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Monday's Special Report highlighted an overwhelmingly bullish macro backdrop for defensive sector relative performance. Health care is a key defensive component, but it has been hit hard in recent weeks, denting investor confidence. The main culprits behind the pullback have been the bounce in inflation expectations on the back of the dip in the U.S. dollar. The sector had rallied in lockstep with intensifying global deflationary pressures for the past few years, and it is only natural that it be used as a source of funds to lift exposure to cyclical sectors on the first whiff of financial stress relief. However, the path of least resistance for health care earnings is still up, in relative terms. Our Cyclical Macro Indicator is emitting bullish signals, supported by the resurgence in sector pricing power, particularly compared with moribund overall corporate sector selling price inflation. Importantly, valuation and technical factors also argue for a bullish reversal. Our relative valuation gauge is at an extremely undervalued level, while technical conditions are deeply oversold. These conditions are unlikely to last if relative forward earnings keep climbing, as we expect. Consequently, the reward/risk tradeoff is sufficiently upbeat to warrant adding the sector to our high-conviction overweight list.
Mixed data on housing turnover and new home prices have created some uncertainty surrounding the S&P homebuilders index over the past year, but we continue to see robust upside potential. Home prices are recovering after experiencing volatility in recent quarters, but not to the extent that affordability has been compromised. In fact, the Fed's dovish shift has helped push down long-term Treasury yields, further depressing mortgage rates and supporting housing affordability. The recent surge in lumber prices suggests that underlying construction activity is solid. Importantly, housing starts and real house prices remain well below prior cyclical peaks, underscoring that homebuilding companies should enjoy a prolonged period of decent growth. Moreover, the homeownership ratio has troughed, removing a major drag on the housing market. Any recovery in this ratio could turbo-charge housing demand. The implication is that homebuilders remain a core portfolio overweight. The ticker symbols for the stocks in this index are: DHI, LEN, PHM.
Risk assets are stuck in a range driven by the Fed feedback loop. But the current rally may continue for another quarter or two.
There are a number of warning signs that the global and EM equity bounce is unsustainable. The latest episode of housing recovery in China will prove temporary due to still-large imbalances. Overweight Indian stocks: the credit cycle in India is less vulnerable compared to other EMs. However, the outlook for Indian equities in absolute terms is not bullish.
While recent financial stress relief has triggered a short covering rally in deep cyclical sectors, this will only be sustainable if macro forces shift in support of profit outperformance. However, our cyclical vs. defensive macro drivers have not yet confirmed the glimmers of light offered by financial variables. Global purchasing manager surveys at both the manufacturing and services levels are still sinking, with many in recessionary territory. While there are pockets of strength, in aggregate, manufacturing is very weak. Global trade is still extremely weak. The Baltic Dry index is hitting new lows, and export growth in key manufacturing regions such as Taiwan, Korea and China is contracting at a double-digit rate. The takeaway from ongoing weakness in trade is that EM currencies have not weakened enough to allow exports to stabilize their growth prospects, likely because developed countries are not spending their low oil price dividend. Our Emerging Asian LEI has failed to make any strides despite the dramatic pullback in their currencies. That dynamic reflects both weak export markets and monetary policy constraints driven by fears of capital flight. That is unnerving, because it means that the necessary deleveraging has not been allowed to occur. These factors will continue to constrain cyclical sector profits, especially relative to defensives, arguing for maintaining a defensive portfolio bias. Please see yesterday's Special Report for more details.
Renewed strength in the U.S. equity market sponsored by another round of global monetary easing has revived the debate about whether it is finally time to transition out of our alpha-generating defensive portfolio strategy. A number of strategists and media outlets have championed the view that yield proxies and non-cyclical sectors are expensive, and no longer offer an attractive reward/risk trade-off, particularly within the context of the recent easing in credit spreads, commodity price relief and the dip in the U.S. dollar. However, it is crucial to distinguish between absolute and relative measures when analyzing valuations. In absolute terms, nearly every sector and group is expensive, given that the broad market is trading at historically rich multiples. Our metrics do not support the notion that defensive sector outperformance has overly skewed relative valuations. Defensive sector strength has been almost entirely earnings driven (top panel), as measured by the steady upward march in relative forward earnings estimates. Our relative valuation gauge for defensives is barely above neutral despite multiyear outperformance. At the same time, cyclical sectors have experienced a steady decline in relative forward profit estimates, which has kept our valuation gauge close to neutral when the energy sector is excluded. The implication is that forecasting a cyclical sector comeback based on a valuation basis could lead investors down the wrong path. Instead, the lack of a major valuation anomaly means that relative performance should continue to be dictated by relative profit trends, please see the next Insight.
Renewed strength in the U.S. equity market sponsored by another round of global monetary easing has revived the debate about whether it is finally time to transition out of our <i>alpha</i>-generating defensive portfolio strategy. This <i>Special Report</i> examines the critical factors shaping this investment decision.
The inflation outlook priced into the market is overly bearish, and TIPS breakevens will move higher as the drag on inflation from food and energy prices dissipates.
The old cyclical market axiom that "nothing cures low prices like low prices" has never held
truer than in today's oil market.
The rally in risk assets could persist. Dollar and oil moves are not yet exhausted. But valuations and poor earnings quality warrant a cautious approach.