Sectors

China has fallen into the same "fiscal trap" that ensnarled Japan in the 1990s. Unprofitable investment projects undertaken by SOEs are a necessary evil. The underlying problem is not overinvestment, but an economy that is demand-deprived. Meanwhile, structural factors will ensure that savings remain high. Any efforts by the authorities to curb credit growth will result in a sharp economic downturn. China will continue to generate excess capacity and export deflation to the rest of the world, which is good for bonds. We recommend going long Chinese banks, the most hated equity sector.

The previous Insight showed that the financial sector remained on its heels as a consequence of ongoing global deflationary backlash. This backdrop is particularly difficult for asset managers & custody banks (AMCB). This index is a high beta play on economic and financial market confidence. When the latter is high, M&A activity, share buybacks and other sources of industry fee income tend to accelerate. The opposite is also true. At the moment, global economic confidence is sinking, as measured by our composite sentiment gauge (top panel) and the stock-to-bond ratio (bottom panel), and is likely to erode further as economic disappointment mounts (third panel). Meanwhile, M&A activity is on the wane as capital availability has become more restrictive (second panel). These forces warn that AMCB profitability is likely to underwhelm. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AMGT- BLK, BK, STT, TROW, AMP, NTRS, BEN, IVZ, AMG, LM.

The S&P financials sector continues to battle deflationary forces. While inflation expectations are off their low courtesy of this year's dip in the U.S. dollar, they remain well below 2014 levels when the U.S. dollar began to surge (top panel). The negative profit backlash from global deflation continues to reverberate across the business sector, and has undermined corporate balance sheets to the extent that banks are much less willing to extend C&I loans, their main source of asset growth (second panel). These trends are also sustaining downward pressure on the long end of the Treasury curve, causing a relentless yield curve narrowing. With the Fed still eager to lift interest rates, despite evidence of growth slippage, the odds of a policy mistake are creeping higher. Against this backdrop, financial sector profits are likely to lose additional steam, raising the odds of a breakdown in relative performance to new lows. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5FINL.

We focus on 3 stress-points in the economy and markets which segue to several high conviction investment recommendations.

The previous Insight showed that rails are working hard to reduce cost structures. However, rail profits are still tightly linked with overall freight trends. The decline in total railcar shipment growth warns that rail earnings estimates will continue to lag those of the broad market. The two major freight categories are struggling. Coal shipments have plunged, with no imminent relief in sight, as utilities, the primary coal purchasers, are suffering from a contracting electricity production. Meanwhile, intermodal shipments, the largest freight category, have slipped into negative territory. Sagging port traffic, soggy retail sales and high inventory-to-sales ratios suggest that demand for consumer goods will remain lackluster. As a result, deflation is likely to prevail a while longer and we continue to recommend only a market neutral weight, despite the appearance of good value. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, NSC, CSX, KSU.

The relief rally in rail stocks has stalled at key resistance levels, but good value and extreme cost cutting efforts make it tempting to buy into any short-term weakness. Would that be a sound strategy? Top-line growth is lagging far below the rate of overall GDP growth, which is a bearish sign. However, rails have aggressively slashed costs, as both employment and capital spending have plunged. Moreover, the decline in railcar order backlogs suggests that new cars are coming on line. Rail operators lease the bulk of their cars, and tight supply in recent years boosted lease rates. As new cars hit the network, then lease rates should ease. These factors warn against extrapolating bearishness, but are they enough to bolster rail profits? Please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, NSC, CSX, KSU.

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.

Within an overweight allocation to Euro Area corporates versus U.S. corporates, favor single-B rated Euro Area High-Yield and Euro Area Investment Grade sectors that offer higher duration-adjusted spreads.

Stronger GDP growth will permit the Fed to hike rates once more before year-end, no earlier than September. However, the feedback loop between the Fed and financial conditions will prevent a second rate hike this year.

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.