Tuesday, February 25th, 2014

Different Strokes

Last week we argued that investors had moved away from a pro-cyclical bet on the US recovery and were now much more interested in pursuing sectors and companies where they could identify a strong secular growth story. Hence their preference for the Healthcare and Technology sectors, currently ranked #1 and #2 in our US sector model. We also believe that this fits well with the asset allocation view. If investors are gradually moving from an overweight position in equities towards a more neutral stance, it makes sense for them focus their equity exposure on long-term earnings (and revenue) growth.

This shift has been reflected in the other regions. In the UK, the Healthcare sector has risen from #5 at the beginning of 2013 to #2 now. The Technology sector in Japan has been #1 or #2 since December. However, the Healthcare sector in Japan has no stocks which could be compared with Johnson & Johnson or GlaxoSmithKline and it would be a mistake to expect the actual constituents to generate the same sort of earnings growth. In the UK, despite the occasional success, there has never been a group of companies capable of achieving global leadership across a broad spread of technologies.

The current situation in the Eurozone bears very little resemblance to any other region. Financials are in #1 position, with Utilities as #3. Elsewhere Financials are #6 in the US and the UK, and #8 in Japan. Utilities are #7 in the US, #9 in the UK and #10 in Japan. The simple conclusion is that applying European logic to global sectors or global logic to the Eurozone would be a very bad idea at the moment.

As it happens, there is a plausible narrative which explains why Financials and Utilities are at the top of the Eurozone sector table. It’s all to do with the rehabilitation of the peripheral countries of the Eurozone. We believe that many of Europe’s most distressed banks are set to raise equity once their results for 2013 have been announced and the ECB’s stress tests have been completed. To facilitate this we expect the ECB to maintain (and possibly even expand) the provision of liquidity. Easy liquidity reduces fears that these issues will not get away, hence the share prices of distressed banks rise.

If the risks attached to its domestic banking sector are reduced, the creditworthiness of the host government is dramatically improved. Bond spreads relative to German bunds tighten (as they have since the summer of 2013) and eventually investors look for a way of gaining equity exposure to these countries. Any investor with an understanding of Eurozone equities knows that it is difficult to buy Spain without buying Iberdrola or Gas Natural, Italy without ENEL, or Portugal without EDP. These companies are amongst the largest stocks in the European Utilities sector.

In a way, there is a growth story underlying our Eurozone sector choices, but the way in which it is expressed is utterly different from the other regions. The differences are not always this great, but when they are, investors need to know, and a global approach won’t help them.

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