Equity markets fell heavily in November, which proved to be the worst month for returns this year. Although equities staged a brief recovery at the end of the month, for most of November fears about a US slowdown and the impact of the credit crisis took a heavy toll.

At the time of writing (28 November) the MSCI World index has fallen 5.7 per cent in local currency terms – 5.2 per cent in dollar terms – since the beginning of the month.

Emphasis on defence
In sector terms, the reaction across Europe and the UK has been exactly as we might expect: defensive stocks have performed well and cyclical stocks have suffered. Furthermore, small-caps have continued to underperform safer large-caps. The best-performing sectors in both the UK and Europe were Utilities, Consumer Staples and Telecoms.

The market-driven Financials sector bore the brunt of the sell-off, falling heavily. Other cyclical sectors also suffered, such as IT, Materials and Consumer Discretionary. However, the UK Materials sector held up relatively well, supported by potential consolidation, including mining firm BHP Billiton’s proposed merger with Rio Tinto.

Sadly, November’s moves have not helped our current sector recommendations. In fact, the recent developments in the market have been the polar opposite of our calls. Our ‘underperform’ recommendation (Utilities) has been the best performer, while our overweight calls, Financials and Materials, were among the worst.

Our sector strategy has underperformed because it is less defensive than the markets. But it is driven by our belief that equity markets are undervalued. We still believe that markets in 12 months’ time will be higher than today’s levels. As evidence, compare the current price to earnings ratios of the UK and European sectors with their five- and ten-year means. Almost all sectors are trading below their long-term means, as are the markets themselves.

Value starts to appear
Financials stocks continue to look cheap relative to their long-term trading ranges, and we still think this sector will lead the UK market higher over the long term. It is true that the banks have many hurdles to cross in the short term. There is no denying that the sub-prime crisis is going to affect current earnings, and it is not inconceivable that there will be some slowdown to growth in the near future. Yet we think the Financials sector is already discounting these concerns. Indeed, the sector is now trading at a multiple not seen since the end of the last US recession.

We also have an overweight recommendation on the Materials sector, although it is less obviously undervalued. However, the structural change we have seen in commodity prices has supported the sector’s valuation. And it now has particularly attractive long-term growth prospects.

The notable exceptions to the general undervaluation are the Utilities and Consumer Staples sectors. As we’ve argued for some time, these sectors look expensive relative to their growth prospects, and the recent market stampede towards defensive stocks has only increased this overvaluation.

Better news for gilts
Elsewhere in the markets, government bonds benefited from the equity market sell-off, with yields tumbling over the month in all markets as investors fled towards safer assets. Corporate bonds continued to underperform as spreads increased during November.

In the commodities space, it was a mixed month. Energy prices notched up slight gains, as did precious metals, agricultural and livestock, but we saw sharp declines in industrial metals. Finally, in the currency markets the dollar had a less volatile time in November, but continued to weaken against the euro and the yen. Looking ahead, we suspect that, with the Fed set to continue cutting interest rates and the US economy performing poorly, the US dollar will continue to shed value.

We do acknowledge that the risks to this view have increased over recent weeks, but for now we are comfortable retaining our current sector recommendations, focusing on valuation – and holding our nerve.

Henk Potts is equity strategist at Barclays Wealth