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Is it time to take another look at cyclicals?

02 March 2015

Defensive sectors have attracted much investor interest since the financial crisis but some experts think now is the opportune time to start adding to cyclical areas.

By Lauren Mason,

Reporter, FE Trustnet

February saw numerous markets soar to record highs. The FTSE All-World, the FTSE 100, the S&P 500 and the Dow Jones Industrials indices have all surpassed their previous closing highs, following Greek debt negotiations and reassurance of low US interest rates from the Federal Reserve.

Performance of indices over 3yrs

 

Source: FE Analytics

However, the main beneficiaries of this rally have been defensive rather than cyclical sectors of the market. This has been prompted by several factors, including the ongoing search for income, demand for the perceived safety of ‘bond proxies’ and quantitative easing programmes across the globe.

In light of this, defensive assets are seen to be relatively expensive. As commentators continue to tip equities for further gains, some believe that an improving economic outlook means it could be time to consider more cyclical sectors.

Kerry Craig, global market strategist at JP Morgan Asset Management, said: “Often when we talk to our clients, we get a lot of people who are concerned about valuations, concerned about markets hitting these all-time highs and concerned about how long this is going to last.”

“Factoring in all the geo-political restlessness around the world and wondering how they should be allocating money and then comparing that to a fixed income market, it doesn’t look very appealing because of the way bonds are.”

“For us, it’s not a question of ‘why equities?’ it’s really a case of ‘why not equities?’ at the moment.”

While Craig would not describe his stance as ‘overly bullish’, he argues that a lot of potentially negative news, such as a Greek debt default, headwinds to European earnings and the Fed’s rate hikes, have not materialised so far.

What’s more, he believes that the support which shares are getting at the moment, chiefly from central banks, makes current investment conditions favourable.

However, with defensive valuations being driven up by the hunt for yield, Craig thinks that cyclical sectors are the place to be right now.

“Markets aren’t as cheap as they once were,” he explained. “Some sectors are looking quite expensive, but there are opportunities within cyclical sectors and within companies, where they can benefit from the improvement and growth that we’re seeing in the eurozone.”

“While it’s not getting massive growth, it’s been better than it was and you are seeing that momentum start to build, so I think that’s why we continue to like equities and the cyclical stocks more than anywhere else.”


Craig points to the potential upside of the equity markets and earnings in Europe as they remain at fairly depressed levels.

He said: “[Investors] are comparing [the European market] to what is getting to be quite a mature market in the US.  There are going to be returns this year [in the US] but just not as strong as they were last year, so they’re just looking elsewhere in the world perhaps to get better returns.”

Performance of indices over 5yrs

 

Source: FE Analytics

Craig is not the only investor who is seeing good opportunities in cyclical assets. Martin Bamford, chartered financial planner and managing director at Informed Choice, also feels encouraged by what is happening in Europe.

He argues that the risker aspect to investing in cyclicals shouldn’t be dwelled upon too much, as economic growth in the most developed nations is not yet secure enough for a sudden withdrawal of QE. What’s more, he thinks that when this does happen, it will be gradual and gentle so as not to spook markets.

He said: “I’m not even convinced that equities do look expensive right now. Despite the various indices setting new record highs, the actual valuations of shares look pretty reasonable. The FTSE 100, for example, is trading at around half the p/e ratio from its previous record high in December 1999, suggesting it has a long way to go.”

“That said, in recent months concerns about global economic growth have prompted investors to avoid cyclical stocks and stick their money in defensive stocks instead. Comparing the two, cyclical stocks look better value as a result.”

While Bamford believes the market to be in a strong position, he still acknowledges that there is the potential for a correction.

“The current market boom could run out of steam, but over the long-term investors are best served by being invested. Selling profits because a stock market index has set a new fairly arbitrary record level is not a sensible investment strategy, at least it is very short-termist,” he added.

However, not every investor is seeing strong signs to buy at the moment. Darius McDermott, managing director of Chelsea Financial Services, said: “I’m neutral to cautious at the moment. I don’t think there’s a strong buying signal but nor do I think there’s a strong selling signal.”

“What we’ve learned over time is that markets have momentum, and with this wall of money and nowhere else really to put your money, who’s to say that equities won’t continue this run for a good long while yet?”

“I’m not saying I think that, I’m saying who’s to say that other investors won’t.”


McDermott (pictured) also observed that the corrections we’ve seen over the last three years have been moderately short term, signalling that the markets are either complacent or less worried about geo-political factors than others.

Nevertheless, he doesn’t have a strong view as to whether cyclicals are a better investment than defensives. He added: “I think that quality stocks are a better place to be in the short term but they’re also more expensive, and if there were to be a big issue then they may struggle more.”

“Value is important, so I can see why quality defensives would continue to be supported, but cyclicals are cheaper. I can see reasons why, when there’s yield safety, that investors might still put more money [in cyclicals].”

Parmenion senior investment manager Meera Hearnden said: “The question should not be about buying cyclicals versus expensive defensives, but about where the value is in the market.”

“Despite markets reaching highs and valuations in some areas looking frothy, if earnings growth remains strong and the company fundamentals attractive, I see no reason why equities cannot be the first choice for long-term investors.”

“Some cite Unilever as an expensive defensive stock but if it continues to grow steadily over the coming years with solid dividend growth prospects, it could remain an attractive investment.”

“On the flip side there are some cyclical sectors looking interesting such as certain financials and potentially some miners, but the key is to be selective in picking the winners.”

Hearnden agrees with other investors that it could pay to maintain a cautious stance in the short term, but that over the longer term the market should benefit from stronger wage growth and stronger company earnings.

She added: “Various factors should be considered in the context of the wider economy and investing with a proven fund manager could hold you in good stead despite the wider economic noise.”

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