Consumer Discretionary

Consumer product stocks have had a tough few weeks, as renewed strength in the U.S. dollar threatens to undermine sales prospects. However, there are reasons to be cautiously optimistic, especially in relative terms. Consumption has a lower economic beta than capital spending, particularly among consumer staples vendors. Consumer goods exports have started to rebound, even prior to renewed strength in emerging market currencies. The latter heralds at least a mild recovery in consumer product top-line growth. Domestically, retail sales at non-discretionary stores are outpacing sales at discretionary stores by a wide margin, another indication that in relative terms, profit conditions favor non-cyclical consumer goods vendors. We are overweight the S&P household products and S&P soft drink indexes. bca.uses_in_2016_10_26_001_c1 bca.uses_in_2016_10_26_001_c1

This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory, as restaurant operators have reported a decrease in traffic. However, cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation. As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing. In addition, restaurant retail sales often follow the trend in the wealth effect. Financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. We recommended booking profits of 9% and lifted positions to neutral in yesterday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI. bca.uses_in_2016_10_25_001_c1 bca.uses_in_2016_10_25_001_c1

Highlights Portfolio Strategy Boost restaurant stocks to neutral, as same-store sales should improve next year. A further upgrade requires evidence of top-line traction. The exodus from health care stocks represents an overreaction rather than a downshift in fundamental forces. Stay long. Recent Changes S&P Restaurants Index - Upgrade to neutral for a profit of 9%. Table 1 Profits: Is Less Bad Good Enough? Profits: Is Less Bad Good Enough? Feature Equity market buoyancy remains a liquidity rather than an earnings story. Fed commentary and the trend in global bond yields, a reflection of the global central bank narrative, continue to exert an outsize influence on short-term price action and momentum. In the background, earnings are a wildcard. Companies may be surpassing beaten down third quarter estimates, but the path of profits over the next several quarters is by no means assured and will determine the durability of any stock market advance. Even excluding the persistent drag from narrowing profit margins, courtesy of falling productivity and increasing unit labor costs, it is dangerous to look at the corporate profit outlook through rose colored glasses. The low level of economic growth, both at home and abroad, represents a major hurdle to the corporate sector. Total business sales have climbed back up to zero, but it is premature to forecast meaningful growth ahead based on moribund global export growth (Chart 1), and/or leading economic indicators. After all, sales growth has been virtually non-existent for years, reinforcing that earnings per share have been driven by cost cutting and buybacks. While measured consumer price inflation has crept higher, corporate sector pricing power remains virtually non-existent. The producer price index is still deflating, despite the rally in oil prices. U.S. import prices are very weak (Chart 1). The negative global credit impulse warns that there is still no impetus to reinvigorate final demand, and by extension, global profits (Chart 1). It is hard to envision an economic reacceleration as long as the corporate sector is more inclined to retrench than expand, as heralded by stressed balance sheets and weak durable goods orders (Chart 2). Chart 3 shows BCA's two U.S. profit models. The first one is based on reflationary variables, such as the dollar, bond yields and oil prices. It is designed to predict the trend in forward earnings momentum. This model has troughed, but is not signaling any upside ahead in already exuberant analyst earnings estimates (Chart 3, second panel). Chart 1Without Sales Growth... bca.uses_wr_2016_10_24_c1 bca.uses_wr_2016_10_24_c1 Chart 2... And Rising Costs... bca.uses_wr_2016_10_24_c2 bca.uses_wr_2016_10_24_c2 Chart 3... How Much Can Profits Improve? ... How Much Can Profits Improve? ... How Much Can Profits Improve? The second model looks at macro data such as new orders, labor costs and productivity growth to forecast the trend in actual operating earnings. This model is slightly more optimistic (Chart 3, bottom panel), and signals a decisive end to the profit contraction, albeit not a growth rate sufficient to satisfy double-digit analysts forecasts or rich valuations. The U.S. dollar is a major wildcard, as any sustained strength would compromise earnings. Typically, major profit expansions only occur after the currency begins to depreciate and labor cost inflation ebbs (Chart 2). The late-1990s was an exception, as profits climbed alongside the currency and amidst rising wage inflation (Chart 2). However, that was during an economic and credit boom, two key factors that are conspicuously absent at the moment. Nevertheless, as discussed in past Weekly Reports, the flood of central bank liquidity could sustain the overshoot in equity prices for a while longer. Investors have demonstrated a willingness to look through soggy profits as long as the liquidity taps remain open. Despite the possibility of a stubbornly resilient broad market, we do not recommend interpreting it as a sign of economic vitality, and consider it high risk. Our portfolio strategy is based on expected sectoral earnings trends, as liquidity is subject to the whims of central bankers. We recommend a largely defensive sector portfolio, with some exceptions, as discussed in last week's Special Report. Our cyclical exposure remains confined to consumption-oriented plays; this week we are lifting our view on restaurants. Restaurants: Buying Into Weakness Investors have gravitated toward washed out deep cyclical sectors rather than consumption-oriented plays in recent months. However, we doubt this trend has staying power, as outlined in our Special Report last week. Consequently, it is time to revisit the outlook for shunned consumer sectors, such as restaurants. This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory (Chart 4), as restaurant operators have reported a decrease in traffic. One of the major drags on restaurant same-store sales has been the gap in restaurant inflation compared with the cost of food inflation for eating at home. Relative inflation has soared (Chart 5). That has caused relative spending growth at restaurants vs. at home dining to drop sharply, in real (volumes) terms. However, next year could be different. If the inflation gap falls, as predicted by the decline in relative spending (Chart 5), then restaurant traffic should stabilize. Importantly, the odds of budgets for dining out being pruned even further are low. As long as wages and salaries growth is decent and consumer income expectations are firm, consumers should still allocate a rising share to restaurants relative to eating at home (Chart 5). There is plenty of scope for relative restaurant spending to rise on a secular basis (Chart 5, bottom panel). Clearly, if relative spending were to reaccelerate too quickly, then the inflation gap would stay wide, and same-store sales growth would stay punk. That is a risk to an optimistic view of future restaurant traffic. But the good news is that cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation (Chart 4). As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. In any case, the most potent profit elixir would be a recovery in top-line growth, sourced both domestically and from abroad. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing (Chart 6), which bodes well for casual dining out in the coming quarters. If our bearish view on refiners and gasoline prices continues to pan out, then a windfall from lower fuel prices may further bolster the outlook. Chart 4Expenses Set To Ease bca.uses_wr_2016_10_24_c4 bca.uses_wr_2016_10_24_c4 Chart 5Inflation Gap Should Narrow bca.uses_wr_2016_10_24_c5 bca.uses_wr_2016_10_24_c5 Chart 6Sales Set To Stabilize... bca.uses_wr_2016_10_24_c6 bca.uses_wr_2016_10_24_c6 In addition, restaurant retail sales often follow the trend in the wealth effect (Chart 7). The latter has pulled back this year, owing to the equity market consolidation and house price correction. However, financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. Even marginal improvements in store traffic should be impactful to same-store sales. Restaurant chains have been in retrenchment mode since the Great Recession. Construction activity is historically low, which implies limited capacity expansion (Chart 7). Contribution from abroad may become less of a drag. The industry garners roughly 67% of sales from overseas. The strong U.S. dollar, particularly against emerging market currencies, has deprived the industry of sales strength. Moreover, even in domestic currency terms, emerging markets consumption has been through a difficult period, as the Asian Hotel and Restaurant Activity Proxy spent most of the last year in negative territory (Chart 8). But EM currencies have stabilized and Asian restaurant activity has climbed back into positive territory in recent months. The upshot is that foreign revenue could make up any lingering domestic sales slack. All of this suggests that leaning into share price weakness in anticipation of improved prospects next year makes sense. Nevertheless, the S&P restaurants index does not warrant a full shift from underweight to overweight. There could still be earnings/headline risk given lackluster readings in coincident activity indicators, despite McDonald's earnings beat last week. Valuations are not cheap. On a normalized basis, the relative forward P/E ratio has dropped below its average, but still trades at a premium to the broad market. A return to above average levels is possible if operating margins expand on the back of sales improvement (Chart 9), thereby sparking higher return on equity, but it may be too soon to position for such an outcome. Chart 7... Or Even Improve In 2017 bca.uses_wr_2016_10_24_c7 bca.uses_wr_2016_10_24_c7 Chart 8End Of Foreign Drag bca.uses_wr_2016_10_24_c8 bca.uses_wr_2016_10_24_c8 Chart 9Still Not Dirt Cheap bca.uses_wr_2016_10_24_c9 bca.uses_wr_2016_10_24_c9 Bottom Line: Lift the S&P restaurant index (BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI) to neutral from underweight, locking in a profit of 9% since our underweight recommendation last November. Health Care Crunch: Buying Opportunity Or Trend Change? The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. In fact, the sector has dropped back down to the levels where we added it to our high conviction overweight list. The question now is whether our positive views still hold, and whether would we add here if we weren't long already, or if something more sinister is at work? The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. While it is impossible to forecast with any precision to what extent pricing models may or may not change, the political appetite may be low for another overhaul of the sector so soon after the Affordable Care Act was implemented. Regardless, several observations suggest that the sector may already be undershooting, i.e. a Democratic victory is already discounted. Relative performance has experienced a clear uptrend over the last forty years, with cyclical swings oscillating around its upward sloping trend-line (Chart 10). It would be extremely rare for a bull phase to peak prior to hitting at least one standard deviation above trend. Instead, the price ratio hit trend and is now not far above one standard deviation below trend, a level one would normally equate with an economic boom when capital flowed to high-beta sectors. Cyclical technical measures also point to an undershoot. Our Technical Indicator has hit an oversold extreme (Chart 11), signaling that the sell-off is in the late stages. Our relative advance/decline line has also stayed firm, suggesting that the decline in the overall sector has not been broad-based (Chart 11). Chart 10Time To Buy, Not Sell bca.uses_wr_2016_10_24_c10 bca.uses_wr_2016_10_24_c10 Chart 11Buying Opportunity Buying Opportunity Buying Opportunity Whether a wholesale flight from the sector, and all defensives in general, looms is largely contingent on the path of inflation expectations, which have been in a multiyear decline. This trend reflects anemic global final demand and the repercussions from over-indebtedness. Lately, inflation expectations have firmed, but that may largely reflect the rebound in oil prices courtesy of hopes for an OPEC production cut, given the lack of confirming indicators of growth acceleration and renewed strength in the U.S. dollar. The latter is testing the top end of its recent range (Chart 11, shown inverted, bottom panel), and it would be highly unusual for inflation expectations to rise concurrent with the U.S. dollar. In a world of zero interest rates and limited aggregate demand strength, a strong currency is deflationary, especially for corporate profits. Those conditions keep bond yields low, and push capital into long duration sectors. Once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (Chart 12, second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption (Chart 12). That is consistent with ongoing earnings outperformance. As noted in past research, the time to forecast negative relative earnings momentum is when consumers balk at higher prices. So far, a few high profile cases of exorbitant drug price increases have grabbed the spotlight, but in aggregate, consumers are not voting with their wallets. The biggest tangible negative for the health care sector may be that shares outstanding are no longer falling (Chart 13). That mirrors overall buyback activity, which has cooled markedly on the back of balance sheet deterioration and waning free cash flow. We doubt the supply of health care stocks is going to rise much, however, because the sector is in good financial shape, earning healthy returns and is not dependent on external financing. Chart 12Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Chart 13Buybacks Are Dwindling bca.uses_wr_2016_10_24_c13 bca.uses_wr_2016_10_24_c13 Bottom Line: Health care sector risk premiums have climbed in response to polling results, but an apolitical check on relative earnings drivers and valuations points to a buying opportunity. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

After vaulting out of the gate at the start of this year, leisure product stocks have endured a steady bout of profit-taking. However, there are no signs of a change in trend. In fact, relative performance is starting to rebound at a key support line (top panel). Consumers continue to demonstrate a large appetite for expenditures on toys and games. Retail sales at toy and hobby stores continue to boon, far surpassing overall retail sales growth. Retail sales lead relative forward earnings momentum (second panel), underscoring that the path of least resistance remains up. Now that expenses are easing, profit margins should expand. Importantly, a hefty short position still exists, pointing to latent fuel for additional share price gains if covering occurs on the back of strong earnings results. We reiterate our high conviction overweight call. The ticker symbols for the stocks in this index are: BLBG: S5LEPR - MAT, HAS. bca.uses_in_2016_10_19_001_c1 bca.uses_in_2016_10_19_001_c1

While we recently boosted the broad consumer discretionary index to overweight, we continue to avoid the auto components sub-group. Relative earnings prospects remain poor. The second panel of the chart shows that relative profitability is on the cusp of a melt-down, according to the relative shipments-to-inventory (S/I) ratio. The decline in the S/I reflects both an unwanted inventory build and decline in shipments. Overproduction will ensure that pricing power stays in deflationary territory (third panel). It would take an upsurge in vehicle demand to reverse these trends, but that is unlikely given tightening auto credit on the back of concerns about auto loan quality and a saturation in vehicle sales (bottom panel). Consequently, auto-related corporate profitability will remain under pressure. Bottom line: Stick with a below benchmark weighting in the S&P auto components index. The ticker symbols for the stocks in this index are: BLBG: S5AUTC - JCI, DLPH, BWA, GT. bca.uses_in_2016_09_08_001_c1 bca.uses_in_2016_09_08_001_c1

The latest housing data paint a bullish picture for the S&P homebuilding index. New home sales are soaring, and are rapidly regaining as a share of total home sales. Demand for new homes is well supported by increased mortgage availability, rising credit scores and faster income growth. Importantly, faster demand has not yet translated into overproduction, as new home prices are soaring, which bodes well for homebuilder sales growth (third panel). The supply of new homes has recently ticked lower in absolute terms, and plunged in terms of months of supply (bottom panel). The surge in construction job openings reinforces that builders have sufficient backlog to aggressively add staff. In turn, that should boost confidence in the longevity of the housing upcycle, translating into a valuation re-rating. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME-PHM, DHI, LEN. Homebuilders Are A Solid Investment Homebuilders Are A Solid Investment

Leisure product relative stock performance is setting up for another leg up. The share price ratio endured a brutal bear market, becoming extremely oversold as company-specific woes caused a short selling frenzy. However, a major trend change occurred earlier this year, with cyclical momentum moving from massively oversold to extremely overbought, as measured by the 52-week rate of change. Overheated conditions have been unwound, and rising relative forward earnings estimates argue for a resumption of the uptrend. As discussed in Monday's Weekly Report, consumer purchasing power has improved markedly, and is driving solid spending growth at toy and hobby stores (third panel). The surge in overall media spending reinforces that a tailwind exists for content-based merchandise sales. We expect ongoing earnings outperformance to propel a further re-rating in the S&P leisure products index, and reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5LEPR-HAS, MAT. bca.uses_in_2016_08_31_001_c1 bca.uses_in_2016_08_31_001_c1

U.S. consumption is the strongest economic link. Consumers are benefiting from low fuel costs, historically cheap borrowing rates and increasing capital availability. Wage growth is outpacing nominal GDP growth, consumer income expectations are climbing, underscoring that the barriers to increased consumption are gradually falling. In particular, retailers should benefit if Treasury yields stay subdued and U.S. currency appreciation reduces the cost of imported consumer goods and boost purchasing power. However, it is instructive to dig beneath the surface. Not all retail sales categories are experiencing positive momentum, with some suffering from more acute deflationary pressures than others, and a homogenous recommendation on retailers is no longer appropriate. Broadly, retail sales at discretionary stores are contracting, while growth is evident at non-discretionary stores, and non-store sales continue to boom. The chart highlights our favored retail categories, which generally have positive sales momentum. Bottom Line: a selectivity bullish stance is warranted on retailing equities, please see yesterday's Weekly Report for more details. bca.uses_in_2016_08_30_002_c1 bca.uses_in_2016_08_30_002_c1

The equity rally has been in a holding pattern, with some tactical fraying around the edges.