Cutting portfolio beta through Capital Goods and Chemicals; upgrading Telecoms and Staples
Further to the signals we highlighted in our May Chartbook, and following a
very strong market upmove, we think it is now prudent to start reducing
the beta in our sectoral allocation.
To be sure, at the overall market level, we still envisage that the ongoing
capitulation by bears and the return of inflows into European equities, are
likely to keep providing support to equities over the next few weeks.
Once these inflows are spent, we would look to use higher market levels as
a good opportunity to reduce directional exposure, as well.
Broad indices might remain well bid short term, but within the market, the
leadership is likely to turn more defensive. As the top chart shows, following
dramatic gains in 2H ’16, US Cyclicals are beating Defensives by a further
510bp ytd and globally by 320bp, with the gap with CESI opening up. This is a
good opportunity, in our view, to lock in some profits for the next 3-4 months.
Our work with respect to US CESI shows that once CESI moves below
zero, Cyclicals tend to clearly lag over the next 1 and 3 months, losing
200bp relative. The air pocket in final demand is a clear risk, as seen in the
latest Chinese and US data softening, Cyclicals are overbought on RSI, bond
yields could remain range-bound and seasonals are moving against beta.
Also, Cyclicals have closed the gap with earnings. Q1 results were great, as
we hoped, but everybody has turned bullish on earnings now, and the bar
for Q2 and 2H has been raised materially. Earnings could, in fact, soften
over the next few months, following a likely rollover in PPI, which keeps
tracking the oil price – see middle chart.
Specifically, we are cutting Capital Goods and Chemicals to UW. Both
are very expensive, with Capital Goods in particular trading back at ’07 and
’11 P/E relative extremes – see bottom chart. The sector appears to have
clearly overshot the move in global PMI orders to inventories ratio. We also
reiterate our recent downgrade of Tech, noting a rollover in Taiwan orders.
What to do with Banks? Banks remain the most correlated sector to bond
yields and PMIs, and are back to highs in Europe as French risks have fallen.
Yields could stay range-bound in coming months as inflation prints roll over
and China PPI weakens. These are concerns, and we are cutting our OW in
Banks by half, but not exiting completely as the Euro recovery trade is still
in the early stages. We keep preference for Eurozone and EM Banks, and a
pair trade of long Eurozone vs short US Banks should keep working.
On the other side, we are raising Telecoms to OW and Staples to Neutral.
Telecoms are extremely cheap post terrible performance. Staples
valuations have de-rated somewhat. Overall, this makes us Neutral between
Cyclicals and Defensives, and we are also Neutral Value vs Growth. We
prefer domestic plays over exporters and stay OW Eurozone vs the US. In
Eurozone, we had Germany and Spain as OW markets, but we are exiting
Germany. Germany is up 29% in the past 12 months, it is a global cycle
play, which in the near term might not be that helpful, and we think Euro
will be stronger, rather than weaker. We stick to our OW Spain, however.