UBS: Time to cut back on cyclicals, favor select defensives

Investing.com -- UBS said in a note Friday that investors should scale back exposure to most cyclical stocks outside of a few favored areas, citing weakening macro trends, stretched valuations, and seasonal underperformance risks.

“We are overweight financials and tech, electrification and domestic European consumer,” UBS strategists wrote, but stressed it is “appropriate to lighten up on cyclicals outside of these areas in general.” 

The firm expects U.S. domestic demand to slow sharply, from 2.3% year-over-year in Q2 to 0.5% in Q4, and forecasts the U.S. 10-year yield at 3.8% by year-end. 

Historically, cyclicals have underperformed 84% of the time when volatility rises, UBS noted.

Valuations are seen as another concern. The price-to-earnings ratio of cyclicals (excluding tech and financials) is “1.8 standard deviations above its norm in Europe and 1.4 standard deviations above in the U.S.” 

Meanwhile, the bank said most cyclical segments are crowded, with only paper and transport screens notably cheap.

UBS recommends increasing exposure to defensive sectors with “high profitability but low volatility of CFROI,” highlighting beverages, healthcare equipment, household products, select utilities, software, and non-U.S. defense. 

"Defensive sectors that score well on our screens are: beverages (we are benchmark), healthcare equipment (overweight) and household products (move to overweight)," the bank wrote. "Our preferred defensive sectors remain: parts of utilities, healthcare equipment, software and flavouring companies, non-US defence (India, Japan), European telecoms and UK food retailing."

They highlighted names such as Alcon (NYSE:ALC), Abbot, DSM, Boston Scientific (NYSE:BSX), Orange, DT, BAE Systems (LON:BAES), Tesco (OTC:TSCDY), MSFT, SAP, Air Liquide (OTC:AIQUY), ENEL, ELIA, RWE (LON:0HA0), Entergy (NYSE:ETR), NiSource (NYSE:NI) and ConvaTec.

The firm has raised household products to overweight, calling the European sector “abnormally cheap against food” and noting its resilience and emerging market revenue exposure.

Healthcare equipment is also a top pick. “Price momentum is now 15% below its 6-month moving average… more than at any point in the past decade,” UBS said, adding that valuations are at a rare discount and earnings revisions are strong.

Conversely, UBS advises trimming capital goods in the near term, warning they are “very overbought” with a sharp disconnect between performance and earnings trends.