Equities
The broad market remains unable to break out of its 18-month long trading range, and risks are rising that it will retest the lower end of the bound. Domestic economic disappoint is a growing probability, which could refocus attention on deteriorating corporate sector balance sheets. Cash flow generation is weakening but companies have continued to add leverage on the view that interest rates will stay low forever. Typically, as free cash flow declines and the non-financial corporate sector suffers through a painful increase in net debt/EBITDA (shown inverted, top panel), the stock market either corrects or has already entered a bear market, as risk premiums climb in anticipation of a self-reinforcing economic and profit downturn. This cycle, a massive divergence has opened up, as any concerns about rising debt stress have been trumped by the view that low interest rates and abundant central bank liquidity will support asset prices indefinitely. That is unsustainable, because debt must be repaid at some point, and the longer that this gap grows, the greater the vulnerability to share prices. In the interim, evidence is slowly emerging that debt excesses are causing economic backlash. Credit standards have tightened, loan loss provisions are creeping higher and corporate bond spreads appear to have troughed for the cycle. Credit concerns likely explain the inability of bank stocks to participate. In past cycles, bank underperformance amidst credit cycle erosion has provided a bearish warning for the broad market.
Stocks whipsawed violently last week. Volatility could intensify if recent whiffs of a domestic economic slowdown proliferate and the Fed still adopts a more hawkish tone.
The next rate hike is unlikely before September, despite the rebound in April retail sales. The dollar could suffer for a time, but the long-term bull market is intact.
Brazilian assets are no longer oversold, are not cheap, and the political reality will likely fall far short of market expectations. Investors should continue to avoid/underweight Brazilian risk assets.
The overall tech sector has been under pressure as a consequence of shoddy profits. We do not expect any imminent reprieve, particularly within the heavyweight S&P computer hardware, storage and peripherals index. This group is highly sensitive to swings in capital spending budgets. The latter are under pressure from a narrowing in the gap between the return on and cost of capital in the overall business sector. New orders for computer hardware products have dropped into the contraction zone, warning of potential shrinkage in top-line growth. To make matters worse, wage inflations has surged in recent quarters. That is a recipe for productivity disappointment. Until overall business sector profits are poised to recovery on a sustained basis, demand for hardware is likely to stay on its heels. We reiterate our underweight position. The ticker symbols for the stocks in this index are: BLBG: S5THSP - AAPL, EMC, HPE, HPQ, SNDK, WDC, NTAP, STX.
The insurance industry is battling generationally low interest rates, which has created a deep undercurrent of pessimism toward related equities. That is borne out by extremely cheap valuations, as measured by relative price/book value ratios (bottom panel). However, such a low expectations hurdle should be easily surpassed. After a prolonged slump, consumers are allocating a rising share of spending to insurance products, consistent with increased housing turnover and buoyant vehicle sales. In turn, insurance companies have been able to lift premiums at a solid rate. This shift in spending patterns bodes well for profit outperformance, and ultimately, a re-rating in dirt cheap relative valuations. The surge in our insurance relative advance/decline line heralds share price outperformance and we reiterate our high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5INSU.
Approaching the referendum on EU membership, what are the prospects for the U.K. economy and financial markets?
The Chinese corporate sector has been reluctant to expand, focusing instead on destocking inventory and hoarding cash. This protects the corporate sector balance sheet, but is not conducive for strong GDP expansion. Q1 earnings reports confirm that an upturn in the Chinese profit cycle is unfolding.
Air freight stocks have been unable to gather speed during the most recent bout of overall market strength and bid under risky assets, reflecting long-term pressure on valuation multiples. Persistently high business inventories mean that companies are not under pressure to use rapid delivery services to fulfill customer requirements. Indeed, when inventories are tight and bottlenecks exist, demand for high margin freight services increase as businesses rush to catch up. This dynamic acts as a weight on valuation multiples for air freight companies, and is unlikely to soon change based on the downbeat message regarding global trade from the IFO survey (third panel). With global trade volumes barely growing and leading indicators warning of downside risks, the message is that air freight profits will have difficulty meeting lofty expectations, particularly now that oil prices are no longer falling in support of profit margins. We are underweight this index. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD.
Pharmaceutical stocks are trading at historically cheap relative valuations on the back of political pressure on a few high-profile specialty pharma companies. We see this as an opportunity to add to positions in the more traditional pharma space. Our concerns about excessive drug pricing will only materialize when there is evidence that consumption patterns are changing. So far, there is scant evidence of higher prices choking consumption. Consumer spending on drugs is hitting new highs. That is true in both real and nominal terms, underscoring that higher outlays are not simply a reflection of rising drug prices. While the growth rate of drug consumption may slow, pent up demand from years of medical procedure deferral following the Great Recession will take time to play out. As such, soaring pharmaceutical shipments should be interpreted as demand-driven. Consequently, we expect profit outperformance to persist, and drive a sustained recovery in relative share prices. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, MNK, ENDP.