Railroads

Cyclical Wounds Remain Open Cyclical Wounds Remain Open Neutral - Downgrade Alert The transportation industry is a bellwether for the economy as rising freight hauling services demand is synonymous with firming economic activity and vice versa. The recent FedEx earnings report raised red flags both for the wellbeing of the transport sector (second panel) and the U.S. economy, especially the highly cyclical manufacturing sector. The company blamed soft global macro conditions and significantly trimmed profit guidance for its fiscal year. FedEX also highlighted that the absence of a trade deal with China complicates the free movement of goods (bottom panel) and the longer the uncertainty between the U.S. and China remains in place, the longer it will take for global trade growth to heal. One saving grace for air freight stocks has been the industry’s pricing power rebound, but there are mushrooming signs that sector inflation will cool down in the coming months (third panel). We have been neutral on the S&P air freight & logistics index since removing it from our high-conviction overweight list following previous FedEx profit warning, and now we are putting this transportation subgroup and the overall transportation index on our downgrade watchlist. Bottom Line: We are neutral the S&P transportation index, but now have it on downgrade alert. Our barbell strategy within transports remains in place overweighting airlines, neutral on air freight & logistics (but it is now on downgrade alert) and underweighting rails. Stay tuned. ​​​​​​​

Avoid Getting Railroaded Avoid Getting Railroaded Underweight Our underweight S&P railroads call has moved into the black as CSX rattled the industry and chopped 2019 revenue growth from positive 1-2% to negative 2%. While UNP’s numbers were better than expected and partially offset CSX’s weakness, transport data does not lie and warns that a sizable slowdown is already underway in rail freight (second panel). In fact, our rail shipments diffusion indicator is sinking like a stone to levels last hit at the depths of the GFC (third panel). Such broad-based weakness in nearly every rail carload category is worrisome and warns that overly optimistic relative profit expectations (not shown) will suffer a setback. Softening demand for rail freight services will likely remain under intense downward pressure as there is little progress made on the U.S./China trade spat front. As a result, industry pricing power will continue to wane and ignite a de-rating phase in rail valuations (bottom panel). Bottom Line: Stay underweight the S&P railroads index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU.

Rail Shipments Are Still Falling Rail Shipments Are Still Falling Underweight We downgraded the S&P railroads index to underweight last month based on falling rail traffic leading railroad pricing power down from its recent highs. Last week’s release of traffic data showed further deterioration in volumes, the fundamental driver of pricing power, confirming our bearish thesis. Only four of the 20 commodity categories tracked by the Association of American Railroads (AAR) saw volumes increase last month and virtually all of this was petroleum products which itself is likely only a temporary gain, owing to easing in pipeline bottlenecks later this year. Overall traffic fell a stunning 5.2% from the same period last year (third panel). The Cass Freight Shipments Index too has recently rolled over, a likely precursor to a fall in the Expenditures component of the index, and predicting that railroad pricing challenges are in the early stages (second panel). Meanwhile, sector leverage ratios are at their highest level in a decade as railroads have retooled their capital structure to increase buybacks at the expense of the balance sheet, adding a new level of risk to the industry (bottom panel). Bottom Line: Valuations in the S&P railroads index have overstated earnings power and understated equity risk premia; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. ​​​​​​​

Highlights Portfolio Strategy Corporate sector selling price inflation is nil while leading wage inflation indicators signal additional labor cost increases in the coming months. The risk is that profit margins have already peaked for the cycle. We reiterate our tactically cautious overall equity market view. Galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A all signal that it still pays to be bullish software stocks Recent Changes Last Thursday we downgraded the S&P railroads index to underweight. Also last Thursday we trimmed the S&P air freight & logistics index to neutral. Table 1 Have SPX Margins Peaked? Have SPX Margins Peaked? Feature The SPX stalled last week, digesting the now-complete Fed pivot. Our sense is that the Fed’s dovish turn is now fully reflected in equities. Importantly, the longer and wider the dichotomy between stocks and bonds gets, the more painful the ramifications from the eventual snap will be, likely with equities yielding to the bond market (Chart 1). As we first posited on March 4, short-term equity market caution is still warranted.1 Chart 1Time To Get Back Together Time To Get Back Together Time To Get Back Together While the Fed meeting and sharp decline in Treasury yields dominated headlines last week, it was the NFIB’s latest release that really caught our attention. Importantly, it revealed that taxes and big government are no longer the biggest problems facing small and medium business owners, but labor is: “Twenty-two percent of owners cited the difficulty of finding qualified workers as their Single Most Important Business Problem, only 3 points below the record high. Ten percent of owners find labor costs as their biggest problem, a record high for the 45-year survey.”2 Historically, such extreme tightness in the SME labor market is a precursor of a yield curve inversion (NFIB cost of labor shown inverted, Chart 2). The link is clearer if we show this same NFIB series with the Labor Department’s average hourly earnings monthly release that is currently running at a 3.4%/annum clip (Chart 3). In other words, a tight labor market is conducive to corporations bidding up the price of labor which in turn causes the Fed to raise interest rates, eventually inverting the yield curve. Chart 2Cycle Is Long In The Tooth Cycle Is Long In The Tooth Cycle Is Long In The Tooth Chart 3Wage Growth... Wage Growth... Wage Growth... This macro backdrop is slightly unnerving and our biggest concern is the S&P 500’s profit margins (Chart 4). Q3/2018 marked the all-time peak in SPX quarterly margins according to Standard & Poor’s,3 and in Q4/2018 margins have deflated from a high mark of 12.13% to 10.11%, or a 16.7% q/q drop. Chart 4...Denting Margins ...Denting Margins ...Denting Margins Undoubtedly, last year’s fiscal easing-induced all-time highs in SPX margins is unsustainable, and a tight labor market is a warning shot. Using the same NFIB series on cost of labor being the most important problem SMEs face and subtracting it from our corporate pricing power proxy, we constructed an equity market margin proxy, shown as a Z-score in Chart 5. Historically, the y/y change in SPX profit margins move in lockstep with our margin proxy and the current message is grim (Chart 5). Chart 5Margin Trouble Ahead Margin Trouble Ahead Margin Trouble Ahead Before getting too bearish though, we want to make three salient points: First, while the NFIB survey’s labor related indicators are disconcerting, unit labor costs – the best measure of wage growth – remain muted as productivity growth has ramped up recently. Second, using empirical evidence dating back to the 1960s, the ultimate SPX profit margin mean reversion occurs during recessions, when EPS suffer a major setback. The implication is that margins can move sideways or grind lower in the coming year. As a reminder, BCA’s review remains that the U.S. will avoid recession in the next 12 months. Third, the most important yield curve slope, the 10/2, has not yet inverted, and even when it does invert, investors will have time to start positioning defensively; we have shown in recent research that the S&P peaks after the yield curve inverts.4 On a related note, we use this opportunity to update our corporate pricing power proxy, and Table 2 summarizes the sectorial results. Table 2Industry Group Pricing Power Have SPX Margins Peaked? Have SPX Margins Peaked? Corporate sector selling price inflation has ground to a halt at a time when wage inflation is rearing its ugly head. Worrisomely, our pricing power diffusion index’s breadth sunk below the 50% line, whereas our wage growth diffusion index spiked higher; 70% of the 44 industries we track are struggling with rising wages (second & third panels, Chart 6). Taken together, there is evidence that broad-based profit margin pressures are escalating, the mirror image of what our gauges were signaling in our last update late-last year.5 Chart 6Margins Have Likely Peaked Margins Have Likely Peaked Margins Have Likely Peaked Digging beneath the surface of our corporate pricing power proxy is revealing. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. 57% of the industries we cover are lifting selling prices, but only 27% are raising prices at a faster clip than overall inflation. Both figures are lower than our early-November report. Outright deflating sectors increased by eight to twenty four since our last update, fifteen of which are deflating at 1%/annum pace or lower. One third of the industries we cover are experiencing a downtrend in selling price inflation, representing a 43% increase since our most recent report (Table 2). Deep cyclicals/commodity-related industries (ex-oil) continue to dominate the top ranks, occupying the top six slots (Table 2). Despite the ongoing global manufacturing deceleration and still unresolved U.S./China trade tussle, the commodity complex's ability to increase prices remains resilient. On the flip side, energy-related industries occupy the bottom of the ranks as WTI crude oil is still 22% lower than the most recent peak in October 2018. In sum, business sector selling price inflation is nil while leading wage inflation indicators signal additional labor cost increases in the coming months. The risk is that profit margins have already peaked for the cycle. We reiterate our tactically cautious overall equity market view. This week we update a high-conviction overweight tech subgroup and recap our transportation subsurface moves from last Thursday. Buy The Software Breakout Software stocks are on fire and leading profit indicators suggest that more gains are in store in the coming months. Last week, we published a table ranking all the sectors and subsectors by 12-month forward profit growth estimates (please refer to Table 2 from the March 18 Weekly Report). While the broad tech sector is on an even keel with the SPX, software EPS are racing at twice the speed of the broad market, roughly 14%. Keep in mind, when growth gets scarce, investors flock to industries with accelerating profit prospects. The software profit juggernaut is intact and we reiterate our high-conviction overweight recommendation. Sustained capital outlays on software are a key driver of industry profits (bottom panel, Chart 7). In an otherwise muted Q4 GDP release, rising non-residential fixed investment in general and surging investment in software in particular suggest that our bullish software capex thesis is alive and kicking (middle panel, Chart 7). Chart 7Software On A Tear Software On A Tear Software On A Tear The move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are also in a structural uptrend. Not only private sector software capex is near all-time highs as a share of total outlays, but also government investment in software is reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments are taking such risks extremely seriously the world over (second panel, Chart 8). Chart 8Earnings Led Advance Earnings Led Advance Earnings Led Advance Meanwhile, fear of missing out has rekindled industry M&A and both the dollar amount and number of deals are sky high, with acquirers bidding up premia to the stratosphere (Chart 9). This supply reduction is bullish for industry pricing power. Chart 9M&A Frenzy M&A Frenzy M&A Frenzy Granted the M&A frenzy has pushed relative valuations on the expensive side especially on a forward P/E basis, but on EV/EBITDA software stocks are trading below the historical mean and still significantly lower than the late-1990s peak valuation (bottom panel, Chart 8). If our bullish software profit thesis continues to pan out, then software stocks will grow into their pricey valuations. Finally, shareholder friendly activities are ongoing in this key tech subsector and buybacks in particular provide an added layer of artificial EPS growth (bottom panel, Chart 9). Adding it up, galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A, all signal that it still pays to be bullish software stocks. Bottom Line: Buy the software breakout. The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ORCL, ADBE, CRM, INTU, ADSK, RHT, CDNS, SNPS, ANSS, SYMC, CTXS, FTNT. Tweaking Transport Subgroup Positioning The S&P transports index’s recovery rally has stalled recently and is a cause for concern for the overall market. In more detail, the recent gulf between relative share prices and the SPX has widened and warns that the overall market is at a risk of suffering a pullback (Chart 10). Chart 10Engine Trouble Engine Trouble Engine Trouble Thus on Thursday last week, we made two subsurface transport changes, downgrading a subgroup to underweight that commands lofty valuations at a time when leading profit indicators are flashing red, and also downgrading to neutral a globally exposed transport sub-index. Get Off The Rails In our downgrade of the S&P railroads index late last year to a benchmark allocation, we highlighted that two of our key industry Indicators, the Railroad Indicator and our Rail Shipment Diffusion Indicator, had turned negative.6 These indicators have continued to deteriorate, including total rail shipments which have now started to contract for the first time since the 2015-16 manufacturing recession (third panel, Chart 11). Intermodal shipments in particular have nosedived, likely a result of weak retail sales, as we highlighted earlier this month.7 Chart 11Downgrade Rails To... Downgrade Rails To... Downgrade Rails To... This contraction would be far less concerning were it not for the rapid degradation of industry balance sheets as firms have sought to increase relatively cheap leverage in order to retire equity. Railroads are now significantly more indebted than the broad market which itself has not shown an aversion to adding leverage (bottom panel, Chart 11). Such a change in railroad capital structure has kept EPS growth rates artificially high while simultaneously adding an extra measure of equity risk premium that does not yet appear fully reflected in relative share prices. Moreover, when we downgraded the S&P railroads index to neutral last year, deteriorating Indicators were offset by exceptionally healthy pricing power.8 After a multi-year expansion, selling price inflation has now rolled over (second panel, Chart 12), taking away the remaining pillar supporting a neutral view which compelled us to move to an underweight allocation last week. Chart 12...Underweight ...Underweight ...Underweight Pricing power is one of the key determinants in our earnings model that, when combined with the previously noted contracting volumes, is indicating the end to the industry’s above-trend earnings growth is nigh (third panel, Chart 12). With relative earnings growth slowing and rising leverage adding incremental risk, the S&P railroads index’s premium valuation multiple looks increasingly dicey (bottom panel, Chart 12). Bottom Line: Broad based declines in traffic volumes, falling pricing power and high leverage suggest that earnings will underwhelm. Accordingly, last Thursday we moved to an underweight recommendation on the S&P railroads index as we expect a de-rating phase to materialize. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Air Freight Had Its Wings Clipped We have been offside on the high-conviction overweight call on the S&P air freight & logistics index and the recent FedEx warning suggests that profits will come under pressure for this index for the rest of the year and will trail the SPX. As such, we trimmed exposure to neutral late-last week and removed it from the high-conviction overweight list for a loss of 14%. Chart 13 shows that all the profit drivers we had identified in early December last year have taken a sharp turn for the worse. Energy costs are no longer in deflation as oil prices have jumped from $42/bbl to near $60/bbl. Not only is global growth still decelerating, but also U.S. growth is in a softpatch: the manufacturing shipments-to-inventory ratio is on the verge of contraction, warning that delivery services’ selling prices are in for a turbulent ride (second panel, Chart 13). In addition, definitive news of Amazon becoming a formidable competitor in courier delivery services is structurally negative for the industry. Chart 13Air Freight: Move To The Sidelines Air Freight: Move To The Sidelines Air Freight: Move To The Sidelines Nevertheless, we refrain from turning outright bearish as air freight stocks are technically oversold and valuations are trading at the steepest discount to the broad market since mid-2002. Bottom Line: Last Thursday we downgraded the S&P air freight & logistics index to neutral and also removed it from the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. 2https://www.nfib.com/assets/jobs0219hwwd.pdf 3https://ca.spindices.com/documents/additional-material/sp-500-eps-est.xlsx?force_download=true 4 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, “Recuperating” dated November 5, 2018, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, “Critical Reset“, dated October 29, 2018, available at uses.bcaresearch.com. 7 Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly“, dated March 4, 2019, available at uses.bcaresearch.com. 8 Please see BCA U.S. Equity Strategy Weekly Report, “Critical Reset“, dated October 29, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Pricing Power Is Derailing Pricing Power Is Derailing   Underweight Our previous Insight referenced the deterioration of indicators that caused us to grow more negative in last year’s downgrade of the S&P railroads index to a benchmark allocation but what kept us from moving to an outright bearish position at that time was exceptionally strong pricing power.1 After a multi-year expansion, pricing power has now rolled over (second panel), taking away the remaining pillar supporting a neutral view and we are compelled to move to an underweight allocation today. Pricing power is one of the key determinants in our earnings model which, when combined with the contracting volumes noted in the previous Insight, is indicating the end to the industry’s above-trend earnings growth is nigh (third panel). With relative earnings growth slowing and rising leverage adding incremental risk, the S&P railroads index’s premium valuation multiple looks increasingly dicey (bottom panel). Bottom Line: Broad based declines in traffic volumes, falling pricing power and high leverage suggest that earnings will underwhelm. Accordingly we are moving to an underweight recommendation on the S&P railroads index as we expect a de-rating phase to materialize. Please see the next Insight for another transportation subsector change. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU.     1 Please see BCA U.S. Equity Strategy Report, “Critical Reset“, dated October 29, 2018, available at uses.bcaresearch.com.

Get Off The Rails Get Off The Rails Underweight In our downgrade of the S&P railroads index late last year to a benchmark allocation, we highlighted that two of our key industry Indicators, the Railroad Indicator and our Rail Shipment Diffusion Indicator, had turned negative.1 These indicators have continued to deteriorate, including total rail shipments which have now started to contract for the first time since the 2015-16 manufacturing recession (third panel). Intermodal shipments in particular have nosedived, likely a result of weak retail sales, as we highlighted earlier this month.2 Such a contraction would be far less concerning were it not for the rapid degradation of industry balance sheets as firms have sought to increase relatively cheap leverage in order to retire equity. Railroads are now significantly more indebted than the broad market which itself has not shown an aversion to adding leverage (bottom panel). Such a change in railroad capital structure has kept EPS growth rates artificially high while simultaneously adding an extra measure of equity risk premium that does not yet appear fully reflected in relative share prices. Our concerns surrounding the S&P railroads index have amplified as our Indicators have deteriorated and leverage has mounted; please see the following Insight for our change in recommendation.   1 Please see BCA U.S. Equity Strategy Report, “Critical Reset“, dated October 29, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Report, “The Good, The Bad And The Ugly“, dated March 4, 2019, available at uses.bcaresearch.com.

Neutral We have been riding the rails juggernaut for roughly 16 months, but the time has come to get off board. As shown in the chart at the side, technical conditions are overbought and relative valuations are pricey, hovering near previous extremes as investors are extrapolating good times far into the future. Such euphoric readings have historically been synonymous with a high relative performance mark for this key transportation sub-index and are a cause for concern. In Monday's Weekly Report, we highlight four key reasons why it is time for us to downgrade. First, this capital intensive industry has been reducing capex but increasing their debt load to retire equity, which erodes a cushion should cash flow growth suffer a mishap. Second, the global manufacturing outlook has downshifted on the back of Trump's trade rhetoric and China's larger than anticipated slowdown. Third, two of our key rail industry Indicators have suddenly turned south, particularly our Rail Shipment Diffusion Indicator which has fallen off a cliff recently. Lastly, industry operating metrics are deteriorating, at the margin, and intermodal rail shipments have rolled over. Bottom Line: We locked in relative gains of 15% since inception in the S&P rails index and downgraded to neutral on Monday; please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Time To Get Off The Rails Time To Get Off The Rails