Equities

The path of least resistance for the small/large cap ratio is higher. As outlined in our August 15 Weekly Report, small cap profit margins have already been crunched, while large cap margins are only just beginning to get squeezed. Wage trends between small and large companies argue for a closing of this gap, providing a catalyst for a re-rating. External factors are also supportive. Risky assets have surged around the world since expectations for additional Fed rate hikes were deferred and central banks in the rest of the world have opened the liquidity taps even wider. The small/large cap ratio typically follows the trend in our Risk Asset Composite, a mix of high beta currencies, commodities and equity markets, with a lag, and the current message is that there is catch up room ahead. We reiterate our recent shift to a small vs. large cap bias.

The budding recovery in the S&P biotech index is likely to gather steam. Big pharma is desperate to replenish its drug pipeline, putting biotech equities back into play following a drawn out de-rating phase. This phenomenon is not limited to U.S. pharmaceutical companies, as European and Japanese firms are also racing to scoop up promising biotech assets. As a result, deal premia for coveted U.S. biotech companies have skyrocketed, hitting all-time highs (middle panel). Both the relative forward P/E and P/E/G ratios are sufficiently depressed to expect a wholesale re-rating as a low cost of capital and receptive markets embolden pharmaceutical companies to buy future growth (third panel). Bottom Line: We reiterate our recent boost to an overweight stance in the S&P biotech index. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX - VRTX, CELG, GILD, AMGN, REGN, BIIB, ALXN, ABBV, BXLT.

Special Report

Fed rhetoric is likely to shift in a somewhat more hawkish direction over the coming months as the FOMC starts to prep the market for a December rate hike. Against the backdrop of weak earnings growth and diminished share buyback activity, stocks have become vulnerable to a correction.

Special Report

Commercial real estate and REITs have benefited greatly from accommodative monetary policy. Though they are approaching a peak, our analysis shows that they remain in a "goldilocks" scenario and still offer plenty of upside.

The lack of inflation makes a Fed rate hike before December unlikely. In the interim, the continued flow of liquidity could sustain the high-risk rally.

Special Report

The populist backlash, if left unchecked, could spiral out of control, leading to severe losses for investors. Concerns about lax financial regulation, rising inequality, unfettered globalization, and fiscal austerity are understandable. Addressing these grievances will hurt corporate profits short-term, but could lead to a more resilient economy longer-term. Investors should position for modestly higher inflation and steepening yield curves. Near-term, equities are technically overbought, but will benefit from the shift to more stimulative fiscal and monetary policies.

Special Report

Brazilian risk assets have rallied on the back of investor optimism about the impeachment of President Dilma Rousseff. But the political games have just begun. With all politicians looking to the October municipal elections and 2018 general elections, the Michel Temer administration is unlikely to impose fiscal and structural reforms. Debt dynamics are set to worsen, and we continue to short Brazilian equities.

The global search for yield, not an improvement in EM fundamentals, has been driving the EM rally. EM/China growth conditions have stabilized but not recovered. Barring a full-fledged cyclical profit upsurge in EM EPS, EM stocks are not cheap at all. EM/China final demand for commodities will disappoint and will likely produce a major reversal in EM risk assets.

Health care equipment stocks are overbought relative to the broad market, and a corrective pullback is inevitable. We had been concerned that the latest leg up might represent the final outperformance phase for this group, given rising wage inflation and a cooling in revenue growth indicators, but our conviction in the longevity of the cyclical bull market has been reinforced. Medical equipment demand is accelerating on a number of fronts. Domestic uptake is being driven by a rising number of procedures, as evidenced by double-digit strength in consumer spending at hospitals. That is a sustainable trend given rising income growth and broader health insurance coverage. Medical equipment exports have also reaccelerated. That is notable because it has occurred within the context of a flat, rather than weak, U.S. dollar. The implication is that demand from abroad is also on the upswing, as confirmed by the surge in the German IFO survey of medical equipment orders. As a result, backlogs should continue to build, ensuring that output growth stays on a solid footing. We recommend staying overweight. The ticker symbols for the stocks in this index are: BLBG: S5HCEP - MDT, ABT, SYK, BDX, BSX, BAX, ISRG, EW, STJ, ZBH, BCR, VAR.

The small vs. large cap ratio peaked in 2014 and should have experienced a tumultuous corrective phase, given that the bulk of the major equity indexes such as the Value Line and Wilshire indexes endured bear markets, driven by tightening financial conditions, credit concerns, a global manufacturing recession and commodity price crunch. However, the corrective phase has been more lateral than down and our concerns about outsized profit margin compression have now come to pass: small cap margins have been crushed, especially relative to large caps. But this gap should close. The NFIB survey of the small business sector shows that labor compensation plans have rolled over. In addition, the NFIB reported price changes index has troughed. At the same time, the overall employment cost index, a good proxy for large cap wage expenses, is accelerating. The upshot is that small cap margins should soon stabilize, while large cap margins continue to get squeezed. Small caps are now slightly cheaper than large caps, according to our gauge, and a move back to a premium is probably if the profit margin gap closes on the back of renewed strength in the U.S. dollar. Bottom Line: shift to a small cap preference and please see yesterday's Weekly Report for more details.