Developed Countries

The risk/reward equity market tradeoff is to the downside and we remain tactically cautious. The trade war re-escalation risks pushing out the global growth recovery to early-2020 and has shaken our confidence in our cyclically constructive equity market view. The stock-to-bond (S/B) ratio is sounding the alarm and is now part of the slew of indicators we track that have rolled over decisively. The S/B ratio has formed a bearish head and shoulders trading pattern and suggests that the SPX is at risk of a further pullback (see chart). While up to very recently falling bond yields were an undoubtedly equity market recovery pillar, any further melting in the 10-year Treasury yield would exert downward pull on the equity market. Bottom Line: We remain tactically cautious and continue de-risking our portfolio. Please see our Weekly Report published yesterday for additional details.

Highlights Portfolio Strategy The risk/reward equity market tradeoff is to the downside and we remain tactically cautious. The trade war re-escalation risks pushing out the global growth recovery to early-2020 and has shaken our confidence in our cyclically constructive equity market view. An enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profit expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retail (HIR) index has ample downside. Recent Changes Lift the S&P telecom services index to neutral for a gain of 6% since inception. Early last week we got stopped out of our S&P homebuilding overweight recommendation, which is now back to neutral, and booked profits of 10% since inception relative to the SPX. Table 1 Feature Equities continued to whipsaw last week and lacked clear direction as the dust from President Trump’s May 5 tariff tweet has still not settled. While the trade talks could go either way, we are reluctant to take a stance and would rather err on the side of caution. Clearly the SPX wants to spring higher and craves a U.S./China trade deal, but our geopolitical strategists believe the trade talks have taken a turn for the worse and the odds of a positive trade resolution are falling quickly. We remain cautious on the short-term equity market outlook and are now increasingly worried that our sanguine cyclical posture is in jeopardy. Worrisomely, the stock-to-bond (S/B) ratio is sounding the alarm and is now part of the slew of indicators we track that have rolled over decisively (Chart 1). The S/B ratio has formed a bearish head and shoulders trading pattern and suggests that the SPX is at risk of a further pullback. While up to very recently falling bond yields were an undoubtedly equity market recovery pillar, any further melting in the 10-year Treasury yield would exert downward pull on the equity market. There are other signs that the U.S. equity market may be hanging by a thread. The average stock has failed to make new all-time highs using the Value Line Arithmetic Index as a gauge. The median U.S. stock is also suffering the same fate, again according to the Value Line Geometric Index (middle & bottom panels, Chart 2). Chart 1Tread Carefully Chart 2More Non-Confirming Indicators The trade-weighted U.S. dollar is also sending a deflationary impulse signal and likely reflects a continued global growth deceleration (top panel, Chart 2). This is a net negative for EPS especially for internationally exposed SPX constituents. Thus, this week we are further de-risking our portfolio by crystalizing gains in a defensive high-yielding communications services sub-index and lifting exposure to neutral from underweight. In addition, we update our bearish view on an early-cyclical subgroup and continue to protect the portfolio by adding trailing stops. Meanwhile, taking the pulse of global bourses is disconcerting. With the exception of the S&P 500 and the NASDAQ, no other stock market (in USD terms) confirms the SPX’s breakout to all-time highs. Highs were either hit in 2006-2007 or in early 2018. Now a big gulf has opened up, reminiscent of last year’s late-summer dichotomies when the SPX vaulted to fresh highs, but none of the other major global bourses confirmed the September highs (Charts 3 &  4). There are rising odds that a repeat may be unfolding. Chart 3I Know What You Did Last Summer Chart 4I Still Know What You Did Last Summer In our view, what explains the reversal of fortunes that led to a U.S. market dominating outperformance since early 2017 has been the massive fiscal injection the Trump administration undertook (Chart 5), with rising fiscal deficits three years running (an unprecedented backdrop during expansions). Chart 6 puts this easing in fiscal policy in a global perspective and shows the average fiscal balance from 2017-2020 using the IMF’s WEO April 2019 dataset that includes projections. The delta in the U.S.’s fiscal largess is quite significant. Our worry is that this is unsustainable and, similar to last fall/winter, the rest of the world may pull down the U.S. stock market until at least there are clear signs of a positive resolution in the U.S./China trade dispute. Adding it all up, the equity market’s risk/reward tradeoff is poor and we remain tactically cautious. The trade war re-escalation risks pushing out the global growth recovery to early-2020 and has shaken our confidence in our cyclically constructive equity market view. Thus, this week we are further de-risking our portfolio by crystalizing gains in a defensive high-yielding communications services sub-index and lifting exposure to neutral from underweight. In addition, we update our bearish view on an early-cyclical subgroup and continue to protect the portfolio by adding trailing stops. Chart 5Explaining U.S. Outperformance Dialing Up Profits In the context of a further de-risking of the portfolio, we are monetizing our gains of 6% since inception in our underweight recommendation in the S&P telecom services index and are upgrading this high yielding sector to neutral (bottom panel, Chart 7). Not only have bond yields plunged of late, raising the allure of fixed income equity proxies, but the recent escalation of the trade spat has caused U.S. manufacturers to pull in their horns. Markit’s flash manufacturing PMI survey that took place post the May 5 Trump tweet fell to 50.6 the lowest level since the history of the data. It is surprising that this latest reading near the 50 boom/bust line is below the late-2015/early 2016 level when global trade came to an abrupt halt. Historically, relative share price momentum has moved inversely with the annual change in this series and the current message is to expect a sustained rebound in the former (middle panel, Chart 7). Beyond this enticing macro backdrop for defensive equities, firming operating metrics also suggest that it no longer pays to be bearish telecom services stocks. Industry CEOs have shown labor restraint of late, at a time when selling prices are on the verge of expanding (middle & bottom panels, Chart 8). While the dust has yet to settle on the T-Mobile/Sprint saga, any reduction in supply should prove positive at the margin for industry selling prices. Chart 7Macro Headwinds Beneficiary Chart 8Firming Operating Metrics Tack on a tick up in consumer outlays on telecom services and this likely troughing in demand will also boost the sector’s revenue growth prospects (top panel, Chart 8). In sum, an enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profits expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Meanwhile, bombed out profit expectations, suggest that the bar is set extremely low for incumbents and is likely a precursor of positive surprises. In fact, the five year out profit bearishness is unprecedented: telecom carriers are expected to trail the broad market by 13 percentage points (third panel, Chart 9). Despite this downbeat EPS message, relative share prices have fallen even faster, pushing the 12-month forward P/E multiple to multi-decade lows (bottom panel, Chart 9). Nevertheless, we refrain from bumping this niche safe haven index to overweight given some structural negative balance sheet issues. Chart 10 shows that telecom services debt burden is deteriorating. Net debt-to-EBITDA is pushing 3x versus below 2x for the broad market, and the interest coverage ratio is sinking steadily. Chart 9Bombed Out EPS Prospects And Valuations Chart 10Balance Sheet Trouble In sum, an enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profits expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Bottom Line: Lift the S&P telecom services index to neutral and lock in gains of 6% since inception. The ticker symbols for the stocks in this index are: BLBG: S5TELSX – VZ, T, CTL. Home Improvement Retailers: Timber Alert   While our high-conviction underweight call in the S&P home improvement retail index is slightly in the red, our confidence has increased that these hard line retailers are about to get chopped. Netting it all out, waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retailing index has ample downside. First, the latest GDP release as it pertains to housing made for grim reading: residential fixed investment is in retreat. Big Box DIY retailers are highly levered to this type of housing activity and the prognosis is negative. Residential fixed investment has subtracted from real GDP growth for five consecutive quarters, which is unprecedented outside of a recession (top panel, Chart 11). Chart 11Time To Converge Lower... Residential investment is on the verge of contracting in absolute terms, a feat already achieved compared to GDP growth (bottom panel, Chart 11). The direct link to HIR typically comes via existing home sales. In other words, when a home changes ownership, typically some renovation activity goes into that newly purchased home (second panel, Chart 12). Thus, any sustained softness in existing home sales especially given heightened competition from the newly built housing stock, will weigh on residential investment. Against such a backdrop, top line growth for building & supply stores will likely remain subdued (third panel, Chart 12). Second, the recently announced tariffs and the specter of additional tariffs on the remaining U.S./China trade balance will also weigh on home improvement retailers' margins and profits. While management teams have yet to pencil in the direct input cost increase hit to future profitability, as revealed in recent HD and LOW conference calls, if all of the cost is passed on to the consumer then sales will suffer the most. Put simply, at the margin, some remodeling projects would have to get trimmed or get postponed, warning that HIR same-store sales will remain under pressure (second panel, Chart 13). Chart 12...To Falling Residential Investment Chart 13Lumber Price Blues Third, lumber prices continue to crumble and, given that HIR makes a set margin on lumber sales, HIR profits will likely underwhelm (third panel, Chart 13). Finally, a buildup in industry inventories at a time when demand is easing has pummeled the sales-to-inventories ratio, warning that the path of least resistance for HIR profitability remains lower (bottom panel, Chart 13). Our HIR model does an excellent job in capturing most of these macro and operating headwinds, and suggests that a felling in the relative share price ratio looms (Chart 14). What is disquieting is that there is no real valuation cushion for these priced-to-perfection retailers to absorb any future profit hiccups that we anticipate in the coming quarters. Our sense is that the de-rating phase that commenced in early 2019 will gain steam in the back half of the year and a premium-to-discount valuation reversal would not surprise us at all (bottom panel, Chart 12). Netting it all out, waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retailing index has ample downside. Bottom Line: We reiterate our high-conviction underweight status in the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.     Anastasios Avgeriou,  U.S. Equity Strategist anastasios@bcaresearch.com Chart 14Model Says Shy Away Housekeeping Early last week we obeyed our stop and booked profits in the S&P homebuilding index of 10% versus the S&P 500 since inception; we also downgraded this niche consumer discretionary index from previously overweight to currently neutral. We are taking this opportunity of de-risking our portfolio to add another trailing stop at 10% to a related market-neutral trade: long S&P homebuilding/short S&P HIR that has recently cleared the 13% return mark since inception.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps