1) Non-financial cyclicals: In a typical rally, cyclicals outperform defensives by 20%, but the current rally has already reached 24%. More significant cyclical outperformance has tended to come early in the cycle, and yet the US, Japan and China appear to be entering later-cycle phases. The ratio of cyclicals to defensives moves closely in line with PMI new orders, but is now discounting levels of PMI consistent with 3-4% euro area and US GDP growth and a 3% US 10yr bond yield. Valuations are clearly expensive on book and earnings measures in the US, although they are more neutral in Europe. Historically, 70% of the time cyclicals have been this overbought relative to defensives, they have then underperformed. Finally, sector risk appetite in the US, Japan and the UK is in 'euphoria' at a time when we think President Trump's policies could disappoint. In aggregate, we raise European defensives to benchmark at the expense of cyclicals. We remain overweight financials.
Areas to be cautious: (i) Expensive cyclicals on HOLT® with negative earnings momentum: Dufry, Tui, Metso, SKF, Illinois Tool Works, SPX Flow, Emerson; (ii) China-exposed and growth capital goods stocks that remain abnormally expensive (Sandvik, Alfa Laval).
Areas to focus on: Financials are cheaper than cyclicals, have superior earnings momentum and are positively correlated with bond yields, which we believe will rise to c.1% in Germany and 3% in the US by end-2017. European banks have lagged cyclicals (unlike US banks) and life companies remain a play on a steeper yield curve. We also focus on domestic demand plays in Europe: CapGemini, SAP, WPP and Adecco are all eCAP stocks with high cont. European exposure. We stick to our overweight of temp. employment agencies and believe investors should favour bond proxy areas that offer a degree of cyclicality: toll road operators (Vinci) and selected telecoms (Orange). Defensive names that have positive earnings momentum, are cheap on HOLT and Outperform-rated include: RWE, Sanofi and UnitedHealth.
2) US high-yield spreads: Our model suggests that spreads should rise. Historically, when the unemployment rate has fallen below the NAIRU, spreads have risen 75% of the time over the subsequent 12 months. Corporate leverage is back to previous highs and thus we would be cautious on US names with high financial leverage and low operational leverage: NiSource and Southern are rated Underperform and have downside potential on HOLT.
3) Industrial commodity prices: All our macro proxies suggest industrial commodity prices should fall by 10-15%. Chinese real estate prices have peaked, suggesting iron ore should too, and some supply-side response is being seen at a time when inflation-adjusted commodity prices are back to long-run norms. The miners are discounting a sharp fall, but the mining capital goods stocks look expensive on book and earnings measures (Sandvik).
4) US small cap: US small caps are at the top end of their historical range on valuations and have discounted ISM and credit spreads staying at this level.