Sectors
The risk to ROE remains to the downside, which suggests that valuation multiples have peaked for the cycle. Beyond a potentially violent near-term counter-trend bounce, valuation multiples will remain under pressure.
The risk to ROE remains to the downside, which suggests that valuation multiples have peaked for the cycle. Beyond a potentially violent near-term counter-trend bounce, valuation multiples will remain under pressure.
The retail drug store industry is enjoying a twin boost from both bullish cyclical and secular forces. The latter is reflected in the long-term advance in personal outlays at pharmacies, which likely reflects increased drug demand as a consequence of an aging population. From a cyclical perspective, the surge in health care sector hiring activity reflects increased health coverage and rising patient volumes. That is a boon for drug demand, and is consistent with rising store traffic. As a result, pharmacies should be able to continue lifting selling prices at a rapid clip, despite deep deflation in the overall corporate sector. The upshot is ongoing productivity gains, as measured by sales/employee, should support robust earnings performance and a relative valuation re-rating. Stay with a high-conviction overweight. The ticker symbols for the stocks in this index are: WBA, CVS.
The previous Insight outlined the case for good building supply store sales growth, but an aggressive rise in wage inflation and intensifying deflation pressures may provide a negative offset. Meanwhile, the gap between house price inflation and mortgage rates has slipped below zero (second panel), suggesting that the financial incentive to buy and renovate a home has eased, on the margin. It is notable the retailing CEO confidence has taken a sharp turn for the worse in recent months, as this series often provides a good lead on industry sales trends. Souring confidence may reflect deflationary pressures. Importantly, our Home Improvement Retail model, which incorporates leading top and bottom line indicators, has not confirmed the advance in relative share performance into overvalued territory. Against this backdrop, we recommend only a market neutral weight. The ticker symbols for the stocks in this index are: HD, LOW.
Both Home Depot and Lowe's produced strong profit results in the most recent quarter, aided by a warm winter weather, which pulled forward sales of many products. The odds of the industry maintaining decent sales momentum are good, given that ultra-low mortgage rates should sustain housing turnover (second panel). Banks are still willing to extend mortgage credit, as rising house prices provide confidence in underlying asset values. Nevertheless, extrapolating future store traffic growth straight down to the bottom line risks being too optimistic. The industry has hired aggressively to meet rising demand, and deflation still plagues the industry (bottom panel). Deflation amidst good store traffic also suggests that a serious market share battle is raging, which means meeting this year's aggressive industry earnings growth estimates is not guaranteed, please see the next Insight. The ticker symbols for the stocks in this index are: HD, LOW.
As world central banks increasingly shift toward negative interest rate policies to combat deleveraging and deflation, the search for yield in financial markets is likely to persist. Global bond yields continue to grind lower, which is raising the allure of income producing equities. Indeed, an Insight on February 9, showed that equity market fixed-income proxies surged in the aftermath of the ECB's decision to implement negative deposit rates. More recently, REITs in the euro area and Japan have soared anew, reflecting this powerful undercurrent of demand for stable cash flow producers. As such, we expect sell-offs in the S&P REIT index to prove transitory, and reflective of short-term swings in risk-on vs. risk-off assets rather than a fundamental change in investor appetite or REIT prospects, please see the next Insight.
The previous Insight showed that REITs in other parts of the world are outperforming smartly, but lagging in the U.S. We expect a re-convergence. Already a yawning gap has opened between REITs and Treasury yields (shown inverted). That is not sustainable, especially in view of positive underlying cash flow fundamentals. Our proxy for the REIT occupancy rate is still trending higher (third panel), supporting good growth in REIT pricing power proxies. Importantly, pipeline supply pressures look set to ease, based on the downturn in multifamily home construction. All of this points to decent cash flow growth prospects. Against a backdrop of still attractive value in a world starved for yield, we continue to recommend an overweight portfolio position in the defensive S&P REIT index.
Credit growth acceleration in China is a bearish development in the long run. Potential non-performing loans at Chinese banks could wipe out 40-55% of their equity capital. "Muddling through" for China, from its own internal standpoint, is possible. However, Chinese stocks and China-related equities worldwide will remain in a bear market. From the perspective of the rest of the world, China is now in recession.
Capital markets stocks have been crushed this year. Over the last few decades, capital market bear phases have ended with a forceful policy response that restores economic growth by rekindling the credit cycle. Fed rate cuts have usually started that process. This cycle, the Fed is still intent on tightening even as evidence of growth softness mounts. Thus, it is difficult to envision the start of a cycle that encourages increased capital formation, which is needed to avert a sustained capital markets profit downturn. Our concern is that the U.S. corporate sector has spent beyond its means long enough to erode balance sheet flexibility, which warns of high odds of a forced retrenchment. Access to capital is restricted to those who don't need it. Once our Corporate Health Monitor moves into deteriorating health territory, M&A activity usually begins to dry up (second panel). M&A has been running red-hot in the past few years, as the lack of organic global growth has forced companies to pursue acquisitions. If this source of investment banking income diminishes, then capital market companies will have a large profit hole to fill. If valuations could not expand with an easy Fed, an M&A boom and rampant stock and bond issuance, what will happen now these conditions are reversing? Stay with a high-conviction underweight. The ticker symbols for the stocks in this index are: GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM.