investment insights
Seizing equity opportunities at the sector level
Key takeaways
- We keep overall equity exposures at strategic benchmark levels, and continue to seek opportunities in regional, sector and individual stock selections
- We remain optimistic on cyclical over defensive stocks, given still-solid US and global growth, as well as superior company fundamentals
- Among cyclical sectors, we like communication services, consumer discretionary and materials firms. Among defensives, healthcare remains our least preferred sector
- Risks to our sector preferences would include a sharp US growth slowdown or a sharp rise in bond yields, leading to a reversal in current equity market leadership.
The need for appropriate sector allocation
Investors have a lot to cheer from equity performance this year. Many markets have recorded successive highs and volatility remains low at the index level. Yet after solid gains year-to-date, the argument for taking more equity risk now looks less appealing. While we see few signs of speculative excesses that tend to coincide with the end of bull markets, investor risk appetite and positioning appear stretched, raising the risks of a short-term consolidation. The attempted assassination of Donald Trump on 13 July should not fundamentally change this outlook but looks likely to strengthen the momentum of sectors that could benefit from a second Trump term.
Cyclicals over defensives
So far this year, our sector allocation preferences have added value to portfolios. Our main preference remains for cyclical over defensive stocks. This is underpinned by our belief that economic growth will remain resilient and that disinflation will continue, easing cost-of-living difficulties for consumers. Cyclical sectors also have a brighter fundamental outlook in our opinion – for example, sales of semiconductors remain robust, and there are signs that demand for consumer hardware such as PCs and smartphones is recovering as a destocking cycle comes to an end. This trend could also be boosted by sales of artificial intelligence-enabled devices in the coming quarters with new product launches.
Beyond technology, whilst it is true that consumption trends have been slowing, investor expectations and market pricing have also been adjusted downward, providing room for positive surprises in the next earnings season if our core scenario of a soft landing for the US economy holds.
On the flipside, we remain underexposed to defensive sectors. Despite recent underperformance, we do not believe that as a group, they offer an attractive entry point. In addition, many defensive sectors continue to face headwinds: listed real estate companies are struggling to refinance a wave of debt, and also face ‘stranded assets’ in the market, primarily buildings that have lost their value due to poor energy performance, or that do not meet sustainability regulations. Meanwhile, food and beverage companies continue to see flat or sluggish increases in volumes sold, as consumers prioritise their spending.
Selectivity and dynamism is key
Our current sector positioning is based on our investment framework, which takes into consideration the macroeconomic backdrop, the earnings outlook, valuations, and technical factors. This keeps us disciplined in our decision-making and is designed to help us find opportunities that best balance risk and potential rewards. For example, we hold technology stocks at strategic benchmark weights in our portfolio despite record high valuations, as we believe their strong earnings potential offsets the valuation headwinds.
In addition, we have had a preference for communication services stocks since late 2023. These offer exposure to growth opportunities in digital advertising and advances in artificial intelligence (AI). For example, as social media and search algorithms further leverage AI and companies’ proprietary datasets, they should be able to improve the return on investment that they offer to advertising clients.
In response to significant underperformance of the utilities and real estate sectors year-to-date, we have also taken the opportunity to close our underweight positioning here.
Consumer fears look overdone
We have recently added consumer discretionary and materials to our list of most preferred sectors, amid significant relative share price weakness. We believe fears of a US slowdown and consumer weakness have now been largely priced in, and we think that earnings for the sector could now outperform rather pessimistic expectations. For example, the share prices of some consumer discretionary stocks have staged a rebound in recent weeks, and we see potential for gains to expand beyond current leaders in ecommerce and electric vehicles to luxury brands, housing-related stocks, and fast-food restaurant chains.
The materials sector offers an interesting mix of companies that should benefit from recovering global manufacturing and industrial activities. Some offer reliable growth at a reasonable price, for example in industrial gases, where companies can benefit from multi-year contracts and pricing power. We also believe the timing could be right to add exposure to high quality cyclical firms such as metals and mining companies. Here, ongoing demand growth and constrained supply make higher-for-longer metal prices the most likely medium-term scenario. Chinese growth and any changes to government policy are an uncertainty here, but we believe expectations are relatively low, and offer a good risk-reward balance for investors.
Assessing energy and healthcare sectors
We believe the energy sector could now offer some defensive characteristics in a late-cycle environment, as well as a strong standalone investment case and diversification benefits for portfolios. We expect oil prices to continue trading in a USD 80-90 a barrel range in the coming months, a level at which the sector can invest for growth, de-lever their balance sheets, pay dividends and buy back shares at the same time. Exposure to these companies can also act as a portfolio hedge amid elevated geopolitical risks. In the event of a second presidential term for Donald Trump, we would also expect traditional energy firms to gain ground.
Conversely, we see difficult times continuing for healthcare companies. High US healthcare costs and poor patient outcomes have now become a bipartisan cause, and we believe pressure on drug pricing will continue. Pharmacy benefit managers in the US will also face continued pressure, amid concerns that their market power could be damaging the accessibility and affordability of healthcare for patients. Here we would see a second Trump term as a potentially less damaging outcome for drug companies, given his initial policy agenda would probably focus on other priorities.
Risks to the outlook
What could change our sector views? Any sign of a sharp US growth slowdown might cause investors to switch from cyclical stocks into more defensive sectors. Conversely, a move higher in interest rate expectations on the back of a strong reacceleration in economic growth could favour value and small cap stocks. For now, we judge such risks to be limited.
We are also watching for any major decisions from this week’s Chinese Communist Party Plenum. Stimulus measures could boost stocks overall and particularly those in the materials and luxury sectors, although a radical package looks unlikely to us at this stage. We also continue to monitor the progress of monetisation among AI-related products and services, which holds the key to the longevity of the rally in AI-related sectors.
Important information
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It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
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