Equities

China has fallen into the same "fiscal trap" that ensnarled Japan in the 1990s. Unprofitable investment projects undertaken by SOEs are a necessary evil. The underlying problem is not overinvestment, but an economy that is demand-deprived. Meanwhile, structural factors will ensure that savings remain high. Any efforts by the authorities to curb credit growth will result in a sharp economic downturn. China will continue to generate excess capacity and export deflation to the rest of the world, which is good for bonds. We recommend going long Chinese banks, the most hated equity sector.

The previous Insight showed that the financial sector remained on its heels as a consequence of ongoing global deflationary backlash. This backdrop is particularly difficult for asset managers & custody banks (AMCB). This index is a high beta play on economic and financial market confidence. When the latter is high, M&A activity, share buybacks and other sources of industry fee income tend to accelerate. The opposite is also true. At the moment, global economic confidence is sinking, as measured by our composite sentiment gauge (top panel) and the stock-to-bond ratio (bottom panel), and is likely to erode further as economic disappointment mounts (third panel). Meanwhile, M&A activity is on the wane as capital availability has become more restrictive (second panel). These forces warn that AMCB profitability is likely to underwhelm. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AMGT- BLK, BK, STT, TROW, AMP, NTRS, BEN, IVZ, AMG, LM.

The S&P financials sector continues to battle deflationary forces. While inflation expectations are off their low courtesy of this year's dip in the U.S. dollar, they remain well below 2014 levels when the U.S. dollar began to surge (top panel). The negative profit backlash from global deflation continues to reverberate across the business sector, and has undermined corporate balance sheets to the extent that banks are much less willing to extend C&I loans, their main source of asset growth (second panel). These trends are also sustaining downward pressure on the long end of the Treasury curve, causing a relentless yield curve narrowing. With the Fed still eager to lift interest rates, despite evidence of growth slippage, the odds of a policy mistake are creeping higher. Against this backdrop, financial sector profits are likely to lose additional steam, raising the odds of a breakdown in relative performance to new lows. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5FINL.

President Tsai's inauguration is unlikely to spark an immediate confrontation with the mainland, but heightened political uncertainty is a certainty, and some of the economic benefits that Taiwan gained in recent years from warming ties with China are set to unwind. Remain cautious on Taiwanese equities.

There is a considerable dichotomy between the EM equity universe and EM corporate credit markets. EM credit markets remain mispriced. EM currencies are at risk of renewed depreciation. This will push sovereign and corporate spreads, as well as high-yielding domestic bond yields, higher. Continue underweighting Indonesian stocks, sovereign credit and domestic bonds within their respective benchmarks.

The tech sector is sagging on the under the weight of contracting sales growth. There is no imminent reprieve, underscoring that the cresting in overall sector margins is likely to accelerate. Consumer spending on technology products and services has climbed as a share of total outlays (second panel), but the sector is not receiving support elsewhere. Businesses are being forced to retrench. Profits are under pressure while balance sheets are increasingly debt-laden. As a result, executives are unable to pursue expansion. Companies have spent the bulk of the money raised to repurchase shares rather than to invest. Why would that improve if the gap between the return on and cost of capital continued to close, as is currently the case? Both our capital spending model and the narrowing gap between the return on and cost of capital warn that business investment on tech goods is headed south (third and fourth panels). Importantly, the financials sector, a large technology spender, is already laying out an historically high portion of its sales on capital spending. Financial sector investment is likely to be reined in now that the credit cycle has taken a turn for the worse and more money needs to be set aside for bad loans (bottom panel), which will remove another support for tech final demand. We reiterate our underweight tech sector view, please see yesterday's Weekly Report for more details.

The broad market remains unable to break out of its 18-month long trading range, and risks are rising that it will retest the lower end of the bound. Domestic economic disappoint is a growing probability, which could refocus attention on deteriorating corporate sector balance sheets. Cash flow generation is weakening but companies have continued to add leverage on the view that interest rates will stay low forever. Typically, as free cash flow declines and the non-financial corporate sector suffers through a painful increase in net debt/EBITDA (shown inverted, top panel), the stock market either corrects or has already entered a bear market, as risk premiums climb in anticipation of a self-reinforcing economic and profit downturn. This cycle, a massive divergence has opened up, as any concerns about rising debt stress have been trumped by the view that low interest rates and abundant central bank liquidity will support asset prices indefinitely. That is unsustainable, because debt must be repaid at some point, and the longer that this gap grows, the greater the vulnerability to share prices. In the interim, evidence is slowly emerging that debt excesses are causing economic backlash. Credit standards have tightened, loan loss provisions are creeping higher and corporate bond spreads appear to have troughed for the cycle. Credit concerns likely explain the inability of bank stocks to participate. In past cycles, bank underperformance amidst credit cycle erosion has provided a bearish warning for the broad market.

Stocks whipsawed violently last week. Volatility could intensify if recent whiffs of a domestic economic slowdown proliferate and the Fed still adopts a more hawkish tone.

The next rate hike is unlikely before September, despite the rebound in April retail sales. The dollar could suffer for a time, but the long-term bull market is intact.