Europe's Worst Quarter Since 2016 Highlights These Shares

(Bloomberg) -- The European stock market’s worst slump in two years is finally paying off for fans of defensive stocks. And the trend is seen continuing next quarter.

While Europe’s cyclical equities have outperformed defensive peers since the start of the year, they have lost out since the beginning of the global market correction at the end of January, as concerns about economic growth turned investor attention to utilities, consumer staples and energy.

Europe's Worst Quarter Since 2016 Highlights These Shares

With Europe’s economic recovery having translated into a corporate earnings boom, the region’s cyclical shares beat defensive peers every quarter since June 2016. But although some strategists, such as Societe Generale SA, continue to bet on cyclicals, an increasing number, including Natixis SA and HSBC Bank Plc, recommend shifting to defensive stocks.

“In Europe, we prefer defensives to cyclicals as the latter have outperformed more sharply than the fundamentals justify and as the region’s manufacturing data is coming off peaks,” said Lars Kreckel, an equity strategist at Legal & General Investment Management Ltd. in London.

European cyclical stocks, which historically have traded below the levels of the region’s defensive shares, have rallied so much that on Feb. 21 they closed higher than defensive peers for the first time since at least 2010 when Bloomberg started tracking the index data. Since then, a slide in cyclical shares has resumed and widened their discount to defensives.

Negative Surprise

Falling euro-area economic confidence, reported on Tuesday, was the latest in a string of data suggesting economic growth in the currency bloc has cooled off after 2017 saw the fastest expansion in a decade. Inflation has remained stubbornly below the European Central Bank’s goal of just under 2 percent.

“I prefer defensive sectors because of potential for further negative economic surprise in the euro zone in the second quarter and expectations that bond yields will decline as inflation comes in below estimates,” said Max Kettner, a London-based cross-asset strategist at Commerzbank AG.

Since the Jan. 30 start of the global equity market correction, among the Stoxx Europe 600 Index’s sectors, cyclical shares of banks and basic resources have slumped more than 9 percent while defensive shares of utilities lost 3.5 percent and oil and gas stocks dropped 7.1 percent. At the same time, some classically defensive sectors, such as telecoms and health care, were outweighed by the selloff and have retreated more than 9 percent.

On Thursday, utilities and healthcare shares were the biggest advancers on the European benchmark, which slipped 0.5 percent.

HSBC analyst Robert Parkes on Monday raised European telecoms and health care equipment to overweight while cutting materials, transport and automobiles to underweight, citing a rotation into longer duration and higher dividend-yielding stocks amid slowing economic growth.

At the same time, Natixis analysts Sylvain Goyon and Thomas Zlowodzki warned against being overly pessimistic about European growth prospects and said that lower-than-expected indicators reflect the high level of activity achieved and don’t signal a recession. But the market correction requires a switch to defensive shares, they added.

“This is clearly good news for equity markets, but it probably needs to be played via different vectors than those employed during the phase of rapid market rise, which played into the hands of cyclicals,” Natixis strategists said in a note. “The exhaustion of cycle acceleration capacity is thus likely to encourage a return to more defensive themes.”

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