Given our macro outlook, we prefer to stay invested, but position portfolios for an extended period of high volatility and keep some hedges in place. The current uncertainty warrants increased diversification across sectors, regions, and styles.
As such, we favour a mix of defensive and cyclical assets, in a barbell strategy, to reduce downside risk in case of another sell-off, while also taking advantage of undervalued opportunities in dislocated parts of the market.
Within defensives, we prefer sectors with predictable earnings, stable margins, and strong pricing power. Our preferred sector in the defensive space remains healthcare.
The healthcare sector has rerated significantly already, from an 8% discount to the market at the start of the year, to an 8% premium today (based on forward price-to-earnings multiples and the MSCI World Healthcare and MSCI World indexes), slightly above its 20-year average. However, we see room for a further rerating in a risk-off phase, and believe that the sector would also be supported by its more resilient earnings stream.
Within cyclicals, we favour sectors which have overreacted (or underreacted) to the recent change in the economic environment, and now appear fundamentally undervalued. More specifically, we look for sectors which have overshot their historical relationship with activity on the downside (proxied by the ISM manufacturing), or sectors which have failed to reflect the substantial rise in yields in recent months and now offer some catch-up potential. This approach highlights industrials and banks as particularly attractive at the moment.
Both sectors were highlighted in November’s Outlook 2022, and the investment rationale remains in place.
- Industrials: Global industrials have suffered from their strong correlation with activity, as growth expectations have been cut. The sector has underperformed the broader market by 6% since July last year, discounting a significant slowdown which seems overdone at this stage. If growth expectations stabilise as we expect, this underperformance should reverse. Industrials are also likely to benefit from an increase in capital expenditure programmes in the coming months (including in the fields of energy independence, defence and green initiatives), and they trade at a small discount to the market compared to their long-term average
- Banks: The 8% outperformance of the banking sector this year appears relatively muted, considering the sharp rise in bond yields (see chart). Historically, banks have tended to outperform in periods of rising yields, often associated with improving economic momentum. Stronger loan growth, wider net interest margins, and better asset quality generally lead to stronger profitability.
However, the recent rise in yields was driven by increased inflation expectations and hawkish central banks, as opposed to stronger growth. Once inflation starts to moderate and growth concerns abate, we would expect the sector performance to catch up with yields. Despite a significant rerating since the end of 2020, global banks still trade at a large discount to the market, relative to history (-1.3 standard deviations below their 20-year average).