Equities

Small caps have enjoyed a modest oversold bounce relative to large caps, but the latest NFIB survey of the small business sector warns that these gains are likely to fully reverse, and more. The tightening in domestic monetary conditions appears to have begun taking a toll on both small business confidence, and access to funding. That is noteworthy, because history shows that small caps underperform large caps when credit tightens (top panel), given that the former rely more heavily on the banking sector for financing than do large caps. Meanwhile, optimism about the economy has tanked, perhaps reflecting the intensification in deflation pressures: the number of companies reporting price increases has plunged. While labor compensation also eased, suggesting increasing overall labor market slack, it was not enough to offset the loss of pricing power. Our small cap profit margin proxy continues to sink. We reiterate our large cap bias.

While high-beta equity areas have rebounded smartly in recent trading sessions, we remain skeptical that earnings-follow through will be forthcoming. Instead, our portfolio remains defensively-geared, where profit support is strongest. For instance, the latest manufacturing data showed that pharmaceutical shipments continue to boom, underscoring that top-line momentum has started on a strong foot in the first quarter. That bodes well for pharmaceutical relative performance. Elsewhere, beverage shipments have also soared on a growth rate basis, sending a similar upbeat message for the S&P soft drink index. Importantly, pricing power remains solid in both industries, underscoring that the surge in manufacturer shipments likely remains demand-driven. We reiterate our overweight position in both indexes.

Expectations of a deepening EM/China growth slump and RMB depreciation have been the key to the selloff in global risk assets. There is no basis for these expectations to improve. Therefore, there are few fundamental reasons for EM and global risk assets to rally much further. Stay put. In Brazil, the impeachment rally is unsustainable and will reverse sooner than later. Stay short Brazilian risk assets.

In yesterday's Weekly Report, we outlined our top ten reasons to underweight the technology sector, an out of consensus call based on the sector's resilience during the past few months' of broad market turmoil. At the root of our concern is that tech sector productivity growth is eroding at the same time that previously bulletproof balance sheets are slowly deteriorating. Declining sector productivity can be remedied through increased capital spending, but the chart shows that tech has underinvested as a share of sales for the better part of a decade. While the latter is slowly creeping higher, it will take time before it feeds into increased efficiency and faster earnings growth. Worse, our overall capital spending model is sinking steadily (bottom panel). In particular, the financial and public sectors have traditionally been large technology spenders. Despite ultra-low borrowing costs, government spending is still politically constrained and thus on a tight leash. Meanwhile, the financial sector has already ramped up its capital spending significantly (middle panel), without a corresponding positive impact on new order growth, signaling that weakness from other end markets has been a large drag. If the financial sector pulls in its horns as overall credit quality sours, it will remove a support for tech capital spending. We are bearish on relative performance prospects, and recommend underweight positions. Please refer to yesterday's report for more details.

As confidence in the sustainability of corporate sector profitability declines, the multiple accorded to equities should recede. Ten reasons to stay underweight the tech sector. Initiate an overweight position in gold shares.

The relief rally is not over, and could benefit from commodity and currency market movements. Oil prices likely are banging out a bottom. In general, however, a healthy dose of caution is warranted. Our bias is to sell into, rather than chase, rallies in risk assets.

Near-term, global yields will remain depressed, but the structural forces suppressing yields should abate and even reverse in the long-run. Slower potential GDP growth - and lower commodity prices - will eventually shift from tailwind to headwind for bonds. Stepped-up efforts to increase inflation will boost long-term nominal yields; populist politics and calls to curb income inequality will amplify this trend. Long-term investors should stay neutral global bonds for now, but prepare to shift to a structural underweight beyond this decade.

While we are neutral the broad industrials sector (please see yesterday's Insight) and sub-surface exposure should remain selective, we continue to recommend an above benchmark weighting in the BCA defense index. Following years of global government austerity, rising global fiscal thrust should boost demand for defense capital goods. Tack on a rise in geopolitical risk in a number of volatile regions in the world, and the outlook for defense spending significantly brightens. In more detail, China/Japan nervousness (with Australia recently joining the chorus of rising defense spending in the pacific) and escalating middle east/Russia tensions are a harbinger of rising defense spending budgets globally. The prime beneficiaries of this cyclical turn in demand are U.S. defense manufacturers/contractors. Already, U.S. defense new orders are surging, signaling that relative performance momentum has more upside (middle panel). Importantly, the U.S. defense capital goods shipments-to-inventories ratio is also expanding at a healthy clip (bottom panel). The implication is that busy defense factory activity should underpin revenue and profit growth. Bottom Line: Stay overweight the BCA defense index. The ticker symbols for the stocks in this index are: LMT, GD, RTN, NOC, LLL.

No significant change was made except that the weight of France was increased to 7% from 1.7%, largely driven by improvement in relative liquidity conditions. It's mainly financed by a reduction in the U.S. weight which remains the largest overweight in the model.