Developed Countries

Going long Treasurys/short bunds has been a “widow maker trade” for the past decade. Similarly trying to short the SPX has also proven impossible since March 2009 as stocks have been climbing the proverbial “wall of worry” and risen roughly 2,200 points or more than fourfold. While the correlation between the bond spread and the SPX may be spurious, it has been ongoing in both rising and falling markets for the better part of the past 25 years. The rationale would be that higher relative yields attract capital to U.S. shores and vice versa and some of that capital gets parked inevitably in U.S. stocks. Another reason behind the past decade’s widening of the bond spread is that U.S. return on capital (ROC) has been significantly higher than euro area ROC. Currently, there is tentative evidence that this bond spread has crested and at least from a tactical perspective some caution is warranted in the SPX.

Overweight This week and last have witnessed the cavalcade of U.S. banks reporting earnings. A headwind in this earnings season has been the transitory impacts of volatility, which was suppressed in Q1, on fixed income and equity trading earnings that have torqued earnings up and down. While each firm has its own idiosyncrasies and exposure to trading gains or losses, a common theme has been the expansion of net interest margins (NIMs), the measure of profit from the core lending activity, despite the 10-year yield falling throughout the first quarter. In fact, this theme is not new as NIMs have been expanding since bottoming in early-2015, regardless of the ebbs and flows of rates. One key reason for wide NIMs is that banks have not been passing higher rates on to the consumer, despite the Fed’s tightening cycle, thus cementing cheap deposit funding. In the past, NIMs have been reliable indicators of banks’ relative performance but the GFC changed that. The radioactive nature of the sector post-GFC meant that banks did not respond to the recovery of NIMs to pre-crisis levels. However, times have changed; U.S. banks are exceptionally well capitalized and the current divergence between resilient and rising NIMs and flat bank relative performance has opened an exceptional buying opportunity. Bottom Line: Stay overweight banks (and remove the downgrade alert) and stay tuned for our April 22nd Weekly Report where we will be offering a more fulsome update on the sector.

Overweight A little over a year ago we moved to the sidelines in the S&P managed health care index, crystalizing significant relative profits of 28% for our U.S. equity portfolio.  Now the time has come anew to explore this niche health care index from the long side and yesterday we moved to an overweight position. Leading indicators of health care insurance profit margins are currently flashing green. Not only are medical costs melting including drug price inflation (second & bottom panels), but also industry cost structures are kept at bay with wages climbing below a 2%/annum rate growth and trailing overall wage inflation (third panel). On the demand front, as the economy is running at full employment, with unemployment insurance claims probing 60-year lows and with wages representing a headache for small and medium business owners, enrollment should stay healthy. Most importantly, the combination of decreasing medical cost inflation and a healthy overall labor market heralds a steep decline in the industry’s medical loss ratio. While risks of a potential “Medicare For All” plan remain nebulous and have clearly weighed on industry stock prices, melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Bottom Line: We boosted the S&P managed health care index to overweight yesterday; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, ANTH, HUM, CNC, WCG.