Sectors

Yesterday we showed an Insight with financial sector relative performance and the yield curve, with the message that the sector's more defensive components outperform while the curve is flattening, as is currently the case. We view the consumer finance group as a positive exception. An extremely attractive valuation starting point and a low correlation between the industry's net interest margins and the government yield curve provide confidence that a new bull run is getting underway. Indeed, the chart shows that the credit card interest rate spread has widened in recent months, even as the Treasury curve has narrowed. Importantly, the personal savings rate has room to decline (top panel), if a decent job market continues to lift consumer income expectations (bottom panel). That will support ongoing growth in revolving consumer credit and low delinquencies, two critical profit drivers. The bottom line is that consumer finance stocks should follow a similar bullish path to the consumer discretionary, media and most domestic consumption-oriented plays, and we reiterate an overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5CFIN - AXP, COF, DFS, SYF, NAVI.

The financial sector has enjoyed a modest respite as the market has pulled forward Fed rate hike expectations. However, we doubt that will last long if the yield curve continues to narrow and the U.S dollar firms, importing deflationary pressures into the U.S. Historically, a flat yield curve has signaled that monetary policy is too tight and that an economic downturn loomed. An inverted yield curve accurately predicted major market tops in 2000 and 2007, as well as shorter but sharp market declines in 1990 and 1998. The yield curve continues to narrow as the Fed lowers its terminal rate forecast and the insatiable global search for yield persists. It will not take many Fed rate hikes for the yield curve to completely flatten or invert. As such, we continue to deemphasize the overall financial sector, preferring its less cyclical components such as REITs and insurance, which stand a better chance of outperforming as the curve flattens.

The latest housing data paint a bullish picture for the S&P homebuilding index. New home sales are soaring, and are rapidly regaining as a share of total home sales. Demand for new homes is well supported by increased mortgage availability, rising credit scores and faster income growth. Importantly, faster demand has not yet translated into overproduction, as new home prices are soaring, which bodes well for homebuilder sales growth (third panel). The supply of new homes has recently ticked lower in absolute terms, and plunged in terms of months of supply (bottom panel). The surge in construction job openings reinforces that builders have sufficient backlog to aggressively add staff. In turn, that should boost confidence in the longevity of the housing upcycle, translating into a valuation re-rating. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME-PHM, DHI, LEN.

Leisure product relative stock performance is setting up for another leg up. The share price ratio endured a brutal bear market, becoming extremely oversold as company-specific woes caused a short selling frenzy. However, a major trend change occurred earlier this year, with cyclical momentum moving from massively oversold to extremely overbought, as measured by the 52-week rate of change. Overheated conditions have been unwound, and rising relative forward earnings estimates argue for a resumption of the uptrend. As discussed in Monday's Weekly Report, consumer purchasing power has improved markedly, and is driving solid spending growth at toy and hobby stores (third panel). The surge in overall media spending reinforces that a tailwind exists for content-based merchandise sales. We expect ongoing earnings outperformance to propel a further re-rating in the S&P leisure products index, and reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5LEPR-HAS, MAT.

U.S. consumption is the strongest economic link. Consumers are benefiting from low fuel costs, historically cheap borrowing rates and increasing capital availability. Wage growth is outpacing nominal GDP growth, consumer income expectations are climbing, underscoring that the barriers to increased consumption are gradually falling. In particular, retailers should benefit if Treasury yields stay subdued and U.S. currency appreciation reduces the cost of imported consumer goods and boost purchasing power. However, it is instructive to dig beneath the surface. Not all retail sales categories are experiencing positive momentum, with some suffering from more acute deflationary pressures than others, and a homogenous recommendation on retailers is no longer appropriate. Broadly, retail sales at discretionary stores are contracting, while growth is evident at non-discretionary stores, and non-store sales continue to boom. The chart highlights our favored retail categories, which generally have positive sales momentum. Bottom Line: a selectivity bullish stance is warranted on retailing equities, please see yesterday's Weekly Report for more details.

We took profits in the S&P software index and downgraded to neutral in January, because the boost to corporate software investment to offset flagging productivity growth looked to have been fully discounted. After a six month consolidation, relative performance has jumped back to this year's highs, but the conditions to sustain a breakout are absent. Software demand is more levered to business investment than consumer spending. In the macro environment we envision, consumption will continue to outpace investment. The rise in the personal savings rate means that there is pent-up consumer spending to be realized as wage inflation recovers. On the flipside, stretched corporate balance sheets and a dearth of sales growth pose significant restrictions to capital spending budgets. Ominously, software sales are already contracting relative to total S&P 500 sales. The software industry's contribution to GDP growth invariably becomes negative, i.e. a drag, when overall capital spending retrenches, as is currently the case. Sales contraction, and profit margin erosion, is not conducive to premium valuations. Cut to underweight and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG-S5SOFT: ADBE, ADSK, CA, CTXS, EA, INTU, MSFT, ORCL, RHT, CRM, SYMC, ATVI.

The equity rally has been in a holding pattern, with some tactical fraying around the edges.

Steel share prices celebrated the introduction of punitive import tariffs earlier this year, but that impact may already be wearing off. The latest data show that U.S. steel imports, while still well below the 2015 peak, have hooked back up, and are rising as a share of domestic production. China's steel prices have plunged, and are well below U.S. prices, a trend that may continue given that Chinese steel production has reaccelerated. Consequently, Chinese steel exports are likely to rise anew, especially given that floor space started is moving laterally and infrastructure spending growth is cooling rapidly (shown inverted, second panel). Less domestic consumption implies increased pressure to export. While U.S. producers may stay somewhat insulated given trade barriers, it will be difficult for U.S. steel prices to rise if prices in the rest of the world are deflating. Balance sheets remain stretched, as measured by historically high net debt/EBITDA ratios, underscoring that risk premiums will increase if low steel prices pressure cash flow. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S15STEL-NUE, STLD, RS, X, WOR, ATI, CMC, CRS, AKS, HAYN, SXC, TMST, ZEUS.