Equities
Most of the economic arguments in favor of the U.K. leaving the EU do not carry much weight, as we discuss in this collaboration between BCA's <i>Geopolitical Strategy</i> and <i>European Investment Strategy</i>. However, the probability is a coin toss - much higher than investors tend to think. We review the geopolitical and investment implications of the "Leave" and "Remain" scenarios.
Similar to the euro area, Japanese consumer discretionary stocks have a long runway ahead. Japan is the latest country to join the NIRP club following the late-January BOJ surprise move to charge deposit-taking institutions a negative deposit rate. While interest rate suppression has negative connotations for Japanese banks, it should spur demand for discretionary consumer outlays if it breaks the deflationary consumer mindset. The top panel of the chart shows that relative share prices are inversely correlated with interest rates and the current message is to expect a rebound in Japanese consumer discretionary relative performance. Japan's NIRP should also lure banks to focus on loan volumes. Loosening bank credit standards typically boost discretionary spending. Importantly, a wide gap has opened between loan growth and relative share prices, which will likely narrow via a catch up phase in the latter. Meanwhile the Japanese labor market is tight, but this is neither reflected in relative consumer discretionary share prices, nor in relative valuations (third & fourth panels). Bottom Line: Overweight Japanese consumer discretionary stocks. For additional information on global consumer discretionary stocks please read the Global Alpha Sector Strategy report titled "In the Eye Of The Hurricane" at gss.bcaresearch.com.
Unlike in the U.S., current opportunities in consumer discretionary stocks lie in Europe and Japan. NIRP in the euro area will likely prove a powerful tonic for local consumers, and discretionary spending (top panel). The ECB is aggressively easing monetary conditions and is injecting unprecedented liquidity into the banking sector which should entice bankers to extend credit instead of hoard cash, on the margin. In fact, the ECB is squarely targeting banks to grow their lending books and provide breathing room to the economy, especially in the credit-starved periphery. Following the double-dip recession, euro area credit growth is slated to reaccelerate, as the ECB's fresh TLTROs and QE should open the lending spigots (second panel). On the labor front, while euro area unemployment is still running at double digit rates, excess slack is diminishing. The implication is that pent up consumer demand is only now being unleashed in the euro area, which should boost relative share prices (third panel). None of this encouraging consumer discretionary demand backdrop is reflected in ultra-cheap valuations, given that euro area consumer discretionary stocks are trading at a 25% EV/EBITDA discount to the global consumer discretionary index. Bottom line: Overweight euro area consumer discretionary stocks in a global portfolio (see the next Insight).
The outlook for the S&P consumer discretionary sector is bearish. The time to buy this early cyclical sector is when the Fed is embarking on an easing cycle, in a bid to improve the labor market conditions and restart the credit cycle. The opposite is now true, full employment has already been reached, and the Fed is poised to continue lifting interest rates this year. Historically, interest rates have been inversely correlated with relative performance and the current message is to avoid the U.S. consumer discretionary sector (top panel). Credit is a powerful fuel for consumer discretionary stocks. On this front, the recent continued tightening in U.S. lending standards is worrisome, especially given waning loan demand, according to the latest Fed's senior loan officer survey. The broad-based deterioration implies that tighter credit will persist, to the detriment of loan growth (second panel). Finally, relative consumer discretionary valuations in the U.S. are expensive. The bottom panel of the chart shows that the U.S. is trading at a 6% EV/EBTIDA premium to the global consumer discretionary sector. Bottom Line: A below benchmark allocation is warranted for the U.S. consumer discretionary sector, but opportunities exist outside the U.S., please see the next Insight.
We recently boosted weightings in the S&P electrical equipment & components index, and the latest data reinforce this view. Final demand has stayed more resilient than other manufacturing and resource-intensive industries, as reflected in both new order and capital investment trends (second panel). Despite this top-line resilience, electrical equipment manufacturers have been among the most aggressive in protecting profit margins through cost cutting and capacity reduction. That is evident in rising utilization rates, a remarkable feat given that the manufacturing sector is flirting with recession, and improving productivity growth. The implication is that health returns on equity should persist, heralding a re-rating in very depressed relative earnings growth expectations, and valuations. The ticker symbols for the stocks in this index are: AME, ETN, EMR, ROK. Chart
The S&P rail index has bounced off its lows but continues to lack profit support to extend the recovery attempt. Total railcar shipments remain under pressure, which signals ongoing weak utilization rates and low odds of a reversal in selling price deflation. Coal markets are likely to stay under pressure as a consequence of high utility coal inventory levels, as electricity production was adversely impacted by an unseasonably warm North American winter. The latest retail sales report was also soft, and has sustained downward pressure on the retail sales-to-inventory ratio. That can be a decent leading indication for intermodal railcar shipments, the largest freight shipping category. Thus, despite attractive valuations and aggressive cost cutting efforts, we maintain a neutral weighting, preferring another industrials group to benefit from a slightly more reflationary tone in overall markets, please see the next Insight. The ticker symbols for the stocks in this index are: CSX, KSU, NSC, UNP.
If the EM rally is sustained, the Fed will once again become resolute in its commitment to hiking interest rates. This in turn will spur another relapse in EM risk assets. Chinese policymakers are attempting to juggle contradictory objectives without a clear and realistic plan of action to resolve existing problems.
A Chinese reflationary cycle is unfolding. Capital spending is showing signs of regained vigor, driven by both housing and infrastructure. Chinese PPI deflation will ease further. This will help reduce balance sheet stress of materials producers and boost overall industrial profits. Remain positive on Chinese investable stocks.
The oversold rebound is at risk of stalling at key resistance levels. While some cyclical and interest rate-sensitive sectors have enjoyed decent bounces, defensive equities have stayed very well bid and are the only sectors making new highs. That suggests that a fundamentally-driven capital rotation into higher beta equities is not occurring, and that overall equity market relief reflects short covering and the resolution of oversold conditions. Why? Financial conditions remain too tight to expect a durable profit recovery, especially one that will match current rosy expectations. The chart shows that an aggressive recovery in S&P 500 earnings is expected this year. Importantly, these expectations are not simply a reflection of hopes for a recovery in resource prices, but are broad-based across sectors. That is wildly optimistic, especially based on the budding profit margin squeeze and ongoing bearish message from our global leading economic indicator. Consequently, we do not recommend chasing the recent rally and would use price strength to raise cash levels and/or transition into a lower risk portfolio structure.
Materials stocks have traditionally been late cycle plays, as earnings outperform when the economy is heating up and global resource utilization is burgeoning. That is not currently the case, as the global manufacturing sector is battling recessionary conditions. As long as this backdrop persists, it will be difficult for materials stocks to sustain any rallies. True, Chinese money growth has perked up, but this may not lead to increased manufacturing activity and/or import demand, given high existing debt-loads, weak export growth and soft domestic activity measures such as real estate and fixed asset investment. Meanwhile, global trade remains poor. The Baltic Dry Index continues to sink, signaling ongoing weakness in global trade (top panel). That will sustain downward pressure on capital goods prices. Our materials sector pricing power proxy continues to contract, and our sales-per-share model is heading south. The implication is that the negative side of operating leverage has not yet fully played out. To make matters worse, the sector is carrying excessive leverage, warning that there is little room for error and/or to absorb a prolonged period of weak pricing power. Stay clear.