Utilities

In order to make room for this week's upgrade of the consumer discretionary sector, we have downgraded the utilities sector to neutral after a strong run. Overweight positions in this sector were predicated largely on external forces rather than sector-specific factors, largely that the overwhelmingly deflationary global backdrop would turbo-charge the search for yield, culminating in a re-rating in equity fixed income proxies such as utilities. Worries about a slide into recession have ebbed, because domestic consumer spending has stayed resilient, job growth has bounced back after a difficult few months, and the U.S. manufacturing sector is showing signs of life. Even the global economic surprise index has climbed into positive territory, driven mostly by an uptick in the U.S. Consequently, utility stocks may have difficulty generating additional outperformance, especially within the context of the broad market overshoot. We recommended taking profits of 17% and trimming to neutral in Monday's Weekly Report. BLBG: S5UTIL. bca.uses_in_2016_07_27_001_c1 bca.uses_in_2016_07_27_001_c1

Expectations of a prolonged period of abundant liquidity and rising confidence that recession is not imminent have created the conditions for a potential blow-off phase. This week we are fine-tuning our portfolio for peak performance.

Our <i>Cyclical Indicator Update</i> reveals that a defensive portfolio strategy remains the best bet to navigate the crosscurrents of stagnant profit/economic growth yet abundant global liquidity.

The sinking global credit impulse warns that reflation has not overwhelmed deflationary forces. Financials will continue to suffer, while utilities and retail drug stores will benefit.

Utilities appear to have successfully consolidated this year's sharp relative performance run up, as the share price ratio is firming anew after holding at its 40-week moving average. The incentive to maintain an overweight exposure to this fixed income proxy is heavily influenced by whether global deflationary forces have finally ebbed. While the U.S. dollar has softened in recent months, it has not caused an upsurge in inflation expectations nor has failed to cause a sell-off in Treasurys. U.S. yields are being pinned down by persistently low global bond yields, which reflect chronic deflationary pressures. As long as the total return of bonds is beating equities, then utilities relative performance momentum should stay positive (third panel). Without any valuation barriers to further outperformance, we continue to recommend an above-benchmark weighting. BLBG: S5UTIL. bca.uses_in_2016_05_05_002_c1 bca.uses_in_2016_05_05_002_c1

The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.

The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.

Our cautious outlook on corporate profits amid ongoing deflation pressures is reason enough to favor non-cyclical equity sectors. But the surprise Bank of Japan move to introduce negative deposit rates adds yet another catalyst for defensive and fixed-income proxies. On the margin, capital is likely to seek out high yielding government bond markets. The U.S. still has comparatively juicy yields compared with other developed countries. In fact, a growing swath of the euro area bond market has negative yields. In addition, the U.S. has a strong currency. That could create a self-reinforcing feedback loop, as the exchange rate will sustain imported deflationary pressures over and above the additional pressure on China and the rest of Asia if the yen weakens. When the ECB announced negative deposit rates in the spring of 2014, the U.S. dollar immediately vaulted higher and Treasury yields declined for the rest of the year (see the vertical line). At the same time, long duration sectors such as health care accelerated, while utilities and REITs caught a bid. We expect these sub-surface equity trends to repeat, and broaden, as telecom services should now fit into the mix, because unlike 2014, overall corporate profits are falling and financial conditions are much more restrictive. The implication is that a defensive portfolio structure remains appropriate. Another Wave Of Deflation Favors Long Duration Sectors Another Wave Of Deflation Favors Long Duration Sectors