Equities

We recently boosted weightings in the S&P electrical equipment & components index, and the latest data reinforce this view. Final demand has stayed more resilient than other manufacturing and resource-intensive industries, as reflected in both new order and capital investment trends (second panel). Despite this top-line resilience, electrical equipment manufacturers have been among the most aggressive in protecting profit margins through cost cutting and capacity reduction. That is evident in rising utilization rates, a remarkable feat given that the manufacturing sector is flirting with recession, and improving productivity growth. The implication is that health returns on equity should persist, heralding a re-rating in very depressed relative earnings growth expectations, and valuations. The ticker symbols for the stocks in this index are: AME, ETN, EMR, ROK. Chart

The S&P rail index has bounced off its lows but continues to lack profit support to extend the recovery attempt. Total railcar shipments remain under pressure, which signals ongoing weak utilization rates and low odds of a reversal in selling price deflation. Coal markets are likely to stay under pressure as a consequence of high utility coal inventory levels, as electricity production was adversely impacted by an unseasonably warm North American winter. The latest retail sales report was also soft, and has sustained downward pressure on the retail sales-to-inventory ratio. That can be a decent leading indication for intermodal railcar shipments, the largest freight shipping category. Thus, despite attractive valuations and aggressive cost cutting efforts, we maintain a neutral weighting, preferring another industrials group to benefit from a slightly more reflationary tone in overall markets, please see the next Insight. The ticker symbols for the stocks in this index are: CSX, KSU, NSC, UNP.

If the EM rally is sustained, the Fed will once again become resolute in its commitment to hiking interest rates. This in turn will spur another relapse in EM risk assets. Chinese policymakers are attempting to juggle contradictory objectives without a clear and realistic plan of action to resolve existing problems.

A Chinese reflationary cycle is unfolding. Capital spending is showing signs of regained vigor, driven by both housing and infrastructure. Chinese PPI deflation will ease further. This will help reduce balance sheet stress of materials producers and boost overall industrial profits. Remain positive on Chinese investable stocks.

The oversold rebound is at risk of stalling at key resistance levels. While some cyclical and interest rate-sensitive sectors have enjoyed decent bounces, defensive equities have stayed very well bid and are the only sectors making new highs. That suggests that a fundamentally-driven capital rotation into higher beta equities is not occurring, and that overall equity market relief reflects short covering and the resolution of oversold conditions. Why? Financial conditions remain too tight to expect a durable profit recovery, especially one that will match current rosy expectations. The chart shows that an aggressive recovery in S&P 500 earnings is expected this year. Importantly, these expectations are not simply a reflection of hopes for a recovery in resource prices, but are broad-based across sectors. That is wildly optimistic, especially based on the budding profit margin squeeze and ongoing bearish message from our global leading economic indicator. Consequently, we do not recommend chasing the recent rally and would use price strength to raise cash levels and/or transition into a lower risk portfolio structure.

Materials stocks have traditionally been late cycle plays, as earnings outperform when the economy is heating up and global resource utilization is burgeoning. That is not currently the case, as the global manufacturing sector is battling recessionary conditions. As long as this backdrop persists, it will be difficult for materials stocks to sustain any rallies. True, Chinese money growth has perked up, but this may not lead to increased manufacturing activity and/or import demand, given high existing debt-loads, weak export growth and soft domestic activity measures such as real estate and fixed asset investment. Meanwhile, global trade remains poor. The Baltic Dry Index continues to sink, signaling ongoing weakness in global trade (top panel). That will sustain downward pressure on capital goods prices. Our materials sector pricing power proxy continues to contract, and our sales-per-share model is heading south. The implication is that the negative side of operating leverage has not yet fully played out. To make matters worse, the sector is carrying excessive leverage, warning that there is little room for error and/or to absorb a prolonged period of weak pricing power. Stay clear.

The heavily-shorted S&P steel index has enjoyed some relief of late, as short sellers were given an excuse to cover when China announced it would attempt to shut roughly 10% of its productive capacity in the next few years. While that is a necessary development to eventually rebalance markets, there are no quick fixes. Chinese steel production has already been drifting lower for some time, but exports continue to trend higher. The country has accumulated massive inventories as a consequence of previous overproduction and sinking domestic demand growth. The sharp downturn in infrastructure investment (shown inverted) is likely to sustain upward export pressure, thereby keeping global markets oversupplied. Without a rebound in resource end markets, steelmakers must rely on other sources of demand growth such as global construction. However, even these outlets are also losing steam. The chart shows that BCA's proxy for global commercial REIT supply is contracting at a steep rate, consistent with weak steel uptake. The implication is chronic downward pressure on steel utilization rates, and by extension, pricing power and profits. We recommend selling into strength and reducing positions back to underweight. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: NUE, STLD, RS, X, CMC, ATI, CRS, WOR, AKS, HAYN, SXC, TMST, ZEUS.

Bearish sentiment, higher oil prices and Chinese policy stimulus leave room for a continued bounce in stock prices. But this rally is unlikely to prove sustainable.

Confirming indicators still do not validate the oversold rally. Fade the materials sector bounce, by selling steel down to underweight.

A number of factors triggered our downshift from a growth over value bent to a neutral style bias in late-January. Value has outperformed growth in 80% of broad equity bear markets since 1960, and in more than half of economic recessions. While neither outcome is assured, they have become much higher probabilities as credit conditions have tightened. Sector weightings also played a role, as growth indexes have nearly quadruple the tech sector exposure as value benchmarks, and more than double the consumer discretionary exposure. We are bearish on both sectors. The incentive to bet on growth stock outperformance from current premium valuation levels continues to diminish. Overall long-term S&P 500 earnings growth expectations have been pared back aggressively of late. Reduced confidence in the secular profit outlook is a headwind for overall valuations, but particularly for growth vs. value stocks. The chart shows that momentum in the G/V ratio closely follows trends in 5-year earnings growth expectations, and the current message is that the price ratio has hit a ceiling.