Financials

Somewhat like 1998, the dilemma for the Fed is that the labor market is approaching full employment and may justify eventual interest rate hikes.

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%. 

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. Banks And Credit Risk: A Cycle-On-Cycle Perspective Banks And Credit Risk: A Cycle-On-Cycle Perspective

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.

Our cautious outlook on corporate profits amid ongoing deflation pressures is reason enough to favor non-cyclical equity sectors. But the surprise Bank of Japan move to introduce negative deposit rates adds yet another catalyst for defensive and fixed-income proxies. On the margin, capital is likely to seek out high yielding government bond markets. The U.S. still has comparatively juicy yields compared with other developed countries. In fact, a growing swath of the euro area bond market has negative yields. In addition, the U.S. has a strong currency. That could create a self-reinforcing feedback loop, as the exchange rate will sustain imported deflationary pressures over and above the additional pressure on China and the rest of Asia if the yen weakens. When the ECB announced negative deposit rates in the spring of 2014, the U.S. dollar immediately vaulted higher and Treasury yields declined for the rest of the year (see the vertical line). At the same time, long duration sectors such as health care accelerated, while utilities and REITs caught a bid. We expect these sub-surface equity trends to repeat, and broaden, as telecom services should now fit into the mix, because unlike 2014, overall corporate profits are falling and financial conditions are much more restrictive. The implication is that a defensive portfolio structure remains appropriate. Another Wave Of Deflation Favors Long Duration Sectors Another Wave Of Deflation Favors Long Duration Sectors

Economic disappointment represents a serious obstacle for stocks. Stay with non-cyclical plays, including telecom services and health care. Upgrade the managed care group, and stay clear of banks, regardless of cheap valuations.

An improvement in the euro area credit impulse is encouraging, but we explain why it is not enough to sustainably boost risk-assets.

A recent article in Barron's painted a bright picture for bank stocks, but we have a more cautious view. While value is attractive, the earnings picture has darkened. The narrowing yield curve and budding downturn in credit quality will put pressure on credit creation to drive profitability. However, we are skeptical that loan growth will improve much. The latest Fed Senior Loan Officer survey showed that banks continue to tighten standards on both C&I and commercial real estate loans. While they remain willing to make consumer and mortgage loans, demand for a number of these categories is drying up. Against a backdrop of increased credit stress and rising corporate bank bond spreads, loan loss reserves are likely to accelerate, warning that low valuations are likely to persist. We recommend only a market neutral weighting. 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. bca.uses_in_2016_02_03_001_c1 bca.uses_in_2016_02_03_001_c1

The plunge in capital markets stocks is not a buying opportunity. Corporate sector credit quality is quickly deteriorating. Ratings agencies are adding fuel to the fire, as bond downgrades are briskly outpacing upgrades. The message is that capital formation will continue to slow as the cost of credit climbs. As access to capital becomes more restrictive, on the margin, the currency to fund deals, share buybacks etc...will erode, undermining key earnings drivers. The implication is that profit prospects will continue to erode, the opposite of what sell side analysts are expecting (middle panel). Capital market return on equity tends to follow, inversely, junk bond spreads, and the current message is bearish (spreads are shown inverted, bottom panel). Bottom Line: The S&P capital markets index is facing stiff profit headwinds. Stick with a high-conviction, below-benchmark allocation. Capital Markets Have Broken Down Capital Markets Have Broken Down

The U.S. corporate re-leveraging cycle is far more advanced than is widely believed. Corporate health looks only mildly better excluding the troubled energy and materials sectors. Mushrooming leverage ratios are not restricted to junk issuers either.