Capital Markets

The previous Insight showed that capital formation has hit a brick wall as a consequence of ebbing risk tolerance. That is robbing the corporate sector of much needed growth capital, and will reinforce the need for retrenchment. As a result, the outlook for capital market profitability is bearish. To make matters worse, capital markets firms have been slow to downsize this cycle. Usually headcount is quick to react to slumping revenue, as a shrinking bonus pool necessitates fewer employees. However, capital markets employment growth has not yet started to contract, warning that revenue disappointment will be compounded on the bottom line. While net earnings revisions are negative, earnings are still expected to outpace those of the broad market in the coming twelve months, which is far too optimistic in the absence of resurgent economic confidence. We expect the S&P capital markets index to sink to new relative performance lows. Stay with a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5CAPM - GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM. (Part II) Capital Markets: From Bad To Worse (Part II) Capital Markets: From Bad To Worse

Last year's sharp tightening in financial conditions is wreaking havoc on the S&P capital markets index. Capital formation has dried up, and the persistent erosion in economic expectations, as measured by the total return ratio of stocks-to-bonds (S/B), warns of little chance for an imminent recovery. The chart shows that new stock issuance is probing the low end of the range, while M&A activity is cooling quickly. The S/B ratio provides a good indication of investor risk appetites, and the current message is that risk tolerance is ebbing. That will constrain the availability of capital, and dent fees for capital markets firms. Tack on historically low trading volumes, and profit prospects darken another notch. Against this backdrop, the only way to preserve profitability is through massive cost cutting, see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5CAPM - GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM. (Part I) Capital Markets: From Bad To Worse (Part I) Capital Markets: From Bad To Worse

Capital markets stocks have been crushed this year. Over the last few decades, capital market bear phases have ended with a forceful policy response that restores economic growth by rekindling the credit cycle. Fed rate cuts have usually started that process. This cycle, the Fed is still intent on tightening even as evidence of growth softness mounts. Thus, it is difficult to envision the start of a cycle that encourages increased capital formation, which is needed to avert a sustained capital markets profit downturn. Our concern is that the U.S. corporate sector has spent beyond its means long enough to erode balance sheet flexibility, which warns of high odds of a forced retrenchment. Access to capital is restricted to those who don't need it. Once our Corporate Health Monitor moves into deteriorating health territory, M&A activity usually begins to dry up (second panel). M&A has been running red-hot in the past few years, as the lack of organic global growth has forced companies to pursue acquisitions. If this source of investment banking income diminishes, then capital market companies will have a large profit hole to fill. If valuations could not expand with an easy Fed, an M&A boom and rampant stock and bond issuance, what will happen now these conditions are reversing? Stay with a high-conviction underweight. The ticker symbols for the stocks in this index are: GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM. bca.uses_in_2016_02_23_002_c1 bca.uses_in_2016_02_23_002_c1

Lean against rally attempts until leading profit indicators improve. The conditions for a tradable oilfield services rebound remain elusive. Capital markets may bounce, but we would sell on strength.

The plunge in capital markets stocks is not a buying opportunity. Corporate sector credit quality is quickly deteriorating. Ratings agencies are adding fuel to the fire, as bond downgrades are briskly outpacing upgrades. The message is that capital formation will continue to slow as the cost of credit climbs. As access to capital becomes more restrictive, on the margin, the currency to fund deals, share buybacks etc...will erode, undermining key earnings drivers. The implication is that profit prospects will continue to erode, the opposite of what sell side analysts are expecting (middle panel). Capital market return on equity tends to follow, inversely, junk bond spreads, and the current message is bearish (spreads are shown inverted, bottom panel). Bottom Line: The S&P capital markets index is facing stiff profit headwinds. Stick with a high-conviction, below-benchmark allocation. Capital Markets Have Broken Down Capital Markets Have Broken Down