Equities
While we recently downgraded financials and banks to underweight, this bearish view does not extend to each of the sector's components. REITs are a positive exception. The group is still not overvalued, despite the relentless decline in yields on competing assets. This may reflect an undercurrent of skepticism regarding the sustainability of cash flow growth and low cap rates. However, both appear sustainable. The CPI for homeowner's equivalent rent, a proxy for REIT pricing power that has a good correlation with relative performance, is still accelerating even though it is already well above the overall rate of inflation. Moreover, commercial property price inflation continues to climb. While Fed rate hikes could be construed as an impediment if they lift the cost of capital, REITs have not typically run into trouble until policy has tightened by enough to cause a cresting in commercial real estate prices, a peak in occupancy rates and by extension, a downturn in the CPI for rental inflation. None of these concerns currently exist. Consequently, we recommend maintaining an overweight position. BLBG: S5REITS
Utilities appear to have successfully consolidated this year's sharp relative performance run up, as the share price ratio is firming anew after holding at its 40-week moving average. The incentive to maintain an overweight exposure to this fixed income proxy is heavily influenced by whether global deflationary forces have finally ebbed. While the U.S. dollar has softened in recent months, it has not caused an upsurge in inflation expectations nor has failed to cause a sell-off in Treasurys. U.S. yields are being pinned down by persistently low global bond yields, which reflect chronic deflationary pressures. As long as the total return of bonds is beating equities, then utilities relative performance momentum should stay positive (third panel). Without any valuation barriers to further outperformance, we continue to recommend an above-benchmark weighting. BLBG: S5UTIL.
Following up from yesterday's S&P banks update, as banks go so do financials, given that they comprise the highest weight in the sector. Worrisomely, financials relative EPS momentum has more downside. Using the latest Fed Senior Loan Officer survey data, we constructed a C&I loan supply/demand indicator (middle panel). The news is grim for financial sector profits. C&I loan volumes are decelerating and banks are tightening lending standards. C&I now represents the highest lending category exposure on bank balance sheets, warning of a magnified negative impact on profitability. As long as deflationary forces prevail, as proxied by persistent weakness in our global leading economic indicator (GLEI), then credit quality will continue to erode: it is no wonder that financials relative performance and the GLEI are highly correlated. Bottom Line: We reiterate our recent downgrade to underweight. BLBG: S5FINL.
We discuss the technical and political problems with helicopter money, plus the near-term outlook for the euro area economy and markets.
At this stage of the business cycle, the bull case for banks rests on the ability of accelerating loan growth to offset the beginnings of deteriorating credit quality. However, the latest Fed Senior Bank Loan Officer Survey has poured cold water on such an outcome. Banks are tightening lending standards on their main source of asset growth, namely C&I and commercial real estate loans. These are the main sources of excess leverage. Consequently, it is logical for banks to become more discerning when doling out related credit when credit quality is eroding (bottom panel). While mortgage and consumer lending demand remains decent, it is unlikely to be sufficient to offset higher charge-offs and a slowdown in business-linked loan creation. We reiterate our recent downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.
A spate of mergers in the medical equipment space has helped propel relative performance to new cyclical highs. In our latest update, we noted our expectation for another upleg, but some niggling concerns about the future revenue outlook caused us to put the group on downgrade alert. However, recent data are supportive of a continuation of the uptrend. The medical equipment shipments-to-inventory ratio is trending steadily higher. Importantly, investment in medical equipment has reaccelerated, as has new health care facility construction. That bodes well for future equipment demand, and should keep factories operating at optimal rates. Consequently, we recommend maintaining overweight positions for a while longer, especially since value is not problematic. The ticker symbols for the stocks in this index are: BLBG: S5HCEP - MDT, ABT, SYK, BDX, BSX, BAX, ISRG, EW, STJ, ZBH, BCR, HOLX, VAR.
The powerful short covering bounce in the S&P steel index is starting to fizzle. The latest upleg had been driven by a surge in Chinese domestic steel prices. That, combined with news that the country plans to reduce steel capacity in the coming three to five years, was enough to send shorts scrambling for cover. However, it will take time for the global steel market to rebalance. In the short run, the jump in Chinese steel prices has already encouraged domestic producers to re-ramp steel production (second panel). Persistent sluggishness in indicators of China's domestic consumption mean that steel inventories are likely to build as production picks up anew, which will put upward pressure on exports to the rest of the world. Fading construction growth and tightening lending standards in many developed countries suggest that increased steel supply from China will have a negative impact on steel prices. We reiterate our recent downgrade back to underweight. The ticker symbols for the stocks in this index are: BLBG: S15STEL - NUE, STLD, RS, X, CMC, ATI, WOR, CRS, AKS, TMST, HAYN, SXC, ZEUS.
It is widely perceived that China suffers from a massive capital misallocation problem. Our indicators defy this conventional wisdom.
Colombia's structural growth outlook is superior to many other developing economies. In the near-term, however, Colombia's economy is set to weaken materially. Upgrade Colombian equities and sovereign credit to neutral versus EM benchmarks. Continue betting on further yield curve flattening/inversion and buy 10-year domestic bonds on weakness. Go long Colombian bank stocks / short Peruvian banks, and stay short the peso.
Profit contractions normally occur during recessions, but there have been three exceptions since 1980: 1987, 1999 and a very brief period in 2012 (shaded portions in the chart). All three cases involved a mid-cycle slowdown in nominal GDP growth, while labor compensation growth trended sideways (second panel). The deceleration in sales activity was evidently perceived to be temporary, such that business leaders did not respond by limiting wage gains, trimming payrolls or slashing capital spending. The absence of Fed tightening at the time likely calmed fears of an extended slowdown. Indeed, the Fed cut rates in 1987 and 1998, and implemented QE3 in 2012. The result was that the slowdown in top line growth and the margin squeeze proved shallow and short-lived. We believe a similar phase is underway today. Several of the factors driving the profit recession appear to be at or close to their nadir. Commodity prices, and oil prices most importantly, have stabilized. Many key indicators of Chinese growth are rebounding, suggesting that monetary and fiscal stimulus is beginning to pay off. The global LEI has not yet turned up, but its slow erosion is in sharp contrast to the plunge that typically occurs before recessions. Purchasing managers' surveys have ticked higher in the U.S., Japan, Canada, the U.K. and China, signaling that the global manufacturing recession is ending. Bank profits could be near the worst as well, depending on the evolution of NIRP policies and net interest margins. Moreover, the manufacturing recession has not spread to the service sector in the major economies, where job creation has held up. While persistently low productivity growth and a secular bottom in the labor share of income in the U.S. will remain a headwind for global earnings, they should be dominated by even a modest cyclical revival in global growth due to high corporate operating leverage. The implication is that we do not foresee a prolonged earnings contraction. Looking again at the chart, global EPS surged following the modest profit recessions in 1987 and 1999. Output growth accelerated sharply, while commodity prices entered a robust bull phase. The global output gap shifted into "excess demand" territory, providing the business sector with some pricing power. Nominal GDP growth re-accelerated in absolute terms and relative to labor costs, contributing to a substantial rise in profit margins. The aftermath of the 2012 profit dip was an altogether different affair. Margins only edged higher due to the tepid rebound in nominal GDP growth. Commodity prices were roughly flat. Meanwhile, the still-large global "excess supply" gap robbed the business sector of pricing power. The result was that EPS growth barely climbed out of negative territory in 2013 and 2014. Today, the global output gap is closer to zero than was the case in 2012/2013, especially in the U.S. However, pricing power is still left wanting at the global level, based on the continued decline in global manufactured goods prices and depressed core consumer price inflation in most of the advanced economies. Oil prices have more upside potential given that the supply-side is responding to low prices, as discussed in the Overview. Nonetheless, our commodity experts do not foresee sustained price increases outside of oil anytime soon. Finally, the global leading economic indicator, a reasonably good bellwether for global EPS growth, has yet to turn higher (bottom panel). Bottom Line: While the profit recession will not be extended or deep, investors should not expect the kind of surge in EPS growth that followed the 1987 or 1997 earnings contractions. Please see yesterday's Special Report for additional details.