Household Products

Overweight S&P consumer staples overall, and the S&P household products sub index in particular, have underperformed the market for much of the past year as their defensive nature has been left behind by their more cyclical peers. While we maintain a cyclical bent in our portfolio weightings, consumer staples is our lone defensive overweight index and we think there are good odds for outperformance in the S&P household products index in 2018. The year has started well; almost all of the component companies have reported revenues ahead of sell-side estimates as the industry continues to show resurgent sales (second panel). This is corroborated by strengthening pricing power of both household product makers and grocery stores (third panel). The latter is critical to the resiliency of the former, particularly if the threat of rising commodity costs is to be held at bay. The market has not been rewarding the household products index for the improving operating fundamentals and as a result, household products are at their cheapest level this decade (bottom panel). With compelling valuations and a better outlook, we maintain our overweight recommendation. The ticker symbols for the stocks in this index are: PG, CL, KMB, CLX, CHD 2018 Could Be The Year To Clean Up 2018 Could Be The Year To Clean Up

The S&P household products index story in 2014-15 was that a firm U.S. dollar had sapped top-line growth from the key export market and a turnaround in the former would provide a lift in the latter. While that thesis has proven correct (second panel) and consumer goods exports have substantially recovered, earnings growth remains flat and trails the broad market (third panel). In the most recent quarter, organic domestic growth concerns weighed on household products stocks. Further, hurricane-driven input price hikes have temporarily crimped margins. The result is that the S&P household products are at their cheapest level this decade (bottom panel). With compelling valuations and the makings of an export-led EPS recovery, we maintain our overweight recommendation. The ticker symbols for the stocks in this index are: PG, CL, KMB, CLX, CHD. Household Products Look Cleaner After Q3 Household Products Look Cleaner After Q3

Highlights Portfolio Strategy The rally in the S&P restaurants index has run its course and a profit recovery is fully discounted. Lock in profits and downgrade to neutral. Intensified inter-industry competition, the onslaught of online retailers and a rebounding U.S. economy are stiff headwinds for hypermarket stocks. Sell positions down to neutral. Recent Changes S&P Restaurants - Downgrade to neutral, booking profits of 11%. S&P Hypermarkets - Downgrade to neutral. Table 1 Rotation Does Not Mean Correction Rotation Does Not Mean Correction Feature The S&P 500 remained resilient in the face of the fourth Fed interest rate hike and the drubbing in the tech sector. The latter is notable given that a select few stocks have contributed roughly one quarter of the overall market's gains this year, and signals that money is not leaving equities en masse, but is merely rotating into other sectors. This suggests that consolidation rather than correction is the main watchword. Our view remains that stocks are in a sweet spot: a lack of inflation pressures has kept long-term interest rates at bay, despite decent economic momentum and rising corporate profits. The latter have been driven by impressive corporate pricing power gains (see Chart 1 from last week's Weekly Report), creating an ideal equity market scenario whereby the business sector can grow profits without any corresponding consumer price inflation pressures. Investors are likely to extrapolate this goldilocks equity scenario for a while longer, given that our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has exploded to the highest level since 2010 and just shy of all-time highs. The RG leads both the U.S. economic surprise index and equity sentiment (Chart 1). If economic activity begins to reaccelerate, as we expect and irrespective of tax reform success, the window is open for additional equity market gains. Meanwhile, the mini sector rotation that commenced two weeks ago is a healthy development and may not be a precursor to a more vicious and widespread correction. In recent Weekly Reports, we have shown that our Equity Market Internal Dynamics Indicator was signaling that upward momentum in the broad market was well supported by the character of market participation (see Chart 2 from the May 15th Weekly Report). Chart 1Coiled Spring Coiled Spring Coiled Spring Chart 2Healthy Rotation Healthy Rotation Healthy Rotation Chart 2 shows that lately the small/large ratio has sprung back to life. Growth/value stalled near the previous all-time peak, and capital has flowed out of frothy tech stocks and into the cheaper and more economic-sensitive financials sector. Against a backdrop of a budding rebound in domestic economic data, this recent market rotation is likely to stay intact. That view is corroborated by the collapse in correlations among stocks and overall assets. The CBOE's implied correlation index has fallen to fresh cyclical lows, which suggests that investors have become increasingly discerning and that earnings fundamentals/valuations should become the primary drivers of stock market returns. Keep in mind that empirical evidence shows that receding stock correlations also underpin the broad equity market (top & bottom panels, Chart 2). All of these fluctuations signal that the broad equity market is more likely to build a base before it resumes its advance to new cyclical highs, rather than suffer an imminent and major correction. As such, we continue to slowly and deliberately recalibrate our portfolio away from its previously heavy bias toward defensives. This week we make two consumer-related shifts. Restaurants: Beware Of Heartburn One quarter ago we posited that the consolidation phase in the broad consumer discretionary sector restored value and created an attractive entry point. Washed out technicals and an upswing in industry earnings fundamentals supported our thesis (Chart 3). An upgrade in the S&P restaurants sub-index to overweight provided an attractive way to execute that thesis. This view has largely played out, as restaurant shares have bested the market by double digits since March 20th. Is there any more upside left to this impressive quarterly relative return? We doubt it. While we remain constructive on the overall consumer discretionary sector (Chart 4), we recommend crystalizing gains of 11% in the S&P restaurants index and downshifting to neutral. Chart 3Stay ##br##The Course... Stay The Course... Stay The Course... Chart 4...As Our Consumer Drag ##br## Indicator Is Flashing Green ...As Our Consumer Drag Indicator Is Flashing Green ...As Our Consumer Drag Indicator Is Flashing Green Q1 industry conference calls revealed that improved store traffic and better offerings boosted same-store sales, and relative share prices followed suit from a technically depressed level. That caused sell side analysts to modestly lift relative EPS forecasts, but a valuation re-rating still explains the bulk of the stock price surge (Chart 5). We are reluctant to pay a 40% premium to the broad market on a 12-month forward P/E basis. The National Restaurant Association's Restaurant Performance Index fell to the boom/bust 100 line and downside momentum has accelerated (second panel, Chart 5). Worrisomely, the Current Situation Index (not shown) of the same survey was in the contraction zone for "the sixth time in the last seven months". Similarly, the Expectations Index also decelerated, heralding an uncertain dining outlook. Indeed, demand for away from home dining is on the decline in absolute terms and compared with overall retail sales and consumption (middle panel, Chart 6). This suggests that the first quarter increase in store traffic may not be sustainable (top panel, Chart 6). The recent spike in restaurant construction expenditures will further dilute same-store sales growth opportunities (bottom panel, Chart 6). Chart 5Too Expensive Too Expensive Too Expensive Chart 6Do Not Overstay Your Welcome Do Not Overstay Your Welcome Do Not Overstay Your Welcome Leading indicators of profit margins have also eroded. An uptick in commodity input costs and 8% growth in the industry's wage bill, stand in marked contrast with anemic industry pricing power. Our restaurants profit margin gauge captures all of these forces and warns that a squeeze looms (Chart 7). Nevertheless, it is not all bad news. The improvement in consumer finances should counterbalance some of the casual dining industry's deficient demand hiccups. Rising household net worth makes consumers feel wealthier, and therefore increases their marginal propensity to spend. Importantly, the $15-$35K income cohort also expects a sizable boost to their take home pay, according to the latest Conference Board survey data (not shown). Importantly, the earnings headwind from foreign sales exposure has likely morphed into a profit tailwind. U.S. dollar softness is not only evident against G10 currencies, but also emerging market (EM) FX rates (Chart 8). In addition, healthy EM domestic demand is the mirror image of fickle U.S. final demand. EM central banks are easing monetary policy - whereas the Fed hiked for a fourth time this cycle last week - in order to rekindle EM consumer spending/growth. As a result, EM restaurant sales should improve (Chart 8). Chart 7Rising Input Costs ##br##Are Eating Into Margins Rising Input Costs Are Eating Into Margins Rising Input Costs Are Eating Into Margins Chart 8Export ##br## Relief Valve Export Relief Valve Export Relief Valve In sum, the playable rally in the S&P restaurants index has run its course and a profit recovery is fully priced in frothy valuations. The V-shaped rebound in share prices has outpaced fundamental improvements, and a consolidation/corrective phase is inevitable. Bottom Line: While we remain overweight the S&P consumer discretionary sector, we recommend booking profits of 11% in the S&P restaurants index (MCD, SBUX, YUM, DRI, CMG), and moving to a benchmark allocation. Time To Downgrade Hypermarkets While investors have shed anything retail related year-to-date (YTD), big box retailers have been a positive exception. In fact, the S&P hypermarkets index has been a stalwart performer YTD, outshining both the broad consumer staples universe and the overall market. Is this impressive run-up sustainable? The short answer is no. Three main headwinds suggest that some caution is warranted now that index outperformance has eliminated the previous valuation appeal: soft pricing power likely further aggravated by new German competitors expanding in/entering the U.S. market, the ongoing assault from online retailers and the improving U.S. economy, especially consumer spending. These factors imply that profit margins will remain under chronic pressure, but concerns could become more acute on a cyclical basis. Consumer goods import prices have surged in recent months (Chart 9), and the depreciating U.S. dollar is likely to sustain this uptrend. Cutthroat competition means that retailers will likely absorb these rising costs, to the detriment of profit margins. While food prices are making an effort to exit the deflation zone, ALDI and Lidl, two deep-pocketed German competitors are entering the U.S. retail scene, reportedly with massive expansion plans. Tesco, Sainsbury's and ASDA in the U.K., Carrefour in Europe and Woolworth's and Coles in Australia continue to feel the wrath of German retailers. Consequently, it would be dangerous to extrapolate the nascent improvement in retail food CPI. All of this is likely to sustain the profit margin squeeze (Chart 9). Further, the online retail onslaught will continue to escalate. The Amazon juggernaut appears unstoppable. The latest news that it will take over Whole Foods Market confirms that even grocery sales are now seriously on its radar screen. Chart 10 shows that non-store retail sales continue to grow at a much faster pace than traditional retailers. The greater the market share gains for online retailers, the larger the downward pressure on hypermarkets relative profitability (relative retail sales shown inverted, second panel, Chart 10). Chart 9Margin Pressures Margin Pressures Margin Pressures Chart 10Beware Online Retailers' Onslaught Beware Online Retailers' Onslaught Beware Online Retailers' Onslaught Under such a tough operating backdrop we are reluctant to pay a premium valuation for this safe haven sector. Worrisomely, soft revenue growth argues against a further a valuation re-rating (Chart 11). Finally, macro forces required to spur better revenue no longer exist. The U.S. economy has entered a self-reinforcing recovery. While personal consumption expenditures have underwhelmed of late, buoyant job certainty and a vibrant housing market are boosting consumer confidence. Before long, consumers should loosen their purse strings and indulge anew. Historically, a lively consumer spending backdrop has been inversely correlated with relative share prices (PCE is shown inverted, Chart 12). Similarly, Federal tax coffers have started to refill following a one year hiatus (bottom panel, Chart 12). The implication is that incomes and profits are expanding, boosting the incentive for consumers to "trade up" and shop at higher ticket stores. Nevertheless, some partial offsets exist. The lower income consumer is the industry's main clientele and low interest rates, low gasoline prices and soaring income confidence for this consumer cohort should cushion store traffic woes (third panel, Chart 13). Chart 11Derating ##br## Warning Derating Warning Derating Warning Chart 12Improving Economy = ##br## Bad Omen For Hypermarkets Improving Economy = Bad Omen For Hypermarkets Improving Economy = Bad Omen For Hypermarkets Chart 13Positive ##br##Offsets Positive Offsets Positive Offsets Meanwhile, the overall retail sales price deflator has tentatively troughed, albeit it continues to deflate. Given the high volume nature of the hypermarket industry, any small positive change in pricing power tends to have a meaningful impact on sales growth (second panel, Chart 13). Multi-year highs in overall income growth signals that on average consumers will have more disposable income. The bottom panel of Chart 13 shows that income growth has been a reliable indicator for hypermarket EPS. Adding it up, this is an opportune time to book modest profits and downgrade exposure in the S&P hypermarkets index to neutral. Intensified inter-industry competition, the onslaught of online retailers and a rebounding U.S. economy argue against extrapolating recent optimism far into the future. Bottom Line: Downgrade the S&P hypermarkets index to a benchmark allocation (WMT, COST). Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The sudden economic exuberance following the Trump election victory has caused a flight out of traditional safe havens that looks to have gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis. The chart shows that forward relative returns have typically been very robust when the group trades at a discount to the market. What could go wrong? History shows that a period of stable and strong GDP growth can cause discounted valuations to persist. Pricing in such an outlook at this juncture is overly optimistic, given the unknown fallout from a strong U.S. dollar on the rest of the world, trade uncertainty, and potential financial strains in the heavily indebted corporate sector as a consequence of rising bond yields. Keep in mind that the consumer products has a positive correlation with the U.S. dollar (top panel). We would be buyers on recent share price weakness. bca.uses_in_2016_11_30_001_c1 bca.uses_in_2016_11_30_001_c1

Consumer products stocks are likely to move to an even larger valuation premium before the cyclical outperformance phase ends.

Household product stocks are gathering momentum relative to the broad market. We expect this trend to persist as profit margins slowly improve. The industry has undergone a forced retrenchment as a consequence of the strong U.S. dollar, which sapped top-line growth. However, both commodity input and labor costs are contracting, providing much needed profit margin relief. The chart shows that operating margins have significant upside, especially if revenue improves even modestly. On this front, the plunge in commodity prices is freeing up disposable income to spend on brand-name essentials: consumer spending on toiletries is outpacing overall consumption for the first time in years. Moreover, Asian real retail sales are still growing at a robust rate, signaling that any emerging market currency stability should translate into better top-line performance. We reiterate our overweight position. The ticker symbols for the stocks in this index are: PG, CL, KMB, CLX, CHD. bca.uses_in_2016_01_27_001_c1 bca.uses_in_2016_01_27_001_c1