Sectors

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.

Yesterday's Weekly Report showed a table of sector operating margins relative to their long-term average, as well as price/sales ratios. Expensive sectors with above average margins appear particularly vulnerable in an environment where overall margins are being squeezed and economic risks are mounting. The consumer discretionary sector stands out as having significant profit margin and valuation downside. The policy backdrop is also turning more hostile. History shows that this sector outperforms when interest rates are falling and/or low, and underperforms when they climb and credit becomes more restrictive. This correlation is evident in the correlation between relative performance and money supply. When the cost of credit is low and liquidity is plentiful, investors discount increased discretionary consumer spending, particularly on durables, and bid stocks up accordingly. The opposite is also true. Currently, money growth is plunging, although remains in positive territory for the time being, suggesting that credit creation is slowing. Importantly, the longer that financial markets stay turbulent, the greater the upward pressure on the personal savings rate and likelihood that discretionary spending is reined in. Even then, a consumption contraction is not a prerequisite for consumer discretionary underperformance. With the Fed determined to keep pushing up interest rates, the macro backdrop is bearish for discretionary stocks.

Equity selloff alone will not catch the Fed's eye unless there is an outright crash.

An oversold bounce may be getting underway, but without a policy assist, it would be a rally to sell. Go to neutral in the growth vs. value trade and beware sub-surface weakness in the consumer discretionary sector.

The previous Insight showed that S&P pharmaceutical index outperformance is well supported by both endogenous and exogenous forces. The same is not true for the riskier biotech space. As discussed in previous research, biotech stocks have exhibited all of the characteristics of a mania. Now the forces that propelled the group higher are working in reverse. Speculation is rapidly being reined in, warning that the flows into biotech stocks are drying up. Margin debt has crested, reinforcing that the high-octane fuel to support momentum stocks is starting to evaporate. Biotech IPOs are going from feast to famine: if share prices continue to fall, expected returns will follow suit, warning against expecting further capital inflows. Consequently, we expect biotech stocks to remain on the mania track, which has not entered the bubble-bursting phase (top panel).

Pharmaceutical stocks have broken from their correlation with biotech stocks, and we expected this divergence to be sustained. Pharmaceutical profits remain one of the few bright spots within the corporate sector. Drug demand continues to boom, as measured by consumer spending data. Inventories have moved higher at both the wholesale and manufacturing level, but this appears to reflect demand-driven stocking of product, given ongoing strong pricing power gains. In a deflationary world, the ability to significantly lift selling prices warrants a premium valuation. Yet the S&P pharmaceuticals index still trades at a large discount to its historic average relative valuation. If domestic economic disappointment mounts, as we expect, it will provide another catalyst for a relative performance re-rating. Stay overweight the S&P pharmaceuticals index. Importantly, it will be important to differentiate pharma from biotech, please see the next Insight.