Chemicals

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 (%) The "IF" Rally The "IF" Rally 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 The Rally Is Fraying Around The Edges The Rally Is Fraying Around The Edges Chart 2Defensive Base-Building? Defensive Base-Building? Defensive Base-Building? Chart 3Cyclical Sector Distribution Cyclical Sector Distribution Cyclical 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 Media Stocks Like Dollar Strength Media Stocks Like Dollar Strength Chart 5Sales Are Set To Accelerate Sales Are Set To Accelerate Sales Are Set To Accelerate Chart 6Secular Strength Secular Strength Secular 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 Shareholder-Friendly Shareholder-Friendly Chart 8Cheap With Low Expectations Cheap With Low Expectations Cheap With Low Expectations Chart 9Still Early In The Recovery Still Early In The Recovery Still 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 Higher PMIs Are Not Enough Higher PMIs Are Not Enough Chart 11Higher Yields Are A Bad Omen Higher Yields Are A Bad Omen Higher Yields Are A Bad Omen Chart 12Expectations Are Inflated Expectations Are Inflated Expectations 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. ... The Dollar Is Hurting The U.S. ... The Dollar Is Hurting The U.S. ... Chart 14... But Helping Foreign Competitors ... But Helping Foreign Competitors ... 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 Persistent Deflation Pressures Persistent Deflation Pressures Chart 16U.S. Cost Structures Are Unattractive U.S. Cost Structures Are Unattractive U.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).

We went overweight the S&P agricultural chemicals index in early May, a contrarian bet to take advantage of extreme bearishness, undervaluation and the potential for a rise in underlying commodity prices. Since then, a rise in industry M&A activity has borne out our thesis of cheap valuations, generating solid relative returns. Nevertheless, operating conditions may be slower to improve than originally anticipated. Burgeoning wheat and corn harvests this year threaten to keep the supply/demand balance for grains out of whack for another year. The USDA forecasts a hefty surplus in both key commodities. When grain prices advance, farm incomes receive a shot in the arm, providing farmers with both the means and the confidence to increase planting acreage, thereby boosting fertilizer demand. If food prices stay soft, then that positive dynamic is not going to take hold on a cyclical horizon. Instead, farmland prices will stay near cyclical lows, and agricultural-related credit availability will continue to tighten. The latter is already at a 10-year low, reflecting reduced farm incomes. Consequently, we recommend taking profits and downgrading to neutral. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5FERT - MON, MOS, CF. Take Profits In Ag Chemicals Take Profits In Ag Chemicals

Equities are celebrating domestic economic disappointment rather than re-pricing the risk of ongoing profit struggles. This reinforces that liquidity and share price momentum are still the dominant market forces.

Overweight Our early-May upgrade of the S&P agricultural chemical index proved timely, as Bayer launched a bid for Monsanto, sending the index up sharply. It is tempting to book gains, but if underlying profit drivers continue to move in a bullish direction, share prices should have further to go before extreme bearishness will normalize. Raw food prices continue to grind higher, and are likely to receive an assist from a weaker U.S. dollar now that the market is pushing out the imminence of future Fed rate hikes. The world grain stock-to-use ratio is still well below average, despite soft demand in recent years, and could fall further given the production decline. That is supportive of food prices, and should help farm incomes stabilize and boost credit availability. As shown in the May 9th Weekly Report, farm cash rents were already off their lows, a positive sign for underlying property valuations and a critical factor determining capital availability. It wouldn't take much of an increase in fertilizer demand to overcome depressed relative forward earnings expectations. We recommend staying overweight, despite the 12% gains that have accrued in such a short time span. The ticker symbols for the stocks in this index are: BLBG: S5FERT - MON, MOS, CF, FMC. bca.uses_in_2016_06_08_001_c1 bca.uses_in_2016_06_08_001_c1

The bright side to higher food prices is that the S&P agricultural chemical index should finally be finished a brutal bear market. This group has been savaged by the collapse in agricultural commodity prices, worries about the return of Argentine supply and China's future import growth. The good news is that these headwinds are more than discounted. The share price ratio is close to a decade low, expectations are now extremely washed out, valuations are dirt cheap and the industry has retrenched, creating an attractive reward/risk profile. Importantly, the combination of U.S. dollar softness and two years of farming financial pain are sowing the seeds for a recovery in food prices. Global grain production contracted last year, after several years of strong growth, while shipments of pesticides and fertilizers are accelerating. Typically, food prices recover after production falls, particularly if the U.S. dollar declines. A weaker U.S. dollar boosts purchasing power in the rest of the world, which bodes well for increased food consumption, and it reduces the ability of global food exporters to flood the market and keep prices depressed. Higher food prices would stop the erosion in farming real estate values after a difficult few years, a necessary step to improving capital availability. Already, cash rents are off their lows, a positive sign for underlying property valuations. In sum, current agricultural conditions are depressed, but we can envision a slow but steady improvement as food prices climb on the back of a weaker U.S. dollar and supply restraint, which would support narrower risk premiums in related equities. Boost the S&P agricultural chemicals to overweight from underweight, locking in a 34% profit on this call, and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5FERT - MON, MOS, CF, FMC. bca.uses_in_2016_05_10_002_c1 bca.uses_in_2016_05_10_002_c1

U.S. dollar softness has failed to lift equities of late, a tentative warning that correlations are changing as the U.S. economy cools.