Developed Countries
Several large capital markets firms have produced better-than-expected profits in the latest quarter, driven largely by a flurry of fixed income trading following the Brexit vote, subsequently triggering a short covering rally in related shares. Is the bear market in capital markets stocks finally over? We doubt it. The top panel of the chart shows that relative stock price performance is tightly linked with relative forward earnings momentum. The latter is negative, and unlikely to receive a boost from higher trading profits, as this source of income is unreliable and lumpy, i.e. here today but gone tomorrow. Instead, a sustained upturn in capital formation is required to reverse the profit downtrend. However, that is unlikely when deflation remains the dominant force, the U.S. dollar is regaining strength and the yield curve is narrowing. Previous relative performance troughs have occurred within the context of rising inflation expectations and a steeper yield curve, both of which signal increased corporate sector capital requirements. At the moment, the latter are on the wane, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5CAPM - GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM.
Refiners will reduce run rates over the next month or so to clear unintended inventory accumulation, but it's not like they've never had to deal with this situation.
In successful investment analysis "less is more, and usually much more effective."
The S&P health care sector's diagnosis is encouraging, as there has been improvement on a number of fronts. Recent profit reports signal that top line growth is recovering smartly at a time when industry selling prices remain resilient. Bellwether JNJ's robust guidance may foretell of a broader trend for the sector. Thus, the valuation discount weighing on this laggard defensive sector is no longer warranted and this earnings season may serve as a catalyst for a re-rating in historically depressed relative valuations (bottom panel). Importantly, the brightening profit backdrop is signaling that industry dividend growth will remain sold, in marked contrast with that of the broad market (second panel). Persistent dividend growth will be increasingly appealing in a world where investors are starved for sources of stable income. Meanwhile, generationally low fixed income yields are sustaining the appeal of share buybacks and the sector's share count will continue to drift lower. That should underpin both EPS and relative performance (third panel). Bottom Line: We are reiterating our high-conviction overweight stance in the S&P health care sector. BLBG: S5HLTH
With Treasury yields backing up from extremely depressed levels, many clients are asking if an overweight allocation to the REIT space remains appropriate. While a sharp spike in yields would clearly be problematic in the short run, we have shown that REITs have often outperformed during periods of strong economic growth and Fed tightening cycles. The key is for REITs to generate above-market cash flow. At the moment, our composite REIT rental rate inflation is running comfortably above overall inflation, led by the CPI for homeowner's equivalent rent (top panel). New supply has been coming on stream for years, but so far has been absorbed with little adverse pricing power impact. Vacancy rates are still historically low. Consequently, operating performance should stay robust. Importantly, relative valuations are not overly demanding, and technical conditions are not overbought, and there have been no negative momentum divergences. We continue to recommend an overweight stance. BLBG: S5REITS
Our newly-developed European bottom-up Corporate Health Monitor is signaling that European corporate balance sheets, in aggregate, are steadily improving.
Developed Market bond yields are too low relative to improving global growth and the strong recovery in risk assets post-Brexit. Reduce portfolio duration to below-benchmark.
U.S. companies have historically traded at a premium to their European counterparts because of better underlying 'financials'. To address this issue, we developed the "Fundamental Approach" to determine the relative value of European equities in comparison to the U.S. Our analysis involved regressing the difference in the valuation metrics between the two markets on differences in financial variables, including RoE, operating margins, trailing EPS, forward EPS, sales-per-share, interest coverage, two measures of leverage and cash flow growth. While not as successful as the mechanical approach, the regressions confirmed the conclusion of the mechanical approach. The historical "batting average" of the fundamental valuation indicators are also good. Taken as a whole, our analysis suggests that Eurozone stocks are on the cheap side of fair value versus the U.S. at the moment, but not by enough to justify overweighing the Eurozone based on value alone. One also needs the expectation that European earnings growth will be better than in the U.S. over the next 1-2 years. Indeed, we are more bullish on Eurozone EPS growth than for the U.S. due to ongoing margin pressure in the latter market. For additional details please see Monday's Special Report.
European stocks have lagged the U.S. by a wide margin in the post-Lehman era. The relative EMU/U.S. total return index is close to its lowest level since the late 1970s in local currency terms. It is tempting to take a contrary position, especially since European stocks appear cheap relative to the U.S. on the surface. Nonetheless, European stocks have traditionally traded at a discount, in part because of persistently lower profitability. A Special Report - first published in the Bank Credit Analyst last month - takes a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for persistent differences in underlying profit fundamentals. The report focused on the non-financial sector, and re-weighted the Eurozone equity index using U.S. weights in order to avoid the problem that differing sector weights could bias measures of relative value for the overall market. The report employed both a mechanical approach and a fundamental approach. Seven valuation measures were used, Price/Sales, Price/Forward Earnings, Price/Cash Flow, Price/Book, EV/EBITDA, Price/Trailing Earnings and Shiller P/E. The mechanical approach adjusted the valuation measures by subtracting the 5-year moving average from both markets. We then divided the Valuation Gap (VG) between the U.S. and Eurozone markets by the 5-year moving standard deviation of the VG. In this way, we adjusted for the persistent, but time-varying, gap between the two markets. The result is an indicator that moves roughly between +/- 2 standard deviations. Valuation is not a timing tool, but our analysis of the historical "batting average" shows that all of these valuation metrics except the trailing P/E provide value added as an investment tool. Historically, there was a high probability of a significant excess return to positioning in a contrary fashion between the two markets when relative valuation reached 1 and, especially, 2 standard deviations away from the mean. Currently, all of the mechanical valuation indicators suggest that Eurozone stocks are on the cheap side of fair value relative to the U.S., except for the trailing P/E. However, only two are more than 1 standard deviation away from the mean. We then approached valuation from a fundamental perspective (see next Insight).
Forecast is diverging from strategy for equities. Intermediate-term positives allow for a blowoff to the upside. But we do not expect the rally to have staying power over a 6-12 month horizon.