Technology
Two weeks ago we outlined our top ten reasons to deemphasize the tech sector in equity portfolios. The tech sector is experiencing a productivity drain that is threatening profit margins and return on equity. However, within the sector there is one positive exception to this view: communications equipment (CE). Investment in CE is climbing relative to total investment and compared with IT investment after a prolonged slump. Years of underinvestment suggest that some pent-up demand has been created, allowing for the potential to outperform even if overall capital spending continues to sink, as we expect. The main CE demand driver has been the telecom services sector. Telecom capital spending has increased significantly, as measured by telecom facilities construction. That leads CE industry top-line growth, signaling revenue expansion ahead (bottom panel). Domestic demand strength has been partially offset by weak global markets. A strong U.S. dollar has undermined U.S. telecom equipment exports at the same time that foreign demand growth, China's imports in particular, has faltered. Still, global headwinds are more than discounted, as the relative forward P/E trades at a massive discount, even though industry productivity is improving. Bottom Line: re-rating potential exists despite our overall economic and broad market concerns. The ticker symbols for the stocks in this index are: CSCO, FFIV, HRS, JNPR, MSI.
While the communications equipment industry provides a contrarian tech sector investment opportunity, in relative terms, computer hardware offers a much different profile. Hardware investment is highly cyclical, rising and falling with discretionary spending budgets. The latter are being pruned as the corporate sector tightens its belt as a consequence of deflation and profit margin pressure. The chart shows that, unlike telecom equipment, hardware investment continues to sink as a share of total spending. That will sustain downward sales pressure and keep manufacturers operating at suboptimal rates. Already, the rate of hardware output has plunged, and is well below the rate of capacity growth. Such a dynamic warns of an intensification of deflationary pressures, particularly given that vendors to end clients are aggressively slashing prices. Without a positive demand impulse, the odds of computer hardware profit disappointment will remain acute. We continue to recommend an underweight position. The ticker symbols for the stocks in this index are: AAPL, EMC, HPE, HPQ, NTAP, SNDK, STX, WDC.
The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.
The Fed's recent dovishness represents an acknowledgement of the feedback loop between Fed policy and financial conditions. Expect Fed hawkishness to ramp back up prior to the next rate hike, likely in June.
A dovish Fed bought the bounce a bit more time, but there is little incentive to add portfolio risk. Buy consumer finance, especially vs. banks, and expect communications equipment outperformance.
We recently boosted weightings in the S&P electrical equipment & components index, and the latest data reinforce this view. Final demand has stayed more resilient than other manufacturing and resource-intensive industries, as reflected in both new order and capital investment trends (second panel). Despite this top-line resilience, electrical equipment manufacturers have been among the most aggressive in protecting profit margins through cost cutting and capacity reduction. That is evident in rising utilization rates, a remarkable feat given that the manufacturing sector is flirting with recession, and improving productivity growth. The implication is that health returns on equity should persist, heralding a re-rating in very depressed relative earnings growth expectations, and valuations. The ticker symbols for the stocks in this index are: AME, ETN, EMR, ROK. Chart
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.
The previous Insight showed that semiconductor top-line growth remains under siege. Worse, there appears to have been little effort to realign cost structures to slower sales. The latter will become even more critical in the coming quarters, because pricing pressures are set to intensify. Our global semi inventory proxy is accelerating. Slowing demand has not been met with a sufficient output reduction to rebalance the market. Utilization rates are hitting new lows, and Taiwan export prices have plunged. These trends are a significant pricing power threat, and will compound profit margin pressures. We continue to recommend a high conviction underweight. The ticker symbols for the stocks in this index are: INTC, TXN, AVGO, MU, ADI, SWKS, LLTC, XLNX, NVDA, MCHP, QRVO, FSLR.