Developed Countries
This month's Special Report reviews the main factors driving the "lower for longer" bond yield view. A key finding is that the demographically-driven portion of the expansion in world capital spending has come to a virtual standstill, representing a major hit to underlying demand growth.
As world central banks increasingly shift toward negative interest rate policies to combat deleveraging and deflation, the search for yield in financial markets is likely to persist. Global bond yields continue to grind lower, which is raising the allure of income producing equities. Indeed, an Insight on February 9, showed that equity market fixed-income proxies surged in the aftermath of the ECB's decision to implement negative deposit rates. More recently, REITs in the euro area and Japan have soared anew, reflecting this powerful undercurrent of demand for stable cash flow producers. As such, we expect sell-offs in the S&P REIT index to prove transitory, and reflective of short-term swings in risk-on vs. risk-off assets rather than a fundamental change in investor appetite or REIT prospects, please see the next Insight.
The previous Insight showed that REITs in other parts of the world are outperforming smartly, but lagging in the U.S. We expect a re-convergence. Already a yawning gap has opened between REITs and Treasury yields (shown inverted). That is not sustainable, especially in view of positive underlying cash flow fundamentals. Our proxy for the REIT occupancy rate is still trending higher (third panel), supporting good growth in REIT pricing power proxies. Importantly, pipeline supply pressures look set to ease, based on the downturn in multifamily home construction. All of this points to decent cash flow growth prospects. Against a backdrop of still attractive value in a world starved for yield, we continue to recommend an overweight portfolio position in the defensive S&P REIT index.
Capital markets stocks have been crushed this year. Over the last few decades, capital market bear phases have ended with a forceful policy response that restores economic growth by rekindling the credit cycle. Fed rate cuts have usually started that process. This cycle, the Fed is still intent on tightening even as evidence of growth softness mounts. Thus, it is difficult to envision the start of a cycle that encourages increased capital formation, which is needed to avert a sustained capital markets profit downturn. Our concern is that the U.S. corporate sector has spent beyond its means long enough to erode balance sheet flexibility, which warns of high odds of a forced retrenchment. Access to capital is restricted to those who don't need it. Once our Corporate Health Monitor moves into deteriorating health territory, M&A activity usually begins to dry up (second panel). M&A has been running red-hot in the past few years, as the lack of organic global growth has forced companies to pursue acquisitions. If this source of investment banking income diminishes, then capital market companies will have a large profit hole to fill. If valuations could not expand with an easy Fed, an M&A boom and rampant stock and bond issuance, what will happen now these conditions are reversing? Stay with a high-conviction underweight. The ticker symbols for the stocks in this index are: GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM.
The sheer scale of underperformance leaves the oilfield services group vulnerable to violent bounces, especially in view of the recent stabilization in oil prices as well as an agreement between several OPEC members and Russia to freeze output at current levels. Is it time to buy? While oil supply will eventually be reined in, demand growth is still up for debate. The global economy is struggling to maintain a decent rate of growth. Importantly, energy service stocks have an abysmal track record during recessions and/or when the ISM manufacturing index is below the boom/bust line. In other words, the group is a late-cycle performer, not an end-of-cycle performer. While the U.S. is not technically in recession, the odds of one are rising steadily as credit conditions tighten. Even then, upside potential may be more muted than in previous cycles. Fracking technology and producer's flexibility to quickly ramp up output suggests that the large boom/bust cycles in supply will not hold true going forward. The natural gas market is a prime example. The implication for oilfield services investors is that peak earnings could be much lower than in the past, which will reduce investor willingness to speculate on upcycles and warrant a higher risk premium. We are sticking with a neutral weighting, despite the likelihood of periodic oversold spikes. The ticker symbols for the stocks in this index are: SLB, HAL, BHI, CAM, NOV, FTI, HP, RIG, ESV, DO.
A near-term rally in risk assets now appears very likely. But we expect it to be cut short when the Fed eventually reacts to easier financial conditions by returning to a more hawkish policy stance. Investors should maintain a defensive portfolio allocation on a 6-12 month horizon, and remain overweight TIPS versus nominal Treasuries.
The deeply negative momentum in oil prices is fading, setting up the possibility of a counter-trend rebound in global inflation expectations and perhaps even the beaten-up U.S. High-Yield bond market.
Lean against rally attempts until leading profit indicators improve. The conditions for a tradable oilfield services rebound remain elusive. Capital markets may bounce, but we would sell on strength.