Equities

Refining stocks have been slammed this year, and we expect more pain ahead. Companies had continued to operate at full throttle, as measured by the relentless advance in refinery production (second panel), likely reflecting expectations for ongoing demand strength and decent export markets. However, both gasoline and refined product inventory have been steadily building since last year, warning of excess inventory accumulation. Worse, refined product consumption is contracting, underscoring that it will take output cuts to work through the supply glut. Refiners have an incentive to pull back, given that refining margins are essentially nil, but the implication is a potentially sizeable profit hit. The index is not priced for an earnings downturn. We maintain our high-conviction underweight. The ticker symbols for the stocks in this index are: MPC, PSX, TSO, VLO.

Plunging commodities have been driven by increased supply and falling investor demand, not a major downshift in physical demand. Stay neutral global equities. The earnings outlook remains uninspiring, but bottoming oil prices and continued monetary stimulus support valuations. The selloff in global bank shares reflects NIRP-related "income statement worries", not "balance sheet concerns" linked to deteriorating credit quality. Downgrade Treasury notes to neutral. The rally in bonds has brought 10-year yields near our long-standing, out-of-consensus target of 1.5%. 

Homebuilders have been caught up in broad consumer discretionary sector weakness, but we expect differentiation to soon materialize. Housing starts are picking up steam (bottom panel) and are still trailing household formation, underscoring that structural demand for housing will remain solid. The NAHB's survey is well above the 50 boom/bust line (middle panel). Resilient housing activity is a testament to robust housing affordability. The 30-year fixed mortgage rate is near generational-low levels, and is being suppressed by the global government bond bull market and the proliferation of negative interest rate policy (NIRP) around the world. This underscores that house prices have not overshot. Importantly, the latest JOLTS survey of job openings points to a firming construction labor market. The top panel of the chart shows that job openings in the construction industry are an excellent leading indicator of homebuilding relative performance, and the current message is positive. Bottom Line: Stay overweight. The ticker symbols for the stocks in this index are: DHI, LEN, PHM.

The defensive consumer staples sector in general, and the soft drinks sub-group in particular, have outperformed smartly of late. Widespread improvement in key soft drink earnings drivers signal additional upside potential. Beverage consumption is outpacing overall PCE, and low energy prices continue to paint a vibrant demand backdrop. Beverage selling prices have spiked, and are rising faster than overall measures of corporate sector pricing power. The upshot is that relative top line growth will expand in the coming quarters (middle panel). This stands in marked contrast with sell-side analysts, who are expecting a relative sales contraction of 180bps in the next 12 months (not shown). Importantly, the industry is enjoying the fruits of the carnage in the commodity pits, as cost relief has generated sizeable gross margin expansion. Rising margins typically lead to a valuation re-rating. We expect ongoing outperformance, despite the steep gains that have already accrued. Stay with a high-conviction overweight. The ticker symbols for the stocks in this index are: KO, PEP, MNST, DPS, CCE. Content Content

The latest National Association of Restaurant survey showed a sharp slowdown in activity, with same store sales contracting for the first time in years. This is not an aberration. Despite rising real disposable incomes, consumers are pulling in their horns, as evidenced by the rising personal savings rate (shown inverted). The implication is slowing revenue growth for the restaurant industry at a time when wage growth is running hot. This was the motivating factor behind our downgrade to underweight late last year. The silver lining in this dark cloud is that consumers are likely to allocate dollars not spent dining out to the retail food store industry. That is supportive of grocery store pricing power. The chart shows that retail food stocks generally trend inversely with restaurant stocks. We are overweight the former and underweight the latter. The ticker symbols for the stocks in the S&P retail food stores and S&P restaurants are: KR, WFM, and MCD, SBUX, YUM, CMG, DRI, respectively.

Bank stocks have been under significant pressure of late, but we continue to caution against any temptation to bottom fish. The ballooning in the number of corporate bond downgrades is signaling a surge in non-performing loans. It will be difficult for valuations to expand when non-performing loans are climbing and global economic growth remains below-potential. The chart shows a cycle-on-cycle analysis of bank stock relative performance during periods of deteriorating credit quality. We proxy the latter using overall corporate bond spreads, which have leading properties for non-performing loans, only with much more historic data. History is clear: when the credit cycle turns, the implication is a higher risk premium for lenders. Against a backdrop of increased credit stress and rising corporate bank bond spreads, loan loss reserves are likely to accelerate. The upshot is that low bank stock valuations are likely to persist. The ticker symbols for the stocks in this index are: BAC, BBT, C, CFG, CMA, FITB, HBAN, JPM, KEY, MTB, PBCT, PNC, RF, STI, USB, WFC, ZION.

The Fed backing off from rate hikes is a necessary but not sufficient step toward putting a floor under global risk assets. Equity market breadth measures are still very weak, suggesting the selloff remains broad-based. The bear market in commodities/EM/China will likely culminate in a credit event. Downgrade Mexican stocks from overweight to neutral within an EM equity portfolio.

Global trade is plummeting as commodity prices remain depressed and emerging markets unravel. Even if oil were not plumbing new lows, we would remain bearish on EM economies, where poor governance and low efficiency suggest that more crises will rear their heads. Above all, we are watching China for policy clarity. After seizing 14% of global exports in recent years, it is now exporting surplus goods into an already deflationary world. Protectionism - not a coordinated response among leading countries - is the likely result. In essence, we reiterate our theme that globalization has peaked. Along the way, we call attention to five geopolitical "Black Swans" that <i>no one</i> is talking about.

Special Report

This week we are publishing a new thematic chartpack <i>The BCA China Industry Watch</i> in an effort to monitor the growth profiles, balance sheet strength and stock market performances of major Chinese industrial sectors.

Against a backdrop of defensive sector outperformance, our bearish call on the S&P managed care index has reduced odds of playing out. Our thesis was that when overall health care spending is accelerating, as is currently the case, health care services providers win out over the industries that bear the cost of these services. However, if the economy cools, as we expect, then upward cost pressure will be slow to materialize. Our managed care cost proxy, a composite of hospital, drug price and labor cost inflation, alongside several other medical expenses. Cost inflation is easing, despite the surge in prescription drug prices. If upward momentum in the latter cannot substantially raise managed care costs, then there should be little upside risk if drug inflation cools. Meanwhile, consumer spending on health insurance continues to outpace overall spending by a large margin, which is facilitating decent increases in premiums, as gauged by the employment cost index for health care insurance. The implication is that the group is more likely to move laterally than down, despite rising overall health care spending, and we are lifting our underweight position to neutral. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: UNH, AET, CI, ANTM, HUM.