Sectors

The S&P hotels index is breaking down. The era of cheap financing costs spurred a multiyear lodging industry construction binge, creating a backlog of new capacity likely to hit markets for some time to come. In the interim, there is evidence that slowing economic growth is starting to undermine revenue. Global revenue per room is contracting, even prior to much of a slowdown in traffic. The implication is that pricing power is being sacrificed to fill rooms. Looking ahead, leading indicators of consumer spending on lodging are pointing to a marked slowdown, consistent with our expectation that corporate sector travel budgets will also be pruned as profit margins get squeezed. We downgraded this overvalued group at the end of last year, and reiterate our underweight stance. The ticker symbols for the stocks in this index are: CCL, MAR, RCL, HOT, WYN.

An improvement in the euro area credit impulse is encouraging, but we explain why it is not enough to sustainably boost risk-assets.

A recent article in Barron's painted a bright picture for bank stocks, but we have a more cautious view. While value is attractive, the earnings picture has darkened. The narrowing yield curve and budding downturn in credit quality will put pressure on credit creation to drive profitability. However, we are skeptical that loan growth will improve much. The latest Fed Senior Loan Officer survey showed that banks continue to tighten standards on both C&I and commercial real estate loans. While they remain willing to make consumer and mortgage loans, demand for a number of these categories is drying up. Against a backdrop of increased credit stress and rising corporate bank bond spreads, loan loss reserves are likely to accelerate, warning that low valuations are likely to persist. We recommend only a market neutral weighting. The ticker symbols for the stocks in this index are: BAC, BBT, C, CFG, CMA, FITB, HBAN, JPM, KEY, MTB, PBCT, PNC, RF, STI, USB, WFC, ZION.

Spread product performance has been foreshadowing changes in market rate hike expectations since early last year, and the recent bout of weakness means it is probably time for the Fed to temper its hawkishness.

The current profit backdrop for the machinery industry is grim, but the relative price ratio has already made a large downward adjustment and short interest is sky high. Importantly, machinery companies are finally addressing the need to reinvigorate productivity as an offset to the competitive drag from a strong exchange rate. Importantly, history underscores the likelihood of at least a temporary hiatus in the bear market. Going back to the 1950s, we have identified five durable machinery relative performance bear markets. On average, they lasted 42 months and recorded 44% in declines from peak to trough. In comparison, the current downturn has been underway since 2011, with the price ratio shedding 36%. Interestingly, a cycle-on-cycle analysis shows that machinery stocks have troughed prior to any turnaround in either the ISM index or the U.S. leading economic indicator. Instead, the group appears to have taken its cue from U.S. dollar weakness and a rally in commodity prices, both of which herald better times ahead for primary machinery end markets. Consequently, continued economic deterioration may not translate into additional relative underperformance. We upgraded to neutral in yesterday's Weekly Report, protecting a profit of 19%. The ticker symbols for the stocks in this index are: CAT, ITW, DE, PCAR, CMI, SWK, IR, PH, SNA, DOV, PNR, XYL, FLS.

The oversold bounce is not supported by policy or profits, and should be treated as countertrend. Lift machinery to neutral and differentiate between pharmaceuticals and the unwinding of the biotech mania.

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.

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.