Cyclicals vs Defensives

Equity and Treasury market positioning support the notion of a bounce in risk assets, possibly egged on by dollar weakness.

While we continue to maintain a defensive over cyclical portfolio structure, yesterday's Weekly Report identified a number of catalysts that could eventually change our view: broad-based and sustained U.S. dollar weakness, particularly against a basket of EM currencies in countries with large current account deficits would, the Chinese manufacturing sector stops deflating, global PMIs firm, global export volumes and prices top contracting, an end to U.S. over global profit dominance and/or inflation expectations turn higher around the world. So far, these potential catalysts have only shown signs of stabilization rather than strength, underscoring that it is premature to position for a recovery in cyclical sector profits. Stay defensive, and please see yesterday's Weekly Report for more details. bca.uses_in_2016_06_07_002_c1 bca.uses_in_2016_06_07_002_c1

Economic disappointment will become the key theme in the second half of the year, driving a return to non-cyclical market leadership and a recovery in the growth vs. value ratio.

Despite the broad market's rebound toward the top end of the 18-month long trading range, defensive sectors have held their own against cyclical sectors of late. We expect non-cyclical dominance to reassert itself, regardless of the short-term direction of the overall market. Financial conditions are tighter than warranted by underlying economic activity, as demonstrated by the Chicago Fed's Financial Conditions Index. Ergo, positioning for economic reacceleration is high risk. Moreover, the yield curve continues to narrow (second panel, curve shown as 2 minus the 10-year Treasury yield), reinforcing that growth rates will stay too low to lift the deflationary pall over cyclical sectors, particularly if the Fed retains its tightening bias. Even the global manufacturing surveys continue to underwhelm (bottom panel). Overall, the message is that the uptrend since 2011 in the defensive/cyclical share price ratio will remain intact. bca.uses_in_2016_06_02_001_c1 bca.uses_in_2016_06_02_001_c1

This week <i>U.S. Equity Strategy</i> is sending you the latest <i>BCA Special Report</i>, where Mark McClellan and Anastasios Avgeriou tackle the questions of "Global Earnings Recession: How Deep? How Long?"

Cyclical sectors are manufacturing-dependent, whereas defensive sectors are services-oriented, highlighting that cyclicals are more levered to the inventory cycle's ebbs and flows. The latest durable goods report made for grim reading. Both the new orders-to-inventories and shipments-to-inventories (S/I) ratios remain tepid. This corroborates the reading from the S/I ratios in the wholesale, retail & manufacturing sectors, where all are steadily sinking, underscoring that forecasting a rise in manufacturing output on the basis of an inventory cycle is overly optimistic. The implication is that additional pain looms for the cyclicals/defensives relative performance (middle panel). Moreover, diverging debt dynamics are weighing on the cyclicals/defensives ratio. Relative interest coverage and net debt-to-EBITDA are sending a distress signal (not shown). Tack on a narrowing in relative profit margins (bottom panel) and the continuing deterioration in relative top-line growth which according to our sales models has more staying power (please see chart 7 from the March 29 Special Report), and the ingredients are in place for a resumption in the downtrend in the relative share price ratio. Relative profit trends will drive the next phase in the cyclicals/defensives ratio and defensives retain the upper hand (top panel). Bottom Line: Continue to favor defensives over deep cyclicals. Fade The Cyclicals Bounce Fade The Cyclicals Bounce

This week <i>Global Alpha Sector Strategy</i> in conjunction with <i>Emerging Markets Strategy</i> is sending out a <i>Special Report</i> on EM deep cyclical sectors, discussing debt and cash flow dynamics, identifying how far advanced the capital expenditure down cycle is, and determining if recent EM deep cyclical strength should be bought or faded.

Equities are back in overshoot territory. We added the health care sector to our high-conviction overweight list, boosted managed care to overweight and put health care equipment on downgrade alert. Buy cable stocks.

While recent financial stress relief has triggered a short covering rally in deep cyclical sectors, this will only be sustainable if macro forces shift in support of profit outperformance. However, our cyclical vs. defensive macro drivers have not yet confirmed the glimmers of light offered by financial variables. Global purchasing manager surveys at both the manufacturing and services levels are still sinking, with many in recessionary territory. While there are pockets of strength, in aggregate, manufacturing is very weak. Global trade is still extremely weak. The Baltic Dry index is hitting new lows, and export growth in key manufacturing regions such as Taiwan, Korea and China is contracting at a double-digit rate. The takeaway from ongoing weakness in trade is that EM currencies have not weakened enough to allow exports to stabilize their growth prospects, likely because developed countries are not spending their low oil price dividend. Our Emerging Asian LEI has failed to make any strides despite the dramatic pullback in their currencies. That dynamic reflects both weak export markets and monetary policy constraints driven by fears of capital flight. That is unnerving, because it means that the necessary deleveraging has not been allowed to occur. These factors will continue to constrain cyclical sector profits, especially relative to defensives, arguing for maintaining a defensive portfolio bias. Please see yesterday's Special Report for more details. bca.uses_in_2016_03_30_002_c1 bca.uses_in_2016_03_30_002_c1

Renewed strength in the U.S. equity market sponsored by another round of global monetary easing has revived the debate about whether it is finally time to transition out of our alpha-generating defensive portfolio strategy. A number of strategists and media outlets have championed the view that yield proxies and non-cyclical sectors are expensive, and no longer offer an attractive reward/risk trade-off, particularly within the context of the recent easing in credit spreads, commodity price relief and the dip in the U.S. dollar. However, it is crucial to distinguish between absolute and relative measures when analyzing valuations. In absolute terms, nearly every sector and group is expensive, given that the broad market is trading at historically rich multiples. Our metrics do not support the notion that defensive sector outperformance has overly skewed relative valuations. Defensive sector strength has been almost entirely earnings driven (top panel), as measured by the steady upward march in relative forward earnings estimates. Our relative valuation gauge for defensives is barely above neutral despite multiyear outperformance. At the same time, cyclical sectors have experienced a steady decline in relative forward profit estimates, which has kept our valuation gauge close to neutral when the energy sector is excluded. The implication is that forecasting a cyclical sector comeback based on a valuation basis could lead investors down the wrong path. Instead, the lack of a major valuation anomaly means that relative performance should continue to be dictated by relative profit trends, please see the next Insight. bca.uses_in_2016_03_30_001_c1 bca.uses_in_2016_03_30_001_c1