Equities

In yesterday's Weekly Report, we outlined our top ten reasons to underweight the technology sector, an out of consensus call based on the sector's resilience during the past few months' of broad market turmoil. At the root of our concern is that tech sector productivity growth is eroding at the same time that previously bulletproof balance sheets are slowly deteriorating. Declining sector productivity can be remedied through increased capital spending, but the chart shows that tech has underinvested as a share of sales for the better part of a decade. While the latter is slowly creeping higher, it will take time before it feeds into increased efficiency and faster earnings growth. Worse, our overall capital spending model is sinking steadily (bottom panel). In particular, the financial and public sectors have traditionally been large technology spenders. Despite ultra-low borrowing costs, government spending is still politically constrained and thus on a tight leash. Meanwhile, the financial sector has already ramped up its capital spending significantly (middle panel), without a corresponding positive impact on new order growth, signaling that weakness from other end markets has been a large drag. If the financial sector pulls in its horns as overall credit quality sours, it will remove a support for tech capital spending. We are bearish on relative performance prospects, and recommend underweight positions. Please refer to yesterday's report for more details.

As confidence in the sustainability of corporate sector profitability declines, the multiple accorded to equities should recede. Ten reasons to stay underweight the tech sector. Initiate an overweight position in gold shares.

The relief rally is not over, and could benefit from commodity and currency market movements. Oil prices likely are banging out a bottom. In general, however, a healthy dose of caution is warranted. Our bias is to sell into, rather than chase, rallies in risk assets.

Near-term, global yields will remain depressed, but the structural forces suppressing yields should abate and even reverse in the long-run. Slower potential GDP growth - and lower commodity prices - will eventually shift from tailwind to headwind for bonds. Stepped-up efforts to increase inflation will boost long-term nominal yields; populist politics and calls to curb income inequality will amplify this trend. Long-term investors should stay neutral global bonds for now, but prepare to shift to a structural underweight beyond this decade.

While we are neutral the broad industrials sector (please see yesterday's Insight) and sub-surface exposure should remain selective, we continue to recommend an above benchmark weighting in the BCA defense index. Following years of global government austerity, rising global fiscal thrust should boost demand for defense capital goods. Tack on a rise in geopolitical risk in a number of volatile regions in the world, and the outlook for defense spending significantly brightens. In more detail, China/Japan nervousness (with Australia recently joining the chorus of rising defense spending in the pacific) and escalating middle east/Russia tensions are a harbinger of rising defense spending budgets globally. The prime beneficiaries of this cyclical turn in demand are U.S. defense manufacturers/contractors. Already, U.S. defense new orders are surging, signaling that relative performance momentum has more upside (middle panel). Importantly, the U.S. defense capital goods shipments-to-inventories ratio is also expanding at a healthy clip (bottom panel). The implication is that busy defense factory activity should underpin revenue and profit growth. Bottom Line: Stay overweight the BCA defense index. The ticker symbols for the stocks in this index are: LMT, GD, RTN, NOC, LLL.

No significant change was made except that the weight of France was increased to 7% from 1.7%, largely driven by improvement in relative liquidity conditions. It's mainly financed by a reduction in the U.S. weight which remains the largest overweight in the model.

Are the arguments for overweighting European equities still valid? If so, overweighting relative to what?

Industrials stocks have been coming out of their funk lately, on the back of a selloff in the U.S. dollar, easing in financials stress, a tentative trough in the commodity hemorrhaging, and a relative calm in China and the emerging markets. We upgraded industrials to a benchmark allocation in mid-February as the brutal sell off in deep cyclicals was due for a breather courtesy of continued U.S. dollar weakness. We expect the relative share price ratio to be range bound in the coming months. The latest ISM manufacturing survey showed some glimmers of hope, but it remains below the 50 boom/bust line. The new orders survey sub-component ticked higher, however the mean reversion in industrials profit margins is well underway, and the path of least resistance remains lower (third panel). Bottom Line: While we are not calling for an imminent resurgence in global manufacturing or business investment, an easing in the U.S. dollar has the potential to cause a meaningful re-rating in overly depressed industrials profit expectations and relative valuations (not shown). We reiterate our recent upgrade to neutral.

The recent rebound is not a harbinger of a prolonged recovery in risk assets. The many potential negatives will keep volatility high and trigger further occasional selloffs.