Cut your exposure to cyclical stocks

IT IS a rare thing that Americans look at Europe with envy. But in recent weeks, more than a few policymakers stateside have been turning a rather violent shade of green. Over the course of the summer, US economic data has been weakening, while Europe is seeing something of a revival as worries about stress tests and Basel III proposals float away.

And as the economic situation in Europe has picked up, so has investors’ confidence. According to the Bank of America-Merrill Lynch’s August Fund Manager Survey, global asset allocators turned positive on Eurozone equities for the first time since November 2009 with a net 11 per cent overweight. Global growth worries have instead been refocused towards the US and Japan.

But does this mean that retail investors looking for exposure to European equities through listed products have missed the boat?

Despite improvements in European stock markets over recent weeks, valuations are still appealing.

Matthew Gilman, associate strategist at UBS, points out that the current 12-month forward price-to-earnings (p/e) ratio is still just 10.3 times compared to 12.4 times at the recent market peak in April.

ATTRACTIVE RETURNS

Oliver Kelton, co-manager of the Waverton European fund, adds: “European equity market valuations remain at historically low levels and the current recovery in corporate earnings offers attractive returns going forward.”

And institutional investors have been putting their money where their mouths are – UBS European flow data for the week ending 6 August also showed a return to positive territory, reflecting the recent pick-up in investors’ risk appetite and the move into cyclicals, says Gilman.

Indeed, net buying of cyclicals has reached its highest level since UBS started tracking the data in 2006 as investors piled into capital goods stocks, miners and banks over the past month and out of healthcare and industrials. Last week Stoxx 600 ETFs received almost €200m of inflows, according to data from Deutsche Bank’s ETF team.

Exchange-traded fund (ETF) investors can either choose to buy funds that give exposure to the whole European stock market or to specific Stoxx 600 sectors for a total cost of around 0.3 per cent.

So should ETF traders still be adding to their cyclical positions or should they be scaling these back and returning to the relative safety of defensives?
Well, historical data shows that cyclical sectors tend to outperform during periods when the euro is strong relative to the dollar while technology, healthcare and personal goods sectors are more likely to underperform. Research by Citigroup strategists reveals that financials and resources stocks are likely to be among the top beneficiaries of sustained euro strength against the dollar while technology and healthcare are forecast to be held back.

But with the euro appearing overpriced against the dollar, it might well be time to scale back on those cyclical ETFs and start rebalancing your ETF portfolio towards those defensives.