Equities

Renewed strength in the U.S. equity market sponsored by another round of global monetary easing has revived the debate about whether it is finally time to transition out of our alpha-generating defensive portfolio strategy. A number of strategists and media outlets have championed the view that yield proxies and non-cyclical sectors are expensive, and no longer offer an attractive reward/risk trade-off, particularly within the context of the recent easing in credit spreads, commodity price relief and the dip in the U.S. dollar. However, it is crucial to distinguish between absolute and relative measures when analyzing valuations. In absolute terms, nearly every sector and group is expensive, given that the broad market is trading at historically rich multiples. Our metrics do not support the notion that defensive sector outperformance has overly skewed relative valuations. Defensive sector strength has been almost entirely earnings driven (top panel), as measured by the steady upward march in relative forward earnings estimates. Our relative valuation gauge for defensives is barely above neutral despite multiyear outperformance. At the same time, cyclical sectors have experienced a steady decline in relative forward profit estimates, which has kept our valuation gauge close to neutral when the energy sector is excluded. The implication is that forecasting a cyclical sector comeback based on a valuation basis could lead investors down the wrong path. Instead, the lack of a major valuation anomaly means that relative performance should continue to be dictated by relative profit trends, please see the next Insight.

The RMB has moderated considerably since mid-last year, which should lead to improved capacity utilization and easing PPI deflation. There is a strengthening case for an upswing in China's profit cycle, driven by falling interest rates and a weaker RMB, while investors are ill-prepared for any positive earnings surprises.

Special Report

Renewed strength in the U.S. equity market sponsored by another round of global monetary easing has revived the debate about whether it is finally time to transition out of our <i>alpha</i>-generating defensive portfolio strategy. This <i>Special Report</i> examines the critical factors shaping this investment decision.

Special Report

The old cyclical market axiom that "nothing cures low prices like low prices" has never held
truer than in today's oil market.

The rally in risk assets could persist. Dollar and oil moves are not yet exhausted. But valuations and poor earnings quality warrant a cautious approach.

For the month of March, the model outperformed both global and U.S. equities in U.S. dollar terms. For April, the model has further pared back its equity risk exposure, shifting the allocation into cash. While Europe remains the largest equity overweight, there was a modest recalibration to defensive markets such as the U.S. and Switzerland. The allocation to EM was also nudged up a bit, on momentum and valuation grounds. In the fixed-income space, the model is sticking with U.S., Italian and Spanish paper.

Special Report

There is little evidence suggesting that declining productivity growth in recent years has resulted from measurement error. Businesses have plucked many of the low-hanging fruits made possible by the IT revolution, while cyclical factors stemming from the Great Recession have also weighed on productivity. Low productivity growth tends to be deflationary in the short run, but inflationary longer-term. For now, this is good news for bonds, but is likely to become bad news by decade-end.

The S&P pharmaceutical index has checked back relative to the broad market, reflecting the powerful short covering and relief rally in higher beta sectors in recent weeks. While this trend may persist in the very near run, we expect relative performance to follow relative forward earnings growth. On this front, conditions are bullish. In absolute terms, pharmaceutical companies are enjoying a productivity revival, as a demand-driven surge in pricing power is underway. That stands in marked contrast with the rest of the corporate sector, which is battling deflation, as evidenced by the relentless decline in bond yields (shown inverted, top panel). The chart shows that when firms are cutting selling prices, pharmaceutical profits outperform, as is currently the case. Moreover, drug companies continue to use excess capital in a shareholder-friendly manner, as shares outstanding continue to sink. The bottom line is that pharmaceutical earnings are on track for further outperformance, which should pull up the share price ratio. Stay overweight. The ticker symbols for the stocks in this index are: AGN, BMY, LLY, ENDP, JNJ, MNK, MRK, MYL, PRGO, PFE, ZTS.

Airline stocks have enjoyed some modest relief in recent weeks, but we expect this resilience to fully reverse. The main issue is overcapacity. Discretionary spending is under pressure, based on the message from global manufacturing woes and the plunge in the National Association of Restaurants survey (second panel). Airlines have been aggressively building capacity, as evidenced by the increase in airline capital spending. Long airplane production cycles mean there is a lag between spending and when new capacity will come on stream, and the tripling in airline parts & components inventory in the last eight years warns that the delivery pipeline remains full. Airlines are already resorting to price cuts to fill seats (bottom panel), which will drag on profitability. Importantly, future capacity increases signal that deflation will remain a prominent industry theme for the foreseeable future, and act as a weight on valuation multiples. Stick with a high-conviction underweight. The ticker symbols for the stocks in this index are: AAL, DAL, LUV, UAL.

Two weeks ago we outlined our top ten reasons to deemphasize the tech sector in equity portfolios. The tech sector is experiencing a productivity drain that is threatening profit margins and return on equity. However, within the sector there is one positive exception to this view: communications equipment (CE). Investment in CE is climbing relative to total investment and compared with IT investment after a prolonged slump. Years of underinvestment suggest that some pent-up demand has been created, allowing for the potential to outperform even if overall capital spending continues to sink, as we expect. The main CE demand driver has been the telecom services sector. Telecom capital spending has increased significantly, as measured by telecom facilities construction. That leads CE industry top-line growth, signaling revenue expansion ahead (bottom panel). Domestic demand strength has been partially offset by weak global markets. A strong U.S. dollar has undermined U.S. telecom equipment exports at the same time that foreign demand growth, China's imports in particular, has faltered. Still, global headwinds are more than discounted, as the relative forward P/E trades at a massive discount, even though industry productivity is improving. Bottom Line: re-rating potential exists despite our overall economic and broad market concerns. The ticker symbols for the stocks in this index are: CSCO, FFIV, HRS, JNPR, MSI.