Developed Countries
The plunge in capital markets stocks is not a buying opportunity. Corporate sector credit quality is quickly deteriorating. Ratings agencies are adding fuel to the fire, as bond downgrades are briskly outpacing upgrades. The message is that capital formation will continue to slow as the cost of credit climbs. As access to capital becomes more restrictive, on the margin, the currency to fund deals, share buybacks etc...will erode, undermining key earnings drivers. The implication is that profit prospects will continue to erode, the opposite of what sell side analysts are expecting (middle panel). Capital market return on equity tends to follow, inversely, junk bond spreads, and the current message is bearish (spreads are shown inverted, bottom panel). Bottom Line: The S&P capital markets index is facing stiff profit headwinds. Stick with a high-conviction, below-benchmark allocation.
The U.S. corporate re-leveraging cycle is far more advanced than is widely believed. Corporate health looks only mildly better excluding the troubled energy and materials sectors. Mushrooming leverage ratios are not restricted to junk issuers either.
The U.S. corporate re-leveraging cycle is far more advanced than is widely believed. Corporate health looks only mildly better excluding the troubled energy and materials sectors. Mushrooming leverage ratios are not restricted to junk issuers either.
Central banks follow backward-looking indicators but economies follow forward-looking indicators. So which indicators should investors follow? And what is the current message? Also, we see signs that London is cooling.
Materials stocks have been beaten down to the point where it is tempting to declare that all the bad news is already discounted. However, we remain reluctant to recommend investors attempt to catch this falling knife. China remains the marginal price setter for commodities, and its growth struggles are very deflationary (bottom panel). That is adding to the profit stress exerted by U.S. dollar strength. Importantly, materials sector cash flow is contracting at a time when its interest rates are rising. Deteriorating materials sector financial health is evident by the sinking interest coverage ratio. Worryingly, spiking high yield materials sector bond spreads are warning that basic materials credit quality has further to fall (spreads shown inverted, middle panel). Balance sheet stress argues for a rising materials sector equity risk premium. Bottom Line: Stay underweight the S&P materials sector.
Household product stocks are gathering momentum relative to the broad market. We expect this trend to persist as profit margins slowly improve. The industry has undergone a forced retrenchment as a consequence of the strong U.S. dollar, which sapped top-line growth. However, both commodity input and labor costs are contracting, providing much needed profit margin relief. The chart shows that operating margins have significant upside, especially if revenue improves even modestly. On this front, the plunge in commodity prices is freeing up disposable income to spend on brand-name essentials: consumer spending on toiletries is outpacing overall consumption for the first time in years. Moreover, Asian real retail sales are still growing at a robust rate, signaling that any emerging market currency stability should translate into better top-line performance. We reiterate our overweight position. The ticker symbols for the stocks in this index are: PG, CL, KMB, CLX, CHD.
The declining correlation between risk assets and Treasury yields suggests that the market perceives monetary policy to be overly restrictive. Historically, this has led the FOMC to adopt a more dovish policy stance.
Yesterday's Weekly Report showed a table of sector operating margins relative to their long-term average, as well as price/sales ratios. Expensive sectors with above average margins appear particularly vulnerable in an environment where overall margins are being squeezed and economic risks are mounting. The consumer discretionary sector stands out as having significant profit margin and valuation downside. The policy backdrop is also turning more hostile. History shows that this sector outperforms when interest rates are falling and/or low, and underperforms when they climb and credit becomes more restrictive. This correlation is evident in the correlation between relative performance and money supply. When the cost of credit is low and liquidity is plentiful, investors discount increased discretionary consumer spending, particularly on durables, and bid stocks up accordingly. The opposite is also true. Currently, money growth is plunging, although remains in positive territory for the time being, suggesting that credit creation is slowing. Importantly, the longer that financial markets stay turbulent, the greater the upward pressure on the personal savings rate and likelihood that discretionary spending is reined in. Even then, a consumption contraction is not a prerequisite for consumer discretionary underperformance. With the Fed determined to keep pushing up interest rates, the macro backdrop is bearish for discretionary stocks.
Growth stocks have trounced value indexes over the last few years. The bulk of our style Indicators signal that macro conditions are still tilted in favor of growth. As a reminder, growth indexes almost always move to a premium when economic growth declines, as is currently the case. Nonetheless, we are losing conviction in the ability of growth stocks to sustainably outperform from current levels, despite our downbeat view of global economic growth prospects. Comparing the genetic makeup of the growth and value benchmarks with our current sector positioning suggests extrapolating recent gains is becoming higher risk. Growth indexes have nearly quadruple the tech exposure of value indexes, at the 32% vs. 8%. Consumer discretionary, another underweight, represents 18% of growth indexes vs. 7% of value indexes. That is a 35% weighting difference from two sectors. Meanwhile, the defensive telecom services and utilities sectors are 10% of value exposure, but only 3% of growth benchmarks. Importantly, growth stocks have a checkered past once equity bear markets and/or recessions set in. Since 1960, value has outperformed in 80% of bear markets. Value has also outperformed in 5 out of the 8 recessions since that time. While neither recession nor bear market is guaranteed at the moment, both are becoming higher probabilities. Adding it all up, we are moving to neutral in our growth vs. value bias after a 10% gain. Please see yesterday's Weekly Report for more details.
With inflation expectations declining alongside asset prices in almost every major economy, central banks can at least not make things worse by being more hawkish than necessary.