A March 2nd report from Morgan Stanley Research Europe highlights that cyclical issues have been on a tear in European stock markets, outperforming the market averages by 11% since October of last year. That said, MS analyst Graham Secker and colleagues argue that European cyclicals are likely to take a breather for a while, and are therefore reducing their cyclicals exposure.
Cutting back on European cyclicals, increasing position in value stocks
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Secker et al. point out that when they first recommended European cyclicals last year, expectations for the eurozone economy were generally too low. Given that the EPS momentum for cyclicals was “was troughing”, valuations were quite attractive.
Today, however, the MS analysts say “the investment case is less compelling.” They are not projecting a big drop off in the sector, but they note that “future gains are likely to be harder to come by.” Therefore, Secker and colleagues recommend investors take some profits in cyclicals positions in the near future. Of note, they are downgrading the Consumer Discretionary sector to Equal Weight from Over Weight, and are also scaling back on the size of their overweight in Industrials.
The Morgan Stanley report also highlights that it’s time for value stocks to shine. The analysts point out the “disconnect in performance between Cyclicals vs Defensives and Value vs Growth has been unusual, Value has lagged the improvement in macro newsflow, and valuations of Value vs Growth have only been lower 10% of the time in the last 40 years.”
They argue that if fundamentals continue to improve, and bond yields were to start to move up or inflation begin to appear value stocks are highly likely to outperform.
Morgan Stanley upgrading European energy and bank sectors
Secker et al are also upgrading Energy to Over Weight as O&G firms are cutting costs aggressively and the Energy sector is at three-decade valuation lows. Oil prices could fall yet further, but “a dividend yield close to twice the market provides a valuation cushion.”
The MS analysts are also increasing their Banks sector Over Weight. Given recent bank stock underperformance, an “increasingly attractive dividend yield and a number of headwinds abating make Banks an attractive play on an improvement in European macro data.” Therefore, Morgan Stanley increases its Bank sector Over Weight from +2% to +4%.
Relative sector valuations
The report also notes that relative valuations appear reasonable. They argue that today’s high valuations are not a “big impediment” for cyclicals. They note: “…absolute valuations are now quite elevated as we show in Exhibit 8, however the group’s relative valuation to the wider market and defensives is still low (Exhibit 9)”
Exhibit 10 illustrates that defensive sectors’ relative valuation remains very high on an historical basis (across an average of PE, PBV and DY, defensives have only been more expensive on a relative basis 4% of the time over four decades).