Developed Countries

If the EM rally is sustained, the Fed will once again become resolute in its commitment to hiking interest rates. This in turn will spur another relapse in EM risk assets. Chinese policymakers are attempting to juggle contradictory objectives without a clear and realistic plan of action to resolve existing problems.

The oversold rebound is at risk of stalling at key resistance levels. While some cyclical and interest rate-sensitive sectors have enjoyed decent bounces, defensive equities have stayed very well bid and are the only sectors making new highs. That suggests that a fundamentally-driven capital rotation into higher beta equities is not occurring, and that overall equity market relief reflects short covering and the resolution of oversold conditions. Why? Financial conditions remain too tight to expect a durable profit recovery, especially one that will match current rosy expectations. The chart shows that an aggressive recovery in S&P 500 earnings is expected this year. Importantly, these expectations are not simply a reflection of hopes for a recovery in resource prices, but are broad-based across sectors. That is wildly optimistic, especially based on the budding profit margin squeeze and ongoing bearish message from our global leading economic indicator. Consequently, we do not recommend chasing the recent rally and would use price strength to raise cash levels and/or transition into a lower risk portfolio structure.

Materials stocks have traditionally been late cycle plays, as earnings outperform when the economy is heating up and global resource utilization is burgeoning. That is not currently the case, as the global manufacturing sector is battling recessionary conditions. As long as this backdrop persists, it will be difficult for materials stocks to sustain any rallies. True, Chinese money growth has perked up, but this may not lead to increased manufacturing activity and/or import demand, given high existing debt-loads, weak export growth and soft domestic activity measures such as real estate and fixed asset investment. Meanwhile, global trade remains poor. The Baltic Dry Index continues to sink, signaling ongoing weakness in global trade (top panel). That will sustain downward pressure on capital goods prices. Our materials sector pricing power proxy continues to contract, and our sales-per-share model is heading south. The implication is that the negative side of operating leverage has not yet fully played out. To make matters worse, the sector is carrying excessive leverage, warning that there is little room for error and/or to absorb a prolonged period of weak pricing power. Stay clear.

The heavily-shorted S&P steel index has enjoyed some relief of late, as short sellers were given an excuse to cover when China announced it would attempt to shut roughly 10% of its productive capacity in the next few years. While that is a necessary development to eventually rebalance markets, there are no quick fixes. Chinese steel production has already been drifting lower for some time, but exports continue to trend higher. The country has accumulated massive inventories as a consequence of previous overproduction and sinking domestic demand growth. The sharp downturn in infrastructure investment (shown inverted) is likely to sustain upward export pressure, thereby keeping global markets oversupplied. Without a rebound in resource end markets, steelmakers must rely on other sources of demand growth such as global construction. However, even these outlets are also losing steam. The chart shows that BCA's proxy for global commercial REIT supply is contracting at a steep rate, consistent with weak steel uptake. The implication is chronic downward pressure on steel utilization rates, and by extension, pricing power and profits. We recommend selling into strength and reducing positions back to underweight. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: NUE, STLD, RS, X, CMC, ATI, CRS, WOR, AKS, HAYN, SXC, TMST, ZEUS.

The ECB's new stimulus measures are a sign that the ECB is now looking to provide more direct stimulus to domestic demand by supporting credit growth. The interest rate cuts, and the weaker Euro that comes with it, are over for now.

Special Report

This <i>Special Report</i> reviews all of our active recommendations, including our over/underweight country and asset allocation positions, as well as our current tactical trades.

The current uptrend in Treasury yields will be cut short once the dollar appreciates in response to an increasingly hawkish Fed. Maintain benchmark duration and add a long 2/10 barbell, short 5yr bullet trade to profit from Fed hawkishness.

Bearish sentiment, higher oil prices and Chinese policy stimulus leave room for a continued bounce in stock prices. But this rally is unlikely to prove sustainable.

Confirming indicators still do not validate the oversold rally. Fade the materials sector bounce, by selling steel down to underweight.

Special Report

The benefit of including alternative assets in a traditional portfolio is almost at an all-time high, due mostly to increased return enhancement. This is despite the growing popularity of the alternatives industry and the larger number of entrants, which have reduced alpha opportunities.