Tuesday, April 28th, 2015

Something’s Gotta Give

<p>Four weeks ago, all of our regional equity models had a recommended underweight of more than 80%on the Energy sector. We are not suggesting that most institutional investors had anything like this negative exposure, but many of them managed to build up a sizeable position simply by not rebalancing as the sector underperformed over the last six months. There comes a time however when investors need to lock in the relative performance, and the only way they can do that is buying the shares.</p>

<p>That moment occurred in early April and was clearly related to the bounce in the oil price. The bulls would have us believe that Brent is going straight back to $80/bbl. We are sceptical because at that price, most US shale oil production is still economic and the Saudis will have to fight their battle for market share all over again. In our view the rally is better explained in terms of upside and downside risk– i.e. the risk of Brent falling to $30/bbl has been removed in the short-term, and companies therefore have more time and cashflow to plan an orderly restructuring. The key point is the rally would have happened sooner or later; all that was needed was a trigger. It is very rare for our models to rate any sector as an 80% underweight for longer than 5-6 months. The Energy sector crossed that threshold on the way down in October 2014, and its six-month sentence was up in April.</p>

<p>We would be surprised if the Energy sector was rated overweight in any region in the near future (unless there is an overseas takeover bid for BP). However  our models suggest that there is further upside, which means at least one other sector will have to be downgraded. Energy is simply too big for this not to happen. The question is which sector and when? The answer varies from region to region and comes with timing differences as well.</p>

<p>In the short-term the prime suspect in the US is Consumer Staples which we downgrade this week from Overweight to Neutral. Some of the root causes are unrelated to the Energy sector such as poor trading in emerging markets and some tired business models (e.g. Coca-Cola and McDonalds), but the recent strength of the dollar is a common theme (depressing overseas earnings and the oil price). It’s the same story in the UK, but this time it’s the Food Retailers which are the real problem. It’s hard to downgrade the consumer-related sectors in the Eurozone while investors are concentrating on the recovery. Fortunately the Telecoms sector provides a handy substitute as the M&A dynamic fades away. We downgraded to Neutral two weeks ago and would be happy to go further. Finally for Japan, (where the Energy sector is least important) it looks as though the model will recommend a straight switch with Materials.</p>

<p>In the long-term however there is one obvious victim. In every regional model there is a persistent and powerful inverse correlation between Energy and Consumer Discretionary. In the US and the UK they peaked and troughed within two weeks of each other in July and August of 2014 (with Energy leading). Exactly the same has happened in reverse in the last month. The time lags are more variable in the Eurozone and Japan, but the correlation is every bit as powerful. So if you believe the Energy sector is going to outperform, you must fund some of that move by reducing Consumer Discretionary.</p>


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