Stay overweight defensives UBS strategists say

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Investing.com -- UBS strategists have reaffirmed their recommendation to maintain an overweight position in defensive sectors, underscoring that the current macroeconomic backdrop strongly favors these industries. 

With global PMI new orders peaking and the yield curve signaling potential economic downturns, defensives such as utilities, healthcare equipment, industrial gases, and selected consumer staples are set for continued outperformance. 

The case for remaining overweight on defensives rests on a series of well-established economic indicators and market trends that suggest cyclical sectors are becoming increasingly vulnerable.

One of the primary reasons UBS are backing defensives is that cyclicals seem to be pricing in high global PMI figures. 

Cyclical stocks, which tend to track closely with global PMIs, are currently discounting higher levels than UBS expects, given the recent flattening of global PMI new orders. 

This disconnect, according to the UBS team, creates a risk for cyclical sectors, which are vulnerable to corrections. In contrast, defensive sectors have a proven track record of outperforming during such periods of economic softness.

Another factor playing into this overweight recommendation is the recent behavior of the yield curve. The yield curve, specifically the 10-year/2-year spread, has recently disinverted, which historically has been a signal of economic slowdown or recession. 

This development makes defensive sectors attractive as they generally thrive in low-growth environments. The likelihood of short-term interest rates declining faster than long-term yields further bolsters the case for defensives, as these sectors tend to outperform when yield curve steepening occurs. 

UBS believes this steepening is highly probable, which further justifies the defensive tilt.

Historically, defensives have outperformed cyclicals by a significant margin during similar periods. Over a typical 10-month span, defensives can outperform by as much as 21%, while cyclicals have recently underperformed by 11% over the past five months. 

UBS sees this as a signal that the rotation out of cyclicals and into defensives is not yet complete, and there is room for further outperformance from defensives. 

Moreover, cyclicals in markets like the US appear expensive when measured against both price-to-earnings (P/E) and price-to-sales (P/S) ratios, adding to the attractiveness of defensives on a relative valuation basis.

Earnings revisions add another layer to this thesis. Earnings expectations for cyclical sectors have started to roll over, whereas defensive sectors continue to see upward revisions.

 When aggregate global market earnings revisions roll over, cyclicals have historically underperformed 65% of the time over the following 12 months. 

This pattern, coupled with rising intra-index volatility, which tends to harm cyclicals, makes defensive stocks an even safer bet.

“Historically, the time to buy cyclicals has been November, not September,” the analysts said, further strengthening the case to hold defensives in the short term. 

This seasonality pattern reinforces UBS’s call for staying overweight defensives while waiting for more opportune entry points for cyclicals later in the year.

“We can get defensive-led bull markets (as seen in August).,” the analysts said. While this is not the most common type of market movement, it shows that equities can rise even when defensives are leading the charge. 

Given UBS’s year-end target for the MSCI All-Country World Index remains modest, a portfolio heavily weighted towards defensives offers an opportunity for upside in a challenging environment.

UBS has also refined their preferences within the defensive universe, identifying key sectors that are well-positioned for outperformance. 

Utilities, for example, are a top pick due to their resilience and stable earnings streams. The sector benefits from regulated income and tends to perform well when economic growth slows. 

Within utilities, UBS flags names such as E.ON, Enel (BIT:ENEI), and NiSource Inc (F:NI), particularly those involved in transmission and distribution (T&D), which is expected to grow at a robust 10% CAGR over the coming years. 

This strong growth, coupled with the sector’s defensive characteristics, makes it an attractive area for investment.

Healthcare equipment is another preferred sector, ranking high on UBS’s defensive scorecard. Companies such as Alcon (SIX:ALCC) and Abbott Laboratories (LON:0Q15) stand out due to their solid earnings growth and relatively low P/E ratios, making them appealing in the current environment. 

Healthcare equipment also benefits from structural tailwinds like aging populations, and its relative immunity to US election outcomes makes it a strong long-term defensive play.

Industrial gases also feature prominently in UBS’s recommendations. This sector, with names like Air Liquide (OTC:AIQUY) leading the pack, is characterized by its non-cyclical revenue streams and long-term contracts. 

With approximately 60% of revenue coming from non-cyclical customers, the sector is well-insulated from economic downturns. Additionally, industrial gases are poised to benefit from emerging trends in hydrogen and carbon capture, positioning them as leaders in new growth markets.

Consumer staples, particularly those with strong exposure to Latin America and Eastern Europe, round out UBS’s defensive picks. Companies like Anheuser-Busch InBev, Heineken (AS:HEIN), and Coca-Cola (NYSE:KO) are singled out for their strong footholds in these high-growth regions. These businesses offer the kind of geographic diversification and steady cash flows that make them attractive in uncertain times.

UBS also sees opportunities in software, particularly firms with large installed bases that generate recurring revenues through subscription models. 

Companies like Microsoft (NASDAQ:MSFT) and SAP are seen as defensive plays despite being part of the broader technology sector. These firms benefit from high barriers to entry, which protect their market positions, and offer a degree of earnings stability that is appealing in periods of economic volatility.

Despite the strong case for defensives, UBS does maintain selective overweight positions in certain cyclical sectors, particularly in Europe. 

European banks and consumer-focused industries, including retail, are seen as undervalued and structurally better-positioned than their global counterparts. 

However, these are viewed as targeted bets rather than a broader cyclical shift, and defensives remain the core of UBS’s strategic positioning.