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The secular bond bull market is over. Safety is in a bubble. The shift from monetary to fiscal easing is the most likely candidate to prick the bubble in safety.
In this piece we revise our yield portfolio to increase its resilience to interest rate shocks.
The previous Insight showed that top-line growth for medical equipment companies was accelerating. It is notable that manufacturers' inventories of medical supplies are contracting at their steepest rate since 2009, which bodes well for factory utilization and pricing power. Moreover, medical equipment wage inflation has turned sharply lower. Higher sales, rising backlogs and a lack of cost inflation imply that there is scope for profit margin expansion. The latter is not factored into valuations, nor earnings growth expectations. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HCEP - MDT, ABT, DHR, BDX, SYK, BSX, ISRG, BAX, ZBH, EW, STJ, BCR, HOLX, VAR.
Health care equipment stocks are pulling back, but this is a correction from overbought levels rather than a trend change. Profit margin prospects remain upbeat. The surge in consumer spending at hospitals has encouraged an expansionist mindset, as highlighted by the surge in health care facility construction activity. The latter is highly correlated with medical equipment new orders, as a larger footprint will add to the volume of procedures performed over and above the increase from faster health care spending. Importantly, revenue gains also reflect global factors. U.S. medical equipment exports are set to return to a growth track, based on the upbeat message from the German IFO survey of medical equipment demand. Wage inflation is also in retreat, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5HCEP - MDT, ABT, DHR, BDX, SYK, BSX, ISRG, BAX, ZBH, EW, STJ, BCR, HOLX, VAR.
China's industrial sector is showing signs of regained strength. Odds of immediate fresh stimulus measures have declined, but Fed tightening will not become a serious policy constraint for the PBoC. Chinese stocks will not be immune in a broader global selloff, but the risk-return profile of this asset class is still favorable. Expect H shares to grind higher, albeit with increased volatility.
On Monday, we downgraded the S&P agricultural chemicals index owing to excess global food supplies, which threaten to dampen prices for a while longer. This also has negative ramifications for heavy equipment and agricultural equipment companies. To make matters worse, other end markets are in even worse shape. Resources companies have neither the financial wherewithal nor incentive to undertake expansion. Free cash flow has plunged in the mining and oil & gas industries, and balance sheets are saddled with debt. Meanwhile, global construction markets are coming off the boil, even prior to any increase in borrowing costs. Both residential and commercial real estate construction growth is decelerating rapidly, suggesting that oversupply has seeped into markets. The bottom line is that the earnings recession in heavy and ag equipment companies will stay intact. Please see Monday's Weekly Report for more details on our downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.
After a prolonged consolidation phase, small caps are now on the cheap side of fair value compared with large caps. We anticipate a return to premium valuations. The main driver will be a narrowing in the yawning profit margin gap. The chart shows that small companies have already experienced a massive margin compression. But the latest NFIB survey of the small business sector showed that labor compensation plans have continued to ease, while price hikes ticked higher. In contrast, the overall employment cost index is grinding higher. We doubt revenue contribution to large companies from the rest of the world will be able to offset this convergence in labor costs, given that the global credit impulse continues to signal that growth reacceleration is not imminent. The bottom line is that the budding advance in the small/large cap ratio should stay intact. We reiterate our bullish view on small caps.
Equities have finally run into some selling pressure. Any time the market pulls back, especially from current lofty valuation levels, many wonder whether a major trend change is occurring. However, history shows that equities typically do not run into serious trouble until the threat of recession feels imminent. The yield curve can provide a helpful timing tool for when recession risks have become too acute for equity investors to ignore. A very flat or inverted yield curve has previously signaled that monetary policy was too tight, warning of previous major cyclical equity peaks. Currently, the 10/2 year Treasury yield curve is still positively sloped, although at the current pace of narrowing it won't take much for it to flatten completely. As the curve flattens, we expect capital to gravitate to non-cyclical sectors, as has historically occurred. The chart shows that the cyclical/defensive share price ratio has generally been positively correlated with the steepness of the yield curve. The major exception was a decade ago, when the Fed was tightening but lagged behind the housing/financial credit boom, which supported optimism toward cyclicals until the onset of the Great Recession. Unless the yield curve begins to widen decisively on the back of a growth-driven pickup in inflation expectations, the risk is that cyclical sector profits will disappoint. As such, we prefer to maintain a core defensive strategy, despite some valuation concerns, because momentum driven markets can reverse at a moment's notice.
We went overweight the S&P agricultural chemicals index in early May, a contrarian bet to take advantage of extreme bearishness, undervaluation and the potential for a rise in underlying commodity prices. Since then, a rise in industry M&A activity has borne out our thesis of cheap valuations, generating solid relative returns. Nevertheless, operating conditions may be slower to improve than originally anticipated. Burgeoning wheat and corn harvests this year threaten to keep the supply/demand balance for grains out of whack for another year. The USDA forecasts a hefty surplus in both key commodities. When grain prices advance, farm incomes receive a shot in the arm, providing farmers with both the means and the confidence to increase planting acreage, thereby boosting fertilizer demand. If food prices stay soft, then that positive dynamic is not going to take hold on a cyclical horizon. Instead, farmland prices will stay near cyclical lows, and agricultural-related credit availability will continue to tighten. The latter is already at a 10-year low, reflecting reduced farm incomes. Consequently, we recommend taking profits and downgrading to neutral. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5FERT - MON, MOS, CF.
Disappointing ISM surveys could signal a growth consolidation.
That, in turn, would spur a correction in risk assets.
Equities are celebrating domestic economic disappointment rather than re-pricing the risk of ongoing profit struggles. This reinforces that liquidity and share price momentum are still the dominant market forces.