In their European strategy report, Morgan Stanley analysts said they believe that in the absence of a sharp economic slowdown, a compelling opportunity has emerged for investors to start selling defensives.

Defensives outperformance European Industrials

Defensives have outperformed strongly

Graham Secker and the team at Morgan Stanley said in their European Strategy report dated May 28, 2014 that while defensives have outperformed strongly despite the resilience of macro data, high beta and cyclical stocks have been hurt.

Cyclicals European Industrials

Unattractive valuations in consumer staples

The Morgan Stanley analysts point out that the consumer staples segment has so far been a big beneficiary of the fall in bund yields. The analysts note that the food, beverage and tobacco segments have been the best performers over the last three months and the biggest beneficiaries of the fall in bond yields.

As can be deduced from the following table, the analysts point out that consumer staples is traditionally the best performer during periods of falling bond yields. With 10Y bund yields now trading over two standard deviations below their 12-month average, the analysts believe that risks are skewed to higher, not lower, yields going forward.

Sector correlation to moves in 10Y bund yields European Industrials

Accordingly, the analysts believe that consumer staples look vulnerable, while financials should witness some benefit, as they traditionally have a positive correlation to bond yields. Moreover, as depicted in the following table, consumer staples is also one of the most expensive sectors in the market, and accordingly, the Morgan Stanley analysts have set an Underweight rating on consumer staples, pushing their estimates down from -2% to -4%:

Relative Sector valuations European Industrials

European Industrials’ underperformance

The Morgan Stanley analysts point out the industrial sector has underperformed by nearly 4% since January, despite relative earnings expectations holding flat versus the wider market. The following graph captures this trend:

Underperformance by  European Industrials

The analysts also say that despite the fact that the relative PE of the industrials sector remains above the long-run average, the sector is now at its cheapest relative PE in five years. This is highlighted in the following graph:

European Industrials at low relative multiples Defensives

Accordingly, the Morgan Stanley analysts have upgraded industrial to Equal-weight, buying Overweight-rated Michael Page. Besides, the analysts recommend switching out of SAP into the higher beta Capgemini. The following table sets forth the Morgan Stanley analysts’ European Model Portfolio, which reflects their Equal-weight rating for industrials and maximum Underweight rating for Consumer Staples:

European model portfolio European Industrials