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Hot stocks: Is it time to move out of cyclicals and into defensives? One top Wall Street bank gives

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Morgan Stanley said it is wary of ‘rotating too hard’ out of cyclicals and into defensive stocks, but it has upgraded its call on the pharma sector – albeit from ‘underweight’ to ‘neutral’.

The Wall Street bank’s European equity strategy team in an end-of-quarter update said: “While we aren’t ready to reverse our preference for cyclical value just yet, the risk-reward for continuing to be long cyclicals at the expense of defensives looks weaker than it did.

“We see a narrowing opportunity set for investors, especially for Cyclicals. Our expectation of continued strong growth data (and a catch-up from European domestic data too), prevents us from wanting to get too defensive just yet, but we think it makes sense to start to reduce the size of our underweight stance.”

Morgan Stanley said the pharma sector stood out as it now trades at a rare price-to-earnings discount to the wider market.

It added the drug stocks offered “amongst the highest upside potential and best risk-reward and should favour recent US dollar strength”.

In a note to clients, the bank also said was screening for other defensives with reasonable valuations including UK-listed stocks Tesco (LON:TSCO), Smith & Nephew (LON:SN.), Coca Cola HBC (LON:CCH) and SSE (LON:SSE).

It moved its bullish stance on consumer services and transport to ‘neutral’.

A case for the defence

Defensive stocks provide consistent dividends and stable earnings regardless of the state of the overall stock market or so says Investopedia.

What qualifies as a defensive stock today probably wouldn’t have 20 years ago and vice versa.

So, for example, Vodafone (LON:VOD) is a former rocket stock whose growth is now so pedestrian and predictable it qualifies as a defensive investment.

The supermarket groups, by contrast, have largely lost this cachet due to structural changes affecting the high street, and shopping malls.

On yer bike

Cyclical stocks are affected by macroeconomic changes, where returns follow the cycles of an economy (once, again thanks Investopedia).

For cyclical, think stocks that are likely to bounce back to form once the pandemic runs its course and business and economic growth have returned to normal.

There is a school of thought that many of the Covid-affected cyclicals may have actually overshot realistic valuations on a wave of vaccine-led euphoria.

So, for example, IAG (LON:IAG), the owner of Iberia and British Airways, has caught the attention of professional investors of a more nervous disposition.

Having doubled in value in six months, there is some twitchiness around its £9bn market capitalisation set against its rising debt pile and a thirst for cash as travel restrictions remain in place.

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