Sector Navigator - Transcript

Welcome to RBC’s Markets in Motion podcast, recorded July 18th, 2022. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. Today in the podcast, an update on our latest RBC equity analyst outlook survey, which we just completed, plus an update on our own latest US equity strategy sector views. Three big things you need to know: First, in our latest analyst survey, our US industry analysts were most constructive on Energy, Financials, Health Care & Tech, and least constructive on Communication Services, Consumer Discretionary, Consumer Staples, and Materials. Second, in terms of sectors we like from a strategy angle, we remain overweight Tech and Financials, and we upgraded Energy and Health Care to overweight from market weight. Third, on the other end of the spectrum, we lowered Consumer Staples to underweight from market weight and upgraded REITs from underweight to market weight. We remain underweight Communication Services.

If you’d like to hear more, here’s another five minutes. While you’re waiting, a big thanks to my colleagues Michael Tran and Chris Louney from our commodities and digital intelligence strategy teams who guest hosted the past few weeks while I was away. If you didn’t hear their timely updates on the outlook for natural gas and oil, be sure to check them out.

Now let’s jump into the details.

Flip to slide 2 (performance outlook)

Takeaway #1: In our latest RBC analyst outlook survey, our analysts were most constructive on forward performance for Energy, Financials, Health Care & Info Tech, and least constructive on forward performance for Communication Services, Consumer Discretionary, Consumer Staples, and Materials.

Flip to slide 3 (performance outlook change)

  • The biggest positive change in view since our last survey in late March was for Energy, where 3 of our 5 teams got more constructive - E&P moved from neutral to very bullish, Oilfield Services bullish to very bullish, Refiners neutral to bullish.
  • Another big positive change in view was for Health Care, where our Health Care Payors or Managed Care team moved from bullish to very bullish and our HC Equipment & Services team moved from neutral to bullish – this offset reduced optimism from Biotech from very bullish to bullish).
  • Most broader sectors saw a deterioration in view so these two really jumped out.

Flip to slide 4 (industry slide on performance outlooks)

  • Materials and Consumer Staples saw the most noteworthy deterioration in performance outlooks. Five of our eight Materials teams had a less constructive view of future performance in July than March (Chemicals, Packaging, Forest Products, Building Products, and Precious Metals & Mining were all lowered to the bearish camp).
  • We just have one analyst who covers all of the major industries within Consumer Staples, and he went from bearish to very bearish.

Flip to slide 5 (comparison)

  • Looking beyond performance, our analysts across all sectors generally see attractive valuations, strong demand in place at the moment, and improving supply chains. Views on where margins are headed and the near-term impacts of a short-term recession are mixed, while capex expectations are fairly muted outside of Health Care and Utilities.

Flip to slide 6 (recession question)

  • On our near-term recession impact question, worries were lowest for Utilities, Health Care, Energy, and Financials.

Flip to slide 7 (new table)

Moving on to Takeaway #2: In terms of sectors we like from a strategy angle, we remain overweight Tech and Financials, and have upgraded Energy and Health Care to overweight from market weight. As noted a moment ago, our analysts’ optimism is higher than other sectors for each of these and in some cases improved significantly relative to our last poll in March. Here are some other thoughts by sector from our top down work.

Flip to slide 8 (recession playbook page)

  • On Tech – it’s our top pick within Growth, which has been outperforming Value since late May and tends to work in when GDP is trending below average, it’s also a recession recovery play, meaning it lags in drawdowns and leads in recoveries, quality is high, and valuations are reasonable back to their long-term average and 2020 lows on our model. Our sector calls are all on a 12 month time frame, this is a sector we like now and later on within that window.

Flip to slide 9 (sector valuation ranking)

  • Next, Financials – This is a sector later on within our 12 month window, as we worry it could stay under pressure near term until questions about the timing, depth and duration of a potential recession are better understood. It’s not clear to me that it’s been derisked enough on earnings, but we love the valuations, which are the most compelling of any sector at the moment, and like Tech it tends to lag in recession drawdowns and outperform in rebounds;

Flip to slide 10 (sector earnings revisions grid)

  • Next, Energy – It’s also got deeply attractive valuations, but what really jumps out to us is that it’s the best sector on earnings revisions trends. We also like it’s compelling dividend yield. Performance has stabilized in July relative to the broader market, though it’s hard to know if demand destruction fears have fully played out. We think this sector may require some patience, but we see an attractive entry point after the recent sell off.

Flip to slide 11 (defensive sector valuation page)

  • Next, Health Care – This is more of a near-term preference as markets search for a bottom or take another major leg lower. Valuations are expensive for this sector, but aren’t peak like levels which is what we see for Utilities and Staples on our model. We also think it’s been more derisked than other defensives – we’ve seen weak earnings revisions here for quite some time and it’s early 2022 drop has been close to past recession drawdowns.

Flip to slide 12 (Dollar / revisions ranking)

Wrapping up with Takeaway #3: On the other end of the spectrum, we lowered Consumer Staples to underweight from market weight and lifted REITs from underweight to market weight. We remain underweight Communication Services.

  • On Consumer Staples – In our survey, our Consumer Staples team shifted from bearish to very bearish, making it the sector our research team is most pessimistic on from a bottom up fundamental perspective. On our own top down work, earnings revisions have turned negative but don’t look extreme, valuations are close to peak vs. the S&P 500, and the sector usually outperforms in recessionary drawdowns but underperforms in recession rebounds, making us believe it is a prime candidate for underperformance once a broader market bottom has been established. These are mostly longstanding concerns of ours. The thing that’s really jumped onto our radar recently is the stronger US Dollar, as the sector tends to experience negative EPS revisions when the US Dollar is strengthening. The sensitivity of earnings revisions to the Dollar is more significant than what we see for most sectors.

Flip to slide 13 (sectors and inflation expectations)

  • And finally, REITs – Overall this sector just feels more like a neutral to us than an underweight. Valuations, using price to FFO are back down to average after having been extremely overvalued. We also like the sector’s compelling dividend yield, and strong earnings revisions trends – which have faded but are still ahead of most other sectors. Our analyst team is fairly neutral in terms of their own performance outlook, a view that’s held steady since March. The main thing restraining our outlook for the sector and risk to our upgrade is its tendency to underperformance when inflation expectations fall.

Close with industries in motion banner

That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s industries in motion, for thoughts on specific sectors from RBC’s team of industry analysts.