Strategist picks out the sector that still has room for a 10% rally

Published Thu, Aug 12 20211:42 AM EDT

The end is nigh for a 15-month bull run in global stock markets as economic growth moderates, according to Bank of America 's head of European equity strategy, but relative pricing in two sectors is still thought to be "extremely low." Speaking in a CNBC Pro Talks interview on Wednesday, BofA's Sebastian Raedler explained that with no further upside expected for European stocks over the coming months, his team had lowered its exposure to cyclical stocks and increased its allocation to defensives. Cyclicals are stocks whose performance tends to align with the trajectory of the global economy, while defensives generally provide stable earnings and dividends irrespective of the economic cycle. However, the Wall Street bank highlighted two major exceptions to the cyclical sell based on their current value: banks and airlines. Both sectors have thus far managed to avoid share prices catching up with the optimism that has driven stock markets to historic highs. Banks Bank of America believes that in the near term, bond yields have the potential to rise, since the market is underpricing the potential for the U.S. Federal Reserve to tighten its historically loose monetary policy sooner than expected. U.S. Treasury yields have pulled back sharply in recent months, disconnecting from their usual relationship with growth momentum, Raedler said. He argued that the combination of higher bond yields and lingering growth momentum for the next few months, before the growth slowdown begins in earnest in the fourth quarter, makes banks one of the "last cyclical catch-up plays that still look attractive." "Banks typically like two things: they like higher rates and they like accelerating growth. So in the near-term, we think that banks have not yet fully caught up with the strong growth momentum that we have in Europe. If bond yields rise, they should be supported by higher bond yields as well," Raedler said. "So in the near term, we still see scope for banks to outperform by around 10% as bond yields rise and growth momentum remains strong, but then once the real slowdown starts, towards the end of the year and going into next year, then we have to acknowledge that financials are very sensitive to the economic cycle." Airlines Bank of America also holds an "overweight" position in airlines , which have been beaten up over the past 18 months as the Covid-19 pandemic brought global travel to a near standstill. Although slowing economic growth would ordinarily affect cyclical stocks like airlines, Raedler said investors need to look not just at the economic cycle, but what is priced into current stock valuations. "Amazingly, the price relative to the market is back to the pandemic lows that we saw in March last year," he said. "If you looked at the airline pricing, you would think that we are still in the depths of a pandemic, there are no vaccines, there is no way out, and so there seems to be a mismatch between what is priced into the sector and what is happening in the real world." Travel stocks have continued to be weighed down as resurgences of Covid-19 and new variants increase the risk of fresh lockdown measures or travel restrictions around the world. "We have looked at the cyclical sectors that have priced in all the good news — that is capital goods, luxury goods and autos and so on — they've already responded strongly to the improvement in the economic picture, and there it's effectively all the good news is already priced in," Raedler said. "We are still overweight the sectors that have lagged, that should have the economic sensitivity but have not yet priced in the good news. That is effectively the banks, as we've discussed, partly because of these bond yield dynamics, but it's also the likes of airlines, where the price relative is simply still extremely low." Why the equity downturn? Raedler highlighted that the "sustainable" run rates for GDP growth in Europe and the U.S. are 1-2%, while the two regions are running at a respective 5% and 5-6% currently. Meanwhile, much of the reopening boost is in the rear view and unprecedented fiscal and monetary stimulus will not continue at pandemic levels, Raedler said. Although excess savings and an improved consumption outlook will mean growth remains above trend, Raedler said it would not be possible to accelerate from current levels, meaning growth rates will fade. Bank of America expects European equities to pull back by 10% by the end of the year, and has turned neutral across European stocks from its long-held positive position. "We think we have seen very clearly the peak in the global cycle and the euro area cycle at the end of the second quarter, and in very simple terms, if you are now decelerating instead of accelerating, then you are really starting to lose the key catalyst for this fantastic equity market performance that you've seen over the last 15 months," he said.

NEW YORK - The Bank of America trading post on the floor of the New York Stock Exchange on August 4, 2011.

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