Developed Countries
The ECB's intended purchases of corporate bonds will not sustainably lift the asset-class. But we have found a compelling long-term opportunity in the sovereign bond market, and a way to hedge Brexit risk.
Gold seems to be leading global share prices. Gold prices have rolled over since March 10. Hence, odds are that the U.S. dollar is about to bottom, and that global and EM stocks, as well as commodities prices, are about to relapse. We recommend two new trades in central Europe: Go long central European banks / short euro area banks and buy 10-year Polish domestic bonds.
The ultimate driver of bank profitability is loan growth. A brighter economic backdrop in the U.S. compared with both the euro area and Japan paints a rosier picture for relative credit growth opportunities (third panel). Already, bank credit growth in the U.S. is outpacing Japan and the euro area (top panel). This divergence has staying power, given that the U.S. economic expansion is becoming self-reinforcing, while the export-dependent euro area and Japan remain fragile. While loan volume generation is a key profit center for banks, loan pricing is equally important. On this front, negative interest rate policy (NIRP) in both the euro area and Japan are worrisome. NIRP puts an interest rate floor on deposit taking institutions that are reluctant to pass negative deposit rates onto their customers. Concurrently, NIRP forces banks to lend out new money, or roll over existing loans, at declining interest rates. This is especially constraining in the euro area periphery where mortgage lending is financed at the very short-end of the curve. The end result is a net interest margin squeeze (bottom panel). Meanwhile, each country is in a different phase of its credit cycle. U.S. and Japanese NPLs are probing multi-year lows, whereas euro area NPLs are very elevated (second panel). Tight labor markets in both the U.S. and Japan argue for a continuation of the downtrend in NPLs, although the rise in corporate bond spreads suggests that business loans are more at risk. The euro area's double-digit unemployment rate warns that NPLs will sap European bank profitability for a while longer. Bottom Line: U.S. financials are the best of a bad lot, while euro area and Japanese financials will continue to struggle to keep pace with broad market returns. For additional information on global financials please refer to the March 18 Global Alpha Sector Strategy report titled "Happy Days?".
Bank stocks comprise the bulk of financials indexes' market cap weights in the G3 (U.S., Euro Area and Japan). Thus, bank profit growth should largely define each region's financials sector earnings path, and by extension, relative performance. The top panel of the chart shows that the euro area and Japan have massive banking sectors as a percentage of GDP, especially compared with the U.S. Bank deleveraging is ongoing in the euro area, as banks continue to retrench from emerging markets and because of domestic economic slack. Sustained asset shedding in Europe is inherently negative for bank profitability, at least in the near-term, as bankers simultaneously become more conservative and reluctant to extend credit. Moreover, bank leverage ratios are stretched in Japan and in the euro area versus the U.S. (second panel). In other words, the equity capital cushion remains insufficient in the euro area and in Japan to absorb a local or global credit shock. U.S. banks are well capitalized following the Great Recession TARP recapitalization, but euro area banks continue to be plagued by ongoing and extremely dilutive equity capital raisings. Worrisomely, despite sporting higher leverage ratios, both Japanese and euro area financials ROEs trail the U.S. by a wide and rising margin (bottom panel). Steeply diverging regional ROEs should continue to drive a relative rerating of U.S. financials versus both euro area and Japanese financials (see the bottom panel of the previous Insight). Meanwhile, diverging credit and economic growth profiles, NIMs and NPLs, all favor U.S. versus both European and Japanese financials (please see the next Insight).
While relative financials stock returns tend to be highly correlated across regions, especially in the developed world (top panel), extremely divergent monetary policy developments and operating metrics suggest that these long-standing tight correlations are destined to loosen. Thus, Global Alpha Sector Strategy has broken down global financials sector coverage into three geographies: U.S., Europe and Japan, following in the footsteps of our recent disentangling of global consumer discretionary coverage (see the March 17 Insights). In that light, the euro area and Japanese financials sectors are at a particularly acute disadvantage relative to the U.S., given diverging leverage, capital cushions and ROEs (please see the next Insight).
Some tentative signs of life in the global manufacturing data suggest that Treasury yields have some room to move higher in the near term.
Last week we added the overall health care sector to our high-conviction overweight list, given our confidence that defensive sectors will continue to outperform the broad market on a cyclical basis, regardless of the latter's near-term trend. As part of this move, the S&P managed care index now warrants overweight exposure. The pressure on payers of medical services relative to the providers of those services has ebbed, because overall health care outlays are no longer accelerating relative to total spending. That should open the door to another upleg in relative performance, provided costs stay under control. On this front, our medical cost proxy is still moving laterally, despite the previous increase in surgeries, procedures and sector pricing inflation. This will keep a lid on the medical loss ratio, alleviating potential downward pressure on profit margins, and by extension, relative valuations. Keep in mind that the impact of previous consolidation on cost containment has yet to be fully felt. The implication is that discount relative valuations should be exploited. Upgrade to overweight and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - AET, ANTM, CNC, CI, HUM, UNH.
Our bearish thesis on the S&P cable & satellite index is not playing out. Instead of skinnier cable packages and cord cutting denting profitability, the industry has managed not only to sustain pricing power, but also to increase selling prices at a faster rate than overall inflation. The latest personal consumption expenditures report showed that cable outlays, in real terms, have begun to march higher again after flat-lining for two years. The cable industry has monopolistic properties, enjoying decades of rising 'real' pricing power. Now that real spending has reaccelerated, it will boost the odds that real selling prices will follow suit. One of our fears had been that slowing sales and rising subscriber churn would force cable providers to ramp up investment to retain customers. However, the largest cable distributors reportedly saw their total cable subscribers decline only 1% in the fourth quarter, similar to the loss in the third quarter, reinforcing that cord cutting is ebbing. The downtrend in capital spending-to-sales has been a major driver of the expansion in operating margins. If capital spending is not going to accelerate, then profit margins won't come under much pressure. We made a full shift to overweight in yesterday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5CBST - CVC, CMCSA, TWC.
We continue to recommend a cautious investment stance, staying at benchmark duration, as the recovery in risk assets looks more like a counter-trend rally than the start of a new bullish run.
Equities are back in overshoot territory. We added the health care sector to our high-conviction overweight list, boosted managed care to overweight and put health care equipment on downgrade alert. Buy cable stocks.