Sectors
At current levels, Treasury yields are consistent with our assessment of fair value. Further, the Fed's Labor Market Conditions Index does not suggest an imminent recession. Expect payrolls to stabilize above levels consistent with further progress on wage growth and inflation, allowing the Fed to hike rates later this year.
For now, maintain a benchmark duration stance leading into the June 23 U.K. Brexit vote, favoring Treasuries and (especially) Gilts over Bunds and JGBs.
Risk assets will take their cues more from the dollar than the Fed if the euro rises above its 16-month range against the dollar. Retain exposure to energy equities and gold.
This week's report discusses whether bad news is good news for stocks, or a potential restraint. Tumbling long-term yields argue for augmenting consumer discretionary sector weightings, <i>via</i> the movies & entertainment group.
The S&P technology sector has been drifting lower in relative performance terms, which is notable given that the broad market has made a charge toward the top end of its trading range. The lack of leadership from this traditionally high beta sector reflects ongoing deterioration in earnings drivers. The San Francisco Fed's Tech Pulse Index, a coincident indicator of tech sector activity including employment, output and shipments, has rolled over after a multiyear expansion. Additional downside is probable, given that tech new orders have slipped into the contraction zone on the back of the nascent retrenchment in corporate sector capital spending and relentless contraction in emerging market exports (bottom panel). Technical conditions are warning that the downturn in relative performance is the start of a sustained bear market. Our Technical Indicator has declined into the sell zone after diverging negatively from the share price ratio. Breadth is thin, as far less than half of the sub-industry groups are trading above their 40-week moving average, in relative terms, and/or with a positive 52-week rate of change. The bottom line is that an underweight stance is the best way to protect portfolios from looming underperformance.
Underweight Following up on yesterday's cautious Insight on the overall financials sector, the heavyweight bank sub-component looks precariously positioned. The latest FDIC Quarterly Banking Profile made for grim reading. Credit losses are on the rise and loan-loss provisions are following suit. Worrisomely, noncurrent C&I loans (the largest bank loan category) spiked to the highest level since 1987, on the back of souring energy-related loans. Historically, relative performance and the noncurrent C&I loan rate have been inversely correlated. The current message is to expect additional bank selling pressure as investors discount the profit drag from faltering credit (top panel). Moreover, the loan loss coverage ratio declined for the first time since 2012 (not shown), as provisions outpaced charge-offs, reinforcing that the credit quality cycle is deteriorating. Given that the labor market is showing signs of softness, non-performing loans are likely to accelerate in the coming quarters (middle panel). Meanwhile, both return on assets and on equity have crested for the cycle and nudged lower last quarter (bottom panel). Risks are skewed to the downside, and we continue to recommend underweight positions. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.
What is liquidity? How is it created and destroyed? And when does it trigger turning-points in financial markets?
The brief bout of relative strength in financial stocks has proven fleeting, as rate hike expectations have been dashed by weakening U.S. employment. Whether the Fed hikes now or later, sluggish domestic growth is sustaining downward pressure on the terminal Fed funds rate, which limits how much interest rate relief investors can ultimately discount. Importantly, deflationary pressures undermining financial sector relative profit performance are a global phenomenon. Global financial stocks led U.S. financials lower at the peak in 2015, and continue to diverge negatively from domestic share prices. That is an ominous sign for a sector that has been struggling to generate positive productivity growth in recent quarters, as proxied by financial sector sales/employment. Now that leading indicators of credit quality and corporate loan demand are deteriorating, it will become even more challenging to generate above-market profit growth. We continue to recommend a below-benchmark financial sector allocation, with our sub-surface exposure focused on the defensive REIT and Insurance groups.
Overweight Our early-May upgrade of the S&P agricultural chemical index proved timely, as Bayer launched a bid for Monsanto, sending the index up sharply. It is tempting to book gains, but if underlying profit drivers continue to move in a bullish direction, share prices should have further to go before extreme bearishness will normalize. Raw food prices continue to grind higher, and are likely to receive an assist from a weaker U.S. dollar now that the market is pushing out the imminence of future Fed rate hikes. The world grain stock-to-use ratio is still well below average, despite soft demand in recent years, and could fall further given the production decline. That is supportive of food prices, and should help farm incomes stabilize and boost credit availability. As shown in the May 9th Weekly Report, farm cash rents were already off their lows, a positive sign for underlying property valuations and a critical factor determining capital availability. It wouldn't take much of an increase in fertilizer demand to overcome depressed relative forward earnings expectations. We recommend staying overweight, despite the 12% gains that have accrued in such a short time span. The ticker symbols for the stocks in this index are: BLBG: S5FERT - MON, MOS, CF, FMC.
In this <i>Special Report</i>, we revisit our list of signpost economic indicators introduced two years ago to identify if the U.S. and Euro Area were falling into a "Secular Stagnation".