Sectors
Highlights Chinese stocks made a comeback as soon as the speed of COVID-19 transmitting outside of the epicenter somewhat moderated. Inside the epicenter, the pandemic has not shown clear signs of easing, and could significantly prolong the region’s lockdown. Despite being a large manufacturing hub, Hubei-based companies represent relatively limited significance in China’s equity market. A protracted regional lockdown in Hubei may disrupt company-specific supply chains, but so far there is little evidence suggesting such disruptions will spill over to China’s broad equity market. Feature The stringent containment measures taken by China in its battle against the COVID-191 epidemic are indeed having economic consequences, both domestically and globally. However, the full extent of the repercussions remains to be seen. In the financial market, Chinese stocks regained significant ground following a sharp selloff when the financial markets reopened after an extended Chinese New Year holiday (Chart 1). The number of confirmed COVID-19 cases continues to rise. On the other hand, the number of new cases outside of Hubei province appears to have peaked on February 3rd and the official number within the province has plateaued (Chart 2). Chart 1Chinese Equities Rebounded Despite The Ongoing Epidemic Chart 2Has The Peak Arrived? Not Within The Epicenter The latest official data reinforces our view that the epidemic outside of Hubei is considerably less severe than within Hubei. While it is still too early to confirm that the number of new cases elsewhere in China has peaked, the epidemic in Hubei - particularly in Wuhan - is far from contained despite what the official data suggests. The near-collapsing municipal system in the epicenter leaves a large margin for error in recording and confirming the number of cases. The region’s strained medical resources also mean that the number of both new infections and fatalities may not reach a sustained peak in the weeks to come. Most cities in China’s 31 provinces and municipalities had partially resumed business activities by February 10, but we think that Hubei and especially Wuhan will likely remain in lockdown through the end of March, a month longer than scheduled by the provincial government. Will an extended lockdown of the Hubei province prevent a budding recovery in China’s economy from manifesting itself? In our view, the answer is no. And even in the case of a prolonged region-wide lockdown, our assessment is that the spillover effects from supply-chain disruptions in Hubei on the domestic equity market are unlikely to be significant. Quantifying The Potential Impact Of An Extended Lockdown In Hubei Hubei accounted for only 4.6% of China’s aggregate economy in 2019. If the majority of businesses in Hubei remain closed until March 20 and we assume no growth in the province in Q1 on an annual basis,2 it will shave 0.3 percentage points from China's total nominal growth in the quarter. Furthermore, if the manufacturing sector restarts production in Q2, but most activities in the service sector such as retail, hotel, transportation and real estate remain depressed, then China’s tertiary sector output growth in that quarter will be reduced by 0.4 percentage points. This will only reduce the country’s overall economic growth in Q2 by 0.2 percentage points. Hubei’s protracted but isolated lockdown will also have a minor impact on China’s overall financial market. Within the MSCI China Onshore Index, there are 16 Hubei-based companies representing only 1.2% of total market capitalization. In the offshore market, there are 14 listed companies registered in Hubei and their market value accounts for a mere 0.3% of the offshore MSCI China Index.3 Chart 3Chinese Equity Performance Rationally Reflects Economic Fundamentals So Far Given the small market capitalization of these Hubei-based companies, China’s index performance simply will not be affected on a fundamental basis by a longer shutdown of the province (Chart 3). Bottom Line: We expect a more protracted shutdown of business in Hubei than is currently scheduled, which has the potential to weigh negatively on investor sentiment. But from a fundamental perspective, this will not derail the economic and stock market recoveries underway in China. Confirming Signals From The Equity Market Chart 4 shows that the relative performance of cyclicals versus defensives is improving in both China’s onshore and offshore markets, which suggests investors share our view that outbreak will subside to a Hubei-specific phenomenon, and that a longer-than-expected shutdown of the province is unlikely to threaten China's overall economic recovery. Chart 4Risk-On Sentiment Ticking Up Chart 5Auto And Tech Manufacturers Having Large Presence In Wuhan Importantly, supply chain disruptions due to a shutdown of Hubei’s production plants have not had significant spillover effects on industry performance in China’s equity markets. Hubei, and more specifically Wuhan-based manufacturers, is a manufacturing hub and key supplier in the automobile and electronic equipment industries (Chart 5). Despite the region’s significant manufacturing presence, Hubei-based manufacturers have relatively limited impact on the equity performance of their industry groups, both onshore and offshore: The stocks of Hubei-based automobile and tech companies have mostly been underperforming relative to their respective industries and the broad Chinese market. Nevertheless, these industries and their overall sectors have managed to outperform relative to the broad market, which indicates that the supply chain constraints have not spilled over to Chinese companies outside of Hubei. For example, Dongfeng Motor Co., a leading state-owned auto manufacturer located in Hubei, is a key supplier for Nissan and Honda. Dongfeng represents 6% of the automobile and components industry in the MSCI China Index. Chart 6 shows that while Dongfeng has been underperforming the industry and the broad market since the onset of the COVID-19 epidemic, performance in the auto industry relative to the broad market picked up last week when the number of new cases in the epidemic peaked. This suggests that supply-chain constraints are limited to Dongfeng and Hubei, and the downside risks in the automobile and components industry elsewhere in China are abating. Hubei-based tech companies account for 5% of the technology, hardware, and equipment industry group in China’s onshore equity market. Due to production cuts and transportation constraints, four of the five companies listed in the MSCI China onshore index have significantly underperformed both the industry and the broad market since the start of the COVID-19 epidemic (Chart 7). The only Hubei-based constituent in the sector that has had large gains is a company that produces thermal imaging systems, an equipment widely used in monitoring contagious diseases. But the company’s 1% weight in the industry equity group means the industry’s outperformance is mostly from gains in companies outside of Hubei. This suggests that despite disruptions inside Hubei, China’s domestic supply chains in the tech industry are relatively agile with manufacturers outside of Hubei stepping in to fill production shortages. Chart 6Supply Disruptions In Hubei's Auto Sector Not Affecting China's Overall Auto Industry Performance Chart 7Flexible Supply Chains In China Domestic Tech Industry Help Offset Production Shortages In Hubei Bottom Line: While it is too early to conclusively say that the risk of further contagion outside of Hubei has abated, we think the positive equity market performance over the past week is warranted. The negative impact of supply-chain disruptions in Hubei on China’s domestic overall equity market and industry performance has been minor. Hence, in the case of a prolonged region-wide lockdown, we think the broad financial market implications will not be significant. Investment Conclusions Chart 8Chinese Stocks Are Still Priced At A Deep Discount We maintain our bullish view on Chinese stocks, both in the near term and in the next 6-12 months. Despite regaining considerable ground in the past week, onshore and offshore equities are still priced at deep discounts (Chart 8). Cities and regions outside of the Hubei epicenter have partially resumed business activities this week. This, coupled with a reduction in the number of new cases, should further boost investors’ confidence in the recovery of China’s economy and risk assets. The reopening of businesses in Hubei could be delayed as late as the end of March. While this will have a devastating impact on the region’s economy and corporate profits, the spillover effects will most likely be contained within the region and not derail China’s economy. In addition, for now the resilience at both China’s industry and broad level equity performance appears to be outweighing the risk of a longer-than-announced shutdown. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Previously labeled as coronavirus or 2019-nCoV, the disease was officially named COVID-19 by the World Health Organization (WHO) on February 11, 2020. 2 We consider this an overestimate of the economic damage caused by the COVID-19 epidemic. Even though manufacturing activities can potentially grind to a halt, healthcare-related investment and consumption will likely skyrocket. 3 As of February 10, 2020, according to the MSCI. Cyclical Investment Stance Equity Sector Recommendations
Neutral In this Monday’s Weekly Report we lifted the hard-hit S&P hotels index to neutral from previously underweight and cemented gains of 20% since inception. Relative retail sales have rebounded over the past several months with discretionary sales reclaiming the upper hand signaling that it no longer pays to be bearish the S&P hotels index (top panel). At the same time, while overall PCE is decelerating, relative consumer outlays on hotels is picking up momentum (middle panel). Importantly, our S&P hotels EPS growth model that encapsulates all the key industry macro drivers is also arguing that relative profit growth is slated to turn the corner in the coming quarters. Bottom Line: Lift the S&P hotels index to neutral and lock in gains of 20% since inception. Please refer to Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG S5HOTL – MAR, CCL, HLT, RCL, NCLH.
Highlights Portfolio Strategy Receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Lift exposure to neutral. An historical parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Recent Changes Lock in gains of 20% and augment the S&P hotels index to neutral. Table 1 Feature Equities ripped higher last week as the coronavirus scare subsided, the Senate acquitted President Trump and the PBoC and the Fed sustained the liquidity injections. From a macro perspective, bond yields have served as a suspension for the SPX, absorbing the economic shock and catapulting the broad equity market to fresh all-time highs. The usual suspects, tech stocks, led the charge as lower interest rates equate to higher multiples. Keep in mind that the SPX is trading near an eighteen-year high on a forward P/E ratio basis (Chart 1). Such investor complacency is worrisome, especially given the persistently soft economic backdrop. Importantly, the latest GDP release revealed that net exports had the largest contribution to real output growth – trumping even PCE – on the back of a collapse in imports (second & third panels, Chart 2). Chart 1Flush Liquidity Chart 2Net Exports Jump Is A Yellow Flag In fact, the quarter-over-quarter plunge in real imports is the steepest since the GFC, and on a par with both the 9/11 induced recession in the early-2000s and the Savings & Loan recession in the early-1990s (top panel, Chart 3). Historically, when imports crest they are a precursor of recession (bottom panel, Chart 3). While this may be a one quarter blip in the data as a result of the trade war, we will continue to closely monitor the US trade balance. Meanwhile, consumer outlays are also decelerating, corroborating last quarter’s real imports collapse (bottom panel, Chart 2). If this pillar of economic strength gives way in the coming quarters, it will stoke up recession fears anew and vindicate the bond market’s message. Ultimately, what matters for stocks, aside from interest rates, is EPS growth. On that front, the Street continues to expect 10% profit growth for calendar 2020 which is a tall order according to our analysis in mid-January, warning that the SPX is still 8% overvalued as per our base case EPS and multiple scenario.1 Chart 3Imports Flashing Red Chart 4Sector Contribution To 2020 SPX EPS GrowthChart 4 shows the sector contribution to profit growth for this year. The tech sector sits atop the table and leads its peers by a wide margin (Table 2). Health care and financials occupy the second and third spots. While these rankings are more or less in line with the sector profit and market cap weights, what stands out is the delta between the market cap and earnings weights (Table 2). Table 2Sector EPS And Market Cap Weights According to this valuation proxy, real estate, tech and consumer discretionary sectors are the most expensive, while energy, health care and financials are the cheapest (Table 2). As a reminder we remain neutral tech, and underweight both real estate and consumer discretionary, and overweight all three undervalued sectors: energy, health care and financials. This week we book gains and lift to neutral a niche consumer discretionary sub sector that the coronavirus epidemic has badly bruised, and update our view on the largest communication services sub-group. Crystalize Gains And Upgrade Hotels To Neutral Google trends data shows that peak interest in the coronavirus was registered on January 26 in China, January 30 in the US and one day later globally (Chart 5). These trends may change in the coming weeks, but it appears that the initial fears and interest on the coronavirus are quickly subsiding, highlighting that the worst may likely be behind us with regard to fear mongering. Thus, we are compelled to lift the hard-hit S&P hotels index to neutral and cement gains of 20% since inception. While Chinese, global and US outputs will likely take a hit in Q1, subsequently recover in Q2 in the aftermath of the epidemic and only Q3 will come in as a clean quarter, the beating down of this niche consumer discretionary sub-group is overdone. Macro headwinds are turning into mild tailwinds. Last week the ISM non-manufacturing report rebounded smartly, and consumer confidence remains resilient. The implication is that it no longer pays to be bearish the S&P hotels index (top & middle panels, Chart 6). Tack on our vibrant industry demand indicator underscoring that the two-year bear market will likely go on hiatus (bottom panel, Chart 6). Chart 5Risks Receding Chart 6Upbeat Demand A number of other indicators we track send a similar message. Relative retail sales are rebounding with discretionary sales reclaiming the upper hand (top panel, Chart 7). While overall PCE is decelerating (bottom panel, Chart 2), relative consumer outlays on hotels is picking up momentum signaling that the bar for positive relative profit surprises is low (middle panel, Chart 7). Importantly, almost all of the negative coronavirus news flow is likely reflected in the roughly 25% forward P/E discount to the broad market that the index is changing hands at. If the coronavirus epidemic is petering out, then such undervaluation is no longer warranted (bottom panel, Chart 7). Importantly, our S&P hotels EPS growth model does an excellent job in encapsulating all these moving parts and is currently signaling that relative profit growth is slated to turn the corner in the coming quarters (Chart 8). Chart 7Grim News Is Priced In Chart 8Model Points To A Turnaround Netting it all out, receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Beyond the risk of a resurgence in the coronavirus epidemic, what prevents us from upgrading all the way to an above benchmark allocation is a challenging profit margin backdrop. Chart 9 highlights that not only are industry CEOs showing no restraint with respect to labor additions, but also lodging inflation is now contracting. Taken together, there are rising odds that the S&P hotels index may suffer from a profit margin squeeze (bottom panel, Chart 9). Netting it all out, receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Bottom Line: Lift the S&P hotels index to neutral and lock in gains of 20% since inception. The ticker symbols for the stocks in this index are: BLBG S5HOTL – MAR, CCL, HLT, RCL, NCLH. Chart 9Margin Squeeze Is A Risk Regulation Is Coming While most mega cap tech stocks had a better-than-expected Q4 earnings season, GOOGL and FB were left behind. We reiterate our underweight stance in the S&P interactive media & services index (we still consider them tech stocks) which serves as a great hedge to our overweight S&P software index. As a reminder we remain underweight this communications services subgroup on a cyclical basis, and since mid-December also on a secular ten-year time horizon.2 Regulation is a powerful force. President Trump is only slightly favored for reelection and there is bipartisan support to toughen anti-trust regulation, which his own Department of Justice has pursued. Republican Senator of Missouri Josh Hawley has spearheaded the assault on tech companies from the right wing, while leading Democratic presidential contenders represent the push from the left wing. Indeed, if the Democrats take power, they are likely to enact a federal privacy law following in the footsteps of California and the European Union. Such a law would face court battles but would ultimately have popular tailwinds: corporate protectionism, wealth inequality, and social demands for privacy across the political spectrum. Looking back to the early- and mid-twentieth century with regard to US government regulation aimed at protecting the consumer is instructive. What catches our attention are the Biologics Control Act, the Pure Food and Drug Act and the Toxic Substances Control Act. The first two acts affected the pharmaceutical and food industries and the third act the chemicals industry. While we do not have sector data dating back to the early 1900s, we have chemicals equity prices since 1958. The Toxic Substances Control Act of 1976 dealt a blow to chemical equity prices in absolute and relative terms (Chart 10). In fact, investments in chemical stocks were dead money for a whole decade until 1985 when they broke out in absolute terms and troughed in relative terms (Chart 10). New regulation will cast a shadow over the S&P interactive media & services index. This is true especially if a privacy law is passed, but even if it is postponed or shot down by the Supreme Court, companies will have to contend with a higher regulatory burden in order to comply with California’s and Europe’s privacy laws. Beyond the threat of privacy regulation protecting the consumer, the monopolistic power these companies exert will also come under the microscope. While we doubt the government will break up these two companies given their industry dominance, and the need to maintain international competitiveness,3 anti-monopoly probes clearly pose a big risk. This is true even under a GOP administration. During times of inequality, especially during recessions, governments will seek popularity by punishing scapegoats. The firms that are the chief beneficiaries of the business cycle will be the first in line for scrutiny. Keep in mind, Ronald Reagan’s Republican administration broke up “Ma Bell” into seven regional “Baby Bells” on January 1, 1984. Interestingly, AT&T also had the largest market capitalization in the S&P 500 in 1982. What concerns us the most is a forced sale of “crown jewel” assets as the result of a court ruling in an anti-monopoly suit. This would jeopardize the companies’ ecosystems. Imagine if Alphabet were forced to divest their Google Marketing Platform (old DoubleClick) and Google Ads, or YouTube or Google Cloud. Facebook could be forced to sell WhatsApp or Instagram. Chart 10Regulation Hurts Stocks Chart 11Risks Are Neither Reflected In Profit Estimates… All of these risks pose a threat to EPS growth and still sky-high industry profit margins. Importantly, relative profit growth is climbing at a 13% rate (middle panel, Chart 11) and coupled with the drubbing in 10-year Treasury yields, have pushed valuations to overshoot territory. As we went to print the S&P interactive media & services index was trading at a 34% forward P/E premium to the broad market (Chart 12). Similarly on a forward P/E/G ratio basis this industry is trading at roughly a 30% premium to the SPX (bottom panel, Chart 12). In sum, an historical regulatory parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Over the past year profit margins have been narrowing as costs have been creeping up for the industry, but are still more than twice the level of SPX margins (second panel, Chart 13). If federal regulation puts a price on consumer data in the coming years, especially through direct legislation, then this added cost will squeeze industry profit margins and dent profitability. Chart 12…Nor In Pricey Valuations Chart 13Margin Compression Looms The chief constraint on US government regulation is the desire to maintain international competitiveness in a world of great power competition, in which US rivals attempt to promote their own tech companies globally. However, neither colonialism nor the Cold War stopped earlier anti-monopoly crusades. Politicians primarily court domestic constituencies with such pursuits. Regulators would have to set the terms of any breakup with various interests in balance, but the point is that even a limited breakup that does not mortally wound the company would still come as a negative shock at first. In sum, an historical regulatory parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Bottom Line: Stay underweight S&P interactive media & services index both on a cyclical and structural ten-year time horizon. The ticker symbols for the stocks in this index are: BLBG S5INMS – GOOGL, GOOG, FB, TWTR. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com.\ 2 Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For the Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 3 Please see BCA US Equity Strategy Special Report, “Is The Stock Rally Long In The FAANG?” dated August 1, 2018, and Geopolitical Strategy Special Report, “Surviving A Breakup: The Investor's Guide To Monopoly-Busting In America,” dated March 20, 2019, available at uses.bcaresearch.com and gps.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights The coronavirus is a real threat for the global economy and financial markets: We expect that the epidemic will be contained before it takes too much of a bite out of global output, but it has become the biggest market wild card. We are watching for a peak in new infections as a tell for when markets may move on from it. Earnings season was once again a ho-hum affair: S&P 500 earnings per share are on track to post 2% growth in 4Q19, about three percentage points above downwardly revised estimates. Profit margin contraction was in line with the previous three quarters. The biggest banks don’t see any immediate signs of credit problems, … : Net charge-off and non-performing loan ratios remain very low and the banks don’t see borrower performance worsening any time soon. … and think an uptick in business confidence is overdue: The banks’ calls occurred before the coronavirus broke out, but every management team saw the easing of trade tensions as a prelude to a pickup in corporate confidence. While We Were Out Chart 1Risk Off, Everywhere But Stocks We last published a Weekly Report on January 6th, and the ensuing five weeks have been anything but boring. The US assassinated Iran’s foremost military leader, escalating the two nations’ conflict; and the coronavirus burst forth in China’s ninth-largest city, sparking worldwide concerns. The VIX awakened, Treasury yields slid, crude oil swooned and the dollar surged, but the S&P 500 only declined 3% trough to peak, and now sits 2-3% above its January 6th close (Chart 1). The coronavirus is a significant threat to the global economy and global markets, and geopolitical tensions have escalated, but the underpinning of our market views has not changed. We continue to view monetary policy as the critical swing factor for financial markets and the macro cycles that influence them. Assuming the coronavirus or another exogenous event does not tip over the US economy, the next recession will not begin until monetary policy settings turn restrictive. Nothing that has happened since the beginning of year has changed our view that the Fed is almost certain not to hike rates before its November meeting, and we think it is unlikely that it will do so at all in 2020. As long as monetary policy remains accommodative, the economy will keep expanding, the equity bull market will roll on, and spread product will continue to generate excess returns over Treasuries and cash. When China Gets Locked Down It has long been said that when the US sneezes, the rest of the world catches a cold. Conversely, challenges in the rest of the world often fail to leave much of a mark on the US. Should US investors really be that concerned about a virus outbreak in China? The answer is yes, despite the S&P 500’s surge last week. There is no such thing as full-on decoupling, even for the US. The US may respond to global events with a longer lag than more export-oriented economies, but they eventually have an impact. Investors should bear in mind that the S&P 500 is considerably more attuned to global conditions than the domestic economy, given that more than a third of its revenues come from abroad. The coronavirus outbreak has turned into the main source of market uncertainty and is the largest risk to our bullish view on global growth and risk assets. For now, our base case is that the global growth recovery will be delayed, though we expect growth will pick up later this year, provided that the outbreak begins to recede by the end of March. That base case is heavily data-dependent, however, subject to the disease’s course and the Chinese government’s response. From a market perspective, tracking the number of new infections may provide a window on investor sentiment. In 2003, the bottom in equities coincided with the peak in the number of new SARS infections (Chart 2). However, a direct analogy between 2003 and 2020 may underplay the impact on growth. China exerts a lot more influence on the global economy than it did at the turn of the millennium (Table 1). A turn in investor sentiment may not be enough to support risk assets in the face of a significant growth headwind. Chart 2Infections Peak, Market Troughs Table 1China’s Importance Now And In 2003 Since it entered the World Trade Organization in 2001, China has grown from being the sixth-largest economy to the second, trailing only the US. It now accounts for 16% of global GDP in dollar terms. Its total imports of goods and services – the main growth transmission mechanism from China to the rest of the world – currently account for 13.5% of global trade, three times its 2002 share. The scale of the Chinese government response is also very different. While the SARS epidemic caused relatively mild disruptions to the travel and retail sectors, quarantines have put some areas in total lockdown, placing meaningful elements of the country’s overall production on indefinite hold. That’s bad enough from a domestic perspective, but it could swiftly lead to a sharp reduction in global manufacturing output if it derails global supply chains that depend on Chinese-produced components. Last week, Hyundai idled a production line in South Korea for lack of essential China-sourced parts, and Fiat Chrysler has warned that it might have to close a European factory in two to four weeks if critical Chinese suppliers are not able to operate. China exerts considerably more influence on the global economy today than it did in 2003. Extended quarantines will have a readily observable impact. Chart 3Services Now Account For A Majority Of Chinese Output Moreover, this time around the outbreak coincided with the Lunar New Year celebration, when spending on services is usually elevated. Services engender less pent-up demand than durable goods; while demand for durables may merely be deferred until the epidemic is contained, demand for services is much more likely to be destroyed. Nonmanufacturing sectors’ increasing importance in the Chinese economy (Chart 3) implies that relative to 2003, less "lost" spending will be made up later. Using SARS’ impact on Chinese GDP to support a back-of-the-envelope estimate, our Global Investment Strategy colleagues judge that the coronavirus could zero out Chinese growth in the first quarter. Our Global Fixed Income Strategy service estimates that major country sovereign bonds are pricing in two months of lost Chinese growth. The prospect of a stagnant two to three months could well force policymakers to focus exclusively on encouraging growth. They have already signaled they will pull forward some scheduled infrastructure investments, and our China strategists note that 2020 is policymakers’ deadline for meeting their target to double GDP over the decade. Bottom Line: The coronavirus outbreak is a serious threat to the global economy and financial markets, but we do not expect that it will induce a US recession or S&P 500 bear market. The Same Old Earnings Song-And-Dance Chart 4A Typical Quarter With 305 of the companies in the S&P 500 having reported earnings through last Thursday’s open, the fourth quarter appears to be nearly exactly like the first three quarters. Earnings growth was nothing to write home about, but it’s tracking to be a few percentage points better than expected when the big banks kicked off reporting season (Chart 4). Revenue growth continues to be in step with nominal global GDP growth, but profit margins are contracting at about the same rate that they did in the first three quarters (Chart 5). The source of the margin contraction remains a mystery, and unraveling it is near the top of our research to-do list. Chart 5The Incredible Shrinking Profit Margin Earnings don't matter much in the near term, but they've been good enough to allay the undercurrent of worry that was a prominent feature of the equity market all of last year. We have previously written about earnings’ limited effect on equity prices.1 In the near term, moves in the S&P 500 exhibit little to no correlation with either earnings growth or the magnitude of earnings beats. Earnings do matter in the long term, and the uneventful 4Q19 reports at least suggest that stocks give no indication of falling off their currently projected path. As has been the case throughout 2019, the bears’ worst fears failed to come to pass in the fourth quarter. Once the coronavirus is contained, accommodative monetary conditions should help keep them at bay in 2020, as well. Follow The Money The big banks reported their fourth quarter earnings in mid-January, and the market reaction suggested their torrid fourth quarter run has fully played out, at least until long yields perk up again. Our review of their earnings calls is not meant to tell us anything about bank stocks, however. We review the calls to gain some insight into the lending market and where it might be headed, seeking color on banks’ willingness to lend, consumers’ and businesses’ appetite for credit, borrower performance, and the banks’ bottom-up perspective on the economy. This time around, we also wanted to hear if the brand-new CECL (Current Expected Credit Loss) loan-loss provisioning standard could constrain lending. 4Q19 Big Bank Beige Book As a group, the banks were constructive on the economy.2 They agree that the consumer is in fine fettle, and they see signs that corporate confidence is returning as trade tensions recede. Overall loan growth has dipped to 4% on a year-over-year basis (Chart 6), while corporate and industrial (C&I) loan growth has contracted on a thirteen-week basis (Chart 7). The C&I contraction is not a sign that corporations are circling the wagons, however, it’s simply that they’ve turned to the corporate bond market instead (Chart 8). Businesses seeking credit generally have access to all they want at tight spreads, given the paucity of yield in the ZIRP/NIRP era. Chart 6Overall Bank Lending Is Decelerating, ... Chart 7... And C&I Lending Is Contracting, ... Chart 8... But The Bond Market Is Capable Of Picking Up The Slack Positive operating leverage was a mantra that all of the management teams recited. Branch footprints are being rationalized, and the biggest banks are successfully automating manual tasks and driving mundane activity to websites and apps and away from branches and ATMs. Shrinking branch counts could intensify the pressure at the margin for retail landlords, and automation could squeeze bank head counts. Every bank grew deposits faster than loans, furnishing them with dry powder for future lending, and padding their holdings of Treasury and agency securities in the meantime. Households And Businesses [S]entiment on the corporate side appears to be looking better. We’re going to be signing [the Phase I] trade agreement with China today, … and the US-Mexico-Canada agreement is well on its way. So I think that some of that uncertainty that might have been impacting discretionary spend on the commercial side of the equation has been alleviated. [W]e feel pretty good. (Dolan, USB CFO) Every bank cited trade tensions as a drag on corporate confidence last year, and pointed to USMCA and the Phase 1 agreement with China as a sign that it will rebound. [T]he US consumer remains in very strong shape, … from a credit perspective, sentiment, [and] spending, [and] obviously [the] labor market is very strong[.] [C]apital spending is still a bit soft, but sentiment is … certainly better than it was six months ago. [B]roadly speaking, [we have a] constructive outlook as we’re heading into 2020[.] (Piepszak, JPM CFO) [T]hroughout the year, we saw … a lot of things out there that [were] driving uncertainty, be it the lack of the China trade deal, USMCA, Brexit, Hong Kong and … now … the horizon looks like some of those things may clear[,] … and we [may] get a bit more action out of the C-suite. [T]he [capital markets] backlog looks pretty good[,] … [a]nd the forward calendar [does, too]. (Corbat, C CEO) [C]ustomers [in our consumer business] are coming off a strong [spending] finish in 2019. In addition, there’s good loan demand, … result[ing] from good employment levels and growing wages. We saw solid loan demand in our commercial client base throughout the year, [though it] moderated in the second half of the year as worries about global economic uncertainty … dragged on. Today we see some resolution of those issues and that combined with continued consumer strength leads us to expect to see businesses continue their solid activity and we’re hearing more optimism. All this provides a great backdrop[.] (Moynihan, BAC CEO) Borrower Performance Overall credit quality indicators in our commercial portfolio remained strong with our fourth quarter internal credit grades at their strongest levels in two years. Non-accrual loans … in the fourth quarter [were at] their lowest level in over ten years. (Shrewsberry, WFC CFO) [Credit quality metrics] show … that asset quality remained strong in [consumer and commercial] categories. (Donofrio, BAC CFO) [C]redit quality was stable in the fourth quarter. … The ratio of non-performing assets … improved linked quarter and year-over-year. (Dolan, USB) [CLO is] still an asset class that we feel comfortable with the risk/reward … in spite of where we are in the cycle[.] (Shrewsberry, WFC) [There’s nothing] we’re overly concerned about [in our own loan portfolio], given how [conservatively] we manage [lending], but we’re certainly paying attention to leveraged lending. We’re certainly paying attention to energy with respect to natural gas prices, we’re certainly looking at retail … malls. (Donofrio, BAC) CECL Impacts We would expect provisions to be a little higher than net charge-offs in 2020 due to CECL. … All else equal, [the new increased provision] would lower our Common Equity Tier 1 capital ratio by roughly 20 basis points[, but we have a sizable capital buffer, and the capital charge] is phased in … evenly through 2023. (Donofrio, BAC CFO) [I]t’s fair to say, under CECL, [that] you could have incremental volatility [of provisioning expenses]. [But] incremental volatility would [not] be material for us. … It’s just timing [of expense recognition, not any increase in expenses.] (Piepszak, JPM) [A]t this point, it’s not likely that [CECL would] change our appetite for longer-duration consumer loans[.] … [I]t hasn’t caused anything to drop below a hurdle level that says to us, we need to either meaningfully reprice it or … [consider] whether [we want to be] in the business. (Shrewsberry, WFC) Investment Implications Chart 9US Data Have Also Weighed On Yields The coronavirus outbreak is a serious threat, but its very seriousness is likely to provoke Chinese policy responses that may better ensure a turnaround once it can be brought under control. Our view is subject to the real-time course of events on the ground, but our base case is that the business cycle and the bull markets in risk assets remain intact, even if they may sputter here and there until the epidemic is brought to heel. While we acknowledge that economic data have been spotty, and the decline in Treasury yields has not solely been a function of coronavirus fears (Chart 9), we think that yields are near the bottom of their likely 2020 range and have more scope to rise than fall from current levels. We continue to recommend below-benchmark duration positioning. We also continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond portfolios. We would relish the chance to buy an S&P 500 dip to 3,000 if it were to occur when the coronavirus threat appeared to be manageable. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst JenniferL@bcaresearch.com Footnotes 1 Please see the November 11, 2019 US Investment Strategy Weekly Report, "Why Bother With Earnings?" available at usis.bcaresearch.com. 2 The calls were all held before the coronavirus outbreak.
Underweight This week we downgraded exposure to below benchmark in the S&P tech hardware, storage & peripherals (THS&P) index. Undoubtedly, relative share prices are extremely extended. The second panel of the chart shows that the relative share price ratio is at the highest level as a percentage of its 200-day moving average since the late-1990s. Shown as a z-score, this technical indicator is stretched to the tune of two standard deviations above the historical mean (third panel). The last three times technical conditions were so overbought, it marked a multi-year peak in relative performance (top panel). Meanwhile, as we pointed out in the most recent Weekly Report, profit fundamentals are waning, warning that trouble is brewing for the S&P THS&P index. Bottom Line: Trim the S&P tech hardware, storage & peripherals index to underweight. The ticker symbols for the stocks in this index are: BLBG S5CMPE – AAPL, HPQ, WDC, HPE, STX, NTAP, XRX.
Underweight The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. China macro dominates the direction of US chemical equities. Chinese authorities continue to ease monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel). The Australian currency, which is hyper-sensitive to China’s growth, further corroborates that Chinese economic activity remains soft (second panel). Simultaneously, the resilient US dollar will continue to weigh on the competitiveness of US chemical exporters (bottom panel). Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS.
Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them. At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure. Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
While Tesla (TSLA) is not part of the SPX yet, it is one of the ten constituents comprising BCA’s Millennial Basket. When we initiated this trade on June 11, 2018 we recommended an equally-weighted basket of stocks. On our December 16, 2019 Special Report titled "Top US Sector Investment Ideas For The Next Decade" we also recommended BCA’s Millennial Basket on a secular ten year view basis, predicated upon the Millennials spending theme. In absolute terms this trade is up 48%, and 25% compared with the broad market, since inception. While earnings fundamentals have not changed over the past six weeks and we reiterate our structural and cyclical overweight view, the recent TSLA action compels us to rebalance this portfolio back to equal weight and protect profits. Bottom Line: Longer-term oriented investors should continue to overweight BCA’s Millennial Basket. The ticker symbols in this equity basket are: AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, and V.
On Monday, BCA's US Equity Strategy service downgraded the S&P tech hardware, storage & peripherals index citing overbought technical conditions and weak operating metrics. Undoubtedly, relative share prices are extremely extended. The last three…