Communications Equipment

A playable pair trade opportunity has emerged on the back of shifting capital spending patterns: long communications equipment/short machinery.

S&P communications equipment greenshoots are turning into full blossom, signaling additional share price outperformance ahead. The latest Federal Reserve industrial production (IP) release highlighted that telecom equipment factories are revving their engines, in contrast with muted overall output growth. Historically, industry IP growth has been closely correlated with shipments-to-inventories momentum and the current message is positive (second panel). Output is booming relative to capacity, inventories are lean and telecom equipment imports are subdued, which is supportive of pricing power. All of this is boosting our industry productivity proxy (third panel). The upshot is that S&P communications equipment profits will outperform the S&P 500, serving as a catalyst for a relative valuation re-rating phase (bottom panel). Bottom line: While we are underweight the broad tech sector, we are reiterating our early-August high-conviction overweight stance in the S&P communications sub-group. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV. bca.uses_in_2016_09_09_001_c1 bca.uses_in_2016_09_09_001_c1

A technical breakout in communications equipment relative performance is being fundamentally-driven. New orders for communications equipment have perked up, led by a re-acceleration in telecom services capital spending (second panel). The telecom service sector has enjoyed the strongest revenue growth of all sectors this quarter, and free cash flow is growing at a mid-teens rate (middle panel). That is driving a pickup in investment, a positive omen for equipment demand. In addition, there is pent-up demand for communications gear following more than a decade of underinvestment. Even telecom equipment exports have recovered, signaling an undercurrent of global demand in an otherwise lackluster world economy. This is powering double-digit sales gains. That is translating into solid output growth and rising productivity. The implication is that dirt cheap valuations are primed for a re-rating, and we moved this group onto our high-conviction overweight list in yesterday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV. bca.uses_in_2016_08_09_002_c1 bca.uses_in_2016_08_09_002_c1

Despite our reservations about the broad tech sector, which has bounced under the leadership of only a handful of stocks, we are encouraged by the outlook for the communications equipment sub-component. This extremely undervalued group is enjoying a broad-based technical breakout, based on fundamental improvements. Our industry relative advance/decline line has touched new highs at the same time that the share price ratio has broken decisively above its multiyear downward sloping trend-line on an upsurge in momentum. That alone is indicative of a major trend change, a view that is driven by positive macro forces, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV. bca.uses_in_2016_08_09_001_c1 bca.uses_in_2016_08_09_001_c1

A two-speed economy requires selective portfolio construction, favoring consumer-oriented and mainly non-cyclical industries. Put communications equipment on the high-conviction overweight list, and stay clear of refiners.

Bearish sentiment is a red herring, as most other measures of investor positioning point to a strong undercurrent of bullishness. That is contrarily worrying.

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. bca.uses_in_2016_03_23_001_c1 bca.uses_in_2016_03_23_001_c1

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.