Developed Countries
Capital markets stocks have been crushed this year. Over the last few decades, capital market bear phases have ended with a forceful policy response that restores economic growth by rekindling the credit cycle. Fed rate cuts have usually started that process. This cycle, the Fed is still intent on tightening even as evidence of growth softness mounts. Thus, it is difficult to envision the start of a cycle that encourages increased capital formation, which is needed to avert a sustained capital markets profit downturn. Our concern is that the U.S. corporate sector has spent beyond its means long enough to erode balance sheet flexibility, which warns of high odds of a forced retrenchment. Access to capital is restricted to those who don't need it. Once our Corporate Health Monitor moves into deteriorating health territory, M&A activity usually begins to dry up (second panel). M&A has been running red-hot in the past few years, as the lack of organic global growth has forced companies to pursue acquisitions. If this source of investment banking income diminishes, then capital market companies will have a large profit hole to fill. If valuations could not expand with an easy Fed, an M&A boom and rampant stock and bond issuance, what will happen now these conditions are reversing? Stay with a high-conviction underweight. The ticker symbols for the stocks in this index are: GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM.
The sheer scale of underperformance leaves the oilfield services group vulnerable to violent bounces, especially in view of the recent stabilization in oil prices as well as an agreement between several OPEC members and Russia to freeze output at current levels. Is it time to buy? While oil supply will eventually be reined in, demand growth is still up for debate. The global economy is struggling to maintain a decent rate of growth. Importantly, energy service stocks have an abysmal track record during recessions and/or when the ISM manufacturing index is below the boom/bust line. In other words, the group is a late-cycle performer, not an end-of-cycle performer. While the U.S. is not technically in recession, the odds of one are rising steadily as credit conditions tighten. Even then, upside potential may be more muted than in previous cycles. Fracking technology and producer's flexibility to quickly ramp up output suggests that the large boom/bust cycles in supply will not hold true going forward. The natural gas market is a prime example. The implication for oilfield services investors is that peak earnings could be much lower than in the past, which will reduce investor willingness to speculate on upcycles and warrant a higher risk premium. We are sticking with a neutral weighting, despite the likelihood of periodic oversold spikes. The ticker symbols for the stocks in this index are: SLB, HAL, BHI, CAM, NOV, FTI, HP, RIG, ESV, DO.
A near-term rally in risk assets now appears very likely. But we expect it to be cut short when the Fed eventually reacts to easier financial conditions by returning to a more hawkish policy stance. Investors should maintain a defensive portfolio allocation on a 6-12 month horizon, and remain overweight TIPS versus nominal Treasuries.
The deeply negative momentum in oil prices is fading, setting up the possibility of a counter-trend rebound in global inflation expectations and perhaps even the beaten-up U.S. High-Yield bond market.
Lean against rally attempts until leading profit indicators improve. The conditions for a tradable oilfield services rebound remain elusive. Capital markets may bounce, but we would sell on strength.
The agreement to freeze oil production should reduce tail risks, even if it does not improve overall corporate sector health and profits.
The recovery in global risk assets and currencies is a temporary oversold bounce. It is not supported by signs that global growth is on the mend. Consequently, we are not willing to embrace more risk in our currency strategy just yet.
The previous Insight showed that the financial sector is likely to experience a reprieve from intense selling pressure if the U.S. dollar weakens by enough to halt the slide in inflation expectations. However, before extrapolating any short-term recovery, it is important to keep the cyclical picture within the proper context. The sector has not hit previous valuation troughs. The yield curve is narrowing steadily, and could continue to flatten if domestic economic conditions erode further. Valuations tend to move positively with the yield curve. Moreover, the corporate debt binge of the last few years is ending. Our Corporate Health Monitor warns that balance sheets no longer have the flexibility to pursue aggressive growth, either through M&A or increased leverage. Weakening C&I loan demand warns that credit creation will slow. Against this backdrop, financial sector profitability will be constrained. Consequently, we recommend only a market weighting, with an emphasis on the more defensive components, including REITs, insurance and consumer finance.
Financials have been tightly correlated with global growth expectations in recent years, given the high risk of deflation this cycle. The sector has been rattled by intensifying global growth shocks emanating from China and Emerging Markets and the spillover onto global economies. This process has culminated in a spike in banking sector fears around the world. However, the S&P financials sector has the capacity to enjoy a meaningful recovery from the drubbing it has taken year-to-date, provided the meltdown in inflation expectations takes a breather on the back of hopes for a less stringent Fed. If the U.S. dollar weakens by enough to reduce EM financial strains and reduce deflationary backlash onto the U.S. corporate sector, credit fears could subside, at least temporarily. Is it worth buying into a sunnier view? Please see the next Insight.