Friday, June 18th, 2021

The Times, They Are a-Changing

In our last two notes, we scaled the mountain-tops of asset allocation theory, looking at the best way to hedge equity returns with other asset classes over the long term. This week, we are back in the jungle of today’s equity markets, trying to work out what to buy and what to sell. Our trip to the mountains was prompted by our view that the jungle was would be rather quiet and a bit boring, which turned out to be correct, but now we hear the sound of animals moving in the undergrowth and we think that change is on the way.

We will focus on European, not US, sectors, simply because this is now our preferred region within equity markets. This regional call is itself part of our view that change is coming and is closely bound up with our sectoral choices.

The most important theme is the switch from industrial to consumer cyclicals. We downgraded Materials from overweight to neutral at the end of May. Since then, it has continued to underperform and has developed a very negative lead indicator. This is a broad sell-off across the whole of the sector, which it is led not by the international miners quoted in the UK, but by the chemicals, steel and paper manufacturers quoted in the Eurozone. Nobody doubts that these companies will produce a powerful recovery in earnings and cashflow over the next 18 months, but our charts suggest that it is already in the price.

We see a similar trajectory beginning to take shape in Industrials. We are still overweight, but the lead indicator is now deteriorating and the recommended weight has failed to breach the high it achieved in November 2020. We also a gradual reduction in the levels at which the sector attracts support. It is all consistent with a normal topping out process, which is running about six weeks behind Materials. This would put the sector on course for its first significant sell-off sometime in August. Again, nobody doubts the recovery – which is another way of saying that there are no more unbelievers left to convert.

In contrast to these two gloomy charts, we see signs of acceleration in Consumer Services, which comprises retail, media, travel and leisure. We upgraded the sector to overweight at the end of May and it is now ranked #2 in the table, ahead of Industrials. One might argue that the recovery in consumer demand is just as predictable as that in industrial margins, but our charts suggest that investors have not yet bought into the idea as strongly. This week the sector hit a new five-year high, having been stuck in a narrow range since late 2016. On our charts there is no obvious resistance before our recommended weight gets close to its all-time high.

We are also becoming more bullish on Consumer Goods, but this is mainly the luxury goods companies, not the defensive food and beverage manufacturers, or even the autos sector, which has traded more like Industrials. The sector as a whole is about to break through an important resistance level in the neutral zone, after which the lead indicator suggests it will be quickly upgraded to overweight. We expect other changes to our views for Small Caps and selective defensive sectors such as Telecom and Healthcare, but we think these will come later in Q3. The immediate need is to reduce exposure to industrial cyclicals and to increase consumer cyclicals.

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