Equities
There is a considerable dichotomy between the EM equity universe and EM corporate credit markets. EM credit markets remain mispriced. EM currencies are at risk of renewed depreciation. This will push sovereign and corporate spreads, as well as high-yielding domestic bond yields, higher. Continue underweighting Indonesian stocks, sovereign credit and domestic bonds within their respective benchmarks.
The tech sector is sagging on the under the weight of contracting sales growth. There is no imminent reprieve, underscoring that the cresting in overall sector margins is likely to accelerate. Consumer spending on technology products and services has climbed as a share of total outlays (second panel), but the sector is not receiving support elsewhere. Businesses are being forced to retrench. Profits are under pressure while balance sheets are increasingly debt-laden. As a result, executives are unable to pursue expansion. Companies have spent the bulk of the money raised to repurchase shares rather than to invest. Why would that improve if the gap between the return on and cost of capital continued to close, as is currently the case? Both our capital spending model and the narrowing gap between the return on and cost of capital warn that business investment on tech goods is headed south (third and fourth panels). Importantly, the financials sector, a large technology spender, is already laying out an historically high portion of its sales on capital spending. Financial sector investment is likely to be reined in now that the credit cycle has taken a turn for the worse and more money needs to be set aside for bad loans (bottom panel), which will remove another support for tech final demand. We reiterate our underweight tech sector view, please see yesterday's Weekly Report for more details.
The broad market remains unable to break out of its 18-month long trading range, and risks are rising that it will retest the lower end of the bound. Domestic economic disappoint is a growing probability, which could refocus attention on deteriorating corporate sector balance sheets. Cash flow generation is weakening but companies have continued to add leverage on the view that interest rates will stay low forever. Typically, as free cash flow declines and the non-financial corporate sector suffers through a painful increase in net debt/EBITDA (shown inverted, top panel), the stock market either corrects or has already entered a bear market, as risk premiums climb in anticipation of a self-reinforcing economic and profit downturn. This cycle, a massive divergence has opened up, as any concerns about rising debt stress have been trumped by the view that low interest rates and abundant central bank liquidity will support asset prices indefinitely. That is unsustainable, because debt must be repaid at some point, and the longer that this gap grows, the greater the vulnerability to share prices. In the interim, evidence is slowly emerging that debt excesses are causing economic backlash. Credit standards have tightened, loan loss provisions are creeping higher and corporate bond spreads appear to have troughed for the cycle. Credit concerns likely explain the inability of bank stocks to participate. In past cycles, bank underperformance amidst credit cycle erosion has provided a bearish warning for the broad market.
Stocks whipsawed violently last week. Volatility could intensify if recent whiffs of a domestic economic slowdown proliferate and the Fed still adopts a more hawkish tone.
The next rate hike is unlikely before September, despite the rebound in April retail sales. The dollar could suffer for a time, but the long-term bull market is intact.
Brazilian assets are no longer oversold, are not cheap, and the political reality will likely fall far short of market expectations. Investors should continue to avoid/underweight Brazilian risk assets.
The overall tech sector has been under pressure as a consequence of shoddy profits. We do not expect any imminent reprieve, particularly within the heavyweight S&P computer hardware, storage and peripherals index. This group is highly sensitive to swings in capital spending budgets. The latter are under pressure from a narrowing in the gap between the return on and cost of capital in the overall business sector. New orders for computer hardware products have dropped into the contraction zone, warning of potential shrinkage in top-line growth. To make matters worse, wage inflations has surged in recent quarters. That is a recipe for productivity disappointment. Until overall business sector profits are poised to recovery on a sustained basis, demand for hardware is likely to stay on its heels. We reiterate our underweight position. The ticker symbols for the stocks in this index are: BLBG: S5THSP - AAPL, EMC, HPE, HPQ, SNDK, WDC, NTAP, STX.
The insurance industry is battling generationally low interest rates, which has created a deep undercurrent of pessimism toward related equities. That is borne out by extremely cheap valuations, as measured by relative price/book value ratios (bottom panel). However, such a low expectations hurdle should be easily surpassed. After a prolonged slump, consumers are allocating a rising share of spending to insurance products, consistent with increased housing turnover and buoyant vehicle sales. In turn, insurance companies have been able to lift premiums at a solid rate. This shift in spending patterns bodes well for profit outperformance, and ultimately, a re-rating in dirt cheap relative valuations. The surge in our insurance relative advance/decline line heralds share price outperformance and we reiterate our high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5INSU.
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