Developed Countries

The setback in global financial markets has not been enough to persuade the FOMC to alter its stance. Although the Fed is signaling that the tightening cycle has further to run, the U.S. dollar is showing signs of fraying at the edges.

The Fed will upset the rebalancing of oil markets if it misreads the current sell-off as weakness in oil demand.

Late last year we highlighted that the S&P telecom services sector had the potential to be a sleeper pick for 2016, and we put it on our high-conviction list. While this sector has jumped sharply out of the gate, the move has not made a dent in the severe undervaluation created by years of underperformance (third panel). While the sector faces many challenges to grow revenue, its focus on profit margins should be sufficient to create value. Chronic competitive pressures have eased a notch following consolidation efforts, enough to drive meaningful pricing power gains. That is supporting growth in average revenue per user (ARPU), opening the door to improved profit margins. These positive internal dynamics alone provide sufficient reason to stay bullish, but tack on global growth concerns and sinking bond yields, and the incentive to funnel capital into this non-cyclical sector rises another notch. We reiterate our high-conviction overweight.

The plunge in capital markets stocks is not a buying opportunity. Corporate sector credit quality is quickly deteriorating. Ratings agencies are adding fuel to the fire, as bond downgrades are briskly outpacing upgrades. The message is that capital formation will continue to slow as the cost of credit climbs. As access to capital becomes more restrictive, on the margin, the currency to fund deals, share buybacks etc...will erode, undermining key earnings drivers. The implication is that profit prospects will continue to erode, the opposite of what sell side analysts are expecting (middle panel). Capital market return on equity tends to follow, inversely, junk bond spreads, and the current message is bearish (spreads are shown inverted, bottom panel). Bottom Line: The S&P capital markets index is facing stiff profit headwinds. Stick with a high-conviction, below-benchmark allocation.

Bank Credit Analyst

The U.S. corporate re-leveraging cycle is far more advanced than is widely believed. Corporate health looks only mildly better excluding the troubled energy and materials sectors. Mushrooming leverage ratios are not restricted to junk issuers either.

Bank Credit Analyst

The U.S. corporate re-leveraging cycle is far more advanced than is widely believed. Corporate health looks only mildly better excluding the troubled energy and materials sectors. Mushrooming leverage ratios are not restricted to junk issuers either.

Central banks follow backward-looking indicators but economies follow forward-looking indicators. So which indicators should investors follow? And what is the current message? Also, we see signs that London is cooling.

Materials stocks have been beaten down to the point where it is tempting to declare that all the bad news is already discounted. However, we remain reluctant to recommend investors attempt to catch this falling knife. China remains the marginal price setter for commodities, and its growth struggles are very deflationary (bottom panel). That is adding to the profit stress exerted by U.S. dollar strength. Importantly, materials sector cash flow is contracting at a time when its interest rates are rising. Deteriorating materials sector financial health is evident by the sinking interest coverage ratio. Worryingly, spiking high yield materials sector bond spreads are warning that basic materials credit quality has further to fall (spreads shown inverted, middle panel). Balance sheet stress argues for a rising materials sector equity risk premium. Bottom Line: Stay underweight the S&P materials sector.

Household product stocks are gathering momentum relative to the broad market. We expect this trend to persist as profit margins slowly improve. The industry has undergone a forced retrenchment as a consequence of the strong U.S. dollar, which sapped top-line growth. However, both commodity input and labor costs are contracting, providing much needed profit margin relief. The chart shows that operating margins have significant upside, especially if revenue improves even modestly. On this front, the plunge in commodity prices is freeing up disposable income to spend on brand-name essentials: consumer spending on toiletries is outpacing overall consumption for the first time in years. Moreover, Asian real retail sales are still growing at a robust rate, signaling that any emerging market currency stability should translate into better top-line performance. We reiterate our overweight position. The ticker symbols for the stocks in this index are: PG, CL, KMB, CLX, CHD.

The declining correlation between risk assets and Treasury yields suggests that the market perceives monetary policy to be overly restrictive. Historically, this has led the FOMC to adopt a more dovish policy stance.