Sectors
Industrials stocks have been coming out of their funk lately, on the back of a selloff in the U.S. dollar, easing in financials stress, a tentative trough in the commodity hemorrhaging, and a relative calm in China and the emerging markets. We upgraded industrials to a benchmark allocation in mid-February as the brutal sell off in deep cyclicals was due for a breather courtesy of continued U.S. dollar weakness. We expect the relative share price ratio to be range bound in the coming months. The latest ISM manufacturing survey showed some glimmers of hope, but it remains below the 50 boom/bust line. The new orders survey sub-component ticked higher, however the mean reversion in industrials profit margins is well underway, and the path of least resistance remains lower (third panel). Bottom Line: While we are not calling for an imminent resurgence in global manufacturing or business investment, an easing in the U.S. dollar has the potential to cause a meaningful re-rating in overly depressed industrials profit expectations and relative valuations (not shown). We reiterate our recent upgrade to neutral.
The recent rebound is not a harbinger of a prolonged recovery in risk assets. The many potential negatives will keep volatility high and trigger further occasional selloffs.
Return on equity (ROE) has clearly peaked for the cycle (top panel). In fact, S&P 500 ROE topped out in 1999 and has shown a pattern of descending cyclical tops since then. Employing the DuPont framework, ROE is declining because of falling asset turnover and decreasing margins, despite rising leverage. In more detail, the structural decline in asset turnover (second panel) reflects deteriorating corporate efficiency - owing to weak productivity growth - since asset turnover measures the amount of revenue generated per dollar of assets. Profit margins have clearly peaked for the cycle (third panel), and downward pressures are intensifying. In a deflationary world rife with excess capacity, pricing power is deteriorating for the majority of U.S. companies, at a time when wages continue to rise, albeit slowly. Importantly, ROE is declining despite rising financial leverage. It made sense for companies to leverage up over the past few years given the low after-tax, real cost of debt. Unfortunately, most of this debt was used for short-term purposes such as stock buybacks and M&A, rather than long-term investment to improve productivity and ROE. Moreover, the capacity of rising debt levels to increase ROE has reached its limit. Bottom Line: All three trends raise the risk profile of U.S. equities. Please see yesterday's Special Report for additional details.
The risk to ROE remains to the downside, which suggests that valuation multiples have peaked for the cycle. Beyond a potentially violent near-term counter-trend bounce, valuation multiples will remain under pressure.
The risk to ROE remains to the downside, which suggests that valuation multiples have peaked for the cycle. Beyond a potentially violent near-term counter-trend bounce, valuation multiples will remain under pressure.
The retail drug store industry is enjoying a twin boost from both bullish cyclical and secular forces. The latter is reflected in the long-term advance in personal outlays at pharmacies, which likely reflects increased drug demand as a consequence of an aging population. From a cyclical perspective, the surge in health care sector hiring activity reflects increased health coverage and rising patient volumes. That is a boon for drug demand, and is consistent with rising store traffic. As a result, pharmacies should be able to continue lifting selling prices at a rapid clip, despite deep deflation in the overall corporate sector. The upshot is ongoing productivity gains, as measured by sales/employee, should support robust earnings performance and a relative valuation re-rating. Stay with a high-conviction overweight. The ticker symbols for the stocks in this index are: WBA, CVS.
The previous Insight outlined the case for good building supply store sales growth, but an aggressive rise in wage inflation and intensifying deflation pressures may provide a negative offset. Meanwhile, the gap between house price inflation and mortgage rates has slipped below zero (second panel), suggesting that the financial incentive to buy and renovate a home has eased, on the margin. It is notable the retailing CEO confidence has taken a sharp turn for the worse in recent months, as this series often provides a good lead on industry sales trends. Souring confidence may reflect deflationary pressures. Importantly, our Home Improvement Retail model, which incorporates leading top and bottom line indicators, has not confirmed the advance in relative share performance into overvalued territory. Against this backdrop, we recommend only a market neutral weight. The ticker symbols for the stocks in this index are: HD, LOW.
Both Home Depot and Lowe's produced strong profit results in the most recent quarter, aided by a warm winter weather, which pulled forward sales of many products. The odds of the industry maintaining decent sales momentum are good, given that ultra-low mortgage rates should sustain housing turnover (second panel). Banks are still willing to extend mortgage credit, as rising house prices provide confidence in underlying asset values. Nevertheless, extrapolating future store traffic growth straight down to the bottom line risks being too optimistic. The industry has hired aggressively to meet rising demand, and deflation still plagues the industry (bottom panel). Deflation amidst good store traffic also suggests that a serious market share battle is raging, which means meeting this year's aggressive industry earnings growth estimates is not guaranteed, please see the next Insight. The ticker symbols for the stocks in this index are: HD, LOW.
As world central banks increasingly shift toward negative interest rate policies to combat deleveraging and deflation, the search for yield in financial markets is likely to persist. Global bond yields continue to grind lower, which is raising the allure of income producing equities. Indeed, an Insight on February 9, showed that equity market fixed-income proxies surged in the aftermath of the ECB's decision to implement negative deposit rates. More recently, REITs in the euro area and Japan have soared anew, reflecting this powerful undercurrent of demand for stable cash flow producers. As such, we expect sell-offs in the S&P REIT index to prove transitory, and reflective of short-term swings in risk-on vs. risk-off assets rather than a fundamental change in investor appetite or REIT prospects, please see the next Insight.
The previous Insight showed that REITs in other parts of the world are outperforming smartly, but lagging in the U.S. We expect a re-convergence. Already a yawning gap has opened between REITs and Treasury yields (shown inverted). That is not sustainable, especially in view of positive underlying cash flow fundamentals. Our proxy for the REIT occupancy rate is still trending higher (third panel), supporting good growth in REIT pricing power proxies. Importantly, pipeline supply pressures look set to ease, based on the downturn in multifamily home construction. All of this points to decent cash flow growth prospects. Against a backdrop of still attractive value in a world starved for yield, we continue to recommend an overweight portfolio position in the defensive S&P REIT index.