Sectors

In recent travel, our clients remain focused on downside risks to today's range-bound markets. And for good reason. Uncertainty regarding Chinese reaction function is the biggest source of political risk in today's markets. We discuss it in detail in this month's report, along with an update on our views of Brazil, Russia, and Turkey. In addition, we examine the potential casualties of the European immigration crisis and the likelihood of Donald Trump becoming the president of the United States.

While high-beta equity areas have rebounded smartly in recent trading sessions, we remain skeptical that earnings-follow through will be forthcoming. Instead, our portfolio remains defensively-geared, where profit support is strongest. For instance, the latest manufacturing data showed that pharmaceutical shipments continue to boom, underscoring that top-line momentum has started on a strong foot in the first quarter. That bodes well for pharmaceutical relative performance. Elsewhere, beverage shipments have also soared on a growth rate basis, sending a similar upbeat message for the S&P soft drink index. Importantly, pricing power remains solid in both industries, underscoring that the surge in manufacturer shipments likely remains demand-driven. We reiterate our overweight position in both indexes.

Fed policymakers will soon shift their focus toward the strong employment and inflation data and stress that further rate hikes this year are likely. This will stem the rally in risk assets and cap the upside in long-dated yields.

In yesterday's Weekly Report, we outlined our top ten reasons to underweight the technology sector, an out of consensus call based on the sector's resilience during the past few months' of broad market turmoil. At the root of our concern is that tech sector productivity growth is eroding at the same time that previously bulletproof balance sheets are slowly deteriorating. Declining sector productivity can be remedied through increased capital spending, but the chart shows that tech has underinvested as a share of sales for the better part of a decade. While the latter is slowly creeping higher, it will take time before it feeds into increased efficiency and faster earnings growth. Worse, our overall capital spending model is sinking steadily (bottom panel). In particular, the financial and public sectors have traditionally been large technology spenders. Despite ultra-low borrowing costs, government spending is still politically constrained and thus on a tight leash. Meanwhile, the financial sector has already ramped up its capital spending significantly (middle panel), without a corresponding positive impact on new order growth, signaling that weakness from other end markets has been a large drag. If the financial sector pulls in its horns as overall credit quality sours, it will remove a support for tech capital spending. We are bearish on relative performance prospects, and recommend underweight positions. Please refer to yesterday's report for more details.

As confidence in the sustainability of corporate sector profitability declines, the multiple accorded to equities should recede. Ten reasons to stay underweight the tech sector. Initiate an overweight position in gold shares.

A stunning 9.9 million-barrel build in U.S. oil inventories this week failed to arrest the upward climb in prices.

Industrials stocks have been coming out of their funk lately, on the back of a selloff in the U.S. dollar, easing in financials stress, a tentative trough in the commodity hemorrhaging, and a relative calm in China and the emerging markets. We upgraded industrials to a benchmark allocation in mid-February as the brutal sell off in deep cyclicals was due for a breather courtesy of continued U.S. dollar weakness. We expect the relative share price ratio to be range bound in the coming months. The latest ISM manufacturing survey showed some glimmers of hope, but it remains below the 50 boom/bust line. The new orders survey sub-component ticked higher, however the mean reversion in industrials profit margins is well underway, and the path of least resistance remains lower (third panel). Bottom Line: While we are not calling for an imminent resurgence in global manufacturing or business investment, an easing in the U.S. dollar has the potential to cause a meaningful re-rating in overly depressed industrials profit expectations and relative valuations (not shown). We reiterate our recent upgrade to neutral.

The recent rebound is not a harbinger of a prolonged recovery in risk assets. The many potential negatives will keep volatility high and trigger further occasional selloffs.

Return on equity (ROE) has clearly peaked for the cycle (top panel). In fact, S&P 500 ROE topped out in 1999 and has shown a pattern of descending cyclical tops since then. Employing the DuPont framework, ROE is declining because of falling asset turnover and decreasing margins, despite rising leverage. In more detail, the structural decline in asset turnover (second panel) reflects deteriorating corporate efficiency - owing to weak productivity growth - since asset turnover measures the amount of revenue generated per dollar of assets. Profit margins have clearly peaked for the cycle (third panel), and downward pressures are intensifying. In a deflationary world rife with excess capacity, pricing power is deteriorating for the majority of U.S. companies, at a time when wages continue to rise, albeit slowly. Importantly, ROE is declining despite rising financial leverage. It made sense for companies to leverage up over the past few years given the low after-tax, real cost of debt. Unfortunately, most of this debt was used for short-term purposes such as stock buybacks and M&A, rather than long-term investment to improve productivity and ROE. Moreover, the capacity of rising debt levels to increase ROE has reached its limit. Bottom Line: All three trends raise the risk profile of U.S. equities. Please see yesterday's Special Report for additional details.