Cyclical Rally Could Look Very Different From Here

By Michael Msika, Bloomberg Markets Live reporter and strategist

A months-long rally in European cyclicals has left some stocks looking outright expensive, raising risks for them as the earnings season is about to start.

Cyclical sectors such as autos, industrials and financials have beaten the overall market hands down so far this year, with a 9% gain. Since the end of October, the Stoxx 600 Cyclical index has added 26%, beating defensive sectors by nearly 20 percentage points. That’s put them into the danger zone for profit-taking, amid signs the group is hitting overbought levels.

JPMorgan strategist Mislav Matejka notes cyclicals have in fact outperformed defensives for 18 months and trade at a significant premium. Other than energy, which he sees as a good hedge against elevated geopolitical risk, Matejka is neutral or bearish on most cyclical shares. “Defensives could look better from here, especially if the overall market starts to weaken, and if earnings growth acceleration expectations do not materialize,” he says.

Not all cyclicals are in the same boat, though. Gains on energy and mining shares follow a long period of underperformance and are driven by geopolitics as well as a brightening world economy. Nor do share valuations seem excessive for commodities and banking shares.

This segment of cyclicals is likely to outperform, according to Goldman Sachs strategists Peter Oppenheimer and Sharon Bell. They recently upgraded banks and energy to overweight and miners to neutral. However, they cut their view on industrials, citing expensive valuations.

Trading at nearly 20 times forward earnings —  a 40% premium to the broader market and in the 90th percentile relative to their history — European industrials do look pricey. They also appear to have seriously overshot the recovery in PMIs — the last time the sector traded at such levels was just after the pandemic when European manufacturing was expanding rapidly. The fear is that companies pricing so much good news risk punishment if they disappoint in the upcoming earnings season.

Bank of America strategists are among those sticking to a very cautious stance. Wary of recent winners such as capital goods, BofA’s Sebastian Raedler sees scope for rotation into beaten-down defensives such as as food and beverages, though he remains overweight miners and chemicals. “Cyclicals overall are priced for sharp EPS upgrades,” he adds.

Cyclicals still have their fans, who point out the recent outperformance was driven by improved earnings estimates and that the overall group only trades at slightly above-average valuations compared with defensives. With interest-rate cuts due to kick off in the coming months, cyclical shares could enjoy further gains, many strategists, including at Barclays and Natixis, expect.

“Don’t fight the soft-landing narrative,” say Natixis strategists Florent Pochon and Emilie Tetard. They like European cyclicals tactically, in anticipation of a pick-up in European and Chinese economic growth, and the first European Central Bank rate cut in June.