European cyclicals could be vulnerable

Global manufacturing activity dropped sharply at the start of the Covid-19 outbreak, but then rebounded just as quickly, sparking sharp positive moves in cyclical stocks. Now, valuations for some of these are looking stretched, and any moderation in the growth of new manufacturing orders could make cyclicals vulnerable to a de-rating. Cyclical companies will need to deliver on earnings expectations to support valuations.

In the early days of the Covid-19 crisis, orders by purchasing managers in the manufacturing sectors collapsed as they anticipated weak demand ahead. In response, investors flocked to defensive companies and sold cyclicals - a typical reaction during economic downturns. But it wasn’t long before the pendulum swung the other way: when manufacturing new orders rebounded, signalling higher expected demand, cyclicals outperformed while defensives underperformed.

This week’s Chart Room takes a deeper dive into the relationship between manufacturing data and the outlook for cyclical versus defensive stocks. Looking at three decades of benchmark US PMI data from the Institute of Supply Management we see that an environment of rising ISM new orders has historically tended to mean that commodity and capital goods sectors outperform, while staples and utilities fared worse than the market. This correlation is especially apparent when it comes to historical European equity performance, given the diversified revenue streams of Europe’s larger companies.




The concern now, given the recent sharp rebound in cyclical stocks, is that markets have gotten ahead of themselves. With many leading indicators near peak levels and production rebounding strongly, some cyclical valuations in Europe are reaching heights that have not been seen for at least 45 years, except for a brief period after the Eurozone crisis, when earnings became depressed and dividends were cut.

The market is anticipating approximately 40 per cent growth in earnings in 2021 and applying high multiples to those earnings. These lofty forecasts could set the stage for a correction if companies fail to deliver. Many factors could trigger a valuation reset, such as stimulus measures being tapered or a worse-than-expected second wave of Covid-19 in Europe.
If a fast recovery doesn’t play out, the pendulum could swing yet again with the effect that cyclicals could potentially de-rate and defensives outperform in the short term. However, though cyclicals as a group appear to be expensive, there are still examples of individual companies in Europe that are trading at compelling valuations while providing exposure to the recovery. Investors should be selective and tread cautiously.