Equities

Equities have finally run into some selling pressure. Any time the market pulls back, especially from current lofty valuation levels, many wonder whether a major trend change is occurring. However, history shows that equities typically do not run into serious trouble until the threat of recession feels imminent. The yield curve can provide a helpful timing tool for when recession risks have become too acute for equity investors to ignore. A very flat or inverted yield curve has previously signaled that monetary policy was too tight, warning of previous major cyclical equity peaks. Currently, the 10/2 year Treasury yield curve is still positively sloped, although at the current pace of narrowing it won't take much for it to flatten completely. As the curve flattens, we expect capital to gravitate to non-cyclical sectors, as has historically occurred. The chart shows that the cyclical/defensive share price ratio has generally been positively correlated with the steepness of the yield curve. The major exception was a decade ago, when the Fed was tightening but lagged behind the housing/financial credit boom, which supported optimism toward cyclicals until the onset of the Great Recession. Unless the yield curve begins to widen decisively on the back of a growth-driven pickup in inflation expectations, the risk is that cyclical sector profits will disappoint. As such, we prefer to maintain a core defensive strategy, despite some valuation concerns, because momentum driven markets can reverse at a moment's notice.

We went overweight the S&P agricultural chemicals index in early May, a contrarian bet to take advantage of extreme bearishness, undervaluation and the potential for a rise in underlying commodity prices. Since then, a rise in industry M&A activity has borne out our thesis of cheap valuations, generating solid relative returns. Nevertheless, operating conditions may be slower to improve than originally anticipated. Burgeoning wheat and corn harvests this year threaten to keep the supply/demand balance for grains out of whack for another year. The USDA forecasts a hefty surplus in both key commodities. When grain prices advance, farm incomes receive a shot in the arm, providing farmers with both the means and the confidence to increase planting acreage, thereby boosting fertilizer demand. If food prices stay soft, then that positive dynamic is not going to take hold on a cyclical horizon. Instead, farmland prices will stay near cyclical lows, and agricultural-related credit availability will continue to tighten. The latter is already at a 10-year low, reflecting reduced farm incomes. Consequently, we recommend taking profits and downgrading to neutral. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5FERT - MON, MOS, CF.

Disappointing ISM surveys could signal a growth consolidation.
That, in turn, would spur a correction in risk assets.

Equities are celebrating domestic economic disappointment rather than re-pricing the risk of ongoing profit struggles. This reinforces that liquidity and share price momentum are still the dominant market forces.

While a September rate increase is still possible, the recent batch of disappointing U.S. economic data, combined with lackluster inflation readings and election uncertainty, suggest that a December hike is much more probable. Similar to last year, risk assets are likely to react negatively to the prospect of further monetary tightening. Stay tactically short global equities and position for a stronger dollar.

S&P communications equipment greenshoots are turning into full blossom, signaling additional share price outperformance ahead. The latest Federal Reserve industrial production (IP) release highlighted that telecom equipment factories are revving their engines, in contrast with muted overall output growth. Historically, industry IP growth has been closely correlated with shipments-to-inventories momentum and the current message is positive (second panel). Output is booming relative to capacity, inventories are lean and telecom equipment imports are subdued, which is supportive of pricing power. All of this is boosting our industry productivity proxy (third panel). The upshot is that S&P communications equipment profits will outperform the S&P 500, serving as a catalyst for a relative valuation re-rating phase (bottom panel). Bottom line: While we are underweight the broad tech sector, we are reiterating our early-August high-conviction overweight stance in the S&P communications sub-group. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV.

Hong Kong's growing political awareness and rising sensitivity to public policy underscores brewing social tensions brought about by decades of <i>Laissez-Faire</i> capitalism. Social policies will likely become progressively more redistributive, with potentially a longer-term negative impact on asset prices.

A common perception is that the euro has been a failure for Italy. We challenge this perception and explain why it is so important for investors, whether it is wrong or right.

The latest FDIC Quarterly Banking Profile showed that bank earnings' improvement remains lackluster. What caught our attention from the release was the persistent widening in the C&I non-current loan rate, coupled with rising C&I charge-offs. C&I loans now comprise the largest category of bank credit and the recent credit quality deterioration is unnerving, despite the low starting point (C&I non-current rate shown inverted, top panel). There are high odds that the credit cycle has turned for the worse given deteriorating corporate balance sheets. Moreover, the latest reading from the labor market conditions index - the Fed's preferred labor market indicator - is signaling that total non-performing loans will soon hook back up (middle panel). This message is also corroborated by the quickly flattening yield curve, which has historically been an excellent leading indicator of the credit cycle (yield curve shown inverted, third panel). Bottom line: Shy away from the banking sector. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, CMA, HBAN, ZION, RF, PBCT.

While we recently boosted the broad consumer discretionary index to overweight, we continue to avoid the auto components sub-group. Relative earnings prospects remain poor. The second panel of the chart shows that relative profitability is on the cusp of a melt-down, according to the relative shipments-to-inventory (S/I) ratio. The decline in the S/I reflects both an unwanted inventory build and decline in shipments. Overproduction will ensure that pricing power stays in deflationary territory (third panel). It would take an upsurge in vehicle demand to reverse these trends, but that is unlikely given tightening auto credit on the back of concerns about auto loan quality and a saturation in vehicle sales (bottom panel). Consequently, auto-related corporate profitability will remain under pressure. Bottom line: Stick with a below benchmark weighting in the S&P auto components index. The ticker symbols for the stocks in this index are: BLBG: S5AUTC - JCI, DLPH, BWA, GT.