How we think about equity sectors
We are excited to introduce our new framework for investing in equity sectors and explore those we believe have the potential to outperform and underperform the broader markets over the next 6 to 12 months. These views, combined with extensive analysis of the evolving economic environment including fundamental factors driving each sector, are used by our asset allocation team to inform decisions to adjust our regional equity allocation
What you need to know
- Positive view: In the current environment we see potential in a mix of defensive and high-quality growth sectors, namely consumer non-durables, health technology, technology services, consumer services and retail trade.
- Negative view: We remain cautious on cyclical and consumer focused sectors such as non-energy minerals, consumer durables, producer manufacturing, finance and industrial services.
- Toolkit: We have developed our own sector selection model to help us differentiate between potential winners and losers in global performance.
- Asset allocation: We integrate sector selection into our tactical asset allocation framework to help us find regions and sectors we think have the greatest potential.
What is an equity sector?
A sector can be a nebulous concept that depends on the definition used. We consider sectors as a diversified group of stocks that are exposed to a similar set of economic drivers. For example, energy minerals captures stocks with business models that are connected to energy commodities like oil or gas prices. We use Factset’s economic sector definitions and figure 1 shows a complete list of those we monitor and the five largest stocks within them.
What is the benefit of sector selection?
Despite equity markets having negative returns so far this year, there has been a significant divergence in equity sector returns. The difference between the best- and worst-performing sector is close to 60% (figure 2), which is extreme relative to the past, with the average usually around 30%. This divergence in performance highlights why we believe that over the medium term it is possible to add meaningful value to a diversified global equity portfolio by actively managing sector allocation.
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How do we pick sectors we believe have the potential to outperform or underperform?
Our sector views are informed by our proprietary sector selection model. This model is a quantitative framework that gives us a view on each sector’s probability of outperforming over the next six months. We supplement this model with a qualitative assessment of markets and when there is a compelling reason to do so we adjust the sector allocations.
When building our quantitative model we focus on two important drivers of sector returns:
- First, we consider the underlying economic conditions and how they have affected sector returns in the past. This is our top-down model.
- Second, we look at the financial attributes of each sector and aim to achieve exposure to themes that over the long term have been associated with the winning sectors. This is our bottom-up model.
These two distinct parts combine to provide a comprehensive view on each sector. Figure 3 shows our process in more detail, including the steps we follow to develop our recommendations.
How do our sector views impact our portfolios?
Our investment team thinks about markets and economies in terms of tactical, cyclical and structural time horizons and we offer a range of equity solutions that exploit these views. Our sector model aims to exploit medium term opportunities in equity markets and acts to complement our longer-term equity views, which cover both cyclical and structural time horizons through individual stocks and long-term thematic trades. Together these three groups can diversify and complement each other to offer a whole that is greater than the sum of the parts.
Our sector views are developed and used by our asset allocation team. Our sector views are not designed to influence the sector exposures in our concentrated single stock (direct lines) portfolios given the differing investment horizons. In fact often we may hold stocks on a longer term basis which are in sectors which we are less positive on over the medium term. This is because our sector views are based on the medium term outlook of the entire sector, whereas our single stocks holdings within a sector as often the results of the specific outlook for a business. Instead our asset allocation team use the information gained from the model as an input into our decisions to adjust our regional equity allocations. Occasionally we may also look to invest in specific sector funds based on the views from our sector model as well.
How have different sectors performed so far this year?
Sector performance year to date has been dominated by two key themes. One is the shift away from high-growth sectors to those that have been trading at cheaper valuations. The second dynamic is the fear of a global recession pushing investors into traditionally lower-risk sectors, with more stable cash flows and earnings.
The first dynamic is most easily viewed by the strong outperformance of the energy minerals sector (the cheapest sector relative to the market and relative to its own history), which has outperformed strongly on higher oil prices. Meanwhile, high-growth areas of the market like online retailing, media and technology services have all underperformed.
The recession theme is more obviously viewed through the relative outperformance year to date of traditionally safer parts of the market like utilities, communications, distribution services and consumer non-durables. Revenues for these sectors tend to be less sensitive to global growth. As growth concerns have become more elevated, these sectors have outperformed some cyclical sector such as non-energy minerals and consumer durables.
What are our current sector views?
Our current stance is for more exposure to a mix of defensive sectors alongside some longer-term growth sectors that have underperformed significantly year to date. In order to achieve this we would reduce our exposure to cyclical sectors with high sensitivity to inflation coupled with those that look less appealing on key financial metrics. Figure 6 summarises our sector views.
Consumer sentiment remains depressed as inflation expectations, although moderating, remain high relative to history. This is occurring at a time where financial conditions are being tightened with real interest rates rising and the yield curve (the difference between long- and short-term interest rates) deeply inverted. In such an environment we opt for defensive sectors that are less exposed to the economic cycle. In particular we find health technology, retail trade (food retailers in particular) and consumer non-durables as attractive. In the past, these sectors have outperformed the market during similar environments.
It is not just their defensive qualities that make these three sectors attractive. When we look at the financial metrics for each, we find them appealing. In the case of consumer non-durables and health technology, both remain highly profitable relative to the broader market. We see retail trade as a good-quality sector despite some recent earnings downgrades, which are more than offset by the supportive economic backdrop for the sector.
Over the medium term we believe these defensive sectors should be complemented with an allocation to two higher-growth sectors – commercial services and technology services. These are two of the stronger sectors according to our bottom-up model as both are dominated by high-quality companies that have market-leading and defendable business models. Despite a more challenging economic backdrop for these sectors, we don’t see the environment as outright negative. We see the recent underperformance as offering an attractive entry point.
We are less positive on a number of more cyclical sectors that tend to struggle when entering the later stage of the economic cycle. In particular, we are cautious on those that are highly exposed to inflation expectations. Our model shows that when inflation expectations become extremely elevated, as they are today, then the future prospects for inflation-hedging sectors become less attractive. On that basis we opt for exposure to those that are negatively or lowly correlated with inflation. Notably, non-energy materials and industrial services are two sectors we remain particularly cautious on this basis.
Two key variables within our model, the University of Michigan Consumer Sentiment survey and the Citi Eurozone Economic Surprise Index, have both been very negative over recent months. Historically, when both these are negative, it tends to be less supportive to sectors with high exposure discretionary spending. In particular, we remain cautious on consumer durables and ancillary sectors like financials and producer manufacturing given their current weak financial attributes relative to the market.
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What are our sectors views?
Positive sectors
Health technology: This highly defensive sector tends to perform well during the later stages of the business cycle, with tightening financial conditions and high inflation expectation. Along with a supportive macro backdrop, we find that the fundamental picture for this sector is compelling with its higher profitability and margins a positive. The sector’s strong performance year to date and weakening profit outlook is a negative, but we believe this is offset by the other attributes.
Technology services: Our top-down model is neutral on tech services, which has been reflected in the sector’s de-rating year to date. However, the drawdown of the sector relative to the market offers a tactical opportunity according to our reversal factor. The fundamental attractiveness of the sector with relative profitability and high reinvestment rates makes it attractive.
Commercial services: We would class the current macro backdrop as neutral for commercial services as it is neither outright cyclical nor a defensive sector. Therefore, we remain positive on the sector given its attractive fundamental attributes. It is high quality and offers above market growth prospects. There has been a moderation in earnings expectations recently, but not enough to offset our positive view.
Consumer non-durables: This sector screens well due to its defensive qualities, particularly with consumer sentiment surveys at multi-decade lows. In the past, it has outperformed as consumers are forced to focus on essential spending over discretionary items. Its higher margins are advantageous as inflation adds downward pressure on profitability for most sectors.
Retail trade: This sector captures a mix of e-commerce and traditional bricks and mortar superstores. It benefits from the attractive defensive attributes of the superstores, which we find attractive from a top-down perspective given the economic backdrop. We combine this with exposure to some high-growth e-commerce names that offer additional attributes. Our bottom-up model is also positive on this sector.
Negative sectors
Finance: We are cautious on financials as many of our top-down and bottom-up indicators point to weak returns. From a top-down perspective, despite higher yields, weak consumer sentiment and high breakeven inflation signal a tough environment for financials. Fundamentally, we believe this sector to be weak with falling profitability, its high dividend yield and negative earnings revisions.
Consumer durables: We are cautious on this sector particularly due to the weakness in consumer sentiment, high inflation and tightening financial conditions. In the past, consumer durables have suffered as discretionary spending falls during the later phases of the cycle. The fundamental picture for the sector has been deteriorating with significant earnings downgrades and a falling profitability outlook which tends to lead to continued underperformance.
Producer manufacturing: Although longer term we see potential in the sector on supportive capital expenditure (capex) trends, we are more cautious over the next 6 to 12 months. As economic conditions have worsened, especially elevated inflation expectations, our top-down model has told us to be more cautious tactically. Additionally weak earnings expectations and relatively strong performance year to date support our view of a more challenged outlook.
Non-energy minerals: This sector captures metals and mining stocks, which is another highly cyclical area we believe will be challenged in the current environment. It is sensitive to inflation expectations, which continue to moderate. Fundamentally, the sector ranks poorly given its focus on capital returns over reinvestment for growth. Although the sector has corrected much of its first quarter outperformance, we still do not find the correction a compelling entry point.
Industrial services: This is the support sector to energy minerals that has outperformed this year due to higher oil prices, which is at risk of a reversal. Unlike energy minerals, the sector still has below-market profitability given the oil boom has not yet triggered significant energy company capex. This is reflected in neutral earnings momentum relative to the market. Similar to many other sectors with negative views, we find the high sensitivity to inflation expectation is a reason to be cautious.
Conclusion
This publication is the first in a series of regular updates of our sector views. We opt for a mix of defensive and growth sectors and we remain cautious on a number of cyclical sectors. Our asset allocation team has increased our portfolios exposure to US equities and reduced the exposure to Eurozone equities. This decision is in part driven by the belief that the US market has a prevalence of the sectors we see potential in whereas Eurozone is more exposed to sectors we are cautious on. We continue to use our sector model to help inform our medium term regional equity allocation decision, whilst at the same time assessing additional ways to incorporate equity views more broadly in our portfolios.
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Information correct as at 5 September 2022.
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