Equities
Greater safety for European taxpayers and bank depositors necessarily means more risk for bank equity and bond investors. We provide some detail, and also initiate two new short-term positions.
Semiconductor stocks finished last year on a strong note, supported by a surge in M&A and hopes that low oil prices would spur an increase in consumer spending, particularly on electronics. While the latter has improved, the M&A backdrop is becoming more hostile as the cost and access to capital become more restrictive. We put this group on our high-conviction underweight list to reflect our concern that once M&A euphoria faded, a renewed focus on fundamental profit drivers would trigger a de-rating. Apart from better spending on electronics, the data continues to support our bearish call. Global semi sales are shrinking, with key producing countries like Korea and Taiwan suffering from a steep export contraction. That implies heightened liquidation pressures, which will undermine profit margins. Worse, semiconductor companies have been slow to downsize despite threats to top-line growth, adding to profit margin pressures, please see the next Insight. The ticker symbols for the stocks in this index are: INTC, TXN, AVGO, MU, ADI, SWKS, LLTC, XLNX, NVDA, MCHP, QRVO, FSLR.
There is no sign that the Chinese economy has suddenly lost momentum. The credit and monetary cycle appears to be picking up. Meanwhile, our bottom-up analysis shows no evidence of a rapid buildup in leverage in China's corporate sector, as commonly perceived.
The S&P electrical equipment & components (EEC) group has comparatively less resource exposure than many other industrial sub-industries. The EEC index is comprised of mature, diversified manufacturing businesses with exposure across a broad range of end markets. This provides stability in periods of macro volatility, but limits upside potential during the initial phase of an economic expansion. The group was savaged by the relentless advance in the U.S. dollar, creating deeply oversold and undervalued conditions. To be sure, electrical equipment sales have been pressured by the global manufacturing recession. However, new orders have stabilized. Shipments are far outstripping inventories, which are contracting, and unfilled orders have held steady. Importantly, our EEC productivity proxy has been very strong throughout the general manufacturing malaise. Productivity gains will help offset the loss of competitiveness from the strong U.S. dollar, and also suggests that earnings expectations are far too bearish. If the U.S. dollar begins to soften as a consequence of U.S. economic disappointment, than a valuation normalization is probable. Upgrade to overweight. This pulls up our overall industrial sector weighting to neutral. The ticker symbols for the stocks in this index are: EMR, ETN, ROC, AME.
We recommended buying into rail weakness in November, on the view that a poor earnings outlook was already discounted and that shipment and pricing power trends would improve as 2016 progressed, allowing cost cutting efforts to shine through. However, this call was too early. Despite attractive valuations and the contrary allure of moving to overweight in the midst of recessionary conditions, the anticipated recovery in freight volumes may be more distant than we had envisioned. Domestic economic disappointment is a rising threat, owing to tightening financial conditions, exacerbated by the stubbornly hawkish Fed. Intermodal rail shipments, which account for nearly half of total freight growth, are not growing. Meanwhile, coal shipments are still a major drag. Warm North American winter weather and a manufacturing recession are keeping a lid on electricity production, which will delay any rundown in utility coal inventories. Consequently, a restocking phase, and recovery in coal shipment volumes, is not imminent. Consequently, we recommend paring back to neutral, recording a 5% loss, and shifting into another industrials group, as discussed in the next Insight. The ticker symbols for the stocks in this index are: UNP, CSX, NSC, KSU.
The defensive qualities of the S&P data processing index have served investors well in recent years, particularly given its hedge against deflation pressures (top panel). However, the index is now priced for perfection and our Indicators suggest that peak performance is in the rearview mirror. Industry sales are linked to transaction volumes. Real consumer spending growth is slipping, despite rising wage inflation, reflecting an increase in the personal savings rate. Access to credit is deteriorating, on the margin, and consumers demonstrate little appetite to re-lever. The slide in revenue is hitting profit margins, as both capital spending and SG&A expenses are accelerating as a share of turnover. Meanwhile, the ISM services index is starting to play catch up with the decline in the ISM manufacturing index. A closing of this gap has previously warned that investor appetite for the services-based data processing group may diminish, at least for a few months. As a result, we recommend taking profits of 23% and downshifting to neutral. The ticker symbols for the stocks in this index are: ADP, ADS, CSC, FIS, FISV, MA, PAYX, TSS, V, WU, XRX.
Somewhat like 1998, the dilemma for the Fed is that the labor market is approaching full employment and may justify eventual interest rate hikes.
Media stocks are undergoing a de-rating, led by the heavyweight S&P movies & entertainment index. Sales prospects have been undercut by shifting viewing habits, which is creating uncertainty surrounding the value of network assets. The ISM services index warns that recreation spending will continue to retreat, which also has implications for ad revenue. Our Advertising Indicator is already deep in negative territory, consistent with the overall profit contraction and our expectation that the corporate sector will retrench. Meanwhile, programming costs remain high, adding to profit margin stress emanating from weakening top-line performance. This toxic mix should ensure that all of the shareholder friendly activities that have supported valuation expansion since 2009 will dissipate, to the detriment of premium multiples. We have a high-conviction underweight on the overall media sector, including the S&P movie & entertainment index. The ticker symbols for the stocks in this index are: DIS, CMCSA, TWX, TWC, FOXA, CBS, OMC, VIAB, IPG, NWSA, DISCK, TGNA, CVC, SNI, DISCA, FOX, NWS.
Refining stocks have been slammed this year, and we expect more pain ahead. Companies had continued to operate at full throttle, as measured by the relentless advance in refinery production (second panel), likely reflecting expectations for ongoing demand strength and decent export markets. However, both gasoline and refined product inventory have been steadily building since last year, warning of excess inventory accumulation. Worse, refined product consumption is contracting, underscoring that it will take output cuts to work through the supply glut. Refiners have an incentive to pull back, given that refining margins are essentially nil, but the implication is a potentially sizeable profit hit. The index is not priced for an earnings downturn. We maintain our high-conviction underweight. The ticker symbols for the stocks in this index are: MPC, PSX, TSO, VLO.
Plunging commodities have been driven by increased supply and falling investor demand, not a major downshift in physical demand. Stay neutral global equities. The earnings outlook remains uninspiring, but bottoming oil prices and continued monetary stimulus support valuations. The selloff in global bank shares reflects NIRP-related "income statement worries", not "balance sheet concerns" linked to deteriorating credit quality. Downgrade Treasury notes to neutral. The rally in bonds has brought 10-year yields near our long-standing, out-of-consensus target of 1.5%.