Equities
The decline in global bond yields and negative interest rates abroad represents a windfall for U.S. housing, to the extent that U.S. mortgage rates are lower than they otherwise would be. The latest plunge in yields is translating into a clear acceleration in mortgage demand, as proxied by the advance in mortgage purchase applications. That is a leading indicator for home sales, the lifeblood of the homebuilding industry. Importantly, the financial incentive to buy a home is high and rising, given the attractiveness of owning vs. renting, and the growing gap between house price inflation and mortgage rates. It is no wonder that the latest National Homebuilder's Survey recorded a sharp jump in sales expectations, heralding faster top-line growth ahead. That should be sustainable, as discussed in the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.
The financials sector led the recent pullback in the broad market. Rather than view this as a buying opportunity, it is symptomatic of the relentless plunge in global bond yields and an increasing scarcity of financial sector pricing power. For instance, the asset management & custody bank (AMCB) index will struggle to overcome profit margin pressure. Punitively low running yields represent a major challenge for the AMCB industry. Anything that can be capitalized has been re-rated. High valuations mean that prospective long-term equity returns are slim. Against this backdrop, management expense ratios look high in both the equity and bond universes. Fees have already been under structural pressure due to the shift into passive equity products (bottom panel), and outperformance of bonds, which garner even lower margins than equity products. Index funds generate much lower fees than actively managed pools of capital. If bonds continue to outperform stocks as global economic sentiment sours, then performance chasing investors are likely to continue putting more capital into lower margin bond products relative to equity funds. In other words, as the equity risk premium climbs, AMCB profit potential will decline. Stay underweight.
For the broad market, capital appreciation potential will be levered to profit trends rather than liquidity/multiple expansion at the current stage of the cycle. The fuel to drive up global aggregate demand remains absent. According to BIS data, global credit growth is contracting. That is significant, because credit greases the wheels of the global economy. The message is that it is too soon to expect profit relief from overseas. Corporate profit margins are already narrowing, but bottom up forecasts discount an aggressive move out to new highs in the coming quarters (middle panel). The growth backdrop is not conducive to such a development. The yield curve, which is an excellent business cycle indicator and a leading signal for profit margins, continues to narrow relentlessly. Fewer than 50% of the non-financial and non-utility industry groups are currently expanding profit margins. Yet 8 out of 10 sectors are expected to grow margins, according to analyst earnings estimates. Specifically, cyclical sectors such as industrials, materials, energy and technology are slated to show broad-based improvement in profitability. That would not be farfetched if the world were on the cusp of a V-shaped, post-recession type of acceleration and the U.S. dollar were set to weaken significantly. However, deleveraging and the global credit contraction warn that global growth is not about to rebound. As such, we remain skeptical that the macro backdrop will validate upbeat analyst forecasts, rendering deep cyclical sectors vulnerable to underperformance.
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.
The Fed has reason to delay the next rate hike until at least September, even if volatility subsides after the June 23 Brexit vote.
Gold stocks have regained traction after a brief interlude in the bull market, and the path forward remains bullishly skewed. The Fed took a slightly dovish turn at this week's FOMC meeting, reinforcing that they remain in reactive mode, thereby sustaining rising policy uncertainty (second panel). Given our bias to expect economic disappointment, the odds are good that policy will need to remain accommodative, with real interest rates staying in negative territory for a prolonged period. That is a plus for a zero yielding asset such as gold. With world economic expectations continuing to grind lower (shown inverted, top panel), the appeal of owning gold stocks as a portfolio hedge remains attractive, particularly given that sentiment towards the yellow metal is far below prior extremes. Stay overweight.
The previous Insight showed that broad macro conditions point to a reduction in managed care risk premiums. This outlook brightens further when considering recent cost inflation trends. The latest inflation reports showed that the cost of physician services is growing at a slower rate, and the relentless advance in pharmaceutical price inflation is also finally cooling. With health insurance pricing power likely to stay on the upswing (third panel), given that premiums are set on a trailing cost basis, there is a window for the group to show more robust profit margins. As a result, industry return on equity (ROE) should continue to handily outpace overall ROE, arguing for a better-than-market valuation multiple. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.
Health insurance equities are on the cusp of breaking out to new all-time highs relative to the broad market, despite the headwinds facing any net creditor, namely low running yields. The macro tide is turning decisively in favor of this non-cyclical group. The S&P managed care index outperforms when overall relative consumer spending on health care decelerates and/or contracts, as it implies that insurance claims will decelerate, reducing costs to managed care providers. When this occurs, the risk premium associated with the group diminishes. The opposite is also true. Thus, the decisive downturn in health care spending growth opens the door to a re-rating, particularly given that cost inflation appears to be ebbing, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.
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