Sectors

The mini-consolidation in equities reflects the ongoing tension between market-supportive liquidity and a sketchy corporate profit backdrop.

Our Treasury yield fair value model suggests that the 10-year Treasury yield has an additional +19bps of upside. Stay at below benchmark duration.

When earnings growth negatively diverges from GDP growth, the gap rarely closes <i>via</i> a rebound in profit growth. The most notable feature of prior episodes is weak corporate pricing power and the current period is no different; an ongoing profit margin squeeze means earnings in the next few months risk being a disappointment.

Fixed income proxies have been pummeled recently, with the S&P utilities underperforming the S&P 500 by nearly 14% since the mid-year relative performance peak, on a mere 32bps jump in 10-year U.S. Treasury yields (UST). Since 2010 there have been three iterations of meaningful bond market selloffs, with yields rising by an average of 120bps (see table). Relative utilities returns in these iterations fell by an average of over 18% (top three panels). Utilities have already sold off by nearly 75% of the average bond yield selloff, even though long-term yields have barely budged. The implication is that a large yield back up has already been discounted and now is not the time to rush for the exits. In fact, our inclination is to look for buying opportunities, given that we do not envision much upside in government bond yields. Stay neutral, but look to buy when value improves. Table 1

The transport group is a positive exception to our otherwise downbeat view on the relative performance prospects of the overall industrials sector. We expect consumption to continue outpacing capital spending, because corporate sector free cash flow is waning and balance sheets are suspect. The railroad group in particular has room for upside surprises. Expectations have been reduced considerably, yet leading revenue indicators have perked up. Our rail freight diffusion index has been holding above the key 50 level for several months, heralding increased traffic. Importantly, the heavyweight intermodal segment should soon recover, based on the message from rising consumer income expectations. Importantly, pricing power has climbed out of the deflation zone, a critical milestone for profitability. We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL-UNP, CSX, NSC, KSU.

Special Report

China's current capacity utilization does not look extreme both from a historical perspective and within the global context. The markets misperception about China's overcapacity issue has heavily punished Chinese equities, which is unjustified and unsustainable. Strategically it makes sense to overweight Chinese stocks and material/energy sectors against their global peers.

Special Report

Contrary to the almost universal bearish market consensus, we are raising our tactical view on iron ore to bullish from neutral. We remain tactically neutral on the steel market over the next three months. Strategically, we are bearish iron ore and steel.

Deutsche Bank's woes highlight a much wider malaise within European banks: under-capitalisation and under-profitability. We explain why getting the banks right is crucial to a successful investment strategy in equity, bond and currency markets.

U.S. bank stocks have been joined at the hip with the expected 12-month change in the Fed funds rate since 2014, based on the notion that a rate hike will boost net interest margins. However, even if the Fed hikes rates, that may do little to help bank profits. The lesson from the dismal performance of Japanese bank stocks in their era of extraordinarily low interest rates is that outperformance has only occurred within the context of a steepening yield curve. We place low odds on a steepening in the U.S. yield curve if the Fed raises interest rates, given the softening in leading economic and employment indicators, not to mention the anchoring of U.S. long-term Treasurys by the shortage of global government bonds. Instead, an end to the long-term U.S. bank share underperformance phase requires broad-based economic reacceleration that drives an upturn in credit growth, stabilization in deteriorating credit quality and steeper yield curve. Until then, stay underweight and please see yesterday's Special Report on bank stocks for more details.

There are two key risks that could derail a bear-flattening of the yield curve. The first is a Trump election victory, the second is a flaring of stress in the non-U.S. banking sector.