Equities
Highlights Chinese fiscal stimulus, both direct fiscal spending and infrastructure investment, has slowed significantly since late last year. This raises a red flag on the sustainability of the cyclical upturn. The Chinese economy should remain buoyant in the near term, despite fiscal retrenchment. Policy initiatives should be closely monitored. Tactically upgrade H shares back to "overweight." Stay cyclically positive, and favor Chinese equities in global and EM portfolios. There are early signs that deflation is re-emerging in Hong Kong. Feature The Chinese economy has maintained strong momentum since the beginning of the year. Some sectors are showing remarkable strength, an extraordinary development considering that January is historically a lackluster month for industrial activity due to seasonality factors. The recent strength is all the more noteworthy as policymakers have apparently rolled back fiscal support significantly since late last year, and have more recently also tightened on the monetary front.1 The divergence between strengthening growth momentum and waning policy support raises hopes that the economy has finally found its footing with self-sustainable dynamics, but at the same time raises the risk that growth may relapse anew without policy tailwinds - especially if struck by an exogenous shock. For now we maintain our benign view on China's cyclical growth outlook, but the risk is tilted to the downside, and policy initiatives should be closely monitored going forward. Meanwhile, we remain positive on Chinese equities on a cyclical basis. This week we are also upgrading our tactical "bullishness rating" on H shares back to "overweight." Strengthening Growth Versus Waning Fiscal Support Despite seasonal noise in the macro data in the first two months of the year, most macro numbers coming out of China of late have surprised significantly to the upside. Producer prices have continued to accelerate, heavy-machine sales have been booming, and even exports have rebounded sharply (Chart 1). The regained strength in the economy is partly attributable to early last year's low base, which has supercharged year-over-year growth rates. However, there is little doubt at this stage that China's growth recovery since early last year has developed into a mini boom. Beneath the robust growth numbers, there are some disconcerting undercurrents on the policy front (Chart 2). Fiscal spending growth has decelerated sharply since early 2016, and actually contracted towards year end. More importantly, capital spending on infrastructure construction, which can be viewed as an indicator for broader policy-driven spending in the economy, also slowed sharply in the last quarter. Fixed asset investment in transportation networks and utility concerns have also abruptly slowed. Investment in railway construction contracted by almost 30% in the final months of last year from a year earlier. All of this underscores a synchronized reduction in the public sector's involvement in the economy of late. Chart 1Growth Recovery... Chart 2... Meets Waning Fiscal Stimulus It is not immediately clear why the government has significantly scaled back fiscal support. Combined with the latest interest rate adjustments by the People's Bank of China, it is likely that the authorities have become content with the economy's performance to a degree that any direct policy pump-priming in their view is no longer necessary or justified. If China's ongoing cyclical growth improvement was due to the authorities' reflationary efforts, then the abrupt change in policy course certainly raises a red flag on how long the recovery may last. Can The Growth Recovery Continue Without Fiscal Support? Chart 3Monetary Conditions Matter More Than Fiscal We expect the Chinese economy to remain buoyant in the next two quarters, even without major acceleration in fiscal spending, for the following reasons: First, China's growth recovery since last year has been driven primarily by easing monetary conditions through a weakening exchange rate and falling real interest rates, rather than strong fiscal boost. Chart 3 shows that industrial sector growth deterioration worsened dramatically in 2014, which in hindsight was due to a combination of aggressive fiscal retrenchment and tighter monetary conditions index (MCI). Even though fiscal expenditures began to accelerate strongly starting in early 2015, the economy only began to improve a year later when the MCI started to ease. In fact, the industrial sector continued to improve throughout 2016 along with a rising MCI when fiscal expenditures decelerated. In other words, the industrial sector's performance is much more tightly correlated with the country's monetary conditions than the cyclical swings in fiscal spending. On one hand, the RMB exchange rate matters fundamentally for the manufacturing sector, which is heavily exposed to overseas markets. On the other hand, lower real interest rates, either through easing deflation or falling nominal rates, has been a primary driver of corporate profitability and overall business conditions, given the country's debt-centric financial intermediation system (Chart 4). As PPI is still rising rapidly and the trade-weighted RMB has once again rolled over, monetary conditions will likely continue to ease, which will further boost the industrial sector despite the fiscal cuts. Second, the slowdown in infrastructure spending will likely be compensated by accelerating investment in other sectors, manufacturing and mining in particular. Easing monetary conditions and ensuing growth improvement have significantly boosted corporate profitability, which should in turn boost manufacturing capital spending (Chart 5). It is likely that the multi-year slowdown in manufacturing sector capital spending has run its course and will accelerate going forward, albeit gradually.2 Investment in the mining sector is still contracting sharply. However, there has also been a dramatic improvement in profits among mining related industries, particularly coal and base metals (Chart 5, bottom panel). If historical correlations hold, the dramatic contraction in mining sector investment has likely already become very advanced, if not already bottomed. At minimum, it is highly unlikely that mining-related capex will continue to contract at an accelerating pace. Chart 4Interest Rates Versus Corporate Profits Chart 5Profits Versus Capital Spending A potential revival in manufacturing and mining capex will reverse a major growth headwind the Chinese economy has faced in recent years, which will continue to buoy growth despite slowing infrastructure construction. Manufacturing and mining account for over 33% of China's total fixed asset investment, higher than the 25% share of infrastructure alone (Chart 6). Indeed, there are signs that the corporate sector's intentions to expand capital investment may already be improving. In recent months medium- to long-term new loans to the corporate sector have accelerated strongly, which could be a sign that the corporate sector is beefing up on investment capital (Chart 7). Chart 6Manufacturing And Mining Capex ##br##Versus Infrastructure Construction Chart 7Longer Term Loans##br## Have Accelerated Sharply Finally, we maintain the view that overall inventory levels in the economy are unsustainably low, and improving growth and easing deflation should push producers to re-stock (Chart 8). This should also ease any near-term pressure on production, even if new orders are hit by slowing public sector demand. In other words, the economy has a built-in buffer for a period of weaker demand which could allow policymakers to re-orient demand-side policies in light of the new growth situation. Chart 8The Case For Inventory Restocking In short, we expect that waning fiscal support in the economy will not derail the cyclical recovery. Macro numbers may look toppy in the coming months, as the favorable base effect from last year's low levels wears out, but business activity should remain buoyant at least in the coming two quarters. Nonetheless, in a global environment that is still facing enormous challenges and mounting uncertainties, domestic policy tightening obviously raises downside risks. The annual People's Congress in early March should offer some important clues on the Chinese government's growth priorities and policy directions, and should be closely monitored. Tactically Upgrade H Shares In terms of Chinese stocks, our attempt to time a market correction in H shares ahead of the U.S. presidential elections in October did not bear fruit as expected.3 This week we are upgrading our tactical "bullishness rating" on H shares back to "overweight". Even though H shares did correct, they found support at key technical levels and have broken out of late, underscoring a strong technical pattern (Chart 9). We are still concerned that some global markets, especially U.S. stocks, appear frothy and are vulnerable to some sort of shakeout, but the market appears to be in a melt-up phase in the near term. The risk of being left out in a rising market is higher than otherwise. More importantly, Chinese H shares are not nearly as frothy, if not outright cheap, which should further limit downside risks. The Trump administration has notably toned down the anti-China rhetoric, and the near term risk of escalating trade tension between the U.S. and China has abated.4 This should also soothe investors' concerns on Chinese stocks. Bottom Line: Tactically upgrade H shares back to "overweight." A shares will likely remain largely trendless. Meanwhile, stay cyclically positive, and favor Chinese equities in global and EM portfolios. Hong Kong: Is Deflation Coming Back? Hong Kong's GDP numbers to be released next week are likely to show the economy accelerated in the final quarter of the year, according to our model (Chart 10). However, the improvement was likely almost entirely driven by exports rather than domestic factors. In fact, retail sales contracted by 3% in December from a year ago. More importantly, with the exception of essential items such as food, alcohol and tobacco, the growth rates of all other major consumer goods are in deeply negative territory. Durable goods, an important barometer for consumer confidence and spending power, dropped by a whopping 20% in value, or 15.8% in real terms from a year ago, underscoring very weak domestic demand. Therefore, Hong Kong's growth outlook will remain heavily dependent on external demand. Chart 9H Shares: A Technical Breakout Chart 10Hong Kong's Growth Recovery Weak domestic demand also weighs heavy on inflation. Hong Kong's headline inflation is falling rapidly, primarily driven by declining rental prices, and odds are high that inflation may dip below zero in the coming months. This means that deflation may re-emerge for the first time since 2005. These developing deflationary pressures underscore the frothy housing market, and also suggest the Hong Kong dollar may have become expensive again. The currency board system prevents nominal exchange rate adjustments, and therefore any adjustment has to be through changes in domestic prices. There is little systemic risk in Hong Kong's financial system, but the re-emergence of deflationary pressures further weakens domestic demand, augments growth difficulties and bodes poorly for asset prices, especially real estate. We will follow up on these issues in the coming weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "On Chinese Tightening," dated February 9, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Growth Watch," dated January 19, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
The S&P asset manager and custody bank index is in a prime position for a catch up rally. This interest rate and market-sensitive financial sector group has lagged most others at a time when macro forces are lining up bullishly. Fed Chair Yellen slightly more hawkish commentary this week raised the possibility of an earlier than expected interest rate hike. That would provide further relief for custody banks, as ultra-low interest rates have been an anchor on profitability. Moreover, the boost in global economic sentiment indicates increased scope for fee generating activity, such as M&A, issuance and even stock lending. Most importantly, the asset preference shift from bonds-to-stocks represents a potential boost to profit margins (bottom panel), which would warrant a valuation re-rating. We are already overweight, and are adding this group to our high-conviction list today. The ticker symbols for the stocks in this index are: BLBG: S5AMCB - BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ, AMG.
An Insight early in the year, highlighted that the NFIB small business survey was at an historic extreme, and that was typically a precursor to a reversal of fortunes in the small/large ratio. Since then, small caps have modestly underperformed large caps. This corrective phase could have a bit further to run, based on relative volatility trends. Large cap volatility is probing multiyear lows, but small cap volatility remains 30% above the 2013 all-time low, and trades at a massive premium to the VIX or large cap volatility. Diverging volatilities have historically forecast corrective phases in the relative share price ratio. Nevertheless, as outlined in Monday's Cyclical Indicator Update, relative profit forces continue to trend in favor of small vs. large companies, and relative valuations do not fully discount this backdrop. Consequently, we recommend riding out any pullback and sticking with a small vs. large cap bias.
Our Industrials sector Cyclical Macro Indicator has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. We retain our high conviction underweight position in the S&P industrials sector.
Our macro models are not signaling that investors should position as if robust and self-reinforcing economic growth lies ahead. Our Deep Cyclical indicators are the weakest, while defensive and interest rate-sensitive models are grinding higher. Deep cyclical sectors are very overvalued and overbought, while defensives are deeply undervalued and oversold. The message from our models is that sub-surface mean reversion is an apt theme for the next few months. The most attractive combination of macro, valuation and technical readings are in the consumer staples, health care sectors with the financials sector a close second, but it is overbought. The least attractive combinations are in energy, materials and industrials. Consistent with the objective readings from these Indicators, prospects for elevated market volatility, stronger economic growth in developed vs developing economies, a tighter Fed and expensive U.S. dollar are consistent with maintaining a largely defensive portfolio structure. Please see yesterday's Cyclical Indicator Update for more details.
Highlights Key Portfolio Highlights Improved world economic growth and rising inflation expectations have buoyed global equities (Chart 1). The downside is that financial conditions are tightening and U.S. dollar-based liquidity is contracting, which is growth restrictive (Chart 2). The massive outperformance of the financials and industrials sectors since the U.S. election implies that U.S. markets have been largely politically-motivated. Positive economic surprises remain mostly sentiment/confidence driven, rather than from upside in hard economic data (Chart 3). That unusually large gap implies that a big jump in 'hard data' surprises is already discounted and represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Federal income tax receipts are contracting, suggesting that an economic boom is not forthcoming (Chart 4). In fact, there has never been a contraction in tax receipts without a corresponding slump in employment growth. Corporate sector pricing power gains have not been evenly distributed. Deep cyclicals gains came off a low base and may already be experiencing a relapse. Conversely, defensive and interest rate-sensitive sectors are demonstrating the most strength (Chart 5). Our macro models are not signaling that investors should position as if robust and self-reinforcing economic growth lies ahead. Our Deep Cyclical indicators are the weakest, while defensive and interest rate-sensitive models are grinding higher (Chart 6). Deep cyclical sectors are very overvalued and overbought, while defensives are deeply undervalued and oversold (Charts 7 and 8). Mean reversion is an apt theme for the next few months. The most attractive combination of macro, valuation and technical readings are in the consumer staples, health care sectors. The financials sector is a close second, but it is overbought. The least attractive combinations are in energy, materials and industrials. Prospects for elevated market volatility, stronger economic growth in developed vs developing economies, a tighter Fed and expensive U.S. dollar are consistent with maintaining a largely defensive portfolio structure (Charts 9-12). Chart 1Pricing Power Revival... Chart 2... But A Liquidity Drain Chart 3Show Me The Money Chart 4Yellow Flag Chart 5Pricing Recovery Is Not Broad Based Chart 6Indicator Snapshot Chart 7Focus On Value Chart 8Mean Reversion Ahead Chart 9Fundamentals Favor Defensives... Chart 10... As Do Market Signals Chart 1112-Month Performance After Fed Hikes Chart 1224-Month Performance After Fed Hikes Chart 13Staples Will Cushion A Volatility Resurgence Chart 14Media Stocks Like A Strong Currency Chart 15Unduly Punished Chart 16Strong Fundamental Support Chart 17Less Production... Chart 18... Means More Rigs Chart 19End Of Sugar High Chart 20A Toxic Mix Chart 21Tech Stocks Don't Like Inflation Chart 22Time To Disconnect Feature S&P Consumer Staples (Overweight - High Conviction) The Cyclical Macro Indicator (CMI) has been grinding higher for several months, even climbing through last year's share price shellacking. The CMI has been supported by the uptrend in relative consumer spending on essential items and consumer preference for saving vs. spending. More recently, a pricing power recovery in a number of groups has provided an assist as has a rebound in staples export growth. Booming consumer confidence and business confidence have held the CMI in check. The strong U.S. currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and has also been an indication of relative valuation expansion because it often signals increased financial market volatility (Chart 13 on page 6). The attractive valuation starting point this cycle, and historic outperformance when the Fed raises interest rates (Chart 13 on page 6), were key factors behind our upgrade to high conviction status in January. Technical conditions are completely washed out. Sector breadth and momentum have reached oversold extremes. That signals widespread bearishness, which is positive from a contrary perspective. Chart 23 S&P Consumer Discretionary (Overweight) Our CMI is forming a tentative trough, supported by rebounding relative outlays on media services, low prices at the pump, a budding recovery in mortgage equity withdrawal and firming wage growth. The biggest drags over the past few months have come from higher Treasury yields and consumers increased propensity to save. However, rising job certainty and a vibrant residential real estate market suggest that consumers should loosen their purse strings. The VI has deflated toward the neutral zone, although remains moderately expensive from a long-term perspective. Our TI started to rebound from oversold levels. History shows that a recovery in the TI from one standard deviation below the mean has heralded a playable relative performance rally. Overweight positions should remain concentrated in housing-related equities and the media space, both of which benefit from U.S. dollar appreciation (Chart 14 on page 6). Chart 24 S&P REITs (Overweight - High Conviction) Our new REIT CMI has ticked lower, but the share price ratio has over-exaggerated this small move down. REITs have traded as if the back up in global bond yields will persist indefinitely, and that they are the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Banks have tightened standards on commercial real estate loans, but this appears more likely to limit supply growth than create a slowdown. Commercial property prices are hitting new highs and our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin (Chart 15 on page 7). While REITs are back to fair value from a long-term perspective, on a shorter term basis the sector is very undervalued (Chart 15 on page 7), particularly with Treasury yields now in undervalued territory. Our REIT TI is extremely oversold, at a point which forward relative returns typically shine on a 12 and 24 month basis, even excluding the dividend yield kicker. Chart 25 S&P Health Care (Overweight) Our CMI continues to grind higher, opening a massive divergence with relative performance. This gap can be explained by the political attack on the pharmaceutical industry, the sector's heavyweight, rather than by a downturn in relative earnings drivers. Pharmaceutical shipments are hitting new highs and pricing power continues to grow at a robust mid-single digit rate. Future pricing gains may slow if government gets more heavily involved in setting prices, but this is already discounted. Pricing power in the rest of the sector remains strong, while wage inflation is tame. Health care spending is still growing as a share of total spending, but the pace is decelerating. Typically, this backdrop signals outperformance for health care insurers, who may also receive a risk premium reduction from a potential revamp of the Affordable Care Act, albeit the timing will likely be drawn out. Relative valuations are very attractive. The sector has been used as a source of capital to fund purchases in areas expected to benefit from increased fiscal stimulus. That is an overreaction, and flows should be restored to reflect the sector's appealing investment profile, particularly given the sector's track record during Fed tightening cycles (Chart 16 on page 7). The TI is deeply oversold. Breadth measures are beginning to recover from completely washed out levels. These conditions reinforce that an exploitable undershoot has occurred. Chart 26 S&P Financials (Neutral) Our Financial CMI has surged, underscoring that the advance in relative performance reflects more than just a reaction to anticipated sector deregulation by the Trump Administration. Leading indicators of capital formation, such as the stock-to-bond ratio, have jumped sharply. Moreover, the yield curve has steepened in recent months, bolstering the CMI. An improvement in overall profit growth and the tight labor market suggest that the credit cycle may not become a profit drag until the economy begins to cool. While not yet evident, the restrictive move in oil, the dollar and bond yields warn that disappoint may emerge in the coming months. It is notable that bank loan growth has dropped to nil over the last 3 months. C&I loan growth is contracting over that time period. Banks are hiring more aggressively, yet are tightening lending standards, suggesting productivity disappointment ahead. Despite the share price jump, value remains attractive after 8 years of financial repression. Our TI is overbought and breadth is beginning to recede, which is often a precursor to a consolidation phase. We are not willing to move beyond a market weight allocation at this juncture. Chart 27 S&P Energy (Neutral) Our CMI has plunged, probing all-time lows. Rising oil inventories and spiking wage inflation are exerting severe gravitational pull on the CMI, more than offsetting the budding recovery in domestic production. Refining margins are probing six year lows as the Brent/WTI spread has evaporated. Nevertheless, OPEC is finally curtailing production, joining non-OPEC producers (Chart 17 on page 8), which should ultimately help eat into excess global oil supply. History shows that once supply growth peaks, the rig count typically firms. That is a plus for energy services (Chart 18 on page 8), even though rising oil production will prove self-limiting for oil prices. High yield spreads have narrowed significantly from nosebleed levels, but industry balance sheets remain bruised. Net debt is historically elevated, EBITDA has yet to return to its glory days, and interest coverage remains anemic and vulnerable to any downside energy price surprises. The surge in our VI reflects depressed cash flow, and is overstating the degree of overvaluation. The TI has returned to the neutral zone, and will need to hold at current levels otherwise a relapse in the share price ratio toward previous lows is probable. Selectivity is still warranted in the energy complex. We remain underweight refiners and overweight the energy services index. Chart 28 S&P Utilities (Neutral) Our utilities sector CMI is stabilizing. That is a surprise, given the rebound in inflation expectations and firming global leading economic indicators, which are typically bearish for this defensive, fixed-income proxy. The latter negative exogenous factors are being offset by falling wage inflation, better pricing power and rising electricity output growth. Power demand is linked with manufacturing activity, underscoring that there is an element of cyclicality to sector profits. The share price ratio has held up better than most other defensive sectors since the U.S. election, perhaps on the hope that an overhaul of the tax code will benefit this domestic sector. Regardless, valuations have retreated from the extremely expensive zone where we took profits and downgraded to neutral last summer, but are not yet at a level that warrants re-establishing overweight positions. An upgrade could occur once our TI becomes fully washed out, provided that occurs within the context of additional CMI strength and a peak in global growth and inflation momentum. Chart 29 S&P Industrials (Underweight - High Conviction) The CMI has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. There continues to be a deflationary undercurrent in the form of more rapid capacity than industrial sector output growth, suggesting that durable pricing power gains may remain elusive (Chart 19 on page 9). The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Our valuation gauge is not at an extreme, although a number of individual groups are trading at historically rich multiples, such as machinery and railroads. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. Industrials fare poorly when the Fed tightens. Chart 30 S&P Materials (Underweight) The CMI has nosedived, reflecting China's diminishing fiscal thrust and the recent tightening in monetary policy. Commodity price inflation peaked in mid-December concurrent with the Fed raising rates, signaling that emerging markets end-demand, in general and Chinese in particular, is likely past its prime. The nascent rebound in EM currencies represents a positive offset, but not by enough to turn around the CMI. Select heavyweight EM manufacturing PMIs are still below the boom/bust line. Relative valuations are becoming extended according to our VI, and stretched technical conditions are waving a red flag. Keep in mind the materials sector has an abysmal performance history after the Fed starts tightening (Chart 20 on page 9). The heavyweight chemical index (75% of the sector) bears the brunt of the downside risks owing to excess capacity (Chart 20 on page 9). On the flipside, overweight exposure in gold mining (via the GDX:US ETF) and the niche containers & packaging sub-indexes is recommended. Chart 31 S&P Technology (Underweight) The CMI has rolled over, driven lower by contracting relative pricing power, decelerating new orders-to-inventories growth, lack of capital expenditure traction and the appreciating greenback. Tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 10). Inflation is making a comeback, so it will be an uphill battle for tech companies to successfully raise selling prices at a fast enough pace to keep profits on a par with the broad corporate sector. While a capital spending cycle would be a welcome development, the narrowing gap between the return on and cost of capital warns against extrapolating improvement in business sentiment just yet. Our S&P technology operating profit model warns that tech profits are likely to trail the broad market as the year progresses, a far cry from what is embedded in analysts' forecasts. The good news is that valuations are not demanding nor are technical conditions overbought, which should cushion the magnitude and sharpness of downside risks. Chart 32 S&P Telecom Services (Underweight) Our CMI for telecom services has gained ground of late, primarily on the back of a sharp decline in wage inflation. However, we recently downgraded exposure to underweight, because of a frail spending backdrop. Our telecom services sales model is extremely weak (Chart 22 on page 10). Softening outlays on telecom services have reinvigorated the industry price war, and our pricing power gauge is sinking like a stone (Chart 22 on page 10). Telecom carrier capital expenditures have been running at a healthy clip, which could further pressure profit margins. Undervaluation exists, but this has been a chronic feature for the sector over the past decade, and does not foretell of cyclical upside or downside risks. Our TI has plunged into the sell zone, but remains above levels that would signal that a countertrend rally is imminent. Chart 33 Size Indicator (Overweight Small Vs. Large Caps) The small/large cap ratio is correcting short-term overbought conditions. The dip in the U.S. dollar has provided a fundamental reason for corrective action in this domestically-oriented asset class. However, we doubt a trend change is at hand. Our style CMI is climbing steadily. Small company business optimism has soared, partly because of an increase in planned price hikes, but also from an anticipated reduction in the regulatory burden. If small company price hikes persist, then rising labor costs will be more easily absorbed. That is critical to narrowing the profit margin gap between small and large firms. A stronger domestic vs. global economy and the potential for trade barriers is also unambiguously positive for small firms that do the bulk of their business at home. Despite the surge in the share price ratio post-U.S. election, our valuation gauge is not yet at an overvalued extreme. The lack of extreme overvaluation suggests that positive momentum will persist, perhaps similar to the 2004-2006 period, when the share price ratio stayed in overbought territory for years. Chart 34
The downside of a transitioning to a self-reinforcing economic dynamic is tighter financial conditions. This backdrop poses a challenge for the high-beta biotech group. The top panel of the chart shows that more restrictive monetary settings tend to coincide with biotech underperformance (the shadow Fed funds rate is shown inverted). Higher interest rates boost the discount rate, undermining valuations in the highest multiple market sectors. Similarly, U.S. dollar liquidity drainage - which represents a tightening in global monetary conditions - has historically been an excellent indicator of biotech stock momentum: the current message is also bearish (second panel). On the back of Gilead's recent revenue warning, we expect the biotech bubble to continue to deflate. Bottom Line: We reiterate our high-conviction underweight status on the Nasdaq biotech index (ETF ticker: IBB:US).
We took profits on our underweight S&P hotel index position and upgraded to neutral in November, because a number of companies reduced 2017 guidance and revenue per room (REVPAR) expectations at the same time that value had improved. Since then, hotel stocks have outperformed significantly, as the improvement in consumer and business sentiment is expected to boost lodging spending. That is necessary to counter the surge in wage inflation, as measured by the acceleration in the lodging industry employment cost index (bottom panel). Perhaps the most appealing development of late has been the downturn in lodging industry construction outlays. If sustained, that will reverse a long-term increase in capacity. The latter is critical to fostering more robust pricing power gains in line with past cyclical upswings. The bottom line is that the outlook for hotel profits has improved, but staying patient for a more attractive entry point is recommended given that the share price ratio is extremely overbought in the short run. Stay neutral, but put this group on upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, WYN.
While bank stocks are quick to react positively to any indication that the regulatory burden may eventually be diminished, beneath the surface, there are mounting signs of profit headwinds. The latest Fed Senior Bank Loan Officer Survey revealed that banks are tightening lending standards on most loan categories. Worrisomely, demand for commercial, consumer, mortgage and C&I loans is also waning. In fact, C&I loan growth is now contracting on a 3-month rate of change basis. A cooling in bank balance sheet expansion may expose a heavier cost structure than desired in the coming quarters, given that bank employment has been on the upswing. Absent any renewed steepening in the yield curve, the surprise could be that bank stocks underperform in the coming months after overshooting since the election. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.