Developed Countries
Monday's upgrade of the energy sector to neutral and the exploration & production index to overweight does not mean that refiners are out of the woods. In fact, the opposite is true, because the crude oil supply glut will morph into a refined product glut. Refiners are still running full out, likely in response to strong gasoline demand, but that is creating a glut of distillate inventories and boosting overall fuel supplies. Overall refined product consumption is barely growing, underscoring that inventories will continue to build. Weakening overall demand for finished oil product is also evident in the plunge in railcar shipments, which heralds a potentially painful decline in relative stock performance (top panel). Part of the plunge in rail shipments of oil reflects reduced shale oil production, which will boost refiner input costs via higher crude oil prices. Keep in mind that refining margins are already under cyclical stress, because of the tight spread between Brent and WTI crude oil prices (third panel). Our refiner earnings model, based on refining margins and utilization rates, is plunging. Consequently, the odds of a sustained profit squeeze are high. We reiterate our high conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, TSO.
The United States and China continue to see relations worsen, particularly over China's activities in the South China Sea. But that is not the only reason geopolitical risk is migrating from the Middle East into Asia Pacific - a trend that investors cannot afford to ignore.
BCA's Energy Equity Strategy, our newest sector-specific service, recently published a report arguing for a rebalancing of global oil markets in the second half of this year, and modestly higher oil prices, a view which was not predicated on an OPEC production freeze. Instead, rebalancing should be driven by larger-than-expected production declines. Low prices are doing their job. Plunging cash flows and the resulting massive increase in capital constraints have strangled exploration budgets, particularly in U.S. shale formations. BCA's forecasts signal that consumption will outpace production significantly by yearend. Consequently, the heavily bombed out S&P energy exploration & production (E&P) index could surprise on the strong side as the year progresses, as relative E&P performance is highly correlated with oil prices, irrespective of the trend in production. In other words, even if production growth is contracting, as long as the latter leads to higher commodity prices, then share prices can outperform. Importantly, producers are enjoying the benefits of technology advancement in drilling techniques, which are driving down production costs. Massive overcapacity in the services industry means that producers will continue to dictate pricing terms. Consequently, we upgraded the S&P E&P index to overweight in yesterday's Weekly Report, which brings our overall energy sector weighting up to neutral, locking in a 14% profit from our underweight call.
One refrain from market bulls is that sentiment is too bearish, which is contrarily positive. Indeed, our own Composite Sentiment Gauge is still decisively in a bearish zone. However, action trumps rhetoric. Investors are responding to polls bearishly, but do not appear to be positioned that way. True bearishness elicits a rush for the equity exits, which prompts position deleveraging, a valuation squeeze, a dramatic increase in cash levels and a premium on portfolio protection, as measured by the VIX and SKEW indexes. Yet valuations are probing historic highs, as measured by the median industry group price/sales ratio (bottom panel). Investors are not nervously hedging long positions, as evidenced by historically depressed readings in the VIX and SKEW indexes. Meanwhile, margin debt remains near record levels, both in absolute terms and compared with market cap and/or GDP (fourth panel). Moreover, investor cash holdings are historically low, the opposite of a bearish signal. The broad market lows in 2000 and 2009 were marked by unanimity among these indicators, namely bombed out sentiment and speculation readings, extreme anxiety about a potential crash, cheap valuations, low margin debt, high cash levels and a high degree of global economic pessimism. At the moment, none of these indicators is confirming that investors are positioned defensively. Consequently, we are reluctant to champion a bullish equity outlook on the basis that pessimism reigns. We expect our outsized exposure to non-cyclical sectors to continue generating alpha.
The balance of risks favors accelerating wages and stable core inflation during the next few months. This will result in a move higher in rate hike expectations, benefitting Treasury curve flatteners.
Japanese policymakers are in the process of shifting away from negative rates and fiscal consolidation, leaving JGB yields exposed to any move to weaken the yen that could raise depressed inflation expectations.
Bearish sentiment is a red herring, as most other measures of investor positioning point to a strong undercurrent of bullishness. That is contrarily worrying.
The equity bear case is obvious. Prices are approaching overhead resistance and face fundamental headwinds.
This week <i>Global Alpha Sector Strategy</i> in conjunction with <i>Emerging Markets Strategy</i> is sending out a <i>Special Report</i> on EM deep cyclical sectors, discussing debt and cash flow dynamics, identifying how far advanced the capital expenditure down cycle is, and determining if recent EM deep cyclical strength should be bought or faded.
An Insight yesterday showed that the overall technology sector was likely to record its worst quarterly earnings performance in four years. The highest beta components of the sector are most at risk. For instance, the semiconductor industry is losing its main source of support, namely an M&A premium. Last year's mini-M&A frenzy is petering out, which will put the onus on profits to support relative performance. However, global chip sales continue to deteriorate, and leading indicators such as Chinese electronics imports and Emerging Market currencies continue to warn of tepid chip demand. With chip producer inventories still growing at a historically rapid clip, there will be downward pressure on average chip selling prices. TSMC's profit warning earlier this week likely provides a good read for the overall industry, and we reiterate our high-conviction underweight rating. The ticker symbols for the stocks in this index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, SWKS, XLNX, MU, LLTC, MCHP, QRVO, FSLR.