Sectors

Several tail risks appear less ominous compared to last month. Nonetheless, the earnings outlook has not improved and the FOMC will turn more hawkish ahead of the June meeting. Stay defensively positioned.

Monday's Special Report highlighted an overwhelmingly bullish macro backdrop for defensive sector relative performance. Health care is a key defensive component, but it has been hit hard in recent weeks, denting investor confidence. The main culprits behind the pullback have been the bounce in inflation expectations on the back of the dip in the U.S. dollar. The sector had rallied in lockstep with intensifying global deflationary pressures for the past few years, and it is only natural that it be used as a source of funds to lift exposure to cyclical sectors on the first whiff of financial stress relief. However, the path of least resistance for health care earnings is still up, in relative terms. Our Cyclical Macro Indicator is emitting bullish signals, supported by the resurgence in sector pricing power, particularly compared with moribund overall corporate sector selling price inflation. Importantly, valuation and technical factors also argue for a bullish reversal. Our relative valuation gauge is at an extremely undervalued level, while technical conditions are deeply oversold. These conditions are unlikely to last if relative forward earnings keep climbing, as we expect. Consequently, the reward/risk tradeoff is sufficiently upbeat to warrant adding the sector to our high-conviction overweight list. Adding The Health Care Sector To Our High-Conviction List Adding The Health Care Sector To Our High-Conviction List

Mixed data on housing turnover and new home prices have created some uncertainty surrounding the S&P homebuilders index over the past year, but we continue to see robust upside potential. Home prices are recovering after experiencing volatility in recent quarters, but not to the extent that affordability has been compromised. In fact, the Fed's dovish shift has helped push down long-term Treasury yields, further depressing mortgage rates and supporting housing affordability. The recent surge in lumber prices suggests that underlying construction activity is solid. Importantly, housing starts and real house prices remain well below prior cyclical peaks, underscoring that homebuilding companies should enjoy a prolonged period of decent growth. Moreover, the homeownership ratio has troughed, removing a major drag on the housing market. Any recovery in this ratio could turbo-charge housing demand. The implication is that homebuilders remain a core portfolio overweight. The ticker symbols for the stocks in this index are: DHI, LEN, PHM. bca.uses_in_2016_03_31_002_c1 bca.uses_in_2016_03_31_002_c1

Risk assets are stuck in a range driven by the Fed feedback loop. But the current rally may continue for another quarter or two.

There are a number of warning signs that the global and EM equity bounce is unsustainable. The latest episode of housing recovery in China will prove temporary due to still-large imbalances. Overweight Indian stocks: the credit cycle in India is less vulnerable compared to other EMs. However, the outlook for Indian equities in absolute terms is not bullish.

The S&P pharmaceutical index has checked back relative to the broad market, reflecting the powerful short covering and relief rally in higher beta sectors in recent weeks. While this trend may persist in the very near run, we expect relative performance to follow relative forward earnings growth. On this front, conditions are bullish. In absolute terms, pharmaceutical companies are enjoying a productivity revival, as a demand-driven surge in pricing power is underway. That stands in marked contrast with the rest of the corporate sector, which is battling deflation, as evidenced by the relentless decline in bond yields (shown inverted, top panel). The chart shows that when firms are cutting selling prices, pharmaceutical profits outperform, as is currently the case. Moreover, drug companies continue to use excess capital in a shareholder-friendly manner, as shares outstanding continue to sink. The bottom line is that pharmaceutical earnings are on track for further outperformance, which should pull up the share price ratio. Stay overweight. The ticker symbols for the stocks in this index are: AGN, BMY, LLY, ENDP, JNJ, MNK, MRK, MYL, PRGO, PFE, ZTS. Is The Pharmaceuticals Pullback Overdone? Is The Pharmaceuticals Pullback Overdone?

Airline stocks have enjoyed some modest relief in recent weeks, but we expect this resilience to fully reverse. The main issue is overcapacity. Discretionary spending is under pressure, based on the message from global manufacturing woes and the plunge in the National Association of Restaurants survey (second panel). Airlines have been aggressively building capacity, as evidenced by the increase in airline capital spending. Long airplane production cycles mean there is a lag between spending and when new capacity will come on stream, and the tripling in airline parts & components inventory in the last eight years warns that the delivery pipeline remains full. Airlines are already resorting to price cuts to fill seats (bottom panel), which will drag on profitability. Importantly, future capacity increases signal that deflation will remain a prominent industry theme for the foreseeable future, and act as a weight on valuation multiples. Stick with a high-conviction underweight. The ticker symbols for the stocks in this index are: AAL, DAL, LUV, UAL. Airlines Are Running Out Of Fuel Airlines Are Running Out Of Fuel

Two weeks ago we outlined our top ten reasons to deemphasize the tech sector in equity portfolios. The tech sector is experiencing a productivity drain that is threatening profit margins and return on equity. However, within the sector there is one positive exception to this view: communications equipment (CE). Investment in CE is climbing relative to total investment and compared with IT investment after a prolonged slump. Years of underinvestment suggest that some pent-up demand has been created, allowing for the potential to outperform even if overall capital spending continues to sink, as we expect. The main CE demand driver has been the telecom services sector. Telecom capital spending has increased significantly, as measured by telecom facilities construction. That leads CE industry top-line growth, signaling revenue expansion ahead (bottom panel). Domestic demand strength has been partially offset by weak global markets. A strong U.S. dollar has undermined U.S. telecom equipment exports at the same time that foreign demand growth, China's imports in particular, has faltered. Still, global headwinds are more than discounted, as the relative forward P/E trades at a massive discount, even though industry productivity is improving. Bottom Line: re-rating potential exists despite our overall economic and broad market concerns. The ticker symbols for the stocks in this index are: CSCO, FFIV, HRS, JNPR, MSI. bca.uses_in_2016_03_23_001_c1 bca.uses_in_2016_03_23_001_c1

While the communications equipment industry provides a contrarian tech sector investment opportunity, in relative terms, computer hardware offers a much different profile. Hardware investment is highly cyclical, rising and falling with discretionary spending budgets. The latter are being pruned as the corporate sector tightens its belt as a consequence of deflation and profit margin pressure. The chart shows that, unlike telecom equipment, hardware investment continues to sink as a share of total spending. That will sustain downward sales pressure and keep manufacturers operating at suboptimal rates. Already, the rate of hardware output has plunged, and is well below the rate of capacity growth. Such a dynamic warns of an intensification of deflationary pressures, particularly given that vendors to end clients are aggressively slashing prices. Without a positive demand impulse, the odds of computer hardware profit disappointment will remain acute. We continue to recommend an underweight position. The ticker symbols for the stocks in this index are: AAPL, EMC, HPE, HPQ, NTAP, SNDK, STX, WDC. bca.uses_in_2016_03_23_002_c1 bca.uses_in_2016_03_23_002_c1

A global comparison suggests that China's capacity utilization does not appear particularly weak compared to other countries. The excess capacity problem is not unique to China, and therefore cannot be explained by China's investment-driven growth model. Chinese stocks have been unduly punished by the "overcapacity" stigma, which is unwarranted and will eventually correct.