Doubt on Yields May Ruin This Sector's Power Trip

(Bloomberg) -- Investors assailed by trade-war worries and slowing growth have turned in recent weeks to defensive stocks, which are by nature less volatile. Utilities, boosted by falling yields, have done particularly well, and on Friday outperformed all sectors. Their relative haven status may be in for some wobbles though, especially as bond yields could be near a tipping point.

Utilities have performed in line with the broader market this year, but looking at the returns since October, when markets became jittery, they are clear winners, alongside food and beverage shares.

“It is not surprising that defensive sectors led the market as it fell in May due to concerns that trade negotiations with China were faltering,” says Edward Perkin, chief equity investment officer at Eaton Vance, noting that the domestic nature of utilities, REITs and telecom shares makes them less vulnerable to trade tensions. This month’s rally led by Treasury yields and expectations of Federal Reserve easing is good for defensive dividend-yield stocks, he says.

That might come to an end, according to Morgan Stanley strategists, who say the strength of the upward trend makes utilities vulnerable to any reverse in the “momentum” factor. The broker had already downgraded the sector to neutral in April, calling it “overowned, overbought and expensive.” Since then, utilities have rallied even more versus peers and investors’ positioning has increased.

There might be a good sell signal ahead if the U.S. 10-year bond yield bottoms out, Morgan Stanley writes. Treasury yields look oversold, which has been a good tipping-point indicator in the past. In fact, the yield is approaching its September 2017 inflection point, a strong technical level.

That’s not all. The regulated business accounts for 50% of the sector’s Ebitda, and regulators tend to claim back extra cash generated by the low-rate environment by periodically adjusting policy, according to Citi strategists. So while the low-rate environment is supporting stock valuations, it’s also adding pressure to utilities’ medium-term earnings and may distort the perception of risks from rising capex and leverage, Citi says. Looking at the chart below, utilities are trading at a premium relative to the broader market.

The 2020 EPS consensus has already come down by 1.9%, a sign that lower rates are no longer supporting earnings. Citi strategists expect the next regulatory reviews to add further pressure on the sector’s EPS, particularly in the gas sub-sector.

Country-wise, the U.K. stands out. The nation’s utilities have missed most of the rally, mainly because of Brexit, as well as concerns about nationalization of the industry. While shares of National Grid, SSE and Centrica are among the worst performers, with the last especially hit by price caps on energy bills, water companies like Severn Trent and United Utilities have been attractively boring enough to at least perform in line with the rest of the market.

In the meantime, Euro Stoxx 50 Futures are trading up 0.3% ahead of the open.

SECTORS IN FOCUS TODAY:

• Watch banks and other rate-sensitive sectors as the ECB’s forum starts and one can expect much discussion and debate about the policy outlook. Vice President Luis de Guindos said the ECB will act should inflation expectations deteriorate and Governing Council member Ewald Nowotny says he favors the bank having more flexibility in reaching its inflation target and that it’s too early to judge the recent dip in inflation expectations.
• Watch oil stocks after U.S. tensions with Iran showed no signs of cooling off, with Secretary of State Mike Pompeo pledging U.S. protection for shipping in the Gulf and Iran planning a further retreat from the terms of its nuclear deal this week. Separately, Saudi Arabia hopes the cartel will agree to further supply cuts at its meeting next month.

COMMENT:

• “The immediate reaction following the (Fed rate) cut tends to be positive, as investors become more optimistic about growth,’’ Goldman Sachs strategists write in a note. “European equities rally 2% in the month following the cut, twice the performance of equities in any given month since the 1970s.’’

COMPANY NEWS AND M&A:

• UBS Is Said to Lose China Bond Deal After Economist’s Pig Remark
• Deutsche Bank Weighs Up to $56 Billion Bad-Bank Unit, FT Reports
• Lufthansa Lowers Profit Forecast Due to Weak Sales in Europe
  • Lufthansa Shares Seen Hit on Warning, Watch Peers: Street Wrap
• Fiat Chrysler, Renault May Seek to Restart Merger Talks: Sole
  • Fiat Leans Toward Trump in Industry Anxious Over Emissions Rules
• Novozymes Says 2020 ‘Negatively Impacted’ by Portfolio Changes
• Knorr-Bremse May See 2H Truck Unit Slowdown: Euro am Sonntag
• Swedish Builder Skanska Says Days of Massive Writedowns Are Over
  • Skanska Divests Oslo Office Property for About SEK1.5b
• Siemens Gamesa Gets Conditional Order for 376 MW in Taiwan
• Aluflexpack Sets IPO Price Range at CHF20 to CHF26 per Share
• AB InBev Asia Pacific Unit Starts Gauging H.K. IPO Demand: Terms
• Babcock’s Board Rejects Serco’s Merger Proposal, Times Says
• AstraZeneca to Invest $630 Million in South Korean Health Sector
• Merck KGaA to Hold Off From Big M&A in Short Term, Boersen Says
• Bristol-Myers, Roche Settle Patent Suit on Tecentriq Cancer Drug
• Time to Sell Saab Shares, DI Tells Its Readers
• Eurazeo Buys Minority Stake in PayFit
• ABN Amro CEO Kees Van Dijkhuizen Won’t Serve New Term of Office
• EDF Says 93.71% of Rights Exercised for Div. Balance in Shares
• Maroc Telecom’s Offering Prices at 125.3 Dirhams a Share

NOTES FROM THE SELL SIDE:

• Citi sees in sectors with balance sheet strength and surplus free cash flow, and that includes industrials, according to a note. Names stocks Siemens, Volvo, Vestas, Epiroc, Rotork and Weir.
• The prospects for the U.K. real estate sector look balanced, Peel Hunt says cutting its average net asset forecasts and making a number of recommendation changes, including upgrading Hammerson to add.
• GlaxoSmithKline’s vaccines growth will need to wait for a step-up in Shingrix (shingles) manufacturing capacity in 2024, while HIV will continue to be pressured by competition short-term, Morgan Stanley says, resuming coverage at underweight (PT 1,520p).

TECHNICAL OUTLOOK for Stoxx 600 index:

• Resistance at 382 (50-DMA); 385.7 (61.8% Fibo)
• Support at 374.5 (61.8% Fibo); 368.2 (200-DMA)
• RSI: 51.9

TECHNICAL OUTLOOK for Euro Stoxx 50 index:

• Resistance at 3,409 (50-DMA); 3,514 (May high)
• Support at 3,309 (50% Fibo); 3,266 (200-DMA)
• RSI: 51.3

MAIN RESEARCH AND RATING CHANGES:
UPGRADES:

• Capital & Regional upgraded to hold at Peel Hunt
• Hammerson upgraded to add at Peel Hunt
• JPJ Group upgraded to buy at Peel Hunt
• Maersk Upgraded to Buy at Handelsbanken; PT 8,500 Kroner
• Shaftesbury upgraded to hold at Peel Hunt

DOWNGRADES:

• Axel Springer cut to hold at Kepler Cheuvreux; PT 63 Euros
• BAT downgraded to underweight at Morgan Stanley; PT 26 Pounds
• Continental downgraded to underweight at JPMorgan; PT 119 Euros
• Chr. Hansen Downgraded to Sell at Handelsbanken; PT 675 Kroner
• Eurobank downgraded to hold at HSBC; PT 94 Cents
• Helical downgraded to add at Peel Hunt
• National Bank of Greece cut to hold at HSBC; PT 2.80 Euros
• Piraeus Bank downgraded to hold at HSBC; PT 3 Euros
• Primary Health downgraded to add at Peel Hunt
• Yara downgraded to neutral at JPMorgan; Price Target 400 Kroner

INITIATIONS:

• Centrica rated new underperform at Macquarie; PT 70 Pence
• DBV Tech rated new buy at Goldman; PT 25 Euros
• Drax Rated New Neutral at Macquarie; PT 2.80 Pounds
• EDF rated new neutral at Macquarie; PT 12 Euros
• EON rated new neutral at Macquarie; PT 9.70 Euros
• EVN rated new outperform at Macquarie; PT 17 Euros
• Engie rated new neutral at Macquarie; PT 13 Euros
• Fortum Rated New Neutral at Macquarie; PT 18 Euros
• Futura Medical Rated New Buy at Liberum; PT 60 Pence
• Glaxo resumed underweight at Morgan Stanley; PT 15.20 Pounds
• National Grid Rated New Outperform at Macquarie; PT 9.30 Pounds
• Pennon Rated New Outperform at Macquarie; PT 8.70 Pounds
• RWE Rated New Outperform at Macquarie; PT 30 Euros
• Severn Trent Rated New Outperform at Macquarie; PT 23 Pounds
• SSE Rated New Neutral at Macquarie; PT 11.40 Pounds
• Suez Rated New Neutral at Macquarie; PT 12.60 Euros
• Uniper Rated New Neutral at Macquarie; PT 26 Euros
• United Utilities Rated New Outperform at Macquarie
• Veolia Rated New Neutral at Macquarie; PT 22 Euros
• Verbund Rated New Outperform at Macquarie; PT 52 Euros

MARKETS:

• MSCI Asia Pacific down 0.3%, Nikkei 225 up 0.2%
• S&P 500 down 0.2%, Dow down 0.1%, Nasdaq down 0.5%
• Euro up 0.07% at $1.1216
• Dollar Index down 0.06% at 97.52
• Yen down 0.06% at 108.62
• Brent up 0.3% at $62.2/bbl, WTI up 0.2% to $52.6/bbl
• LME 3m Copper up 0.2% at $5832/MT
• Gold spot down 0.2% at $1339.3/oz
• US 10Yr yield up 2bps at 2.1%

ECONOMIC DATA (All times CET):

• 8:30am: (EC) Bloomberg June Eurozone Economic Survey
• 8:35am: (GE) Bloomberg June Germany Economic Survey
• 8:40am: (FR) Bloomberg June France Economic Survey
• 8:45am: (IT) Bloomberg June Italy Economic Survey
• 8:50am: (SP) Bloomberg June Spain Economic Survey
• 10:30am: (IT) April General Government Debt, prior 2.36t
• 11am: (EC) 1Q Labour Costs YoY, prior 2.3%

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