Sectors

Approaching the referendum on EU membership, what are the prospects for the U.K. economy and financial markets?

Air freight stocks have been unable to gather speed during the most recent bout of overall market strength and bid under risky assets, reflecting long-term pressure on valuation multiples. Persistently high business inventories mean that companies are not under pressure to use rapid delivery services to fulfill customer requirements. Indeed, when inventories are tight and bottlenecks exist, demand for high margin freight services increase as businesses rush to catch up. This dynamic acts as a weight on valuation multiples for air freight companies, and is unlikely to soon change based on the downbeat message regarding global trade from the IFO survey (third panel). With global trade volumes barely growing and leading indicators warning of downside risks, the message is that air freight profits will have difficulty meeting lofty expectations, particularly now that oil prices are no longer falling in support of profit margins. We are underweight this index. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD.

Pharmaceutical stocks are trading at historically cheap relative valuations on the back of political pressure on a few high-profile specialty pharma companies. We see this as an opportunity to add to positions in the more traditional pharma space. Our concerns about excessive drug pricing will only materialize when there is evidence that consumption patterns are changing. So far, there is scant evidence of higher prices choking consumption. Consumer spending on drugs is hitting new highs. That is true in both real and nominal terms, underscoring that higher outlays are not simply a reflection of rising drug prices. While the growth rate of drug consumption may slow, pent up demand from years of medical procedure deferral following the Great Recession will take time to play out. As such, soaring pharmaceutical shipments should be interpreted as demand-driven. Consequently, we expect profit outperformance to persist, and drive a sustained recovery in relative share prices. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, MNK, ENDP.

The reflation rally continues. Despite our bearish outlook for the year, we think the risks of the current rally lie to the upside given China's redoubling of stimulus at the expense of reform. Populist troubles are picking up in Europe, but we maintain our positive structural view and note that the migration crisis is slackening. Rather, the greatest risks of populism continue to flourish in the Anglo-Saxon world with Brexit and Trump.

The bright side to higher food prices is that the S&P agricultural chemical index should finally be finished a brutal bear market. This group has been savaged by the collapse in agricultural commodity prices, worries about the return of Argentine supply and China's future import growth. The good news is that these headwinds are more than discounted. The share price ratio is close to a decade low, expectations are now extremely washed out, valuations are dirt cheap and the industry has retrenched, creating an attractive reward/risk profile. Importantly, the combination of U.S. dollar softness and two years of farming financial pain are sowing the seeds for a recovery in food prices. Global grain production contracted last year, after several years of strong growth, while shipments of pesticides and fertilizers are accelerating. Typically, food prices recover after production falls, particularly if the U.S. dollar declines. A weaker U.S. dollar boosts purchasing power in the rest of the world, which bodes well for increased food consumption, and it reduces the ability of global food exporters to flood the market and keep prices depressed. Higher food prices would stop the erosion in farming real estate values after a difficult few years, a necessary step to improving capital availability. Already, cash rents are off their lows, a positive sign for underlying property valuations. In sum, current agricultural conditions are depressed, but we can envision a slow but steady improvement as food prices climb on the back of a weaker U.S. dollar and supply restraint, which would support narrower risk premiums in related equities. Boost the S&P agricultural chemicals to overweight from underweight, locking in a 34% profit on this call, and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5FERT - MON, MOS, CF, FMC.

Last autumn we recommended using weakness in the S&P containers & packaging index to augment positions to overweight, on the basis that that global disinflation would optimize profitability at a time when excess bearishness existed. After all, the decline in global export prices would spur an increase in the volume of globally traded goods, and packaging companies benefit from the number of goods sold rather than their value. Packaging firms primarily serve the food and beverage industry. The volume of food and beverages sold is inversely correlated with prices paid. Declining food prices lead to increased spending, and vice versa. The weak U.S. dollar is helping to boost raw food prices (shown inverted, second panel), which could put a damper on the recovery in packaging demand. The contraction in intermodal rail car shipments, mostly consumer goods, is also disconcerting, and warns that non-food packaging demand is also under pressure. Thus, even though valuations are reasonably attractive, our bias is to take profits and downshift to neutral, redeploying the proceeds into a group that benefits from higher food prices. Please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, SEE, AVY, OI.

U.S. dollar softness has failed to lift equities of late, a tentative warning that correlations are changing as the U.S. economy cools.

While we recently downgraded financials and banks to underweight, this bearish view does not extend to each of the sector's components. REITs are a positive exception. The group is still not overvalued, despite the relentless decline in yields on competing assets. This may reflect an undercurrent of skepticism regarding the sustainability of cash flow growth and low cap rates. However, both appear sustainable. The CPI for homeowner's equivalent rent, a proxy for REIT pricing power that has a good correlation with relative performance, is still accelerating even though it is already well above the overall rate of inflation. Moreover, commercial property price inflation continues to climb. While Fed rate hikes could be construed as an impediment if they lift the cost of capital, REITs have not typically run into trouble until policy has tightened by enough to cause a cresting in commercial real estate prices, a peak in occupancy rates and by extension, a downturn in the CPI for rental inflation. None of these concerns currently exist. Consequently, we recommend maintaining an overweight position. BLBG: S5REITS

Utilities appear to have successfully consolidated this year's sharp relative performance run up, as the share price ratio is firming anew after holding at its 40-week moving average. The incentive to maintain an overweight exposure to this fixed income proxy is heavily influenced by whether global deflationary forces have finally ebbed. While the U.S. dollar has softened in recent months, it has not caused an upsurge in inflation expectations nor has failed to cause a sell-off in Treasurys. U.S. yields are being pinned down by persistently low global bond yields, which reflect chronic deflationary pressures. As long as the total return of bonds is beating equities, then utilities relative performance momentum should stay positive (third panel). Without any valuation barriers to further outperformance, we continue to recommend an above-benchmark weighting. BLBG: S5UTIL.

Following up from yesterday's S&P banks update, as banks go so do financials, given that they comprise the highest weight in the sector. Worrisomely, financials relative EPS momentum has more downside. Using the latest Fed Senior Loan Officer survey data, we constructed a C&I loan supply/demand indicator (middle panel). The news is grim for financial sector profits. C&I loan volumes are decelerating and banks are tightening lending standards. C&I now represents the highest lending category exposure on bank balance sheets, warning of a magnified negative impact on profitability. As long as deflationary forces prevail, as proxied by persistent weakness in our global leading economic indicator (GLEI), then credit quality will continue to erode: it is no wonder that financials relative performance and the GLEI are highly correlated. Bottom Line: We reiterate our recent downgrade to underweight. BLBG: S5FINL.