Equity Research: Rising recessionary risks - Continue to tilt more defensively

7 Jul 2022 Ditulis oleh: Low Pei Han and Camilia Goh (Bank of Singapore)

Our macroeconomics team now sees 50-50 odds of a recession in the next 18 months, and there are signs that higher rates and tighter financial conditions are beginning to form a drag on the US economy.

  • Rising recessionary concerns warrant an increasingly defensive stance.
  • Downgrade Energy from Overweight to Neutral, upgrade Healthcare and Utilities from Neutral to Overweight.
  • Current Underweights are Consumer Discretionary, Industrials and Real Estate.

Continue to move to a more defensive stance

Our macroeconomics team now sees 50-50 odds of a recession in the next 18 months, and there are signs that higher rates and tighter financial conditions are beginning to form a drag on the US economy. Indeed, countries are now experiencing a meaningful slowdown in growth, and with increasing recessionary risks, we have been moving the stance for our equity sectors to a more defensive profile.

Downgrading Global Energy from Overweight to Neutral

Although geopolitical concerns would still lend support to energy prices due to supply-side issues, rising recessionary concerns are dimming the outlook for the sector, which is still a cyclical one dependent on global demand and growth. Our bank has also recently lowered our forecasts for oil prices, including the 12-month Brent crude forecast from USD100/bbl to USD90/bbl on rising growth concerns as central banks speed up tightening in the face of higher-than-expected inflation. Moreover, having outperformed other sectors so far this year (and also last year), investors would be tempted to profit take should overall risk sentiment continue to deteriorate.

Fundamentally, we expect capital expenditure to increase with a renewed focus on energy security, after past under-investment in the sector. Energy policy is starting to become less restrictive as developed countries look to address the current supply/demand imbalance, but even then this will also take time. Hence, we believe a Neutral rating for the sector is appropriate at this juncture.

Upgrading Global Healthcare from Neutral to Overweight

Despite a moderation in the sector’s earnings growth outlook from ~24% in 2021 to a new post-pandemic normal of a modest ~5% forecast for FY22 and FY23E, we expect sector earnings to be relatively more resilient than other cyclical sectors in a backdrop of evolving macro headwinds and increasing growth uncertainties. With the Healthcare sector generating less than 2% of its top line from Ukraine and Russia, and its relatively stronger pricing power backed by relatively more inelastic demand, patents and switching cost considerations, we expect quality healthcare firms to be largely able to pass on rising input cost pressures, which should be supportive of margins and mitigate the impact of inflation on the sector’s bottom line. On the regulatory front, given the ongoing focus of the Biden’s administration on the economy, war in Ukraine and inflation, we believe the likelihood of disruptive US healthcare policy initiatives materialising in the near future should remain relatively low, which implies lower pricing pressure risks for biopharma firms.

Given that more than two thirds of the world population has received at least a dose of a Covid-19 vaccine, the global healthcare industry continues to undergo a post-pandemic transition towards an endemic world. This is driven by faster reopening in key developed markets such as US and Europe, with diagnosis rates improving due to normalizing discretionary healthcare demand (e.g. health checkups, non-critical treatments), which provides some tailwinds particularly in areas such as human immunodeficiency virus/HIV, hepatitis C virus, oncology  and diabetes. 

Valuations wise, the MSCI World Healthcare sector last traded at ~16.4x forward price-to-earnings (P/E) ratio (as of 6 July 2022), which is slightly below the sector’s past 10Y historical average multiple of 16.6x. Comparing amongst the different sub-segments within the sector, we continue to see more attractive risk reward in select names within the pharma and device industry.

Upgrading Global Utilities from Neutral to Overweight

Looking ahead, we expect greater uncertainty in the markets to drive investors to the sector, and given increasingly attractive valuations, we upgrade our rating for the sector from Neutral to Overweight. That said, there are some nuances in the sector one should keep in mind.

Many US utilities have little pricing power, as state and federal regulators determine if and when utilities can raise customer rates. This process can take months—if not years—to litigate. Meanwhile, utilities have large capital and labour costs along with the legal obligation to supply as much of their product—electricity, gas, water—as customers demand. Fixed revenue and rising costs pinch margins and returns on capital. Given such a backdrop, utility companies whose management teams are adept at managing costs and those which maintain constructive relationships with regulators, customers, and policymakers are better positioned.

Unlike US utilities, European utilities tend to perform well during periods of high inflation, given their lower share of rate-regulated earnings and more constructive ratemaking. That said, we are now in a period of energy crisis in Europe, which has put energy affordability at the forefront of political agenda, and one should keep regulatory risks in mind during such trying times for the masses. In addition, investors should avoid gas-exposed names given the possibility of a significant disruption in natural gas flows from Russia.

Over the longer term, however, renewable energy growth remains a tailwind for utilities, supporting an expected 5-7% annual earnings and dividend growth outlook for most of the US utilities sector, though firms may need to contend with rising renewable project costs in the meantime.

This article was first published by Bank of Singapore on July 7, 2022. The Opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of Bank OCBC NISP Private Banking Tbk. or its affiliates.

OCBC NISP Private Banking provides a suite of products for wealth creation, preservation and transmission including holistic wealth management services, independent research, customized solutions for all investor preferences, and genuine open architecture, with expertise in Indonesia and Asia Pacific markets. OCBC NISP Private Banking is a part of OCBC Group.

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