Equity Sector Views: Overweight Energy, Underweight Consumer Staples

Summary

• Overall, we remain underweight equities versus other asset classes due to the rising rate environment, and the risk of an economic slowdown and weaker earnings, which is not priced into the market now.
• We add the major US and European equity indices. We are overweight the S&P 500 and underweight the Russell 2000, NASDAQ 100, and European indices.
• We retain our overweight on energy and clean energy and move healthcare to overweight.
• We move consumer staples to underweight. It is overvalued by our earnings and cashflow measures, and earnings season has revealed many companies are struggling to pass on rising costs.

Overview

We remain underweight equities versus other asset classes. We do not believe investors have priced in the risks of rising rates and a slowing economy, nor the likely impact on corporate earnings in 2H 2022. One clue is the sharp selloffs experienced by companies that report revenue and earnings outlooks that are weaker than consensus estimates, even if they reported solid beats in the past quarter.

Sector Views

Indices – Within the equities asset class, we are overweight the S&P 500 (SPY) and underweight the Russell 2000 (IWM) and NASDAQ 100 (QQQ). The NASDAQ 100 has rallied recently and is trading well above EPS trends. Both indices show weaker free cashflow, which is often a precursor to earnings weakness.

We are also underweight the major European equity indices (Europe Stoxx 600 (SXXP), EuroStoxx 50 (SX5E) and FTSE 100 (UKX)). As we discussed in a recent article, these indices appear cheap relative to earnings trends and on a P/E basis. But analysts are projecting aggressive EPS gains in the coming year. Given the ongoing Russia/Ukraine war and risks to energy supplies, these are unlikely to be realised. As earnings outlook weaken, European equities will be at risk of a selloff.

Homebuilders – We move homebuilders to marketweight from overweight. This trade has underperformed by about 12% since we initiated it. We fully recognise housing is slowing; however, we continue to believe homebuilders can continue to make money in this market. Today’s housing market is nothing like 1990 or 2008 when housing inventory was considerably higher than underlying demand. Current housing supply is well below underlying demand. Still, conventional wisdom is carrying the day here even if we think it is wrong. We will look to re-establish an overweight when the housing industry stabilises.

Growth vs Value – Growth stocks have recovered some lost ground in recent weeks. In late June, growth was down 15% versus value year to date; now it is down 7%. We think this tactical move has run its course, and that value will rally again in 2H.

Reopening Trades – We move these positions to marketweight. The reopening trade is close to running its course, and we expect it will slow once schools open.

Semiconductors – Semiconductor companies have had a mixed performance in 2022, soaring early then giving up most gains. Recently, companies that make components for consumer electronics have reported weak earnings and bloated inventories as demand for stay-at-home products languishes with the reopening. But the recent signing of the CHIPS and Science Act should breathe new life into the sector.

Financials – We leave insurance as overweight given strong recent earnings. We move the broad XLF ETF and regional bank KRE ETF to marketweight and the large bank KBWB ETF to underweight. Large banks with their trading and investment banking operations may be more vulnerable in a slowing economy.

Clean Energy – No change here – but with the Inflation Reduction Act all but sure to be signed into law, we expect ETFs focused on batteries, solar and wind power, and the grid to outperform.

Retail – We move retail from marketweight to underweight. Free cashflow has collapsed across the sector, suggesting that earnings will soon follow.

SPX Sectors

Communications – We move communications (XLC) from underweight to marketweight. Communications appears very cheap relative to earnings and free cashflow. It went from heavily overbought to heavily oversold. A lot of bad news is priced into the sector.

Consumer Discretionary – This sector has been a big beneficiary of the recent rally in growth stocks, up over 12% in the past month. It is rich relative to earnings and free cashflow, and highly vulnerable to another selloff.

Consumer Staples – Consumer staples is typically favoured in a recessionary environment. But the ongoing earnings season has shown that many of these companies are struggling to pass on rising costs, and, when they do, they see volumes fall. The sector is still rich relative to earnings trend, and free cashflow has been falling in 1H 2022, which will become a drag on earnings if this does not reverse.

Energy – We continue to recommend an enthusiastic overweight. The energy ETF XLE boomed after the Russia/Ukraine war started, outperforming the SPX by 25% by mid-June. It then collapsed to essentially flat to SPX recently as investors applied a conventional wisdom reality check. But earnings season is confirming that energy companies are wildly profitable and not planning big exploration and CAPEX to take advantage of high oil and gas prices. Their mantra continues to be generate free cashflow and return it to investors.

Healthcare – We move healthcare sector to overweight from marketweight. It is cheap relative to earnings and free cashflow. There is some headline risk from recent legislation to allow Medicare to negotiate a limited set of drug prices and a potential cap on the price of insulin. But looking at the sector overall, there is little reason to think that earnings or free cashflow are at risk.

Materials – By our earnings and cashflow measures, the materials sector is unambiguously cheap, similar to energy. It is also heterogeneous, with exposure to companies that will benefit from growth in clean energy and others exposed to homebuilding and consumer/industrial products that will be hurt in a slowing economy. In a recovering economy, it would be an overweight. We move it from underweight to marketweight because a lot of bad news appears to be priced in.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)