative to neutral: the health crisis seems fairly under control in the Western world, even though at the moment some doubts have resurfaced about lockdown easing measures having been taken a little too hastily in some American states. However, leading trend indicators are clearly improving and industrials are obviously correlated to these. We believe that this strong recovery should support the sector. China's experience has shown that most industries can resume operations quite quickly, and we expect the same thing to happen in Europe and the US. However, we recommend selectivity within this sector as visibility remains low and the risk is high for many segments, particularly aerospace. It is also better to stay with the most solid companies because restructuring, recapitalisations and even bankruptcies are expected. This is why our recommendation upgrade does not exceed neutral. Among the broad industrial sectors, we consider that the automobile sector is too heavily discounted at present (note that, strictly speaking, this industry is included in the MSCI consumer discretionary indices). There are good opportunities to buy on dips, but be aware of the very high volatility presently.
3. Pharmaceuticals downgraded from positive to neutral: a tactical call. Our short-term preference is for cyclicals, which should outperform in our scenario of an accelerated economic improvement. Some pharmaceuticals hit new highs in April/May, given their good fundamentals and the need to support the sector in order to stem the health crisis and to be able to respond more quickly when new diseases emerge. But a pause for breath is needed for pharmaceuticals even though we consider that they still have medium- to long-term potential and are not very expensive (price to earnings ratio 2021: around 16x for Europe and 14x for the US). Hence our still positive view on the health care sector in general. In addition, potential seems even greater for a range of biotechs, medtechs (with their business normalising following easing lockdowns) and other ‘health care technology innovators.’
4. The consumer staples sector has been downgraded from neutral to negative: it had also fallen during the general dislocation of the equity market in March, while some segments (especially food stores, but also HPC, ‘healthy’ food, snacks, etc. - see our ‘Stay at home’ theme) were expected to perform very well during the health crisis. There were fewer reasons to remain negative. Now, following its rebound with the rest of the market and following the end of lockdowns, the sector is once again fairly valued (price to earnings ratios around 18x) and is likely to underperform during the current economic recovery.
Sectors on which we are positive:
· Materials (from = to +): see above
· Health care, especially med tech, biotechs and other health care technologies, favouring promising small- and medium-sized companies: see above, notably the recommendation downgrade from + to = for pharma.
· The energy sector, in particular European oil majors (+), remains cheap despite the recent rise, especially as we expect oil prices to continue to rise by the end of 2020 to a range of USD 45 - 55. Few measures have been taken to support the US oil and gas industry following the double black swan at the beginning of the year (Covid-19 & political tensions between Russia and Saudi Arabia leading to a collapse in oil prices). As a result, many derricks and platforms have interrupted production, thereby reducing supply in an accelerated manner. The shale oil and gas industry is particularly suffering now with for instance the American company Chesapeake likely to go bankrupt. Conversely, demand is recovering rapidly with lockdown measures easing and economic activities restarting. As a result, oil quickly rose above USD 40 in early June before consolidating somewhat. Even if challenges persist (especially the ecological transition), we believe that the restructurings under way will support the sector. Of course, we need to be more selective now following the recent rally of many stocks, and our preference remains for the strongest players in the sector in view of the context. The European Majors (+) have little exposure to shale oil & gas and display stronger balance sheets.
Sectors on which we are neutral:
· Financials: In early March, we became more cautious in general on financials (=) due to the looming economic crisis. While, as previously explained, US banks will face bankruptcies in the energy sector (e.g. Chesapeake, which is expected to file for bankruptcy in the US) and other sectors, many consumers will be unable to repay their loans or credit card bills. Generally-speaking, interest rates remain very low.
Before turning more positive on banks, we need to see a more sustainable economic recovery leading to a pick-up in inflation and higher yields and interest rates, which would provide a much more favourable backdrop for the banking sector.
European banks (=) are also suffering from the ECB's decision to prohibit the payment of dividends in the spring (see our Strategy Flash on our general expectations for dividend payments). And there are now ongoing discussions in the ECB's risk committee to refuse all payments in 2020! Although this is probably temporary, European banks have just lost 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 the Brexit saga are making the UK banks less attractive.
Therefore, we still recommend selectivity by favouring the strongest banks in the US and in the eurozone core countries.
Among financials, we prefer the insurance sector (+) which, at the market trough this year, was 40% lower (way too much, in our view) before many companies and analysts confirmed the strength of the sector. Solvency has in some cases doubled (from around 100% to 200%) over the past 12 years! P/E 2021 ratios in Europe are now around 8x for insurance against 15x for the market, and in the US: 10x against 19x. In Europe, insurers’ dividend yields look relatively safe at around 6% (although many dividends are likely to be paid only at the end of the year).
There are indeed some doubts about potential compensation of businesses hurt by the crisis. But we believe these claims are unlikely to significantly hit insurers' profits, and certainly not their strong balance sheets. In addition, these disputes could take years before they are settled. On the other hand, given the new risks involved, there are new opportunities to raise prices or even to develop new 'Covid' or 'pandemic' insurance.
· Industrials (from - to =): see above
· Technology: we continue to favour Europe (+) and the 5G and Artificial Intelligence (AI) themes: European technology is still abnormally discounted relative to the US. This is particularly true given that some debates and disputes are regularly reappearing in the United States about the power and unsocial attitude of some Tech Giants. More control and regulation could emerge in the coming years to counter abuse and allow healthier competition.
Moreover, lockdowns have shown some benefits of teleworking and have led to an accelerated boom in online leisure and shopping. But all this requires better connections to the internet and many other IT developments. In addition, 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.
· The consumer discretionary sector (neutral opinion) is also suffering, but the impact of the 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’ of the new consumer trends. In the short term, we continue to recommend caution on traditional leisure-related stocks (restaurants, cinemas, theme parks, etc.). and on travel in general.
Now we prefer the automobile sub-sector, which is very heavily discounted, while the e-commerce sector is likely to consolidate somewhat after the recent good performances. In general, it is important to be selective and we favour a more thematic approach to this sector.
· Similarly, for communication services, utilities and real estate (neutral opinions), we recommend selectivity and/or a thematic approach.
Sector on which we are negative:
Consumer Staples (from = to -): see above.
Please find attached the PDF that contains all annexes.