Developed Countries
Increasing uncertainty over the Brexit vote will keep the Fed from raising its overnight policy rate at this week's FOMC meeting, but it may not keep the USD from rallying in the event of a decisive win for Brexit advocates on June 23.
Three strategies that could win whatever the outcome of Britain's referendum on EU membership. And what to look out for in the final days before the vote.
The overall retailing sector is still struggling with aggressive price discounting, as the retail price deflator hit its lowest level since the 1990s. Consumers have a high propensity to save, which is making it difficult for traditional retailers to manage and budget. The contraction in intermodal railcar shipments and rising retail inventory-to-sales ratios reinforce that conditions remain extremely difficult. However, there are some bright spots. Yesterday's retail sales report showed that pharmacies are enjoying a boom in top-line growth, while hypermarkets are finally regaining traction. On the flipside, restaurants continue to lose sales momentum, which bodes particularly ill for profitability given that labor costs are running at a high-single digit inflation rate (please see Monday's Weekly Report for more details). We are negative on retailers, with the exception of hypermarkets and retail drug stores, both of which warrant above benchmark status.
Airline stocks have been walloped of late, as the downside of an industry with high operating leverage is beginning to rear its head. The past few years of low oil prices and decent demand encouraged a large investment in capacity, which is now leaving the industry with an inability to fill planes at an attractive profit margin price point. Indeed, revenue per passenger mile is contracting and our proxy for global CPI airfares has plunged. We doubt that improvement is imminent, given that fuel prices are back on the upswing, and leading business cycle indicators continue to warn that retrenchment in travel budgets is a higher probability than expansion. Against this backdrop, airfare price concessions are likely to remain intact, or even intensify, to the detriment of airline revenue and profitability. We are sticking with a high-conviction underweight stance. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK.
Media stocks have been through a choppy consolidation phase in recent years, as investors digest competitive threats and changing consumption habits. However, evidence is materializing that media companies are through the worst. Specifically, value has been restored to the S&P movies & entertainment (ME) index. Consumers continue to demonstrate a healthy appetite for content consumption: personal spending on recreation and electronics has reaccelerated as a share of total outlays. While, cord cutting, skinny pay TV packages and OTT threats have cast a dark cloud over both content creators and cable companies, evidence suggests that gloom has been excessive. Personal spending on cable services is hitting new highs in level terms, even excluding price increases, and is soaring in growth rate terms. Importantly, other elements of the industry are strong. Recreation spending is growing at a mid-single digit rate, in real terms, underscoring that both movie and theme park admission traffic is healthy. That is facilitating aggressive price hikes, as evidenced by the surge in the CPI for entertainment. Against this solid revenue backdrop, wages are barely growing, a recipe for profit margin resilience. We recommend using price weakness and near-term volatility to augment positions to overweight, which brings our overall consumer discretionary sector weighting up to neutral.
Equities initially cheered the soft employment report, because it cooled prospects for imminent Fed interest rate hikes. However, whether equities can break out on the back of growth slippage depends on whether profits or liquidity will be the dominant market force and/or if the economy weakens by more than expected. In other words, is bad economic news actually good news for stocks, or is bad news bad? The tight correlation between the 2-year Treasury yield, an excellent tracker of Fed funds rate expectations, and equities suggests that higher share prices require better economic/profit growth rather than simply a less hawkish Fed. Moreover, history shows that P/E multiples get squeezed on a sustained basis once monetary conditions tighten courtesy of the Fed. The chart shows a cycle-on-cycle analysis of how the S&P 500 forward P/E has fared after the onset of Fed interest rate increases since the early-1980s. Without exception, forward multiples contract. Thus, a sustainable advance from current levels requires a new profit up-cycle. To forecast that a weaker U.S. dollar will revitalize rather than simply stabilize profits on a broad-basis, it is critical for the rest of the world to demonstrate an internal demand impulse. However, that remains elusive and we remain reluctant to forecast a sustained profit recovery, especially on a par with the massive rebound analysts currently expect. We retain a defensive portfolio bias.
At current levels, Treasury yields are consistent with our assessment of fair value. Further, the Fed's Labor Market Conditions Index does not suggest an imminent recession. Expect payrolls to stabilize above levels consistent with further progress on wage growth and inflation, allowing the Fed to hike rates later this year.
For now, maintain a benchmark duration stance leading into the June 23 U.K. Brexit vote, favoring Treasuries and (especially) Gilts over Bunds and JGBs.
Risk assets will take their cues more from the dollar than the Fed if the euro rises above its 16-month range against the dollar. Retain exposure to energy equities and gold.