MARKETS SPECTATOR: Sweet spot in a cyclical rotation

Deutsche Bank says cyclical stocks hold the greatest earnings upside as Australia's economy begins rebalancing.

In an Australian Equity Strategy update note, Deutsche Bank is looking to add to its cyclical exposure as it believes the earnings cycle has bottomed and fund flows are likely to be supportive.

Among sectors, cyclical industrials and resources have been heavy underperformers in this rally. Valuations favour these sectors over defensives and banks, prompting the rotation.

Having slid lower for the last two years, earnings looks to be turning higher, according to Deutsche’s ‘profit pulse’ indicator. For the banks and industrials (more than 75 per cent of ASX 200), earnings have been rising for a while.

The broker believes forward earnings are edging up, with the earnings revisions ratio back to normal levels and fund flows acting as support. Although it sees the market price-earnings ratio as quite high, the positive earnings and supportive flows could easily see the market continue to push higher.

“Earnings revision momentum for cyclicals is neutral, after being heavily negative for the past two years," the broker said. "This, along with low margin forecasts, gives us comfort that forecasts of good earnings growth can be largely achieved. Rate cuts already in the pipeline should prompt a rebalancing of the economy that benefits housing and leads to a restocking cycle. On the global front, US growth is on a firmer footing, which is positive for offshore-exposed stocks.”

Deutsche believes the banks looks expensive from a number of angles with the PE/growth and PE ratio high relative to history, other sectors and overseas peers. Having said that, yield support remains, which keeps the broker from a large underweight position. Nonetheless, it sees better options elsewhere. 

Given recent poor performance, the broker believes resource valuations look more moderate, noting that spot commodity prices imply upgrades and metal prices have underperformed equities and industrial production growth. While it is adding to its mining exposure, it prefers exposure in the energy space.

Source: Deutsche Bank