Developed Countries

Our cautious outlook on corporate profits amid ongoing deflation pressures is reason enough to favor non-cyclical equity sectors. But the surprise Bank of Japan move to introduce negative deposit rates adds yet another catalyst for defensive and fixed-income proxies. On the margin, capital is likely to seek out high yielding government bond markets. The U.S. still has comparatively juicy yields compared with other developed countries. In fact, a growing swath of the euro area bond market has negative yields. In addition, the U.S. has a strong currency. That could create a self-reinforcing feedback loop, as the exchange rate will sustain imported deflationary pressures over and above the additional pressure on China and the rest of Asia if the yen weakens. When the ECB announced negative deposit rates in the spring of 2014, the U.S. dollar immediately vaulted higher and Treasury yields declined for the rest of the year (see the vertical line). At the same time, long duration sectors such as health care accelerated, while utilities and REITs caught a bid. We expect these sub-surface equity trends to repeat, and broaden, as telecom services should now fit into the mix, because unlike 2014, overall corporate profits are falling and financial conditions are much more restrictive. The implication is that a defensive portfolio structure remains appropriate.

Special Report

Despite its substantial decline, the 10-year Treasury yield still appears reasonably valued relative to our base case scenario of a flat or slightly weaker U.S. dollar. In this <i>Special Report</i> we outline our Treasury valuation framework, in which the dollar plays a key role.

With global bond yields converging toward the lower levels of the NIRP countries, it still makes sense to favor markets with higher nominal and real yields and steeper curves, like U.S. Treasuries (especially U.S. TIPS) and U.K. Gilts.

Economic disappointment represents a serious obstacle for stocks. Stay with non-cyclical plays, including telecom services and health care. Upgrade the managed care group, and stay clear of banks, regardless of cheap valuations.

Stay cautious. The Fed is only beginning to acknowledge what markets already realize. Eventually, they will back off, which reduces the odds of a further sustained equity decline. So far, however, the central bank is lagging deflationary forces acting on the U.S. economy, markets and profits. The weak ISM surveys are consistent with this. The risk is that employment follows suit.

The BoJ's latest rate cut will not have much impact on the Japanese economy or currency. The BoJ and ECB are closer to the end rather than the beginning of their unconventional policies. The biggest policy event of the year will be a 180-degree reversal from the Fed. The divergence in monetary policies that drove the euro and yen lower is largely over.

DM central banks are shifting back into easing mode, with the BoJ's surprise cut the most dramatic example. Japan's adoption of negative rates represents another deflation-fighting step, ultimately leading to a price-level targeting regime and debt monetization. While the real yen will ultimately decline, near-term strength would force more aggressive policy. Stay neutral global equities, preparing to decrease exposure on any sustained rebound. U.S. 10-year yields are still on track to reach our target of 1.5% by year-end.

Stronger-than-expected profit results have propelled the S&P leisure products group higher in recent trading sessions. Despite the sharp gains that have already accrued, we continue to see meaningful upside potential. Positioning had become exceedingly bearish on this group, as measured by the surge in the short interest ratio. The latter showed it would take roughly ten days to cover these bearish bets. Meanwhile, analyst profit estimates were challenging multi decade lows, in relative terms. However, the plunge in oil prices and rising income are growth pushing up spending on leisure products, and retail sales and toy and hobby stores are booming. Consequently, the stage is set for a major re-rating in earnings expectations (second panel), which should force ongoing short covering. We reiterate our high-conviction overweight. The ticker symbols for the stocks in this index are: MAT, HAS.

Deflationary pressures in the media space as a result of cord cutting and changing consumer consumption habits are undermining profit prospects. To make matters worse, the service sector is closing the gap with the weakening manufacturing sector: the latest ISM non-manufacturing survey showed a large drop, particularly in its employment component. Worrisomely, industry productivity (sales/employment) has ground to a halt, warning that relative profits will likely disappoint in the coming quarters, the opposite of what sell-side analysts are currently anticipating for the next 12-months (bottom panel). With media credit spreads steadily widening following the debt binge to retire equity, the risk premium in this sector is set to steadily widen. We reiterate our high-conviction underweight stance. The ticker symbols for the stocks in this index are: DIS, CMCSA, TWX, TWC, FOXA, CBS, OMC, VIAB, IPG, NWSA, DISCK, TGNA, CVC, SNI, DISCA, CMCSK, FOX, NWS.

The S&P hotels index is breaking down. The era of cheap financing costs spurred a multiyear lodging industry construction binge, creating a backlog of new capacity likely to hit markets for some time to come. In the interim, there is evidence that slowing economic growth is starting to undermine revenue. Global revenue per room is contracting, even prior to much of a slowdown in traffic. The implication is that pricing power is being sacrificed to fill rooms. Looking ahead, leading indicators of consumer spending on lodging are pointing to a marked slowdown, consistent with our expectation that corporate sector travel budgets will also be pruned as profit margins get squeezed. We downgraded this overvalued group at the end of last year, and reiterate our underweight stance. The ticker symbols for the stocks in this index are: CCL, MAR, RCL, HOT, WYN.