Stepping out from the crowd on cyclicals

We were at the Battersea Fireworks a couple weekends ago, and it was a great show which made us wonder why we haven’t been before; I’d highly recommend it for next year if you’re in London and not been. The one annoying aspect was the long queues for food stalls, made even more annoying for some by the fact that people were sometimes blindly queuing in the “collection” queue rather than the “orders” queue. Thankfully, I didn’t simply follow the crowd and managed to navigate things without too much time wasted.

Based on conversations this week, I find myself stepping out from the crowd also when it comes to owning cyclicals, especially those of a European variety. While I understand concerns over weak Chinese data and the threat of negative rhetoric out of a Trump Presidency, that feels a little too much like looking in the rear-view mirror. From a China perspective, we have seen M2 y/y growth trough and economic surprises for China rebound meaningfully. As for Trump and his entourage, it seems strange that the mood music is suddenly so relaxed around the ultimate impact of his policies on inflation, yet at the same time talking about very hawkish appointments to his team when it comes to trade.

All this headline tennis is also distracting investors from the fact that there are some valid macro-economic reasons to believe things are starting to line up for cyclicals into year end. Particularly those more geared into a manufacturing PMI recovery, which tend to be less well owned. This applies to both US and European names, though given valuations, sentiment and recent performance, European cyclicals have a particular appeal in the near-term.

Following elections and with more visibility on high level policies to expect, I would expect businesses to resume more normal activity around ordering, hiring and investing. Compared to a month ago, it is obvious how someone answering a survey would feel more confident about the outlook today. Furthermore, under a Trump presidency, we could even see a pull-forward of some ordering activity to get ahead of potential tariffs and supply chain disruptions. It is therefore not surprising to see there is historically a stronger rebound in the ISM during election years compared to non-election years.

The Central Bank rate cutting cycle is in full flow. Historically this is a good lead indicator for improving Manufacturing PMIs. In the chart below, BNP overlay the global central bank cutting-hiking cycle (in grey) against a lagged ISM Manufacturing PMI (in red), and it looks like we are due for an upturn in manufacturing PMIs from here. We have already begun to see new orders to inventory ratios improve in October and there is room for that to continue.

Small business activity and outlook has been weighing on the broader manufacturing sector, but look at how NFIB Small Business Optimism readings reacted to a Trump presidency in 2016.

While positive seasonality for risk assets is well documented into year end, there is also a seasonal tailwind for European economic surprises relative to US economic surprises (dotted white line plots average for CITI Economic Surprise index for Europe minus the US equivalent).

If worried about a Momentum drawdown (because of crowding, seasonality, tax loss selling, etc) then note that US Cyclical/Defensives have a slight positive correlation to Momentum while European Cyclicals/Defensives have a negative correlation to Momentum, so could work well on a Momentum drawdown.

They would also serve as a hedge to an unwind in the continued rally in the USD which is becoming more crowded, as well as a continued back up in 10 year yields given higher inflation expectations. As seen in the chart below, the MS European Cyclicals/Defensives basket (in orange) has materially lagged the move in US 10 year breakevens (in white) recently.

While there is still plenty of uncertainty around what German snap elections will bring, the directional of travel does suggest there will be some loosening of the fiscal purse strings as the debt brake stance is eased, which can’t be a bad thing for some of these cyclicals.

When European cyclicals were performing well in Q1 you had European economic data positively surprising relative to US, you had improving PMIs, you had weekly oversold technical relative to the US, rising inflation expectations and poor sentiment and light positioning – potentially similar to the backdrop now. MS PB recent data suggests European gross leverage is in the 3rd percentile on a 5-year lookback vs the US in the 98th percentile. Despite the weakness in Europe this week, the weekly technical setup for Cyclicals relative to Defensives still looks favourable with positive buy signals similar to past multi-month rallies.

Bernie’s weekend eats – Smoking Goat, Shoreditch

I mentioned this one on a recent Bloomberg TV appearance and while it can be hard to get a table at certain times, its worth queuing here if you’re looking for some punchy spicy flavours with food that is made to be paired with cocktails and beer. Tables are packed closely together so you can eye up what looks delicious before ordering, but its basically most of the menu and I struggle not to over-order. Must haves are the fish sauce chilli wings, any of the salads, grilled cuts of pork or mutton, or the whole grilled fish. Service is efficient but friendly and there is a buzzy atmosphere even at lunchtime or on weekdays.

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