Equities
The powerful short covering bounce in the S&P steel index is starting to fizzle. The latest upleg had been driven by a surge in Chinese domestic steel prices. That, combined with news that the country plans to reduce steel capacity in the coming three to five years, was enough to send shorts scrambling for cover. However, it will take time for the global steel market to rebalance. In the short run, the jump in Chinese steel prices has already encouraged domestic producers to re-ramp steel production (second panel). Persistent sluggishness in indicators of China's domestic consumption mean that steel inventories are likely to build as production picks up anew, which will put upward pressure on exports to the rest of the world. Fading construction growth and tightening lending standards in many developed countries suggest that increased steel supply from China will have a negative impact on steel prices. We reiterate our recent downgrade back to underweight. The ticker symbols for the stocks in this index are: BLBG: S15STEL - NUE, STLD, RS, X, CMC, ATI, WOR, CRS, AKS, TMST, HAYN, SXC, ZEUS.
It is widely perceived that China suffers from a massive capital misallocation problem. Our indicators defy this conventional wisdom.
Colombia's structural growth outlook is superior to many other developing economies. In the near-term, however, Colombia's economy is set to weaken materially. Upgrade Colombian equities and sovereign credit to neutral versus EM benchmarks. Continue betting on further yield curve flattening/inversion and buy 10-year domestic bonds on weakness. Go long Colombian bank stocks / short Peruvian banks, and stay short the peso.
Profit contractions normally occur during recessions, but there have been three exceptions since 1980: 1987, 1999 and a very brief period in 2012 (shaded portions in the chart). All three cases involved a mid-cycle slowdown in nominal GDP growth, while labor compensation growth trended sideways (second panel). The deceleration in sales activity was evidently perceived to be temporary, such that business leaders did not respond by limiting wage gains, trimming payrolls or slashing capital spending. The absence of Fed tightening at the time likely calmed fears of an extended slowdown. Indeed, the Fed cut rates in 1987 and 1998, and implemented QE3 in 2012. The result was that the slowdown in top line growth and the margin squeeze proved shallow and short-lived. We believe a similar phase is underway today. Several of the factors driving the profit recession appear to be at or close to their nadir. Commodity prices, and oil prices most importantly, have stabilized. Many key indicators of Chinese growth are rebounding, suggesting that monetary and fiscal stimulus is beginning to pay off. The global LEI has not yet turned up, but its slow erosion is in sharp contrast to the plunge that typically occurs before recessions. Purchasing managers' surveys have ticked higher in the U.S., Japan, Canada, the U.K. and China, signaling that the global manufacturing recession is ending. Bank profits could be near the worst as well, depending on the evolution of NIRP policies and net interest margins. Moreover, the manufacturing recession has not spread to the service sector in the major economies, where job creation has held up. While persistently low productivity growth and a secular bottom in the labor share of income in the U.S. will remain a headwind for global earnings, they should be dominated by even a modest cyclical revival in global growth due to high corporate operating leverage. The implication is that we do not foresee a prolonged earnings contraction. Looking again at the chart, global EPS surged following the modest profit recessions in 1987 and 1999. Output growth accelerated sharply, while commodity prices entered a robust bull phase. The global output gap shifted into "excess demand" territory, providing the business sector with some pricing power. Nominal GDP growth re-accelerated in absolute terms and relative to labor costs, contributing to a substantial rise in profit margins. The aftermath of the 2012 profit dip was an altogether different affair. Margins only edged higher due to the tepid rebound in nominal GDP growth. Commodity prices were roughly flat. Meanwhile, the still-large global "excess supply" gap robbed the business sector of pricing power. The result was that EPS growth barely climbed out of negative territory in 2013 and 2014. Today, the global output gap is closer to zero than was the case in 2012/2013, especially in the U.S. However, pricing power is still left wanting at the global level, based on the continued decline in global manufactured goods prices and depressed core consumer price inflation in most of the advanced economies. Oil prices have more upside potential given that the supply-side is responding to low prices, as discussed in the Overview. Nonetheless, our commodity experts do not foresee sustained price increases outside of oil anytime soon. Finally, the global leading economic indicator, a reasonably good bellwether for global EPS growth, has yet to turn higher (bottom panel). Bottom Line: While the profit recession will not be extended or deep, investors should not expect the kind of surge in EPS growth that followed the 1987 or 1997 earnings contractions. Please see yesterday's Special Report for additional details.
The factors that drove the recent rally - Fed dovishness, China reflation, and a pickup in economic data - are largely over.
Corporate earnings rarely shrink outside of economic contractions, so investors can be forgiven for worrying that we are on the brink of a global recession. Earnings-per-share (EPS) for the MSCI all-country world index are estimated to have fallen by 7% in the year to March, the fourth quarter in a row of annual decline (top panel). This is by far the worst performance since the Great Recession. EPS growth in both the U.S. and the U.K. (local currency) is deep in negative territory. Profit growth is still positive, albeit decelerating, in the Eurozone and Japan in local currencies (bottom panel). How much more downside is there? When will EPS bottom and how strong will the recovery be? These are obviously key questions for the appropriate equity weighting within balanced portfolios, especially given that stocks are not cheap, downside global growth risks abound and the FOMC is biased to lift rates. It is difficult to justify being overweight equities without seeing some profit relief on the horizon. In yesterday's Special Report, we took a top-down approach to projecting EPS for the global index, the U.S., the Eurozone and Japan. The rebound in oil prices and some positive economic signs out of China have raised hopes that the profit recession is close to the end. Indeed, the good news is that world EPS annual growth should bottom in the third quarter. However, the bad news is that the climb back into positive growth territory will take time. Barring very strong (and unrealistic) growth assumptions for the rest of 2016, investors should not expect positive year-on-year global EPS growth until early in 2017. Bottom-up earnings estimates currently are too optimistic. On a regional basis, U.S. earnings growth will likely trail both Japan and the Eurozone over the next two years, although much depends on currency movements (see the next Insight).
The model has downgraded France to underweight due to deteriorating liquidity and technical conditions. U.S. weight is boosted by 4 points at the expenses of European countries.
Profits are bottoming but the outlook is lackluster, even if further dollar weakness provides a temporary boost.
This week <i>U.S. Equity Strategy</i> is sending you the latest <i>BCA Special Report</i>, where Mark McClellan and Anastasios Avgeriou tackle the questions of "Global Earnings Recession: How Deep? How Long?"
For the month of April, the model's performance was in line with the S&P 500, but lagged global equities. For May, the model is aggressively paring back its equity risk exposure. Both Europe and Emerging Markets were downgraded, but still possess the lion's share of the equity allocation, while defensive markets such as the U.S. and Switzerland received a boost. In the fixed-income space, U.S., Italian and Spanish paper were the model's favorites.