Developed Countries

Special Report

Headline and aggregate-economy statistics such as GDP and income are no longer representative statistics for the living standards of the vast majority of the population. This <i>Special Report</i> discusses the implications for politics, economics and investment.

Two weeks ago we outlined our top ten reasons to deemphasize the tech sector in equity portfolios. The tech sector is experiencing a productivity drain that is threatening profit margins and return on equity. However, within the sector there is one positive exception to this view: communications equipment (CE). Investment in CE is climbing relative to total investment and compared with IT investment after a prolonged slump. Years of underinvestment suggest that some pent-up demand has been created, allowing for the potential to outperform even if overall capital spending continues to sink, as we expect. The main CE demand driver has been the telecom services sector. Telecom capital spending has increased significantly, as measured by telecom facilities construction. That leads CE industry top-line growth, signaling revenue expansion ahead (bottom panel). Domestic demand strength has been partially offset by weak global markets. A strong U.S. dollar has undermined U.S. telecom equipment exports at the same time that foreign demand growth, China's imports in particular, has faltered. Still, global headwinds are more than discounted, as the relative forward P/E trades at a massive discount, even though industry productivity is improving. Bottom Line: re-rating potential exists despite our overall economic and broad market concerns. The ticker symbols for the stocks in this index are: CSCO, FFIV, HRS, JNPR, MSI.

While the communications equipment industry provides a contrarian tech sector investment opportunity, in relative terms, computer hardware offers a much different profile. Hardware investment is highly cyclical, rising and falling with discretionary spending budgets. The latter are being pruned as the corporate sector tightens its belt as a consequence of deflation and profit margin pressure. The chart shows that, unlike telecom equipment, hardware investment continues to sink as a share of total spending. That will sustain downward sales pressure and keep manufacturers operating at suboptimal rates. Already, the rate of hardware output has plunged, and is well below the rate of capacity growth. Such a dynamic warns of an intensification of deflationary pressures, particularly given that vendors to end clients are aggressively slashing prices. Without a positive demand impulse, the odds of computer hardware profit disappointment will remain acute. We continue to recommend an underweight position. The ticker symbols for the stocks in this index are: AAPL, EMC, HPE, HPQ, NTAP, SNDK, STX, WDC.

Both the demand for and availability of capital favors consumers over businesses, on the margin. The latest Fed senior loan officer survey showed that banks are tightening standards on C&I loans, the most rapidly growing component of bank assets. This reflects the broad-based deterioration in corporate sector balance sheet health. Conversely, willingness to extend consumer credit remains high. Previous deleveraging has vastly improved household balance sheets. Debt servicing payments are historically low as a share of income. Consumer spending is outpacing capital spending, which is driving a rise in personal loans relative to business credit. A narrowing yield curve has much more bearish implications for banks than it does for credit card companies, whose interest rate spreads are far less susceptible to yield curve swings. This is borne out in the tight inverse correlation between the yield curve and the share price ratio (bottom panel). Consequently, we recommend initiating a pair trade in the undervalued consumer finance/banks share price ratio. Please see yesterday's Weekly Report for more details.

Consumer finance stocks have been among the worst financial sector performers in the last six months creating a negative divergence with bullish macro drivers. For instance, relative performance has far undershot the level implied by the decline in unemployment claims and the housing market (top panel). Household net worth has spiked back toward all-time highs as a share of disposable income courtesy of the recovery in financial markets and residential real estate value. Importantly, wages & salaries growth is robust, courtesy of U.S. dollar strength and the collapse in fuel prices, which should underpin consumer appetite for debt. Revolving consumer credit, a good proxy for credit card debt, has been growing at a pre-financial crisis clip since last autumn. That is a major change from the first few years after the crisis, when debt growth was extremely volatile, which created uncertainty about the sustainability of credit card company receivables growth, and capped valuations. A more stable outlook should translate into a higher multiple, all else equal. We recommend an overweight position, and a new long/short trade vs. banks, please see the next Insight. The ticker symbols for the stocks in this index are: AXP, COF, SYF, DFS, NAVI.

The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.

The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.

The Fed's decision to scale back intended interest rate hikes reflects economic reality.

A dovish Fed bought the bounce a bit more time, but there is little incentive to add portfolio risk. Buy consumer finance, especially vs. banks, and expect communications equipment outperformance.

While the FOMC was more dovish than expected, rising inflation may cause the Fed to escalate hawkish rhetoric. The bounce in oil should help high-beta stocks. Underweight U.S. equities versus Europe, Japan and H-shares. We estimate U.S. equities will deliver returns of 4%, ann. over the next 10 years, <i>vis-à-vis</i>  9% for the euro area and Japan, and 14% for H-shares. Central banks have more options to combat any possible debt-deflation spiral in Europe/Japan/China than is often recognized.