Equities
The previous Insight showed that the overall industrials sector was in recession territory, based on the message from sinking capital goods orders. At a minimum, that argues for a highly selective investment approach. For instance, in December, we separated our coverage of the S&P aerospace & defense index into its two distinct components, underweight the former and overweighting the latter. We showed that a divergence between these two groups is typical during recessions. The latest data bear out this view. Aerospace new orders are very soft, arguing the commercial aerospace cycle is on the downswing. In turn, that implies lower plane deliveries and future profit margin pressure, as evidenced by Boeings' earnings miss. Conversely, defense orders are moving higher, which is supportive of ongoing earnings growth. We reiterate our overweight view of defense stocks, and underweight stance on aerospace names.
The industrials sector stands out as having operating margins well above its historic average, along with an elevated price/sales ratio, as shown in Table 1 from this week's report. The ISM manufacturing index heralds a reversion to the mean in profit margins (bottom panel). The latest durable goods report confirmed this bearish message: core durable goods orders were very weak, which is consistent with negative relative forward earnings momentum. The Philadelphia Fed Survey of corporate capital spending intentions is sinking steadily, warning that durable goods orders are likely to stay weak. The implication is that profits remain at risk of disappointing. It is too soon to lift underweight positions, and sub-surface exposure should stay selective, please see the next Insight.
We are introducing a quantitative equity country allocation for the MSCI World universe. Currently the model recommends overweight U.S. and eurozone while underweight Japan, U.K., Canada and Australia, broadly in line with our judgement except that we are more bullish on Japan than the model.
Late last year we highlighted that the S&P telecom services sector had the potential to be a sleeper pick for 2016, and we put it on our high-conviction list. While this sector has jumped sharply out of the gate, the move has not made a dent in the severe undervaluation created by years of underperformance (third panel). While the sector faces many challenges to grow revenue, its focus on profit margins should be sufficient to create value. Chronic competitive pressures have eased a notch following consolidation efforts, enough to drive meaningful pricing power gains. That is supporting growth in average revenue per user (ARPU), opening the door to improved profit margins. These positive internal dynamics alone provide sufficient reason to stay bullish, but tack on global growth concerns and sinking bond yields, and the incentive to funnel capital into this non-cyclical sector rises another notch. We reiterate our high-conviction overweight.
The plunge in capital markets stocks is not a buying opportunity. Corporate sector credit quality is quickly deteriorating. Ratings agencies are adding fuel to the fire, as bond downgrades are briskly outpacing upgrades. The message is that capital formation will continue to slow as the cost of credit climbs. As access to capital becomes more restrictive, on the margin, the currency to fund deals, share buybacks etc...will erode, undermining key earnings drivers. The implication is that profit prospects will continue to erode, the opposite of what sell side analysts are expecting (middle panel). Capital market return on equity tends to follow, inversely, junk bond spreads, and the current message is bearish (spreads are shown inverted, bottom panel). Bottom Line: The S&P capital markets index is facing stiff profit headwinds. Stick with a high-conviction, below-benchmark allocation.
The U.S. corporate re-leveraging cycle is far more advanced than is widely believed. Corporate health looks only mildly better excluding the troubled energy and materials sectors. Mushrooming leverage ratios are not restricted to junk issuers either.
Central banks follow backward-looking indicators but economies follow forward-looking indicators. So which indicators should investors follow? And what is the current message? Also, we see signs that London is cooling.
Corporate profits are more sensitive to selling prices than to volumes. Falling prices even amid mildly rising volumes could produce a meaningful profit contraction. Stay with deflation trades. In particular, maintain the short EM stocks / long U.S. 30-year Treasurys position. Indian stocks are still pricey and will deflate further in absolute terms.
Materials stocks have been beaten down to the point where it is tempting to declare that all the bad news is already discounted. However, we remain reluctant to recommend investors attempt to catch this falling knife. China remains the marginal price setter for commodities, and its growth struggles are very deflationary (bottom panel). That is adding to the profit stress exerted by U.S. dollar strength. Importantly, materials sector cash flow is contracting at a time when its interest rates are rising. Deteriorating materials sector financial health is evident by the sinking interest coverage ratio. Worryingly, spiking high yield materials sector bond spreads are warning that basic materials credit quality has further to fall (spreads shown inverted, middle panel). Balance sheet stress argues for a rising materials sector equity risk premium. Bottom Line: Stay underweight the S&P materials sector.
Household product stocks are gathering momentum relative to the broad market. We expect this trend to persist as profit margins slowly improve. The industry has undergone a forced retrenchment as a consequence of the strong U.S. dollar, which sapped top-line growth. However, both commodity input and labor costs are contracting, providing much needed profit margin relief. The chart shows that operating margins have significant upside, especially if revenue improves even modestly. On this front, the plunge in commodity prices is freeing up disposable income to spend on brand-name essentials: consumer spending on toiletries is outpacing overall consumption for the first time in years. Moreover, Asian real retail sales are still growing at a robust rate, signaling that any emerging market currency stability should translate into better top-line performance. We reiterate our overweight position. The ticker symbols for the stocks in this index are: PG, CL, KMB, CLX, CHD.