Developed Countries

Health care equipment stocks are overbought relative to the broad market, and a corrective pullback is inevitable. We had been concerned that the latest leg up might represent the final outperformance phase for this group, given rising wage inflation and a cooling in revenue growth indicators, but our conviction in the longevity of the cyclical bull market has been reinforced. Medical equipment demand is accelerating on a number of fronts. Domestic uptake is being driven by a rising number of procedures, as evidenced by double-digit strength in consumer spending at hospitals. That is a sustainable trend given rising income growth and broader health insurance coverage. Medical equipment exports have also reaccelerated. That is notable because it has occurred within the context of a flat, rather than weak, U.S. dollar. The implication is that demand from abroad is also on the upswing, as confirmed by the surge in the German IFO survey of medical equipment orders. As a result, backlogs should continue to build, ensuring that output growth stays on a solid footing. We recommend staying overweight. The ticker symbols for the stocks in this index are: BLBG: S5HCEP - MDT, ABT, SYK, BDX, BSX, BAX, ISRG, EW, STJ, ZBH, BCR, VAR.

The small vs. large cap ratio peaked in 2014 and should have experienced a tumultuous corrective phase, given that the bulk of the major equity indexes such as the Value Line and Wilshire indexes endured bear markets, driven by tightening financial conditions, credit concerns, a global manufacturing recession and commodity price crunch. However, the corrective phase has been more lateral than down and our concerns about outsized profit margin compression have now come to pass: small cap margins have been crushed, especially relative to large caps. But this gap should close. The NFIB survey of the small business sector shows that labor compensation plans have rolled over. In addition, the NFIB reported price changes index has troughed. At the same time, the overall employment cost index, a good proxy for large cap wage expenses, is accelerating. The upshot is that small cap margins should soon stabilize, while large cap margins continue to get squeezed. Small caps are now slightly cheaper than large caps, according to our gauge, and a move back to a premium is probably if the profit margin gap closes on the back of renewed strength in the U.S. dollar. Bottom Line: shift to a small cap preference and please see yesterday's Weekly Report for more details.

Shift to a small vs. large cap bias as a stealth way to play the overall equity market overshoot. The oversold bounce in banks is not worth chasing, and buy dips in medical equipment stocks.

U.S. inflationary forces remain tame, forcing the Fed to maintain an easy bias. Yet, the global economy is improving. This confluence could weigh on the dollar and boost commodity currencies. The NZD has more upside, but it will lag petro currencies. The BoJ will act, but timing is uncertain. Keep a negative bias toward the yen. CAD/NOK has more downside.

More aggressive monetary and fiscal stimulus will be necessary to resuscitate the Japanese economy. While the BoJ's forthcoming review is likely to endorse the current policy stance, there is a good chance that Kuroda will open the door to more radical measures. These measures will push down the yen, giving Japanese stocks a lift in the process. Sentiment on the U.K. economy has gotten too bearish. We are closing our short GBP/SEK trade and going long GBP/JPY.

Drug retail relative valuations have divorced from bullish indicators of top and bottom-line performance. Retail sales momentum continues to accelerate. The ongoing hospital hiring frenzy is indicative of rising procedures, and provides a good indication for future prescription drug demand, and thus pharmacy retail sales. Importantly, drug retailers are gaining market share from hypermarkets (third panel), underscoring that they will receive a disproportionate share of rising store traffic. From a contrarian perspective, there appears to be little buy in to a positive sales view, given that analysts have pared back relative sales growth expectations (fourth panel). Meanwhile, investors have attached a massive risk premium to the group (bottom panel). There is room for both profit and multiple expansion, and we reiterate a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5DRUG - CVS, WBA.

The S&P retail drug store index has been undermined by concerns about the opaque pricing structure of its pharmacy benefits management arms, which has pushed relative valuations to extremely attractive levels. While it is difficult to forecast whether any major concessions will be made to appease health insurers, this focus is masking an increasingly upbeat picture for the rest of the core business. Consumers are allocating a record share of their spending to pharmacy-related items, continuing a trend in place for more than two decades. It is rare for relative performance to deviate from relative spending trends for long, as the latter provides a clear indication of the industry's ability to deliver better-than-market profitability. Importantly, drug retailers have retrenched in recent years, paving the way for solid same-store sales growth. Shorter-term performance indicators are even more upbeat, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5DRUG - CVS, WBA.

The deepening interconnectedness of the "global eco-system" brought front-and-center by NY Fed President Dudley will keep inflation at the consumer level synchronized in the world's largest economies. The importance of global variables in the evolution of local inflation rates will remain elevated.

The euro area's NPL problem is unlikely to be solved quickly, constraining bank profitability and the capacity to lend. There are three important repercussions for investors.

A bearish outlook for refiners is becoming a more mainstream thesis, but there likely is one more meaningful relative performance downleg before it will be time to book profits. Refined product consumption has been solid for much of the past year. As a result, refiners have operated at full tilt in order to produce enough gasoline to meet demand. However, overproduction has occurred, compounded by accelerating refinery production outside the U.S. Increased import competition is a serious threat. Saudi Arabia, China and India have all ramped up refined product output this year on the back of cheaper OPEC oil supplies; consequently, exports are flooding the global market, depressing relative demand for U.S. oil product exports, which are falling steadily. Consequently, U.S. refiners will need to both cut refinery production and selling prices in order to rebalance the market. That is a toxic combination for any low margin, high volume cyclical industry. Against a structural backdrop of rising global refining capacity, rich valuations need to be reset. Stay underweight The ticker symbols for the stocks in this index are: BLBG: S5OILR-MPC, PSX, TSO, VLO.