Corporate Profits
Highlights Portfolio Strategy Internal dynamics warn that a broad market consolidation phase has begun. The jump in growth vs. value stocks has provided an opportunity to shift to a neutral style bias. Transports have sold off sharply, but downside risks have not yet been fully expunged, especially for the airline group. Recent Changes Growth Vs. Value - Shift to a neutral stance. Table 1Sector Performance Returns (%) Feature The perceived dovish Fed shift and doubts about the achievability of Trump's policy goals are causing equity market consternation. To the extent that the run up in stocks has largely reflected an improvement in sentiment and other 'soft' economic data, the lack of follow through in 'hard' data has created a validation void. While a weaker U.S. dollar, lower oil prices and less hawkish Fed imply easier monetary conditions, which are ultimately positive for growth, profits and the stock market, a digestion phase still looms. Financials, and banks in particular, had been market leaders, driven up by hopes for a meaningful upward shift in the yield curve and unleashing of animal spirits. But these assumptions are being challenged and there is limited fundamental support. Indeed, bank lending growth remains non-existent and there is no tailwind from improving credit quality. Our view remains that banks carry the most downside risk of all financial groups (please see the March 6 Weekly Report for more details). Regional banks are now down on a year-to-date relative performance basis (Chart 1). In fact, our newly constructed gauge of the equity market's internal dynamics suggests that additional tactical broad market turbulence lies ahead. A composite of relative bank stock, relative transport, small/large cap and industrials/utilities share prices has been a good coincident to leading market indicator in recent years (Chart 2). While no indicator is infallible, the message is that overall market risk is elevated and a choppy period lies ahead, reinforcing our defensive vs. cyclical bias. Nevertheless, it will be important to put any corrective action into a longer-term context. Over the years, we have kept an eye on several qualitative 'unconventional indicators' that have helped time major market turning points. They are meant to augment rather than replace fundamental factors. Chart 1Market Leaders Are Stumbling Chart 2A Yellow Flag From Internal Dynamics Below we highlight five critical variables to gauge whether a correction will devolve into a sustained sell-off. Each of the indicators measures either; profits; business confidence; investor confidence; and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated (Chart 3), there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income. M&A activity is losing momentum (Chart 4). A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds. Economic signals are mostly positive. Durable goods orders have tentatively perked back up (Chart 5), reinforcing that profits and confidence have improved after a soft patch. Temporary employment continues to rise (Chart 5). When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist (Chart 4, bottom panel). If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Chart 3Borrowing Costs Are Not Yet Restrictive Chart 4M&A Is Starting To Labor Chart 5Economic Signals Are Decent In all, these indicators suggest that any pullback will be corrective rather than a trend change. If the profit cycle continues to improve and the Fed has no inflationary need to become restrictive, then any broad market correction could provide an opportunity to selectively add cyclical exposure to portfolios in the coming weeks. In the meantime, we are revisiting our growth vs. value view and providing an update on transports. Growth Vs. Value: Shifting To Neutral Our last style bias update in the December 19 Weekly Report concluded that we would likely recommend moving to a neutral stance over the coming weeks/months from our current growth vs. value (G/V) stance, but expected to do after growth stocks had staged a comeback. That recovery is now well underway and so we are revisiting the outlook. Growth indexes have outperformed value since the depths of the Great Recession. The preference for growth reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. In addition, the composition of the growth index is much longer duration than that of the value space. The surge in long-term earnings growth expectations suggests that investors have increased conviction in the durability of the expansion, which has aided the G/V recovery (Chart 6). That monetary experiment has recently begun to pay off, as global economic growth has finally demonstrated evidence of self-reinforcing traction, led by developed countries. As a result, most central banks are well past the point of maximum thrust, which would mean the loss, albeit not a reversal, of the primary support for the secular advance in growth vs. value indexes. Keep in mind that growth benchmarks have a massive technology sector weight, at just over 1/3 of the total index capitalization. Value indices carry only a 7% weight. As shown in previous research, the technology sector underperforms when economic growth is fast enough to create inflationary pressure and therefore, the interest rate structure. Furthermore, value benchmarks have more than 25% of their weight in the financials sector vs. less than 5% for growth indexes. The upshot is that a meaningful interest rate increase would pad the profits of financials-rich value indices while having little to no impact on growth benchmarks by virtue of their tech-dependence. It is no surprise that the G/V ratio trends with technology/financials relative sector performance (Chart 7). The latter has clearly peaked, with an assist from the renormalization in Fed policy. Chart 6Time To Shift Chart 7Two Key Sector Influences These sector discrepancies mean that a critical question for the style decision is what is the path for government bond yields? The U.S. economy is exhibiting signs of self-reinforcing behavior. The small business sector's hiring plans have surged, and the ISM employment index remains solid (Chart 8). Chart 8Economy No Longer Favors Growth Chart 9A Mixed Bag While at least a modest employment slowdown is probable given that the corporate sector is feeling the profit margin pinch from higher wage costs, these gauges do not suggest a major crunch is imminent. The personal savings rate is drifting lower, supporting consumption growth (Chart 8). Value indexes have a higher economic beta than growth benchmarks, owing to their exposure to shorter duration sectors. The gap between growth and value operating margins tends to close when the economy enjoys a meaningful acceleration (Chart 8). Chart 10Volatility Is A Style Driver Other markers of global economic growth are more mixed. The global manufacturing PMI survey is very strong, but oil and other commodity prices have started to diverge negatively (Chart 9). That may soon change if the U.S. dollar has crested, which would provide a much needed fillip to emerging markets and remove a source of deflationary pressure. Real global bond yields are grinding higher, suggesting that in all, economic prospects have improved, and alleviating a major constraint on value stocks. Against this backdrop, it is timely to shift to a neutral style preference after the sharp rebound in the G/V ratio since late last year. Why not a full shift into value indexes? Developing countries are conspicuously lagging developed countries, which caps the outlook for commodities and their beneficiaries. EM capital spending is still very weak in real terms. Deep cyclical sectors are much more heavily-weighted in value benchmarks. A global recovery that has a greater thrust from consumption than investment, at least at the outset, argues against expecting value stocks to outperform. Moreover, the fallout from potentially protectionist U.S. trade policies remains unknown, which could restrain economic growth momentum and unleash volatility in the equity markets. The latter has been incredibly muted in recent months. In fact, BCA's VIX model, which incorporates corporate sector health and interest rate expectations, is heralding a higher VIX. Clearly, elevated volatility has supported the G/V ratio over meaningful periods of time (Chart 10). Bottom Line: Shift to a neutral style bias. A full shift to a value preference would require BCA to forecast a much weaker U.S. dollar and/or demand-driven inflationary pressure. Transports: Stuck In Neutral The S&P transports index peaked in mid-December versus the broad market, the first major sub-group to fizzle after the post-election sugar high (Chart 11). The recent setback has been broad-based. We had been overweight both the rails and air freight & logistics industry sub-groups, but booked gains in both prior to their respective pullbacks. Is it time to get back in? Transportation equities are ultra-sensitive to swings in global economic growth. Chart 12 shows that the relative share price ratio is an excellent leading indicator of both the ISM manufacturing survey and Citi's economic surprise index. The message is that at least a mild mean reversion in both of these indexes looms in the coming months, i.e. beware of some form of economic cooling. Chart 11Transports Have Cracked... Chart 12... Signaling Economic Cooling Ahead Against this backdrop, we are revisiting our last remaining underweight, the S&P airlines index. While rails and air freight & logistics stocks are directly linked to global trade, the same does not hold true for the S&P airlines index. Business and consumer travel budgets are the key drivers of industry demand. A revival in animal spirits and a healthy U.S. consumer could be clear positives for air travel. Moreover, the recent pullback in fuel costs should cushion profit margins for unhedged airline operators (Chart 13). Finally, renowned investor Warren Buffett has recently become a major shareholder in the U.S. airline industry, raising its profile. While betting against Buffett is always fraught with risk, our cautious take on the airline industry boils down to our view that excess capacity will continue to hold back profitability. If the overall transport index is accurately signaling that some loss of economic momentum looms, then a rapid expansion in business and travel spending may not be quick to materialize. A pricing war has already gripped the industry, as airlines are scrambling to fill up planes. Revenue-per-available-seat-mile and U.S. CPI airfare are contracting (Chart 14), reflecting a fight for market share. That is a serious impediment to profit margins. Chart 13Airlines Are Losing Altitude... Chart 14... As Price Wars Persist The headwinds extend beyond the U.S. Chart 15 shows that global airfare deflation also bodes ill for top line industry growth. The lags from previous U.S. dollar strength could compound this source of drag. Absent a decisive recovery in total travel spending, there does not appear to be any catalysts to reverse deflationary conditions. Carriers are still allocating an historically high portion of cash flow to capital spending. While upgrading aging fleets to become more fuel-efficient in an era of low interest rates is a long-term positive, the payback period may be extended. Revenue has failed to keep up with the increase in capital expenditures (Chart 16, bottom panel), suggesting that capacity growth continues to outpace industry demand, a recipe for ongoing pricing pressure. Chart 15Deflation Is Global Chart 16Too Much Capacity This difficult backdrop has begun to infect analyst earnings estimates. Net earnings revisions have nosedived. Relative performance momentum is tightly lined with the trend in earnings estimates (Chart 16). The message is that the breakdown in cyclical momentum has further to run. Indeed, the 52-week rate of change rarely troughs until it reaches much lower levels, warning of additional downside relative performance risks. Bottom Line: The S&P transports group is heralding a period of economic cooling, but the airline sub-component has not yet fully discounted such an outcome. Stay underweight. The ticker symbols for the stocks in the S&P airlines index are: UAL, AAL, DAL, LUV & ALK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Portfolio Strategy Contrary to popular perception, non-cyclical sectors have led the market so far this year, while deep cyclical sectors are breaking down, in relative performance terms. Our models point to more of the same ahead. The oversold rebound in the pharmaceutical group may soon run into resistance so we recommend trimming positions to neutral. Put the proceeds into restaurants, a quasi-defensive group that enjoys a brightening sales outlook without pharma's political and regulatory risk. Recent Changes S&P Pharmaceuticals - Downgrade to neutral. S&P Restaurants - Upgrade to overweight. Table 1 Feature Equities are exhibiting signs of mild fatigue. Breadth has begun to narrow, and new highs have sagged compared with new lows (Chart 1). Both of these technical developments have warned of previous tactical pullbacks. The recent reset in oil prices may also test investor nerves. Oil prices have been a critical macro variable, because they influence inflation expectations and the corporate bond market (high yield bond spreads shown inverted, Chart 1). Crude oil price corrections have accurately timed equity retreats (Chart 1), and general risk aversion phases. To be sure, the global economy is no longer on a deflationary precipice, suggesting that weaker oil prices may not foreshadow a soft patch, but they may be a good enough excuse for profit taking in the equity market after a good run. Contrary to popular perception, cyclical sectors have not led the broad market so far in 2017. In fact, energy, materials and industrials have all broken down in relative performance terms (Chart 2), after peaking in mid-December. Only the technology sector has stayed resilient. Chart 1Short-Term Fatigue Chart 2Cyclicals Have Broken Down Chart 3Overshoot Renormalization Insipid cyclical sector performance has occurred within the context of a synchronized lift in global economic growth and recovering corporate sector pricing power. So why are cyclical sectors lagging? It may simply be a digestion phase. However, a different interpretation is that a number of key macro factors fail to confirm the durability of last year's outperformance, suggesting that defensive outperformance could last. Concerns that the current global inventory cycle may not morph into a broad-based upturn in global final demand continue to linger: the global credit impulse remains anemic, the Fed and China are tightening monetary policy and commodity markets are cracking (Chart 3). The lack of any meaningful improvement in Chinese loan demand signals that the economy may be quick to cool as the authorities tap the breaks on credit growth. It would take a decisive depreciation in the U.S. dollar to boost the relative profit fortunes of capital spending-dependent cyclical sectors on a sustainable basis. On a more positive note, the Fed's benign forward guidance last week bears close attention. If the U.S. dollar loses upside support, particularly with the ECB contemplating a retreat from full throttle easing, it could change the investment landscape. By reminding markets that their inflation target is symmetric, the Fed signaled it will be willing to tolerate a modest inflation overshoot, which is positive for risk assets in the short run. A softer U.S. dollar would take the pressure off of developing countries, support commodity prices, and bolster our cyclical sector sales models and Cyclical Macro Indicators. However, Chart 4 shows that the objective message from our models remains consistent with continued defensive sector outperformance. With a more protectionist U.S. Administration, we remain reluctant to position exclusively for a much weaker dollar. The ongoing underperformance of emerging market equities relative to U.S. and global benchmarks reinforces that foreign-sourced profit growth continues to lag (Chart 5). Positioning for cyclical sector earnings outperformance requires healthier profits abroad, to spur a new capital investment cycle. Chart 4Heeding The Message From Our Models... Chart 5... And The Markets We will look to selectively add cyclical exposure when the objective message from our Indicators provides confirmation that earnings-driven outperformance lies ahead. At the moment, there is no such confirmation. In fact, the elevated reading in the SKEW index continues to signal that a defensive posture will optimize portfolio performance (Chart 5). In sum, we continue to characterize the broad market's current momentum as an overshoot phase, with additional technical upside potential, but the rally is starting to fray around the edges. In this environment, holding a mostly defensive basket with selective beta exposure is still recommended. Importantly, within the defensive universe, there are tweaks to be made, especially if the U.S. dollar stops rising. Fade The Pharmaceuticals Rebound Health care has been the second strongest of the eleven broad sectors year-to-date, contrary to popular perception. That is in line with the flattening yield curve, cresting in inflation expectations and a modest correction in oil prices (Chart 6), all of which have revived the allure of non-cyclical sectors. Moreover, our Cyclical Macro Indicator (CMI) for the health care sector remains firm, supported by the ongoing large pricing power advantage. Relative value is the most attractive it has been in five years. While the latter provides little timing help, it indicates low risk, especially with technical conditions still deeply oversold (Chart 7). Chart 6Health Care Is Storming Back Chart 7Still Cheap And Oversold The heavyweight pharmaceutical group has led the sector's tactical charge, recouping the ground lost, in relative performance terms, leading up to the U.S. election. While we were caught off guard by the severity of the pullback last September/October, we refrained from selling into an oversold market and noted our intention to lighten positions whenever the inevitable relief rally occurred. The time has come to execute on this thesis. Pharmaceutical stocks are very cheap and have discounted a hostile regulatory environment. The relative forward P/E is well below its historic mean, even though both 12-month and 5-year relative forward earnings growth expectations are depressed (Chart 8). Typically, the latter would serve to artificially inflate valuations. These conditions exist even though free cash flow growth remains strong; merger activity has been solid, albeit ebbing in recent months; and companies have used excess capital to reduce total shares outstanding (Chart 8). In other words, relative forward earnings would have to decline substantially to validate these expectations. Is this plausible? Much depends on the regulatory environment. While details of the U.S. Administration's proposal to replace the Affordable Care Act have started to leak out, final details are still elusive and legislative action is not imminent. So far, it appears as if a worst case scenario would see an increase in the number of uninsured Americans, with a rising cost of insurance (to the benefit of managed care companies). According to the Department of Health & Human Services, the uninsured rate of the U.S. population nearly halved from 16% in 2010 to 9% in 2015. That led to a lift in the number of procedures performed and bolstered hospital bottom lines. Hospitals are a major pharmaceutical buying group. Higher utilization rates fed increased pharmaceutical demand for a number of years. However, drug spending growth has dropped off, and if the legion of uninsured patients rises anew in the coming years, then hospital utilization rates will decline, taking drug consumption growth down with it. Moreover, Trump wants to streamline the FDA's approval process, which would ultimately boost the number of high margin new drugs coming to market. Drug stocks boomed back in the mid-1990s, the last time FDA approval rates accelerated meaningfully (Chart 9). Chart 8Full Capitulation Chart 9Full Capitulation But at the same time, if government is given leeway to negotiate drug prices directly with drug companies, then pricing power will continue to converge down toward overall corporate sector pricing power, especially if drug consumption rates ease (Chart 9). At the moment, drug consumption growth remains above the rate of overall consumption growth, but that is much slower than during the boom following the introduction of the Affordable Care Act. Retail sales at pharmacies are growing robustly, and hospitals are still adding staff, signaling that they continue to position for expansion, i.e. rising procedure volumes (Chart 10). On the downside, the strong U.S. dollar is a big drag on top-line growth. Drug imports exceed exports by a wide margin, resulting in a negative trade balance and a drag on U.S. drug company profits, all else equal. The combination of a sales growth deceleration and adequate channel inventories has capped drug output growth (Chart 10). That is a productivity and profit margin headwind. Against this background, the industry will need an external assist to deliver profit outperformance. Relative profit estimates rise when disinflationary forces reign supreme, as measured by the NFIB planned price hikes series (shown inverted, Chart 11). This measure of future corporate pricing power intentions has rolled over, but broader measures of inflation are creeping higher. Ergo, drug earnings forecasts may be challenged to keep pace with the overall corporate sector. Chart 10... But Growth Rates Are Slowing Chart 11Mixed Signals The good news is that even though U.S. dollar strength is an export drag, the negative drug trade balance suggests that it will hurt other industries more. Indeed, a rising currency often coincides with profit outperformance (Chart 11). There is not enough evidence that exogenous factors will offset slowing domestic drug consumption growth. In all, the case for a further and sustained relative performance recovery has weakened, and we are taking advantage of this year's oversold bounce to move to the sidelines. Bottom Line: Trim the S&P pharmaceuticals index to neutral. This position was deep in the money initially, but last year's downdraft pushed it into a loss position of 10%. BLBG: S5PHARX-JNJ, PFE, MRK, BMY, LLY, AGN, ZTS, MYL, PRGO, MNK. Restaurants: Increasing Appetite The broad consumer discretionary sector has been treading water, largely owing to fears that a border adjustment tax (BAT) will undermine the retailing sub-component. This consolidation has restored value and created an attractive technical entry point (Chart 12, bottom panel). Importantly, industry earnings fundamentals are on the upswing. Our consumer discretionary sector Cyclical Macro Indicator has perked up (Chart 12), supported by an increase in wages, and more recently, the decline in oil prices. The latter is freeing up disposable income, which consumers have an incentive to spend given that household net worth (HNW) has climbed to all-time highs as a percent of disposable income (Chart 13). Chart 12A Good Place To Shop Chart 13Piggyback The Wealth Effect While we remain overweight housing related equities (homebuilders and home improvement retailers) in addition to our upbeat view on the media and advertising complex, a buying opportunity has surfaced in the neglected S&P restaurants index. We booked gains on an underweight position and lifted exposure to neutral back in late-October. Since then, value has improved further, while leading sales indicators continue to firm. Stronger consumer finances should flow into the casual dining industry. Sales have already started to reaccelerate, and should climb further based on the leading message from HNW (Chart 14). The lower income, $15K-$35K, cohort is also feeling increasingly confident, according to the latest Conference Board survey data (Chart 14). Meanwhile, the National Association of Restaurants Performance Index has regained momentum (Chart 15), signaling increased activity and rising confidence among restaurateurs. While the gap between the cost of dining out and dining in remains wide, it has begun to narrow, which is a plus for store traffic, all else equal. Chart 14Buy Into Weakness Chart 15At A Turning Point Domestically... Chart 16... And Globally? Our restaurants profit margin proxy (comprising restaurants CPI versus a blend of the industry's wage bill and food commodity costs) is trending higher. That is notable because it has a good track record in leading relative earnings growth estimates (Chart 15). Nevertheless, it is not all good news. International exposure remains a headache. Typically, soft EM currencies warn of translation drags on foreign sourced revenue (Chart 16). This cycle, there is an offset, as EM interest rates have come down, which is a plus for domestic demand (Chart 16). Thus, the headwind from outside the U.S. should abate as the year progresses. Adding it all up, factors are falling into place for a playable rally in the under-owned and unloved S&P restaurants index. This group offers attractive quasi-cyclical defensive exposure to replace the S&P pharmaceuticals index, without the political and regulatory risks. Bottom Line: Redeploy funds from the pharma downgrade and boost the S&P restaurants index to overweight. BLBG: S5REST-MCD, YUM, CMG, SBUX, DRI. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Highlights Portfolio Strategy A relapse in the global financials sector threatens to spill into U.S. financials as credit growth sinks. Bank equities are the most vulnerable to such a phase, given their reliance on rising interest rate expectations rather than increased lending. Take profits in the S&P health care facilities index and downgrade to neutral. Recent Changes S&P Health Care Facilities - Take profits of 12% and downgrade to neutral. Table 1Sector Performance Returns (%) Feature Momentum continues to trump all else, with the equity market surging to new all-time highs last week. However, in the background, the Fed is becoming steadily more hawkish, and the odds of a March rate hike have risen substantially. This should be cause for some trepidation. Chart 1Multiples Are Headed##br## Lower As The Fed Hikes The market advance since November has been supported primarily by valuation expansion, along with some improvement in corporate profits. The forward P/E has climbed to 18, its highest level in well over a decade. The scope for further expansion is limited. Importantly, if a transition to an earnings-led rally is in the offing, Fed funds expectations likely need to be ratcheted higher. Chart 1 shows that valuation multiples contract during Fed tightening cycles, using cycle-on-cycle analysis. Thus, the valuation expansion is inconsistent with a significant upgrade in the economic and profit outlook, particularly with return on equity so weak (Chart 1). In other words, the economy has good momentum, but that is not translating one for one to the corporate sector. Keep in mind that even a small two P/E multiple point decline requires 11% earnings growth for the market just to hold its ground. That is a tall order given the squeeze on profit margins from labor cost inflation and a strong U.S. dollar. Ironically, high multiples would be more durable if economic data softened enough for the Fed to hold its fire. Against this background, it is not surprising that a stealthy flight to safety has developed, although it is not uniform across asset classes. For instance, gold has outperformed most major currencies (note we recently upgraded the gold shares group as a portfolio hedge); global government yields have eased back while sovereign bond spreads have widened (Chart 2). In the U.S., the economically-sensitive transport group has rolled over in line with the yield curve narrowing (Chart 2), the equity SKEW index remains historically elevated, and a defensive vs. cyclical portfolio bias has outperformed handily since early December (Chart 2, bottom panel), on broad-based non-cyclical sector participation. These shifts, on the margin, signal that some investors are bracing for a bout of volatility. On the flipside, U.S. junk bond spreads have narrowed back to 2014 lows, and emerging market corporate bond spreads are testing similarly tight levels. The global purchasing manager survey recorded yet another monthly gain (Chart 3). Chart 2Contrarian##br##Alert... Chart 3... Defensives Can Outperform##br## When Growth Is Good Ergo, a systemic economic threat is not the main obstacle to further asset price appreciation. Rather, it is that expectations in some assets and sectors have become divorced from reality. Indeed, we have noted for the last two months the disturbing downtrend in bank credit growth and the unprecedented gap between strong 'soft' and pedestrian 'hard' economic data. Mixed economic and financial market messages suggest that any equity turbulence may be marked by a mostly rotational correction rather than a savage drawdown in the broad averages. Still, the latter cannot be ruled out given the high degree of complacency and buoyant profit and economic expectations. It is notable that defensive equities embarked on a massive outperformance phase when both U.S. and EM bond spreads were just as low as they are currently, i.e. they hit 'as good as it gets' levels (Chart 3). Any widening in corporate bond spreads would tighten financial conditions, spurring a slowdown in growth down the road. In sum, the odds of an equity market sweet spot extension beyond the very near run have diminished as a consequence of ongoing strong economic data, which reflects the easing in financial conditions a year ago. In terms of positioning portfolios, there is still a mismatch between developed and developing markets, as measured by the relative ISM indexes (Chart 3, fourth panel). The upshot is that defensives will continue to generate much more cash than their cyclical counterparts (Chart 3, bottom panel), supporting the nascent relative share price recovery. The financial sector could also be due for a correction. Financials And Banks: Where To Next? The global financials sector has cheered the firming in leading economic indicators and back up in bond yields since last autumn, but that celebration is likely drawing to a close. Euro area financials have rolled over, in line with renewed weakness in German government bond yields (Chart 4). Continued slippage in global yields could cap U.S. yields, thereby flattening the yield curve (Chart 5). U.S. financials are much more expensive than their euro area counterparts (Chart 5, bottom panel), suggesting heightened vulnerability. Chart 4Are EMU Financials ##br##Sending A Warning Signal? Chart 5Watch The##br## Yield Curve In our view, the S&P bank index contains the most downside vulnerability, in relative performance terms, of all the financial sector sub-components, especially if regulatory reform disappoints and/or is slow to evolve. True, as outlined in a Special Report published on October 3, 2016, interest rate expectations have a checkered history of predicting bank stock relative performance. When they do drive bank stocks, it is typically because most other profit drivers are lacking, as is currently the case (Chart 5, top panel). This cycle, interest rate spreads have been unduly suppressed by the zero lower bound. Under normal circumstances, when short-term interest rates are well above zero lower bound, banks can target a spread between rates on assets and liabilities. But when the fed funds rate is at zero, the spread is compressed, because banks generally cannot charge customers a penalty implied by negative interest rates on deposits (at least in the U.S.). As the Fed pushes interest rates back upward, banks may be able to return their spreads to their target levels, by raising deposit rates more slowly than loan rates. However, this dynamic has been fully priced in over the last few months and the risk is that higher net interest margins will not offset the lack of credit creation and/or that Fed funds rate expectations will level off if economic data start to disappoint. After all, Chart 6 shows that net interest margins can both widen and narrow when the Fed is hiking interest rates. Moreover, the yield curve is narrowing, after peaking two months ago. If rising fed interest rate expectations are the primary factor driving bank stock performance, then it follows that market expectations must continue to price in a much more hawkish rate environment in order to extend any rally in bank share prices. However, the global credit impulse is still negative, albeit less so, reflecting capital constraints and deleveraging. The Bank of International Settlements global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and it is premature to expect earnings outperformance (Chart 7). U.S. credit data are also inconsistent with a major upshift in Fed funds interest rate expectations. Total loan growth is contracting, led by commercial & industrial loans (Chart 8). Commercial real estate loan growth has also turned lower. Chart 6Net Interest Margins And The Fed Chart 7Don't Chase Without Profit Support Chart 8Shrinking Balance Sheets The most recent Fed Senior Loan Officer Survey showed that banks are tightening lending standards in most categories, with the exception of mortgages (Chart 9). The number of banks reporting increased loan demand has also softened. Since the credit crisis, banks have shifted their balance sheet exposure toward businesses and away from consumers and residential mortgages, underscoring that a decent housing market is unlikely to provide an offset to lackluster corporate credit demand. Only mortgages have experienced an uptick in loan demand and availability of funds (Chart 9). This credit backdrop is not conducive to a much more aggressive Fed, reinforcing that it would be dangerous to discount a sustained and meaningful uptrend in net interest margins. To further confound the bank stock reward/risk profile, bank employment continues to rise steadily (Chart 10), even though balance sheet expansion is no longer a sure thing. We have shown in past Reports that bank stocks have almost always underperformed when bank employment is rising. Chart 9Credit Standars Are Tightening Chart 10Sagging Productivity The current combination of fading credit creation and rising employment has done a number on our bank productivity proxy. The latter is now contracting on a rate of change basis, warning that the expansion in bank stock valuations is due for a squeeze (Chart 10). Bottom Line: The run in bank stocks over the past few months is on the cusp of a reversal, based on the leading message from the euro area, sinking productivity and punk credit demand. Our financial sector preference remains skewed toward areas not dependent on credit creation, such as asset managers. Book Profits In Health Care Facilities We bought the S&P health care facilities index last December after a steep post-election sell-off created a valuation and technical undershoot relative to the fundamental outlook. The doomsday concern was that President Trump would tear up the Affordable Care Act (ACA), potentially leaving millions without insurance: treating the uninsured is the bane of any hospital's existence. At the time of purchase, the 52-week rate of change was diverging positively from the share price ratio after hitting deeply oversold levels, often a harbinger of a playable rally (Chart 11). That was particularly true given an historically high short position. The index has outperformed by 12% since then, encouraged by a jump in analyst net profit revisions following upbeat profit results and guidance from industry heavyweights such as HCA Holdings (Chart 11), and a realization that any ACA action is likely to be more of a rework than a total rebuild. Valuations remain appealing, but a technical breakout above key resistance levels requires increased confidence in the durability of profit outperformance. Is such a phase forthcoming? Our conviction level has decreased a notch. Our concern is primarily revenue based, rather than fear that provisions for doubtful accounts will suddenly deteriorate as a consequence of treating uninsured patients. Instead, the main push from the surge in the insured population and increase in procedures on the back of rising consumer confidence/job security is likely to peter out. Consumer spending on hospitals has already rolled over decisively on a growth rate basis (Chart 12, third panel), and is contracting compared with total consumer spending. The same is true of spending on physician visits. Fewer doctor visits mean a reduction in procedures performed at hospitals. Chart 11Hitting Resistance Chart 12Top-Line Trouble Ahead? Health care is a labor-intensive industry. Health care facilities staff up when they get busy and prune when capacity utilization slips. As such, slowing growth in hospital employment reinforces that patient volume growth is likely to ebb (Chart 12). In fact, the contraction in hospital hours worked signals the same ahead for hospital sales (Chart 12, bottom panel). The good news is that labor costs remain in check, as measured by the employment cost index for hospitals (Chart 13). Other input costs, such as the cost of medical equipment and supplies, have perked up (Chart 13), which may require increased pricing power in order to sustain profit margins. However, the revenue trends noted above suggest that hospitals may not experience a sufficient rise in patient volumes to the extent that restores pricing power to a more solid footing. Chart 14 shows that the consumer price index for hospitals is losing momentum relative to overall inflation. Durable outperformance phases require accelerating relative pricing power, in addition to a cooling in overall economic growth, as proxied by the ISM manufacturing index (see shading, Chart 14). Those conditions provide a durable competitive profit advantage. Chart 13A Mixed Picture For Costs Chart 14Shaky Long-Term Support Chart 15Macro Headwinds In addition, the ideal macro conditions for hospital stocks exist when consumer spending on overall health care services is accelerating relative to total spending. That implies that the providers of health care services have an advantage over those that pay for them, such as insurers. Total medical care spending is steadily decelerating (Chart 15), underscoring that investors are better off targeting investments in other parts of the sector. In sum, the forces required to sustain the oversold rally in the S&P 1500 health care facilities index are losing clout, so we recommend booking profits. Bottom Line: Downgrade the S&P 1500 health care facilities index to neutral, locking in a 12% profit since inception in December 2016. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Highlights Since the 1950s, the trends in margins and earnings growth have been one and the same: as profit margins decline, so does earnings growth. The decline in profit margins that began in early 2015 has gone on hiatus for the past two quarters. But this rebound in margins is unlikely to be sustained. However, even if profit margins turn lower on a sustained basis, there is scope for equity returns to stay positive, based on historical precedent. Similar to a broad-based profit margin decline, further currency strength will be an earnings headwind, but not a show-stopper for profit growth. All in all, with forward multiples now at multi-decade highs, there is lots of room for earnings growth to disappoint, but the conditions for an equity bear market are not in place. Feature Equity prices continue to march higher and the S&P 500 made another all-time high last week. Q4 earnings reporting is now nearly complete, with about two-thirds of companies surprising to the upside. According to FactSet, the share of Q4 surprises is below the 5-year average, while the size of surprises (2.9% above the estimate) is also a smaller margin than the "average surprise" in the past five years (Chart 1). Nonetheless, that has not stopped analysts from getting even more bulled up about 2017 earnings. Analysts' consensus for S&P 500 operating earnings is 10.2% for the calendar year, and the forward multiple now stands at 17.5x, its highest level since 2004 (Chart 2). Chart 1Q4 Earnings Surprises: Better, ##br##But Not That Surprising Chart 2Forward P/E At ##br##Decade Highs A 10% rise in earnings within the year would not be an unprecedented move - there are numerous historical re-accelerations of operating earnings of that size. However, it would be unprecedented for earnings growth to move consistently higher over the next year without an upward trend in profit margins. As Charts 3A and 3B shows, the turning points in earnings growth always correspond with turning points in profit margins. True, there have been 13 minor episodes whereby profit margins have declined but earnings growth accelerated. But these periods were very short-lived, never lasting more than three months at a time. In the majority of these episodes, equity investors saw through the blip down in margins; equity prices continued to rally higher and returns for the year were larger than average. Chart 3AProfit Growth And Margins: An Iron Link Chart 3B There have been far more one-quarter episodes whereby earnings growth decelerates and profit margins continue to rise (39 times since 1951). In these cases, equities exhibit below average returns. Chart 4Slow Growth Will Stay A Profit Headwind The key takeaway is that when profit margins and earnings growth temporarily fail to pull in the same direction, investors have tended to focus on earnings growth. However, the caveat to the above analysis is that we rely on data going back to 1951. The current cycle is unique in that potential GDP growth has never been this low (Chart 4). In a low-growth environment, it is harder for volume expansion to compensate for any fall in margins. We believe that understanding the profit margin backdrop in this environment will remain particularly important. The Outlook For Profit Margins The trend in profit margins is determined largely by the relative growth rates of selling prices, compensation and productivity. Unit labor costs (ULC), which is compensation divided by productivity, account for about 60% of production expenses: the ratio of selling price to unit labor costs is a good proxy for profit margins (Chart 5). In terms of the denominator, unit labor costs have been choppy, but have nonetheless been on a rising trend since the beginning of the recovery. Since the early 1990s, unit labor costs tended to rise throughout the business expansion, and then fall sharply once businesses retrenched during recessions. If this cycle follows historical patterns, then unit labor costs could push higher toward 3%. In other words, labor expenses may not accelerate quickly, but it is highly unlikely that profits will benefit from a fall in ULC growth at this stage of the expansion. In a recent Special Report,1 we made the case that the economy is at full employment and there would be cyclical pressure for wages to rise, despite some structural headwinds. We do not anticipate a surge in labor costs, rather a slow creep higher. Chart 5Can Selling Prices ##br##Catch Up To Labor Cost? Chart 6Businesses Will Find It Hard ##br##To Pass On Price Increases Our major concern is whether or not selling prices (i.e. the numerator in our proxy) can keep up with even mild cost pressures. Traditionally, the conditions that allow companies to raise prices are also associated with rising costs of inputs and labor, and higher inflation prompts the Fed to impose monetary restraint. Thus, profit margins - and therefore equity prices - have generally done better when price inflation is low. However, the concern today is that inflation (corporate selling prices) is too low and that it is difficult for firms to pass on rising input costs, i.e. that a margin squeeze occurs because businesses cannot sufficiently pass on rising labor costs, as consumers have become conditioned to entrenched deflation, particularly at the retail level. We have written extensively in recent publications about inflation. Our bias is to expect broad-based inflation (PCE and CPI measures) as well as corporate selling price inflation (i.e. businesses pricing power) to rise slowly this cycle. The key points are as follows: Inflation expectations are extremely well anchored (Chart 6). True, there is a gap that has opened between survey and market-based inflation expectations. But as we explained in our January 9 Weekly Report, there are several reasons why market-based measures are likely overstating the rise in inflation expectations. Even so, these measures remain well below historic averages and continue to signal that even if the trend is up, the rate of inflation remains very benign. If survey-based inflation expectations are correct, then this business cycle could be a mirror opposite of the 1970s/80s. In that cycle, strong inflation expectations became self-fulfilling/self-reinforcing and lead to higher realized inflation. Today, after a long period of fearing deflation and experiencing massive price discounting at the retail level (Chart 6), consumers have become conditioned to expect prices will never go up. Even once the output gap is fully closed, it could take several years for inflation to gain traction. A strong dollar argues for constant drag on 30% of consumer price inflation (i.e. tradable goods and services). This will keep a lid on inflation for the foreseeable future. Overall, wage costs have outpaced pricing power since 2014, with the exception of the prior two quarters. We do not have a strong view on whether profit margins are finally in a sustained mean-reverting phase, but the above framework suggests that due to a very solid anchoring of inflation expectations, businesses could be faced with a tough pricing backdrop much later than is typical in the business cycle. Flat/falling margins are historically not enough to derail the bull market at this stage of the expansion. However, as we highlighted above, equities are now trading at sky-high forward valuations and have become extremely vulnerable to earnings disappointment. What About The Dollar? A frequent question from clients is about the role of the dollar in U.S. earnings and how enthusiastic can one be about earnings growth if the dollar is rising? As our U.S. Equity Strategy team has pointed out in the past, there are two distinct camps on the impact of U.S. dollar strength on equities.2 Bulls believe that dollar strength will depress commodity and import prices, tamping down inflation pressures and allowing the Fed to avoid monetary tightening. Therefore, the net monetary conditions impact will be positive for the U.S., which is a relatively closed economy. Under these conditions, capital would continue to flow into stocks. Bears see the currency as undermining profitability, given that foreign translation will take a hit along with income from foreign affiliates selling into weaker demand abroad (Chart 7). In other words, the rest of the world is exporting deflationary pressures to the U.S. via currency depreciation. This threatens the earnings outlook, particularly relative to still lofty growth expectations. Chart 7Dollar Headwind Our take is somewhere in between these two extremes. It is certainly true that a strong dollar helps contain inflation pressures, and allows for a prolonged business cycle. But as highlighted above, in an economy still struggling to grow much above 2%, inflation pressures are not an overly large concern to begin with. Meanwhile, hedging means that the currency translation effect on financial performance is not immediate. And the impact of any dollar strength surely depends on the conditions under which it is strengthening: dollar strength in a period of weak global growth will be more detrimental to returns than a dollar that is rising due to exceptionally strong domestic conditions. We are currently at neither one of these extremes (Chart 8). Chart 8U.S. And Global Economy: Not Hot, Not Cold Our Bank Credit Analyst service recently presented a matrix of different scenarios for the dollar and economic growth applied to a model for EPS growth. The key finding was that the effect of even small changes in growth assumptions dominate the effect of much larger moves in the dollar. A 10% dollar appreciation from current levels would shave about 2% from profits, assuming no change to the GDP growth outlook. The bottom line is that the recent improvement in margins has helped earnings recover from last year's profit recession. However, it is unlikely that margins have entered a lasting uptrend; firms lack pricing power and the labor market is now tight enough that unit labor costs will rise on a sustained basis. As profit margins trend lower in the coming years, this will present a headwind for profit growth. Similarly, our expectation that the currency will continue to appreciate over the next 12-18 months is a headwind to earnings growth. Current sky-high equity valuations leave little room for these risks. We expect that disappointments will eventually cause an equity price reset, but timing is uncertain. As we wrote last week, technical indicators do not currently suggest an important pullback is imminent. Looking further out, the overall backdrop of slowly building inflation, a go-slow Fed, and a mild pickup in nominal GDP growth, is a positive backdrop for long-term stocks. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?", dated November 28, 2016, available at usis.bcaresearch.com 2 Please see U.S. Equity Strategy Service Special Report, “Equity Sectors And The Soaring U.S. Dollar,” dated November 3, 2014, available at uses.bcaresearch.com
Highlights Portfolio Strategy Pricing power has improved across a number of industries, with the exception of technology, a necessary development to sustain an overall profit recovery. The S&P railroads index has surged to the point where it will take massive upside earnings surprises to drive additional gains. Profit-taking is appropriate. Telecom services profit drivers have deteriorated significantly of late, and a full shift to underweight is recommended. Recent Changes S&P Railroads Index - Take profits of 22% and downgrade to neutral. S&P Telecom Services Index - Take profits of 6% and downgrade to underweight from overweight. Table 1 Feature Chart 1Pricing Power Is Profit Positive... Momentum remains the dominant market force. Fear of missing out is pulling sidelined cash into the market, supported by a decent earnings season to date and rising economic confidence. While consumer inflation expectations remain very low, market-derived inflation expectations have moved up markedly since the U.S. election (Chart 1), a surprising development given the surge in the U.S. dollar. Inflation expectations are back to levels that existed prior to the 2014 kickoff to the U.S. dollar rally. A shift away from deflation worries is supporting a re-pricing of stocks vs. bonds. That trend could continue until the U.S. economy begins to disappoint, potentially causing inflation expectations to retreat. Our pricing power update shows that while deflation remains prevalent, its intensity is fading. We have updated our industry group pricing power (Table 2), which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. The table also compares those pricing power trends with overall inflation rates to help determine which areas are at a profit advantage or disadvantage. Based on our analysis, the number of groups suffering deflation in selling prices has shrunk to 19 from 23 in our update last September, and 32 last March. In all, 34 out of 60 groups are still unable to raise prices by more than 1%, but that is also an improvement from the 40 out of 60 industries that couldn't keep a 1% price hike pace last September. The bad news is that less than 1/3 have a rising selling price trend, even if the absolute level is negative, down from 50%, and another third has a flat trend. The implication is that upward momentum in pricing power may already be fading. Where is the pricing power improvement? Deep cyclical sectors such as energy and materials account for the lion's share, reflecting higher commodity prices. However, as discussed previously, 6-month growth rates have rolled over (Chart 2), signaling that the unwinding of the negative rate of change shock has run its course. The technology sector is also notable, as several groups are cutting selling prices at a faster clip. Table 2Industry Group Pricing Power Defensive sectors such as consumer staples, health care and utilities remain well represented in the positive category, while a reacceleration in consumer discretionary and financials sector selling price increases has boosted interest rate-sensitive sector pricing power (Chart 2). This would suggest that profit advantages continue to reside in these areas, rather than in cyclical sectors. That is confirmed by the uptrend in developed vs. developing market PMIs. This manufacturing gap would presumably widen further if the U.S. ever imposes import taxes. The latter would weaken developing country exports, thereby forcing currency devaluation and hurting capital inflows. Regardless, the PMI divergence reinforces that, in aggregate, cyclical sectors are not as fundamentally well supported as other sectors, and that a highly targeted and selective approach is still the right strategy (the PMI ratio is shown advanced, Chart 3). Even external factors warn against chasing lingering cyclical sector strength. Using the options market, the SKEW index provides a good read on perceived tail risk for the S&P 500. A rise toward 150 indicates significant worries about potential outlier returns. The SKEW has soared in recent weeks, which is often a harbinger of increased equity volatility and defensive vs. cyclical sector strength (Chart 4). Chart 2... But Is Not Broad-Based Chart 3Global PMIs Are Signaling Defense First... Chart 4... As Are Market-Based Indicators In sum, the broad market has a powerful head of steam and it could be dangerous to stand in its way, but the rally continues to exhibit signs of a late stage blow-off, vulnerable to sudden and sharp corrections. Maintain a healthy dose of non-cyclical exposure to protect against building and potentially sudden downside overall market risks, while being careful in terms of cyclical industry coverage. This week, we are taking advantage of exuberance in the rail space, and reversing our call on the telecom services sector in response to broad-based erosion in profit indicators. Rails Are Now Priced For Perfection For such a mundane and staid industry, railroad stocks have garnered considerable attention of late. Most recently, rumors that railroad maven Hunter Harrison will be installed at CSX to engineer yet another corporate turnaround have spurred a massive buying frenzy. We upgraded the S&P railroads index to overweight on August 1, 2016. Our analysis suggested that analysts and investors had made a full bearish capitulation, slashing long-term growth estimates to deeply negative territory and pushing valuations decisively into the undervalued zone. That pessimism overlooked efforts to cut costs and stabilize profit margins in the face of waning freight growth, setting the stage for a re-rating. While that thesis has worked out, we are concerned that the needle has now swung too far in the other direction, much like what occurred in the air freight industry. The latter had a steep run up only to disappoint newly buoyant expectations. We took air freight profits in late-November, as the soaring U.S. dollar was an anti-reflationary threat to the anticipated recovery in global trade that both investors and the industry had positioned for. Indeed, industry hiring has expanded rapidly (Chart 5). However, hours worked are contracting (Chart 5). Ergo, the hoped for increase global revenue ton miles has not materialized to the extent that was expected (Chart 5). Over-employment is a productivity and profit margin drag, and we were fortunate to take profits before the payback period. We can envision a similar scenario for railroads. There has no doubt been an improvement in freight activity, and there is more in the pipeline. The question is one of degree. Total rail shipment growth has climbed back into positive territory, and our rail shipment diffusion index, which measures the number of freight categories experiencing rising vs. falling growth, is near the 80% level (Chart 6). The key consumer-driven intermodal segment, which accounts for over half of total freight volumes, has finally begun to recover. Rising personal incomes should underpin credit availability and demand, and therefore, spending. The increase in business sales-to-inventories and growth in Los Angeles port traffic also augur well for intermodal shipments (Chart 6). One caveat is that autos represent a large portion of this segment, and pent-up demand has been fully realized at the same time that auto credit quality is beginning to crack. That could keep a lid on the magnitude of the intermodal shipment recovery. Coal volumes have also shown signs of life after a brutal contraction. Coal is a high margin product and another large freight category, and any sustained recovery would provide a meaningful profit boost. Rising natural gas prices typically bode well for coal volumes (Chart 7), via increasing the cost of competing fuels to burn for power generation. However, it is premature to celebrate, because the abnormally warm North American winter may mean that the rebound in electricity production is passed its peak. That would slow the burn rate and keep coal (and natural gas) supplies higher than otherwise would be the case. Chart 5Stay Grounded Chart 6Broad-Based Freight Recovery Chart 7Coal Is Critical History shows that pricing power and coal shipment growth are tightly linked. Selling prices have firmed in recent months, but are not at a level that heralds meaningful improvement in return on equity (Chart 8, third panel). True, rising oil prices typically lead to rail companies reinstituting fuel surcharges. But that is profit margin protective, not expansionary, as true pricing power gains come on the back of increased demand and the creation of bottlenecks. It is not clear that such a point has been reached. The Cass Freight Expenditures Index has been flat for several months, signaling that companies do not intend to raise transportation outlays. This series correlates positively with relative forward earnings estimates (Chart 8). That will make it difficult for rail freight to grow faster than GDP (Chart 9), a necessary development to drive earnings outperformance. Meanwhile, productivity gains may be slow to accrue if freight only grows modestly. Weekly train speeds have been stuck in neutral (Chart 8), and the industry may be in the early stages of a capital spending reacceleration. Rail employment growth has jumped in recent months, which is often a leading indicator of investment (Chart 9). If capital spending begins to take a larger share of sales in the coming quarters, then recent investor excitement may ease, leading to a prolonged consolidation phase. After all, valuations are stretched. Over the past two decades, whenever the relative forward P/E has crossed above a 10% premium, relative forward 12-month returns have averaged -4%, and been negative in 4 out of 5 cases. Overheated technical momentum also warns against extrapolating the latest price gains (Chart 10). Chart 8Earnings Will Only Improve Slowly... Chart 9... If Capital Spending Re-Accelerated Chart 10A Profit Recovery Is Discounted Bottom Line: Take profits of 22% and downgrade the S&P rails index (BLBG: S5RAIL - UNP, CSX, NSCX, KSU) to neutral, as the index appears to be setting up for a 'buy the rumor, sell the news' scenario. Stay neutral on the S&P air freight index (BLBG: S5AIRF - UPS, FDX, CHRW, EXPD). Telecom Services: Can You Hear Me Now? The niche S&P telecom services sector (comprising 3% of the S&P 500) has served our portfolio well, up 6% since inception. However, operating conditions have downshifted and we recommend lightening up a notch and reducing weightings to underweight. There are five factors driving this downgrade: the relative spending profile, sales outlook, margins pressure, interest rates and capital spending trends. First, telecom services personal consumption expenditures (PCE) have sunk anew after a brief attempt to stabilize last year. While consumer spending on telecom services has increasingly become a discretionary item, the improvement in consumer finances and vibrant labor market appear to be generating even more outlays on non-telecom goods and services (top panel, Chart 11). Second, this spending backdrop has undermined the sector sales outlook. Top line growth has retreated to nil, and BCA's telecom services sales-per-share model is signaling that a contraction phase looms (middle panel, Chart 11). Worrisomely, the latest producer price index release revealed that industry pricing power has taken a turn for the worse, which will sustain downward pressure on revenue growth. Third, profit margins are under stress. Selling prices are deflating at a time when the wage bill is still expanding at a mid-single digit rate. The implication is that margins, and thus earnings, are unlikely to improve much in the coming quarters (Chart 12). Chart 11Sales Prospects Have Dimmed Chart 12Ditto For Profit Fourth, telecom services is a high yielding sector and the recent sell-off in 10-year Treasurys (UST) is an unwelcome development. When competing investments rise in yield, the allure of telecom carriers diminishes, and vice versa. Chart 13 shows that relative performance momentum and the change in UST yields are inversely correlated, underscoring that as long as the bond market selloff persists relative share price pressures will remain intact. Finally, industry capital expenditures are reaccelerating, which is a short-term negative for profitability. This message is corroborated by the government's construction spending release, which shows a pickup in telecom facilities construction (bottom panel, Chart 13). Taken together with the deteriorating sales backdrop, higher capital spending would be negative for profit margins. While we would normally be reluctant to move an attractively valued sector all the way to underweight (Chart 14), the marked deterioration in these five drivers of relative profitability warrants such an extreme move, regardless of our reticence about the sustainability of the broad market's recent gains. Chart 13Higher Bond Yields Aren't Helping Chart 14Technical Breakdown Our Technical Indicator has crossed decisively into the sell zone, and the share price ratio has failed to break back above its 40-week moving average, providing technical confirmation of a breakdown (Chart 14). Bottom Line: Lock in profits of 6% in the S&P telecom services sector since the Nov 9th, 2015 inception and downgrade exposure all the way to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Highlights Portfolio Strategy Media stocks are poised to challenge previous relative performance highs as sales growth reaccelerates. Stay overweight. The materials sector has lagged behind the commodity price rally, a sign of underlying weakness rather than latent strength. Chemicals overcapacity will remain a headwind until U.S. competitiveness improves. Stay clear. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature The broad market has been very strong since the November election. While advance/decline lines have firmed, participation in the rally has been uneven and may be fraying around the edges. For example, the number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth (Chart 1). In fact, the industrials (I) and financials (F) sectors have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The 'IF' rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the IF rally will become iffy indeed, unless sector breadth improves. Last week we showed that market cap-to-GDP was so far above its long-term average that even if nominal growth boomed at 8% per annum for the next five years this valuation ratio would still not have normalized. That valuation backdrop may not upend additional short-term market momentum, but it is a true measure of just how bullish sentiment has become and should be a critical input to the portfolio construction process, because of its warning about divergences from fundamental supports. Another unconventional sentiment gauge is observed from sub-surface market patterns. Chart 1 shows that the number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunged to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks (Chart 1). The steep drop in the put/call ratio confirms that euphoria and greed are trumping mistrust and fear. The put/call ratio has recently bounced, but is well below levels that signal investors are accumulating significant portfolio protection. The Fed's tightening bias, contracting U.S. dollar-based financial liquidity amid the strong U.S. dollar all threaten to keep a lid on corporate sector sales prospects. As such, we remain biased toward non-cyclical and consumer sectors, even excluding fiscal policy uncertainty. Chart 2 shows that these areas are in a base-building phase, in relative terms, following their post-election drubbing. We expect momentum to steadily build toward sustained outperformance by midyear. Conversely, a reversal in the 'IF' sectors already appears to be developing, while other capital spending-dependent sectors are unable to gain momentum (Chart 3). This week we highlight both a winning group and an area we expect to disappoint. Chart 1The Rally Is Fraying Around The Edges Chart 2Defensive Base-Building? Chart 3Cyclical Sector Distribution New Highs Ahead For Media While the consumer discretionary sector has a poor track record during Fed tightening cycles, the S&P media sub-component can buck this trend. Media stocks outperformed in the second half of the 1990s and also trended higher in the 1980s while the Fed was tightening. The key was the U.S. dollar (Chart 4). As long as the dollar was strong, media companies sustained a profit advantage over the rest of the corporate sector owing to limited external exposure. A replay is currently playing out, and has the potential to persist for at least the next few quarters based on upbeat cyclical indicators. Media sales growth is in recovery mode. Consumers have significantly boosted spending on media services, as measured by personal consumption expenditures data (Chart 5). Pricing power has surged in response to demand strength (Chart 5, bottom panel). In turn, strong demand is boosting measures of productivity: our proxy for sales/employment is accelerating toward the double-digit growth zone (Chart 5). Productivity is diverging positively from relative forward earnings expectations, implying there is room for a re-rating. As long as the U.S. economy is growing, media companies should be able to garner an increasing share of consumer wallets. Chart 6 shows that real spending on media services has been in a steady uptrend for well over a decade, reflecting its ability to continually innovate, only pausing during recessions when consumers are forced to retrench. Typically, a rise in spending pulls up pricing power (Chart 6). Chart 4Media Stocks Like Dollar Strength Chart 5Sales Are Set To Accelerate Chart 6Secular Strength All of this has spurred a recovery in media cash flow growth (Chart 7, top panel). Relative performance and cash flow move hand-in-hand. Rising cash flows also imply that the media sector can further reduce shares outstanding through buybacks and/or M&A activity (Chart 7), bolstering ROE. The S&P movies & entertainment index has been one of the driving forces behind the broader media index recovery. We upgraded the former to overweight after the vicious selloff related to Disney's ESPN woes and the takeover saga at Viacom had pushed the index to an undervalued extreme. While slightly early, this upgrade is now paying off (Chart 8). The expectations hurdle remains surmountable. Both forward earnings and sales growth estimates are deeply negative (Chart 8), reflecting the well-known cooling in cable subscriber growth. But even here, there is room for potential upside surprises. Consumer spending on recreation has been growing at a low single-digit clip, but the surge in consumer confidence, courtesy of rising wage growth and a positive wealth effect from rising real estate and financial asset prices, should support increased discretionary consumer spending. The message from the jump in the ISM services index is bullish for recreation spending (Chart 9, second panel). Chart 7Shareholder-Friendly Chart 8Cheap With Low Expectations Chart 9Still Early In The Recovery In turn, faster spending would support ongoing pricing power gains (Chart 9). The industry is already sporting one of the most robust selling price increases of all that we track, as advertising rate inflation is growing anew. Importantly, real outlays on cable services have recovered after a steep decline (Chart 9), suggesting that the drag from disappointing cable subscriber growth and cord cutting may be easing. Less churn implies more pricing power. Content cost inflation also remains under wraps. The implication is that the fundamental forces to propel a retest of previous relative performance highs are in place. Technical conditions are also sending a bullish signal. Cyclical momentum, as measured by the 52-week rate of change, is on the cusp of breaking into positive territory (Chart 9), while the share price ratio has already crossed decisively above key resistance at its 40-week moving average. A dual breakout would confirm a new bull trend. Bottom Line: Media stocks have good odds of retesting previous relative performance highs as discretionary consumer spending perks up. Stay overweight the overall media group, and the S&P movies and entertainment index in particular. Chemical Stocks: A Toxic Portfolio Blend The commodity price recovery has not carried over into the S&P materials sector, as relative performance has been moving laterally for much of the last twelve months. Rather than view this as an opportunity to play catch up, the more likely outcome is that the sector has missed its chance to outperform. In fact, downside risks have intensified. The strong U.S. dollar will exact a toll on U.S. exporters, particularly if emerging markets and China do not experience accelerating final demand. While there has been a massive amount of stimulus in China over the past 18 months, the thrust of that impulse is fading. Fiscal spending growth has dropped sharply and the authorities trying to cool rampant real estate speculation. The yield curve remains flat (Chart 10), as local funding costs rise on the back of the authorities attempt to mitigate capital outflows, and loan demand remains weak. Persistent weakness in the Chinese currency may reflect a lack of confidence in local returns, i.e. sub-par growth. All of that argues against expecting a major impetus to raw materials demand, at a time when the materials sector total wage bill is inflating more aggressively. Our Cyclical Macro Indicator for the materials sector is hitting new lows (Chart 10), heralding earnings underperformance, underscoring that below-benchmark allocations remain appropriate. The S&P chemicals group represents for than 70% of the overall materials market cap. It has underperformed since its peak and our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity (Chart 11). Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push (global real yields are shown inverted, second panel, Chart 11) that revives chemical final demand. Analysts have latched on to the firming in global purchasing manager survey sentiment, aggressively pushing up sales growth expectations in recent months (Chart 12). Clearly, manufacturing sector expansion is expected to reverse the contraction in chemical output growth (Chart 12). Chart 10Higher PMIs Are Not Enough Chart 11Higher Yields Are A Bad Omen Chart 12Expectations Are Inflated However, this may be yet another case of analysts chronically overestimating the industry's earnings power. Global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. Chart 13 shows that chemicals relative performance is heavily influenced by the U.S. dollar. Valuations and sentiment are tightly linked with chemical export growth (Chart 13), as the latter represent 14% of total U.S. exports. The U.S. dollar surge is diverting orders away from U.S. manufacturers: German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future (Chart 14). Chart 13The Dollar Is Hurting The U.S. ... Chart 14... But Helping Foreign Competitors U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. The industry is in the crosshairs of anti-globalization and protectionism, and a strong U.S. dollar and rising domestic cost structures threaten to reduce competitiveness. Chemical imports are a fairly large portion of sales, rendering profitability vulnerable should an import-tax ever be introduced. From a cyclical standpoint, deflationary pressures are already very acute. Chemical capacity is growing much faster than production, warning that pricing power will be under significant pressure (Chart 15). Many chemical products are destined for interest rate-sensitive end markets such as autos, underscoring that a Fed tightening cycle is a headwind. While capacity expansion was planned when interest rates and feedstock costs were expected to remain at rock bottom levels for the foreseeable future, this is no longer the case. Chemical companies can either use natural gas (ethane) or oil (naphtha) as a primary feedstock. U.S. production is largely ethane-based, while global capacity is geared to naphtha. Rising U.S. natural gas prices are undermining the U.S. input cost advantage (Chart 16). Chart 15Persistent Deflation Pressures Chart 16U.S. Cost Structures Are Unattractive Increased capacity has also put significant upward pressure on wage costs, as our proxy for the total wage bill is rising at a high single-digit rate (Chart 16). With capital spending slated to stay robust in the coming years, it will likely continue to take a larger share of sales, impairing profit margins. While the planned merger between heavyweights Dow Chemical and Dupont may eventually help to rationalize costs, this is a necessary but not sufficient step in the face of a loss of global market share. Without accelerating sales, U.S. chemical makers will be hard pressed to improve productivity sufficiently to reverse the slide in relative forward earnings estimates. Bottom Line: The S&P materials sector hasn't been able to outperform during a period of improving global manufacturing activity, raising doubts about its performance potential when global output growth inevitably slows. Part of this reflects the challenging outlook for the sector heavyweight chemicals index, and we recommend staying underweight both. The symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Highlights BCA's U.S. Equity Strategy team would like to wish our clients a healthy, happy and prosperous New Year. Portfolio Strategy The growth vs. value style bias is due for a bounce, but beyond the near run, the outlook has become more balanced. Stick with a small vs. large cap bias for the time being, but get ready to book profits if domestic wage inflation continues to accelerate. Buy into the health care facilities sell-off. Value is surfacing as profit margin pressures subside. Recent Changes S&P 1500 Health Care Facilities - Boost to overweight today. Downgrade Alert Growth vs. Value - Downgrade alert. Table 1Sector Performance Returns (%) Feature Stocks look poised to maintain their momentum-fueled march higher into yearend, seemingly impervious to potential profit backlash from tightening monetary conditions, a more hawkish Fed and/or overheating sentiment. Sellers are holding back in anticipation of lower tax rates next year. In fact, our Composite Sentiment Gauge has surged to extremely bullish levels (Chart 1). This gauge comprises surveys of traders, individuals and investment professional sentiment. Overtly bullish readings have been a reliable contrary indication of building tactical risks, although not foolproof. The broad market has returned nearly 80%, excluding dividends, since the beginning of 2012, and over 5% since election night in November. Lately, earnings expectations have increased their contribution to the market's return, but the vast majority of the gains over the last five years can be explained by multiple expansion. Soaring median industry price/sales ratios are consistent with lopsidedly optimistic sentiment (Chart 1). Now that the Fed has signaled its intention to steadily raise interest rates in 2017, a critical question is whether profits can take over the reins from liquidity as the main market driver, at least partially validating the valuation increase? On this front, our confidence level is low. Profit margins are steadily narrowing. Our profit margin proxy is not signaling any imminent relief (Chart 2). With labor costs rising, faster sales are needed to halt the squeeze. But U.S. dollar appreciation is a significant headwind to top-line performance, given that 45% of sales come from abroad. As hedges fall off, the impact on 2017 revenue will become increasingly meaningful. Corporate debt levels are disturbingly high, in absolute terms and as a share of GDP (Chart 2, bottom panel). If borrowing costs continue to climb, then it will be hard for companies to turn expansionist, potentially offsetting any benefit from a reduced tax rate. Against this backdrop, it is difficult to envision a robust rebound in corporate profits. Our confidence level would be higher if monetary conditions were still reflationary. Instead, our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has plummeted at its fastest rate ever (Chart 3)! The speed and ferociousness of the plunge underscores the economic need for a massive and imminent fiscal offset. Chart 1Sentiment Is Overheating Chart 2Stiff Headwinds For The Corporate Sector Chart 3Reflation Is Dead The RG leads both equity sentiment and the U.S. Economic Surprise Index (ESI, Chart 3). If economic activity begins to disappoint in the coming months, i.e. before any meaningful fiscal stimulus arrives, there is a window of risk for the equity market because valuations will narrow as optimism fades, especially in those sectors that have gone vertical since the U.S. election. Keep in mind, last week we showed that typical Fed tightening cycles augur well for non-cyclical sector relative performance on a 12 and 24 month horizon. Surprisingly, financials and utilities have also managed to at least keep pace with the broad market, with cyclical sectors lagging behind overall market returns. The bottom line is that a number of objective indicators are signaling that the post-election rally will hit turbulence, perhaps in the first quarter of the New Year. Investors would be well served from a cyclical perspective to take advantage of value creation in defensive sectors while reaping any windfalls received in deep cyclical sectors. Will Growth Vs. Value Recover? The sudden surge in the financials and industrials sector has caused a sharp correction in the growth vs. value (G/V) share price ratio. The scope of the move has been both powerful and unnerving, catching many off guard, including us. Is this the start of a value renaissance after nearly eight years of growth stock dominance? History shows that sustained rotations into the value complex require validation from strengthening global economic growth. We have shown in previous research that G/V share price momentum is negatively correlated with the growth in durable goods orders, house prices and profits, i.e. when these variables accelerate, growth underperforms value. By virtue of the improvement in our global PMI composite (Chart 4), it would be easy to conclude that value stocks are coming back in vogue. Financials, energy and industrials account for over 50% of the value composite. These sectors only comprise roughly 15% of the growth benchmark. In addition, the technology sector weighs in at one third of the growth index, while representing only 8% of the value cohort. In addition, consumer discretionary and health care also represent about the same weight as technology in the growth composite, but only contribute about half that in the value index. It is no wonder that rising bond yields and hopes for a fiscal stimulus bonanza have triggered such a violent G/V reaction. While we are sympathetic to this view, extrapolating the last six weeks to continue over the next six months is dangerous. Much of the Treasury yield advance has been driven by inflation expectations. Global real yields are up, but not by as much as share prices have discounted (Chart 5). That is not surprising, as the soaring U.S. dollar is a deflationary force, and heralds a sharp rebound in the G/V ratio (Chart 5, top panel). Chart 4A Vicious Correction... Chart 5... That May Soon Reverse U.S. currency strength will make it difficult for developing economies to service large foreign debt obligations and could drain domestic liquidity if they are forced to sell foreign exchange reserves to defend their currencies. It is notable that EM capital spending is virtually nil in real terms, and their share prices are underperforming the global benchmark by a wide margin (Chart 5). Our Global Economic Diffusion Index has crested (Chart 5, shown inverted), perhaps picking up emerging market sluggishness. Unless the U.S. dollar begins to weaken, it is premature to forecast robust economic growth in the coming quarters, thereby raising some skepticism about the durability of the value stock rebound. The objective message from our Cyclical Macro Indicators for the growth vs. value style is slowly shifting from bullish to neutral, and the pricing power advantage no longer exists (Chart 6). However, the latter is an unwinding of the rate of change shock in the commodity complex rather than renewed demand-driven pricing power gains in the deep cyclical space. From a longer-term perspective, growth stocks should stay well supported by the increase in long-term earnings growth expectations (Chart 7). When the latter are rising, growth stocks tend to enjoy multiple expansion relative to value shares. Moreover, if equity volatility perks up on uncertainty over the path and pace of future fiscal policy and a more hawkish Fed, then growth stocks should receive another source of natural support. The VIX and G/V indices tend to correlate positively over time (Chart 7). Chart 6Mixed Signals Chart 7Structural Supports In sum, choosing value over growth is not a slam dunk, nor is forecasting a recovery to new highs in the G/V ratio given the large sector weightings discrepancies. Rather, a reflex rally in the G/V ratio is probable as post-election financials/industrials sector enthusiasm wanes, with a lateral move thereafter. Bottom Line: We will likely recommend moving to a neutral style bias over the coming weeks/months from our current growth vs. value stance, but expect to do so from a position of strength. A Revival In Small Business Animal Spirits? A broad-based and powerful rotation into small caps has occurred, as all the major small cap sectors have surged relative to their large cap counterparts (Chart 8), flattering our current stance. Small caps fit nicely into one of our overriding longer-term themes, namely favoring domestic over global industries. Small companies are typically domestically-geared regardless of geography, underscoring that if anti-globalization trends pick up steam, this theme could gain traction around the world. The potential for U.S. corporate tax cuts has provided another source of domestic company enthusiasm, because multinationals already have low effective tax rates. However, these developments are not assured, details remain scant, and chasing small cap relative performance on that basis alone could be a mistake from a tactical perspective. We have noted that we would recommend profit taking if evidence of a reversal in the small vs. large cap profit outlook materialized. Recent labor market and pricing power data are slightly worrying. The NFIB survey of the small business sector showed that planned labor compensation is still diverging markedly from the overall employment cost index (Chart 9, second panel). While reported price changes have also nudged higher, the discrepancy in labor cost gauges may be signaling that the massive profit margin gap between small and large companies will not be quick to close (Chart 9, bottom panel). Still, the overall NFIB survey was strong, and suggests that animal spirits in the small business sector may finally be reawakening (Chart 10, second panel). The latter may reflect an easing in worries about government red tape, excessive bureaucracy and health care costs. Chart 8Broad-based Small Cap Outperformance Chart 9Yellow Flag For Margins Chart 10Overbought, But Not Overvalued These sentiment shifts may allow extremely overbought technical conditions for the relative share price ratio to persist for a while longer (Chart 10, middle panel), particularly if the Trump honeymoon phase for the overall market lasts until early in the New Year. Importantly, there is no meaningful valuation roadblock at the moment (Chart 10). From a longer-term perspective, however, it is notable that the share price ratio is trading well above one standard deviation from its mean. Such a stretched technical level warns against getting too comfortable with small caps. In fact, the share price ratio is tracing out a pattern similar to the early-1980s (Chart 11), when it enjoyed a brief run to new highs in 1983 on the back of similar aspirations of meaningful fiscal thrust and as the U.S. dollar sprang higher. However, that surge was short-lived and in hindsight, was a blow-off top that marked the beginning of a massive underperformance phase. Chart 11The Big Picture Bottom Line: Stick with a small/large cap bias for now, but get ready to take profits if the relative profit margin outlook does not soon improve. Buy Into Health Care Facilities Weakness Rapid sub-surface market gyrations are creating attractive value in a number of areas, particularly in the defensive health care sector. In particular, we downshifted our view on the S&P health care facilities index at mid-year, because consumer spending on health care was decelerating, which favored moving into equities that paid for medical services (managed care) vs. those that provided them. While that trend remains intact, health care facilities stocks appear to be discounting an extreme scenario. The current concern is that the Affordable Care Act (ACA) will be repealed, leaving hospitals to foot the bill for uninsured patients. While such a scenario would potentially reverse the decline in the provision for doubtful accounts (PDA, Chart 12), a major profit margin support, the ACA is more likely to be reworked than repealed especially in the absence of a replacement plan. Importantly, there are other offsets. PDA follows the unemployment rate, which is signaling that the former will decline further. Hospital cost inflation is beginning to recede, led by drug costs (Chart 12). Physician services costs and inflation in other medical supplies is also subsiding. Health care facilities have also reduced capital spending in a bid to protect profit margins. Construction data show that hospitals have eased back on the throttle significantly (Chart 13). A shift to a profit margin preservation mentality is confirmed by the sharp reduction in headcount growth and decline in total wage inflation (Chart 13). Labor cost control provides another positive profit margin support, over and above the fillip from the reacceleration in hospital pricing power (Chart 13). Consumers are allocating an increasing portion of their spending to hospitals, which provides confidence that pricing power gains will stick. It would take massive earnings downgrades to validate the pessimism embedded in current valuations (Chart 14). Technical conditions argue that the sell-off is overshooting. The share price ratio has made new lows, but cyclical momentum is diverging positively. Given that this group is traditionally a strong U.S. dollar winner (Chart 14, top panel), there is scope for a playable relative performance rally in the coming six months. Chart 12Hospital Costs Are Easing... Chart 13... While Sales Improve Chart 14Dirt Cheap Bottom Line: Augment the S&P 1500 health care facilities index (BLBG: S15HCFA - HCA, UHS, WOOF, HLS, LPNT, SEM, SCAI, THC, ENSG, USPH, KND, CYH, QHC) to overweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Highlights Portfolio Strategy The rise in Treasury yields is approaching a threshold that has often caused equity market indigestion. Stay focused on current monetary conditions rather than fiscal unknowns. The bear market in lodging stocks has played itself out: take profits on an underweight position. The sell-off in home improvement retail shares is overdone, and a contrarian long position should pay off despite the backup in mortgage rates. Recent Changes S&P Hotels Index - Take profits of 3% and raise to neutral. Table 1Sector Performance Returns (%) Feature Momentum may carry the market higher in the short run, but from current valuation levels, stocks, the dollar and bond yields can only climb sustainably in tandem if a non-inflationary economic boom is taking hold. In that sense, equities appear to be taking their cue solely from the anticipated U.S. political shift while ignoring the tightening in monetary conditions and hints of emerging market financial strains. The equity market outlook hinges on a judgement call as to whether the action in the currency and Treasury yields is reflective or restrictive? There are no easy answers, but below we discuss some of the variables that influence this decision. Chart 1 shows that the 10-year Treasury yield has climbed above fair value. Equity bulls may rejoice because yields have sauntered much deeper into undervalued territory before stocks have run into trouble. The big difference this time is that the greenback is also climbing. Parallel powerful rises in both the currency and yields are rare, and typically culminate in steep market pullbacks. Importantly, most of the recent yield rise reflects an increase in inflation expectations. The real component, i.e. economic growth expectations, has been far more muted (Chart 2). Chart 1Stocks, Yields, And The Dollar##br## Can't Climb Together For Long Chart 2Inflation Expectations ##br##Are Driving Up Yields Equities shrugged off the surge in yields during the 2013 taper tantrum. However, yields never rose above fair value then, and the increase was almost entirely due to the real component rather than a rise in inflation expectations, i.e. it was more reflective than restrictive (Chart 2). Meanwhile, equities had just been through a difficult stretch in 2012 on fears the euro was going to break apart, and sovereign yields in the periphery were in the early stages of a long descent (Chart 3). In other words, there was a structural tailwind for equities. In addition, the U.S. dollar was range-bound during that period, overall profit growth was strong, business lending was picking up and corporate bond spreads stayed tight (Chart 3). The outlook today is much different. Euro area periphery yields are up sharply, EM bond spreads are flaring out, profit growth is much weaker and the U.S. is importing deflation through U.S. dollar strength (Chart 3), particularly against China and other developing market currencies. Thus, we are uncomfortable making comparisons between today and 2013 broad market resilience. The speed of upward adjustment in Treasury yields also influences equity prices. At the moment, yields are rising faster than profit growth. The overall market has typically become more volatile and often corrects when the growth in yields outpaces profit growth (Chart 4). Chart 3The 2013 Taper Tantrum##br## Is Not A Good Guide Chart 4Too Far,##br## Too Fast? The most painful equity corrections have occurred when this gauge drops below -10%, as the latter suggests that inflation expectations are increasing rapidly, warning of valuation and monetary tightening ahead. This threshold is in danger of being breached on any further rise in yields. However, if the currency continues climbing, yields are unlikely to rise much further, if at all, underscoring that the next big tactical sub-surface market move may be a recovery in yield-dependent sectors as investors begin to fret about the deflationary and profit-sapping impact of a strong dollar. Against this backdrop, we caution against getting too comfortable extrapolating market momentum, because recent gains could be erased just as quickly as they accrued if monetary conditions keep tightening. On a sub-surface basis, value is being created in interest rate-sensitive sectors and destroyed in cyclical sectors, primarily industrials, as discussed last week. Meanwhile, we maintain a domestic vs. global focus, and recommend buying into the pullback in housing stocks. Buy Home Improvement Retailers Like many other interest rate-sensitive groups, home improvement retailers (HIR) have lagged recently, fueled by the surge in bond yields, and hence, mortgage rates. We doubt this is sustainable. U.S. currency strength will refocus attention on the lack of top-line growth in global-oriented industries, which will reverse recent countertrend intra-sector capital flows, and ensure that bond yields are capped. The housing market slowed this year by most metrics (housing starts, permits, sales growth), which undermined remodeling activity. In response, building supply store sales cooled (Chart 5, bottom panel). Recent earnings reports from housing-geared industries such as appliances and furniture vendors have also disappointed. Analysts have been quick to slash both sales and earnings growth estimates (Chart 5). However, as often happens, an overreaction appears to be occurring. There is little indication of a return to punitively deflationary industry conditions. In fact, the producer price index for appliance and furniture makers has shot up in recent months, heralding stronger HIR pricing power (Chart 6, second panel). Lumber prices are also up sharply, despite U.S. dollar strength, which will boost the top-line and profit margins (Chart 6). At a fixed spread over lumber prices, the higher the latter go, the more profit earned at a constant volume sold. We continue to be encouraged by the long-term outlook. Household formation is accelerating now that the unemployment rate is below 5%. Building permits are below average levels, even excluding the housing bubble period (Chart 7). Chart 5Housing Slowdown Already Reflected Chart 6No Sign Of Deflationary Stress Chart 7Still Early In The Mortgage Cycle Consumers have only recently become comfortable taking on mortgage debt, and first time buyers represent a rising share of total home sales. Banks are ready and willing to extend mortgage credit (Chart 7, bottom panel), unlike most other credit. Ergo, housing activity still has legs. While the backup in Treasury yields will no doubt make housing somewhat less affordable, Chart 8 shows that even a 100 basis point rise would not push affordability back to average levels. Mortgage payments would still be well below the long-term average as a share of income, and effective mortgage rates are still extremely low. Therefore, we would not be surprised to see stable housing metrics in the coming months, despite the yield back up. Existing house prices are flirting with new highs (Chart 7), despite the early stage of mortgage re-leveraging, which bodes well for future house price increases. If homeowners are confident that house prices will stay solid, they will be more inclined to make home improvement investments. These factors are represented in our HIR model. The model is climbing steadily, exhibiting a rare positive divergence from relative share prices (Chart 9). Our inclination is to side with the objective message from the model. The valuation case for the group has improved markedly. The forward P/E is well below the average of the last decade and the dividend yield is now on a par with that of the broad market. Typically, a positive yield differential has been a bullish relative performance signal (Chart 10). Chart 8Higher Yields Are Not A Game Changer Chart 9Our Model Remains Firm Chart 10Discounting A Weak Housing Market Most importantly, the industry continues to generate sky-high return on equity, and free cash flow is booming. The implication is that shareholder-friendly stock buybacks and dividend increases should continue apace, especially compared with the overall corporate sector. At current valuation levels, there is room for a playable recovery in relative performance, especially if Treasury yields level off on the back of relentless U.S. dollar strength. Bottom Line: Home improvement retail (BLBG: S5HOMI - HD, LOW) stock price weakness is a buying opportunity. We recommend an above-benchmark allocation. End Of The Bear Market In Hotel Stocks The S&P hotels index has been in a relative performance bear market since late last year when we reduced it to underweight, but downside risks have diminished even though a number of players have lowered 2017 guidance and revenue per room (REVPAR) expectations. Relative value has been created by the past year of underperformance. A variety of valuation metrics show that the price ratio is plumbing recessionary-type levels (Chart 11). Most notably, the relative price/sales ratio is almost on a par with the lows during the Great Recession, when a steep contraction was anticipated for the foreseeable future. Such a dire forecast is not in the cards, even if economic growth disappoints an increasingly optimistic consensus. The plunge in net earnings revisions has not been confirmed by a downturn in hours worked. Typically, these two series move hand-in-hand (Chart 12). Instead, hours worked continue to trend higher suggesting that reduced profit guidance is bringing analyst expectations to more attainable levels rather than signaling impending doom. After all, persistent hotel construction growth means that demand needs to run hot in order to keep deflationary pressures at bay. This has been a tall order in the past year, as tight business budgets and lackluster discretionary consumer spending have kept REVPAR under wraps (Chart 13). Occupancy rates remain below previous expansionary run rates, leaving revenue per room more exposed than normal to demand soft spots. Chart 11End Of Bear Market Chart 12An Undershoot In Estimates Chart 13Slow, But Steady, Growth REVPAR could be supported by decent consumer spending. Wage growth, and thus aggregate income, are perking up, job security has risen and income expectations are on the upswing. Consumers are behaving as if income gains will be permanent, given the increase in consumer loan demand. Low fuel prices and the surge in vehicle miles driven are consistent with solid lodging outlays. The latter have recently reaccelerated, and are supporting better than market hotel pricing power (Chart 13). Importantly, hotel profit margins are no longer under extreme duress. Decent pricing power gains and an easing in the industry's total wage bill inflation have combined to support an increase in our profit margin proxy (Chart 14). All of this implies that profit conditions are stabilizing, just as valuations have been squeezed, warranting an upgrade to neutral. Why not a full shift to overweight? There are a number of factors to consider. The lodging industry is battling secular crosscurrents. On the positive side, the lodging industry has consistently managed to increase its share of total consumer spending, in real terms (Chart 15), with periodic underperformance phases, typically during recessions. This likely reflects well-timed capacity investments and strong brands. As a result, hotel pricing power has also been in a structural uptrend (Chart 15). This cycle, pricing power has lagged, consistent with subdued REVPAR gains, but hotels have still managed to aggressively grow earnings per share. While buybacks have undoubtedly played a role in this advance, EPS is following a typical pattern. In the last four decades, hotels have suffered four major recession-related earnings contractions. After each contraction, profits ultimately surpassed their previous peak by more than 75%, on average. The duration of the upcycle averaged five years. This cycle the recovery has already lasted more than six years, but hotel profits have only increased 30% from the 2007 peak. That implies substantial profit upside ahead just to reach the average, albeit pricing power will need to kick in as it has in past cycles. On the downside, consumers are still showing a penchant for spending more on essentials compared with non-essentials. The ratio of retail sales at cyclical stores to non-discretionary stores has been highly correlated with relative performance (Chart 16, top panel). Chart 14The Margin Squeeze Is Over Chart 15Structural Tailwinds... Chart 16... And Headwinds That raises some question about the latest burst of strength in lodging outlays, especially in view of the pruning in business travel budgets, as confirmed by anecdotes from recent earnings reports. BCA's capital spending model is not forecasting any improvement (Chart 16, bottom panel). Lingering in the background has been the relentless increase in lodging construction. Capacity growth represents a long-term threat to pricing power (Chart 16), over and above the threat from new entrants such as AirBnB. Expansion explains why real hotel consumer prices have not come close to hitting new highs even though real hotel spending has. Hotel capacity expansion heralds intensifying deflationary pressure. Meanwhile, hotels have sizeable global operations, exposing profitability to risks of incremental U.S. dollar strength. Consequently, we would prefer to await signs of an impending improvement in capital spending, and thus, business travel, and/or a sharp downturn in hotel construction spending, before lifting positions all the way to overweight. Bottom Line: Lift the S&P hotels index (BLBG: S5HOTL - MAR, CCL, RCL, WYN) to neutral, locking in an 3% relative performance profit since our initial underweight call nearly a year ago. A further upgrade is tempting, but awaits relief from pricing power constraints. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.