Equities

The oversold rebound is at risk of stalling at key resistance levels. While some cyclical and interest rate-sensitive sectors have enjoyed decent bounces, defensive equities have stayed very well bid and are the only sectors making new highs. That suggests that a fundamentally-driven capital rotation into higher beta equities is not occurring, and that overall equity market relief reflects short covering and the resolution of oversold conditions. Why? Financial conditions remain too tight to expect a durable profit recovery, especially one that will match current rosy expectations. The chart shows that an aggressive recovery in S&P 500 earnings is expected this year. Importantly, these expectations are not simply a reflection of hopes for a recovery in resource prices, but are broad-based across sectors. That is wildly optimistic, especially based on the budding profit margin squeeze and ongoing bearish message from our global leading economic indicator. Consequently, we do not recommend chasing the recent rally and would use price strength to raise cash levels and/or transition into a lower risk portfolio structure.

Materials stocks have traditionally been late cycle plays, as earnings outperform when the economy is heating up and global resource utilization is burgeoning. That is not currently the case, as the global manufacturing sector is battling recessionary conditions. As long as this backdrop persists, it will be difficult for materials stocks to sustain any rallies. True, Chinese money growth has perked up, but this may not lead to increased manufacturing activity and/or import demand, given high existing debt-loads, weak export growth and soft domestic activity measures such as real estate and fixed asset investment. Meanwhile, global trade remains poor. The Baltic Dry Index continues to sink, signaling ongoing weakness in global trade (top panel). That will sustain downward pressure on capital goods prices. Our materials sector pricing power proxy continues to contract, and our sales-per-share model is heading south. The implication is that the negative side of operating leverage has not yet fully played out. To make matters worse, the sector is carrying excessive leverage, warning that there is little room for error and/or to absorb a prolonged period of weak pricing power. Stay clear.

The heavily-shorted S&P steel index has enjoyed some relief of late, as short sellers were given an excuse to cover when China announced it would attempt to shut roughly 10% of its productive capacity in the next few years. While that is a necessary development to eventually rebalance markets, there are no quick fixes. Chinese steel production has already been drifting lower for some time, but exports continue to trend higher. The country has accumulated massive inventories as a consequence of previous overproduction and sinking domestic demand growth. The sharp downturn in infrastructure investment (shown inverted) is likely to sustain upward export pressure, thereby keeping global markets oversupplied. Without a rebound in resource end markets, steelmakers must rely on other sources of demand growth such as global construction. However, even these outlets are also losing steam. The chart shows that BCA's proxy for global commercial REIT supply is contracting at a steep rate, consistent with weak steel uptake. The implication is chronic downward pressure on steel utilization rates, and by extension, pricing power and profits. We recommend selling into strength and reducing positions back to underweight. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: NUE, STLD, RS, X, CMC, ATI, CRS, WOR, AKS, HAYN, SXC, TMST, ZEUS.

Bearish sentiment, higher oil prices and Chinese policy stimulus leave room for a continued bounce in stock prices. But this rally is unlikely to prove sustainable.

Confirming indicators still do not validate the oversold rally. Fade the materials sector bounce, by selling steel down to underweight.

A number of factors triggered our downshift from a growth over value bent to a neutral style bias in late-January. Value has outperformed growth in 80% of broad equity bear markets since 1960, and in more than half of economic recessions. While neither outcome is assured, they have become much higher probabilities as credit conditions have tightened. Sector weightings also played a role, as growth indexes have nearly quadruple the tech sector exposure as value benchmarks, and more than double the consumer discretionary exposure. We are bearish on both sectors. The incentive to bet on growth stock outperformance from current premium valuation levels continues to diminish. Overall long-term S&P 500 earnings growth expectations have been pared back aggressively of late. Reduced confidence in the secular profit outlook is a headwind for overall valuations, but particularly for growth vs. value stocks. The chart shows that momentum in the G/V ratio closely follows trends in 5-year earnings growth expectations, and the current message is that the price ratio has hit a ceiling.

In recent travel, our clients remain focused on downside risks to today's range-bound markets. And for good reason. Uncertainty regarding Chinese reaction function is the biggest source of political risk in today's markets. We discuss it in detail in this month's report, along with an update on our views of Brazil, Russia, and Turkey. In addition, we examine the potential casualties of the European immigration crisis and the likelihood of Donald Trump becoming the president of the United States.

Small caps have enjoyed a modest oversold bounce relative to large caps, but the latest NFIB survey of the small business sector warns that these gains are likely to fully reverse, and more. The tightening in domestic monetary conditions appears to have begun taking a toll on both small business confidence, and access to funding. That is noteworthy, because history shows that small caps underperform large caps when credit tightens (top panel), given that the former rely more heavily on the banking sector for financing than do large caps. Meanwhile, optimism about the economy has tanked, perhaps reflecting the intensification in deflation pressures: the number of companies reporting price increases has plunged. While labor compensation also eased, suggesting increasing overall labor market slack, it was not enough to offset the loss of pricing power. Our small cap profit margin proxy continues to sink. We reiterate our large cap bias.

While high-beta equity areas have rebounded smartly in recent trading sessions, we remain skeptical that earnings-follow through will be forthcoming. Instead, our portfolio remains defensively-geared, where profit support is strongest. For instance, the latest manufacturing data showed that pharmaceutical shipments continue to boom, underscoring that top-line momentum has started on a strong foot in the first quarter. That bodes well for pharmaceutical relative performance. Elsewhere, beverage shipments have also soared on a growth rate basis, sending a similar upbeat message for the S&P soft drink index. Importantly, pricing power remains solid in both industries, underscoring that the surge in manufacturer shipments likely remains demand-driven. We reiterate our overweight position in both indexes.

Expectations of a deepening EM/China growth slump and RMB depreciation have been the key to the selloff in global risk assets. There is no basis for these expectations to improve. Therefore, there are few fundamental reasons for EM and global risk assets to rally much further. Stay put. In Brazil, the impeachment rally is unsustainable and will reverse sooner than later. Stay short Brazilian risk assets.