Equities
We upgraded gold shares to overweight in early March, because gold rises in stature as monetary policy loses its efficacy. The spreading global shift to negative deposit rates is creating a significant amount of uncertainty, as the unintended consequences of this unorthodox policy remain unknown. In the meantime, real interest rates, the opportunity cost of holding a zero-yielding asset like gold, have slipped back into negative territory, and may need to fall further to reverse the decline in economic confidence. That is a plus for gold, and gold shares. While gold and gold shares may look overbought on a short-term basis, it is important to keep the longer-term context in mind. Gold is still far below its 2012 highs, while gold share relative performance is barely above its secular lows, which should trump any near-term concerns about overbought conditions. Consequently, we continue to believe that gold equities provide attractive portfolio protection and are an excellent hedge against monetary policy exhaustion. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S15GOLD - NEM, RGLD.
The latest rebound in risk assets raises the question of whether small caps have become more attractive compared with large caps. However, fundamental analysis signals little chance of a sustained recovery. While the relative P/E for small vs. large caps has downshifted out of overvalued territory, an undershoot is still a serious risk. Our Cyclical Capitalization Indicator, which uses macro variables to forecast relative profit trends between small and large companies, is sinking deeper into negative territory, sending a sell signal. Specifically, there is a large and growing gap between small and large company profit margins. The latest NFIB survey of the small business sector showed that planned labor compensation continues to grind higher, even though reported price changes are falling and CEO confidence is sputtering. Typically, labor compensation plans and price changes move hand in hand, but the gap this cycle is indicative of small cap profit margin pressure. Consequently, small cap valuations are likely to move to a steep discount to those of large caps.
Chinese PPI deflation will likely continue to ease going forward. There are non-trivial odds that the PPI deflation may turn positive. Our models predict a sharp upturn in China's profit cycle. Meanwhile, Anti-corruption investigation cases have dropped substantially since the beginning of the year, a sign that the Communist Party may be reorienting priorities to boost economic growth.
We do not expect Russia and OPEC members to reach a production-limiting agreement at the April 17 meeting in Doha, but that does not diminish our bullish expectations for a rebalancing of oil markets in H2 2016.
The previous Insight showed that macro forces were shifting in favor of a trough in the brutal backdrop for hypermarkets sales. Even if the latter are slow to recover, there is scope for positive profit margin surprises in the coming quarters. The massive U.S. dollar appreciation has invigorated the retailing industry's largest buying group's purchasing power. It would be highly unusual for operating margins not to expand on the back of currency strength. Keep in mind that varying lags exist between currency swings and their impact on profitability, given long-term contracts and hedges. Consequently, the recent currency depreciation does not mean the window for margin improvement has closed. Other sources of reduced cost inflation exist. For instance, the cost of goods sold should benefit from deflation in transportation costs. Asian manufacturers are also in full inventory liquidation mode, which suggests little upward pressure on imported consumer goods prices, despite the recent U.S. dollar dip. These factors will support margins. Adding it all up, on a cyclical basis, hypermarkets are well positioned to produce better-than-market returns and we recommend upping weightings to above-benchmark on price weakness. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.
Hypermarkets are off their relative performance lows, despite the rebound in the broad market. That is a solid showing for a defensive industry that has been in the doldrums for more than three years. It is easy to understand why underperformance has been so stark. Sales growth has been abysmal. Deflation has rocked the retailing sector. It is hard for earnings to grow sustainably without sales gains, particularly in a low margin, high turnover business. But there are signs that the worst is over. Retail deflation has passed through its most intense phase. The pickup in overall income growth suggests that the average consumer will have more disposable income, which has often been a reliable indication of sales and profit turning points. When the personal savings rate rises and overall consumption growth cools, hypermarkets benefit (top and bottom panels). Fading federal income tax growth reinforces that consumers are unlikely to soon 'trade up' to shop at higher ticket stores (middle panel, taxes shown inverted). Even if sales growth is slow to regain traction, hypermarkets have room to improve profitability, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.
A lack of confirming growth indicators puts the equity advance at risk. Lift hypermarkets to overweight, stick with homebuilders and fade any small and/or mid cap relative strength.
We are confident that the reward/risk tradeoff to holding equities and high-yield corporate bonds is deteriorating and that rallies in these assets are high-risk affairs.
The previous Insight showed that capital formation has hit a brick wall as a consequence of ebbing risk tolerance. That is robbing the corporate sector of much needed growth capital, and will reinforce the need for retrenchment. As a result, the outlook for capital market profitability is bearish. To make matters worse, capital markets firms have been slow to downsize this cycle. Usually headcount is quick to react to slumping revenue, as a shrinking bonus pool necessitates fewer employees. However, capital markets employment growth has not yet started to contract, warning that revenue disappointment will be compounded on the bottom line. While net earnings revisions are negative, earnings are still expected to outpace those of the broad market in the coming twelve months, which is far too optimistic in the absence of resurgent economic confidence. We expect the S&P capital markets index to sink to new relative performance lows. Stay with a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5CAPM - GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM.
Last year's sharp tightening in financial conditions is wreaking havoc on the S&P capital markets index. Capital formation has dried up, and the persistent erosion in economic expectations, as measured by the total return ratio of stocks-to-bonds (S/B), warns of little chance for an imminent recovery. The chart shows that new stock issuance is probing the low end of the range, while M&A activity is cooling quickly. The S/B ratio provides a good indication of investor risk appetites, and the current message is that risk tolerance is ebbing. That will constrain the availability of capital, and dent fees for capital markets firms. Tack on historically low trading volumes, and profit prospects darken another notch. Against this backdrop, the only way to preserve profitability is through massive cost cutting, see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5CAPM - GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM.