Equities

An Insight yesterday showed that the overall technology sector was likely to record its worst quarterly earnings performance in four years. The highest beta components of the sector are most at risk. For instance, the semiconductor industry is losing its main source of support, namely an M&A premium. Last year's mini-M&A frenzy is petering out, which will put the onus on profits to support relative performance. However, global chip sales continue to deteriorate, and leading indicators such as Chinese electronics imports and Emerging Market currencies continue to warn of tepid chip demand. With chip producer inventories still growing at a historically rapid clip, there will be downward pressure on average chip selling prices. TSMC's profit warning earlier this week likely provides a good read for the overall industry, and we reiterate our high-conviction underweight rating. The ticker symbols for the stocks in this index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, SWKS, XLNX, MU, LLTC, MCHP, QRVO, FSLR.

A stronger yen is hampering efforts to revive the Japanese economy and the BoJ's failed NIRP experiment leaves open the option of direct currency intervention. Probability is also high that the April 2017 sales tax hike will be postponed, perhaps indefinitely. A major stimulus package, "helicopter drops" of money, and a 4% inflation target may be the only way to permanently overcome deflation. Near-term, further yen strength is likely, but the long-term path is down.

The S&P technology sector is forecast to deliver its worst quarterly earnings performance since 2012/2013, when the sector suffered a relative performance steep correction (top panel). That period was marked by a downturn in capital spending momentum, and a contraction in technology new orders-to-inventories. A similar backdrop is currently unfolding. BCA's Capital Spending Model has moved sharply lower, heralding share price underperformance. In addition, demand for tech goods remains anemic, as proxied by tech new orders and exports (second panel). That represents a headwind to future production growth, and by extension, productivity. The implication is that tech sector deflationary conditions are likely to remain intense, and it is too soon to position for better technology earnings. We remain underweight the overall tech sector.

Special Report

One of our highest-conviction investment ideas for the next few years.

Clients should forgive us for being too gloomy at the start of the year -- it is difficult to be optimistic in the dead of a Montreal winter. However, with springtime comes the reflation trade, born on the wings of massive Chinese fiscal and credit expansion. In this report, we discuss how long (not very) the trade can go (and how to play it). Our In Focus feature returns to pessimism, with a discussion of why the Anglo-Saxon laissez-faire economic model may be in for a big pendulum swing.

We upgraded gold shares to overweight in early March, because gold rises in stature as monetary policy loses its efficacy. The spreading global shift to negative deposit rates is creating a significant amount of uncertainty, as the unintended consequences of this unorthodox policy remain unknown. In the meantime, real interest rates, the opportunity cost of holding a zero-yielding asset like gold, have slipped back into negative territory, and may need to fall further to reverse the decline in economic confidence. That is a plus for gold, and gold shares. While gold and gold shares may look overbought on a short-term basis, it is important to keep the longer-term context in mind. Gold is still far below its 2012 highs, while gold share relative performance is barely above its secular lows, which should trump any near-term concerns about overbought conditions. Consequently, we continue to believe that gold equities provide attractive portfolio protection and are an excellent hedge against monetary policy exhaustion. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S15GOLD - NEM, RGLD.

The latest rebound in risk assets raises the question of whether small caps have become more attractive compared with large caps. However, fundamental analysis signals little chance of a sustained recovery. While the relative P/E for small vs. large caps has downshifted out of overvalued territory, an undershoot is still a serious risk. Our Cyclical Capitalization Indicator, which uses macro variables to forecast relative profit trends between small and large companies, is sinking deeper into negative territory, sending a sell signal. Specifically, there is a large and growing gap between small and large company profit margins. The latest NFIB survey of the small business sector showed that planned labor compensation continues to grind higher, even though reported price changes are falling and CEO confidence is sputtering. Typically, labor compensation plans and price changes move hand in hand, but the gap this cycle is indicative of small cap profit margin pressure. Consequently, small cap valuations are likely to move to a steep discount to those of large caps.

Chinese PPI deflation will likely continue to ease going forward. There are non-trivial odds that the PPI deflation may turn positive. Our models predict a sharp upturn in China's profit cycle. Meanwhile, Anti-corruption investigation cases have dropped substantially since the beginning of the year, a sign that the Communist Party may be reorienting priorities to boost economic growth.

Special Report

We do not expect Russia and OPEC members to reach a production-limiting agreement at the April 17 meeting in Doha, but that does not diminish our bullish expectations for a rebalancing of oil markets in H2 2016.

The previous Insight showed that macro forces were shifting in favor of a trough in the brutal backdrop for hypermarkets sales. Even if the latter are slow to recover, there is scope for positive profit margin surprises in the coming quarters. The massive U.S. dollar appreciation has invigorated the retailing industry's largest buying group's purchasing power. It would be highly unusual for operating margins not to expand on the back of currency strength. Keep in mind that varying lags exist between currency swings and their impact on profitability, given long-term contracts and hedges. Consequently, the recent currency depreciation does not mean the window for margin improvement has closed. Other sources of reduced cost inflation exist. For instance, the cost of goods sold should benefit from deflation in transportation costs. Asian manufacturers are also in full inventory liquidation mode, which suggests little upward pressure on imported consumer goods prices, despite the recent U.S. dollar dip. These factors will support margins. Adding it all up, on a cyclical basis, hypermarkets are well positioned to produce better-than-market returns and we recommend upping weightings to above-benchmark on price weakness. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.