Equities
While banks are tightening the lending screws in most categories, they remain willing to extend mortgage credit. Long-term mortgage rates are extremely low, and consumers are taking full advantage, as recent U.S. housing data has been on the strong side. We expect the trend to accelerate on the back of firming income growth. The steady uptrend in mortgage purchase applications suggests that owner-occupied purchases are taking over from financially motivated transactions. That has bullish implications for housing-related equities such as homebuilders and home improvement retailers. Importantly, new home sales and existing home prices have surged, with the latter providing increased incentive for homeowners to renovate and invest in order to boost the value of their homes. We reiterate our bullish stance on the S&P homebuilders and S&P home improvement retail indexes. The ticker symbols for the stocks in S&P homebuilders index are: BLBG: S5HOME-DHI, LEN, PHM. The ticker symbols for the stocks in S&P home improvement retail index are: BLBG: S5HOMI-HD, LOW.
Typically when the Fed has begun to lift interest rates, overall credit growth is expanding at a rapid clip because banks have been increasingly lax in doling out credit. Consequently, any deterioration in credit quality can be offset by an expansion in assets. This cycle, according to the latest Fed Senior Loan Officer Survey, banks are tightening lending standards even before the Fed has raised interest rates by much, because there has already been an upturn in non-performing loans. While a more discerning banking sector is a plus for bank balance sheet health over a full cycle, the downside is that overall credit growth is likely to cool. The implication of slower loan growth is that the profit drag from increased reserving may be more pronounced than in past cycles, particularly given razor thin net interest margins and an historically low loan loss coverage ratio. Despite the perception of good value, banks are likely to continue underperforming the broad market. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, RF, CMA, HBAN, ZION, PBCT.
The current risk premium embedded into Brazilian financial markets is too low and will widen as investors come to realize Brazil's unsustainable public debt dynamics. The government is planning a major shift in its fiscal policy framework that will ease pressure to cut budget expenditures, but is bearish for the nation's public debt trajectory. Although the economy could stabilize going forward, financial markets are already discounting a lot of good news. Stay put.
Unlike rails, the S&P industrial machinery index has tested prior relative performance highs even though the global manufacturing sector is still laboring under excess capacity in Asia and weak commodity prices. Relative share price performance has already diverged wildly from oil prices, a rare occurrence, and a re-convergence is probable if profits fall short. While companies have cut inventories and staff to address productivity slippage, there is little top-line relief ahead. U.S. machinery new orders continue to contract and there is no help forthcoming from abroad. Non-U.S. developed economies are struggling. Capital spending is in retreat, based on the contraction in capital goods orders and capital goods imports. Our proxy for global machinery orders, excluding the U.S., is contracting. Consequently, there is little scope for a recovery in machinery output, which is necessary to lift utilization rates and allow the industry to sustainably escape deflation. We put this group on our high-conviction underweight list on Monday. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, SWK, IR, PH, PNR, DOV, SNA, XYL, FLS.
Investors looking for a lower risk vehicle to participate in broad equity market strength than from chasing momentum driven areas with dubious fundamentals need look no further than the S&P rail index. Expectations have been crushed and valuations are on the cheap side of neutral. While rail freight is currently in a funk, leading indicators have perked up, particularly for the largest category, intermodal. The latter largely reflects the transportation of consumer goods. Thus, the surge in personal bank loans, strength in trucking tonnage and port traffic all bode well for a recovery in freight in the coming quarters. Against a backdrop of steep cost cutting, any stabilization in top-line performance should have an immediate positive impact on the bottom line. We upgraded to overweight in Monday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5RAIL: CSX, KSU, NSC, UNP.
The Chinese manufacturing sector has remained under downward pressure, but the stress level has alleviated compared to a few months ago. The Chinese labor market will likely continue to deteriorate, which will force policymakers to stay accommodative. Despite the recent rally, Chinese investable stocks remain exceptionally cheap.
We are recommending profit taking in gold shares after a dramatic surge since our overweight call earlier this year. The long-term outlook for gold remains appealing, given the need for low or even negative real interest rates for a prolonged period in order to restore global growth to trend or above-trend levels. Nevertheless, on an intermediate-term basis, we are concerned that a rise in the U.S. dollar could cap the upside in bullion and related-share prices. Evidence of speculative zeal is mounting. ETF gold holdings have skyrocketed since late-2015, reflecting massive inflows into related funds. Net speculative positions have surged as a percent of open interest (third panel), underscoring that momentum and performance-chasing have turbo-charged the yellow metal's advance. Sentiment toward gold has also spiked. Importantly, relative stock price performance has become extremely overbought. The 52-week rate of change has soared to its highest level in decades. While that upsurge partially reflects a lasting cyclical and structural trend change, an intermediate-term digestion phase is inevitable to relieve overbought conditions in the coming months, with a stronger currency the most likely catalyst. Take profits of 45% and downshift to neutral.
Stocks remain well bid despite the questionable fundamental rationale for price gains. The run to new highs has been driven by renewed valuation expansion a dubious trend given the lack of profit growth, the likelihood that the Fed will resume hiking interest rates this autumn and the potential for the U.S. dollar to climb anew. Still, abundant liquidity expectations are trumping earnings risks in the near run. Nominal GDP growth remains above long-term Treasury yields, a simple yet reliable measure of excess liquidity. Meanwhile, money growth is accelerating relative to output growth. When this occurs, history shows that defensive sectors outperform the broad market (top panel). Deep cyclicals underperform until after economic activity picks up enough to drain excess liquidity from the market (deep cyclicals are inversely correlated with our liquidity gauge, bottom panel). Consequently, we continue to emphasize non-cyclical sectors and groups in our portfolio strategy, with a splash of beta coming from the interest rate-sensitive consumer discretionary sector.
The GAA DM Equity Country Allocation model is updated as of July 29, 2016. The non-U.S. (level 2) model made some changes by increasing the overweight in Sweden and Italy while reducing the overweight in Netherland and Germany such that now Germany is in underweight position.
The odds of an inflation "mini-scare" are rising, although deflationary tail risks from abroad cannot be dismissed.