Equities

We turned more cautious on banks in January, but in hindsight, could have become outright bearish. Banks are headed for a triple whammy of profit trouble. Loan growth is set to cool, the credit cycle has shifted from tailwind to headwind and the yield curve continues to flatten. Moreover, following several years of downsizing, banks are no longer shedding labor. In fact, banks are adding staff, according to BLS data (middle panel). The timing of hiring is questionable, given that our measure of productivity growth, bank loans/bank employment, is now decelerating (bottom panel). That will undermine profitability, particularly against a backdrop of net interest margin compression. Expectations in the swap curve are for an ongoing yield curve flattening (top panel). It will be very difficult for long-term Treasury yields to rise sustainably as long as other global government bond yields are melting, because the divergence will cause outsized U.S. dollar appreciation which transmits deflationary pressure into the U.S. The implication is ongoing net interest margin compression. Bottom Line: Downgrade the S&P banks index to underweight. This also moves our overall financials exposure to below benchmark. For additional details please see yesterday's Weekly publication. The ticker symbols for the stocks in this index are: BLBG: S5BANK - BAC, BBT, C, CFG, CMA, FITB, HBAN, JPM, KEY, MTB, PBCT, PNC, RF, STI, USB, WFC, ZION.

Like the economy, banks show no major imbalances. But the "glide path" for credit is slower than in previous cycles.

Sell the bounce in banks, which face a triple whammy of earnings threats. This will reduce our financials sector allocation to underweight, making room for last week's energy upgrade.

Last month, we highlighted that the S&P consumer finance index had far undershot bullish readings from our macro indicators, reflecting company specific issues. As the latter fade into the rearview mirror, relative performance should reengage with its upbeat outlook. For instance, the tighter U.S. labor market is pushing up wage & salary growth, supporting robust gains in revolving consumer credit (second panel). Rising income growth also suggests credit quality is unlikely to become a profit drag, paving the way for a re-rating in historically attractive relative valuations. That contrasts with the corporate sector, which is struggling with highly-indebted balance sheets and faltering profit growth (our Corporate Health Monitor is shown advanced, bottom panel). It is no wonder that personal loans are outpacing C&I credit growth (third panel) This backdrop is bullish for consumer finance stocks relative to the market, and relative to the S&P bank index. We reiterate our overweight S&P consumer finance index recommendation as well as our recently established pair trade vs. banks. The ticker symbols for the stocks in this index are: BLBG: S5CFINX - AXP, COF, SYF, DFS, NAVI.

The reflation trade will continue for a few more months on Chinese fiscal/monetary stimulus and a more dovish Fed. Despite a slightly better-than-expected start to the earnings season, Q1 S&P 500 profits are set to fall for a fourth consecutive yoy decline. Ex-energy, things aren't so bleak. Domestically-focused companies will experience flat earnings and modestly-positive revenue growth in Q1. Although margins have almost certainly peaked, their decline will be drawn-out. Remain overweight Europe/Japan/China versus the S&P 500 (currency-hedged).

While technology sector profits are disappointing on the back of the paucity of volume growth and deflation (i.e. INTC, IBM), the same is not true for health care companies. Several large cap health care firms have reported robust earnings results (i.e. JNJ, UNH), reflecting steady non-cyclical demand growth and burgeoning pricing power. Indeed, managed care companies are successfully lifting premiums, while pharmaceutical firms continue to enjoy nearly unprecedented pricing power (bottom panel). While the latter is a point of political contention in the U.S., history shows that it is an extremely difficult and drawn out process to effect change. In the meantime, the health care sector's ability to lift selling prices stands in stark contrast with the overall corporate sector. For instance, the small business sector is showing an inability to lift selling prices, as reflected by the NFIB reported price change series, (shown inverted, top panel), which is bordering on recessionary readings. As a result, health care profits should continue to outperform, and we reiterate our recent move to a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5HLTH.

The euro area's nominal GDP and wage bill are growing at 3%, suggesting that fears of deflation are overdone. But a higher wage bill has implications for profits growth.

EM/China growth improvements and the associated rally will falter on their own without tightening by policymakers. The short duration of these mini-cycles and a lack of observable catalysts make it impossible to precisely time selling out of EM positions. This makes us reluctant to chase the rally. Regardless how the impeachment process proceeds, Brazil is heading into a fiscal/public debt crisis.

Earlier this month we made a rare shift from underweight to overweight in the S&P cable & satellite index, because fears of cord cutting and skinnier cable packages undermining profitability were no longer justified. In fact, in real terms, consumer outlays on cable have jumped to new highs. Unsurprisingly, the latest consumer price report showed that cable TV inflation is following in the footsteps of spending: the rate of pricing power growth is accelerating (bottom panel). That implies low subscriber churn, reducing the likelihood that capital spending will need to materially increase to maintain competitiveness. Importantly, cyclical share price momentum is still well below levels that have marked previous interim relative performance peaks, and should continue to climb based on the uptrend in real consumer spending (middle panel). We reiterate our upgrade to overweight. The ticker symbols for the stocks in this index are: BLBG: S5CBST - CMCSA, CVC, TWC.

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.