Economy

Highlights Portfolio Strategy Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Stay on the sidelines on cyclicals versus defensives. While the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon. Recent Changes There are no changes to our portfolio this week. Table 1 Feature The SPX shrugged off the persistently negative coronavirus epidemic news and made fresh all-time highs last week (top panel, Chart 1). Domestic flush liquidity remains the dominant macro theme coupled with the expectation of a sizable fiscal and monetary easing out of China in the coming months. Importantly, according to the CME there is a 60% chance of a Fed interest rate cut priced in for the July 29, 2020 FOMC meeting which jumps to over 80% probability for the December 16, 2020 meeting. This is sustaining downward pressure on the 10-year Treasury yield, which in turn is boosting equities. A glum JOLTS report along with the 12-month fed funds rate discounter corroborate that additional Fed easing is likely nearing (middle & bottom panels, Chart 1). Chart 1Is A Fed Interest Rate Cut Looming? Chart 2Unsustainable Rise In “Tenuous Trio” The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently. Nevertheless, beneath the surface trouble is brewing. Chart 2 shows three asset classes rising concurrently. The “tenuous trio” as we have called stocks, Treasurys and the greenback in the past, cannot rise in tandem. When all three asset prices appreciate, it typically foreshadows equity market trouble. In this particular iteration, even the VIX is up for the year, representing a big break in historical correlations. Worrisomely, since 2018 every time the VIX and the SPX became positively correlated, the broad market subsequently suffered a setback (Chart 3).  While the SPX is making all-time highs, the VIX is neither making all-time lows nor cyclical lows. Importantly, equity market volatility is staying stubbornly close to 15, slightly below the ten-year average. As a reminder, a “VIX reading of 15 means that in 30 days the S&P 500 is expected to trade between 4.3% lower and 4.3% higher than its current level”.1 Chart 3Watch Out For Vol The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently.2 Chart 4 shows the percentage of GICS2 sectors with negative two-year relative share price momentum. The higher this diffusion rises the fewer the sectors that drive the SPX’s return. Historically, when our diffusion hits the 70% mark, it signals exhaustion in equity market returns. In fact, 70% readings in this diffusion indicator led both the 2000 and 2007 peaks in the SPX. Chart 4Heed The Diffusion Index’s Message This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Meanwhile on the economic front, the JOLTS report made for grim reading. Labor market softness was evident across the board and it was not squarely concentrated in the manufacturing sector. While this indicator only goes back two cycles, it is flashing yellow for the prospects of the broad equity market (top panel, Chart 5). Importantly, we will continue to monitor the job openings numbers as they are sending the exact opposite signal compared with unemployment insurance claims (job openings shown inverted, middle & bottom panels, Chart 5).  This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Chart 5Avoid Getting JOLTed Mixed Signals We have been neutral the cyclicals/defensives ratio for the past 8 months and continue to recommend investors stay on the sidelines for a while longer. It has been particularly difficult to distinguish a clear signal from noise lately for the cyclicals versus defensives ratio. Relevant macro drivers, operating metrics and profit fundamentals, valuations and technicals all have been emitting conflicting messages and the recent coronavirus epidemic will likely make the waters murkier still. US Equity Strategy’s Global Trade Activity Indicator has turned south recently following in the footsteps of the Chinese manufacturing PMI data that ticked down and are slated to drop below the boom/bust line in the current month (top & bottom panels, Chart 6). The bond market also reflects a gloomy global economic backdrop with the global 10-year Treasury yield sinking like a stone. Such a lackluster bond market will likely weigh on relative share prices (middle panel, Chart 6). CEOs remain a depressed bunch and it is all but certain that for, at least, the next three months executives will put capex plans on the backburner. Basic resources are most at risk and keep in mind that relative capex growth was already decelerating prior to the coronavirus epidemic (top & second panels, Chart 7). Chart 6Trade Uncertainty… Chart 7… And Capex Softness Weighs On Cyclicals A soft sales backdrop coupled with inventory accumulation are firing a warning shot. Relative share prices will likely succumb to the still weak total business sales-to-inventories ratio (third panel, Chart 7). Importantly, an inventory liquidation phase will continue to exert downward pressure on relative profit margins (bottom panel, Chart 7). Chart 8Pricing Power Proxy Blues Our simple relative pricing power proxy for the cyclical/defensive ratio best encapsulates these relative selling price pressures. The CRB metals-to-gold price ratio is on the verge of a breakdown and warns that the wide gulf that has opened up between our pricing power proxy and relative share prices will narrow via a sell off in the latter (Chart 8). Nevertheless, this stands in marked contrast to the ISM manufacturing prices paid subcomponent of the Report On Business survey and actual cyclicals/defensives pricing power momentum (bottom panel, Chart 9). Chart 9The US Dollar Holds The Key Were the greenback to depreciate in the coming months as our FX strategists expect, then cyclicals selling prices would definitively regain the upper hand versus their defensives counterparts (top & middle panels, Chart 9). But, the jury is still out. Sell-side analysts remain optimistic that relative profits will stage a significant comeback in the next year, but on a short-term basis have been trimming cyclical versus defensive earnings revisions (middle & bottom panels, Chart 10). While our macro-factor relative profit growth models were staging a comeback all last year, they ticked down last month (second panel, Chart 10). Finally, relative technical and valuation conditions are both tracing out a bottom near the one standard deviation below the historical mean, a level that has marked prior recoveries in relative share prices (Chart 11). Chart 10Mixed Bag Chart 11Unloved & Undervalued Bottom Line: Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Remain on the sidelines on cyclicals versus defensives, but stay tuned. Clipped Wings? Airline stocks have taken it to the chin lately on the back of coronavirus demand destruction fears, but we reiterate our overweight stance as extreme bearishness appears overdone. Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however looking further out such demand destruction will likely prove transitory. Chart 12 shows that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices (bottom panel, Chart 12). US domestic and international passenger enplanements are running near the 5%/annum growth rate and the recent rebound in the global and US services PMIs suggests that any kink in demand will likely prove short-lived (Chart 13). Chart 12Firming Cyclical… Chart 13…Demand Backdrop… Importantly, this firm cyclical demand backdrop is reflected in accelerating airline selling price inflation both on domestic and international routes (second & third panels, Chart 14). However, profit margins have yet to reflect this encouraging top line growth backdrop. The airline load factor spread (calculated as load factor minus break-even load factor) also heralds a profit margin expansion phase (bottom panel, Chart 14). Chart 14…Is A Boon For Selling Prices Chart 15Lower Fuel Costs Should Turbocharge Profit Margins Tack on the roughly 16% year-to-date drubbing in oil prices and airline profit margins will expand in 2020. This is true especially for the bulk of the industry that does not hedge kerosene costs (jet fuel shown inverted, Chart 15). The analyst community has been pessimistic about the prospects of airline stocks. Revenue and profit growth expectations are slated to tail the SPX in the coming twelve months. This sets a low bar for the industry to surpass in coming earnings seasons (Chart 16). Finally, investors have thrown in the towel, pushing relative valuations to extremely depressed levels to the tune of nearly two standard deviations below the historical mean (middle panel, Chart 17). Relative technicals are also washed out and signal that, at least, a reflex rebound is in store in the coming months (bottom panel, Chart 17). Chart 16Low Bar To Surpass Chart 17Contrary Alert: Pessimism Reigns Supreme In sum, while the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon.      Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://us.spindices.com/vix-intro/ 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, and “When The Music Stops…”, dated January 27, 2020, both available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Why did S&P 500 profit margins fall in 2019?: Compensation gains, trade tensions and spotty growth were the most likely culprits, though the absence of standardized disclosure hinders full attribution. Was it a one-off, or the beginning of a trend?: We believe that profit margins have likely peaked, though we expect that they will contract only modestly this year. The outcome of the election could have a significant margin impact going forward. The coronavirus outbreak may be worsening around Wuhan, but it does not appear to be metastasizing elsewhere: Our China strategists foresee an extended lockdown of Hubei province, but expect that the rest of the Chinese economy will be able to overcome it. They are cautiously optimistic about the prospects for containment. Sustainability What a difference a year makes. Last President’s Day, the S&P 500 was more than 5% below its September 2018 peak (18% below its current level), amidst widespread fears that the Fed may have tightened into a recession. The month-long government shutdown was an embarrassing own goal, and trade tensions loomed as a threat to corporate earnings and global growth. It would take another two months before the S&P 500 fully recovered, only to have the yield curve invert soon thereafter. The coronavirus epidemic (COVID-19) has the curve flirting with inversion again, but stocks have shrugged off the growth risks. They continue to scale the wall of worry as self-appointed bubble spotters’ blood pressure soars, leaving them sputtering like Judge Smails or the bank official overseeing Charles Foster Kane’s trust. While we acknowledge that COVID-19 and Bernie Sanders’ post-Iowa-and-New Hampshire position at the head of the Democratic pack could yet become problematic for markets and the economy, our take aligns much more closely with Fed Chair Powell’s House testimony last week. “There’s nothing about this expansion that is unstable or unsustainable.” COVID-19 Update Chart 1What Happens In Hubei Our China Investment Strategy colleagues were encouraged by the latest Chinese data on the outbreak. Although they foresee that Wuhan, and quite possibly all of Hubei province, will be shut down through the end of March, they do not think the action will thwart China’s nascent growth recovery. In their estimation, domestic companies will be able to reroute their supply chains with minimal disruption. If the equity market avoids a virus-related plunge, as they expect, the economy may dodge the deleterious impact on confidence that might otherwise emerge. Our sanguine China outlook encountered some resistance from clients, who have been surprised at how swiftly markets seemed to put the outbreak aside, and skeptical of official reports that seemed a little too good to be true. We suggested that they employ a trust-but-verify approach similar to ours. We are taking official data as given, while using other countries’ data as a reasonableness check. We are monitoring the magnitude of PRC policy efforts to mitigate the virus’ drag and remaining vigilant for any signs of global supply chain disruptions. Bottom Line: Our China strategists were heartened by official reports indicating that the coronavirus has been mostly contained in Hubei province (Chart 1), but are actively seeking out other evidence for corroboration before concluding that the worst is over. Making Sense Of Declining Profit Margins As we showed last week, S&P 500 profit margins narrowed across 2019, with 2% EPS growth lagging 5% growth in per-share revenue. Margins do not remain fixed over time, but the contraction represented a notable shift after several years of steady margin expansion. Even when EPS declined on a year-over-year basis for four straight quarters across 2015 and 2016, margins mainly held their own as revenues, which contracted year-over-year for six consecutive quarters, had it worse (Chart 2). Chart 2Fun While It Lasted We primarily attribute last year’s decline to gains in labor’s share of income. Although average hourly earnings growth decelerated from 2018 to 2019, real unit labor cost growth flipped from negative to positive. Tariffs also likely detracted from income, as domestic businesses were surely not able to pass through all of their increased cost of goods sold to their customers against a backdrop of persistently low inflation and limited pricing power. Decelerating US and global growth was also a drag (Chart 3). Chart 3Growth Decelerated Everywhere In 2019 Have Profit Margins Peaked? Excepting meaningful structural changes, profit margins are a mean-reverting series. Following steady margin expansion over three business cycle expansions spanning nearly three decades, mean reversion is an unappealing prospect for equity investors (Chart 4). Unless corporate tax rates are raised, though, the mean going forward will be higher than the mean established when federal taxation was more onerous. Additionally, an in-depth Bank Credit Analyst study argued that profit margins have not grown as much as it would appear to the naked eye,1 but they are elevated, and their future direction will influence prospective equity returns. Chart 4Margins Have Thrived In The Last Three Expansions A definitive analysis of S&P 500 margins would compile detailed revenue and expense data for each constituent in the index, but compiling the bottom-up data would repeatedly bump up against inconsistent disclosure conventions across companies and industries. For now, we will have to content ourselves with what we can glean from top-down analysis. Margins shrank in 2019 because of rising real unit labor costs, increased tariffs and global growth deceleration. Employee compensation is far and away the single biggest expense item for businesses as a whole. Changes in compensation are therefore the most consistently critical driver of changes in margins. Other key factors include: overall economic growth, growth relative to capacity, globalization, competitive intensity, and growth of the capital stock. GDP Growth Over time, growth in a company’s revenues should converge with the weighted average of economic growth in the countries in which it operates. The sensitivity of any given company’s net income to changes in sales revenue depends on its operating leverage, but any company with at least some fixed costs will see its margins expand as sales rise. We expect that US GDP growth will moderate going forward, given that hoped-for increases in economic capacity do not appear to have offset the growth overhang from the stimulus package’s increased deficits.2 For the current year, however, we expect that an acceleration in non-US growth may largely offset moderating US growth for the aggregate S&P 500. (Chart 5) Chart 5Sales Growth Feeds Operating Leverage The Output Gap The degree of excess capacity in the economy is most easily proxied by the output gap, the difference between the economy’s actual output and its long-run potential output, which is a function of productivity and labor force growth. Pricing power is directly related to the output gap; it’s weak when the gap is negative, and robust when the gap is positive. Excess capacity is the enemy of profits, and margins benefit when it is worked off, even if positive output gaps can’t persist indefinitely (Chart 6). With the economy continuing to grow at close to its estimated trend rate, the output gap isn’t likely to have an impact this year. Globalization allows US companies to tap lower-cost inputs in the developing world. Chart 6Excess Capacity Erodes Pricing Power Globalization Globalization has been a major force promoting margin expansion over the last 20 to 30 years, granting US-domiciled businesses access to the developing world’s lower-cost inputs. Outsourcing saves money and global supply chains have significantly reduced product costs. Tariffs and other trade barriers are an obstacle to outsourcing, and it is our in-house geopolitical strategists’ view that the US will continue to backtrack from globalization no matter which party captures the White House in November. Changes in the sum of exports and imports as a share of GDP provide a simple proxy for changes in the intensity of globalization (Chart 7). Chart 7More Open Borders = Higher Margins Competitiveness Margins are directly related to the intensity of globalization, but they are inversely related to the intensity of competition, which is itself inversely related to the degree of industry concentration. The laissez-faire approach to anti-trust enforcement which has generally prevailed since the Reagan administration has promoted concentration. Businesses gain pricing power as their industries move along the spectrum from perfect competition toward monopoly, just as they gain increasing power to set wages as individual labor markets move toward monopsony. Pressure for federal action to reverse the four-decade trend toward concentration will rise if the Democrats win the White House, especially as our Geopolitical Strategy service holds that the party that takes the presidency will also take the Senate. Productivity Changes in margins are directly related to the pace of productivity gains. Workers are able to do more in a given period of time when they’re endowed with more and/or better tools, and investment provides those tools. Increases in the size of the capital stock lead to productivity gains. The NFIB survey suggests that small businesses are poised to increase capital expenditures, and the capex intentions components of the regional Fed manufacturing surveys have begun pointing in that direction as well, but investment has consistently disappointed since the crisis (Chart 8), and productivity growth has been tepid for an extended period of time as a result. Chart 8Investment Pays Off In Higher Margins Unit Labor Costs Rising labor costs by themselves do not necessarily mean that margins will contract. If output increases more than rising wages, margins will expand. We therefore watch unit labor costs, which measure output-adjusted changes in compensation. Growth in real unit labor costs is our preferred measure for their additional insight into profitability, given that changes in the overall price level are a solid proxy for changes in sales prices. When real unit labor costs are falling, corporate margins are likely expanding as revenue gains can be expected to outpace employees’ compensation per unit of output. Given the especially tight labor market, we expect real unit labor costs to continue to rise, chipping away at profit margins (Chart 9). Chart 9Persistently Negative Real Unit Labor Costs Have Boosted Margins Taxes, Interest Rates And The Dollar The biggest driver of after-tax margins in recent years has been the 40% reduction in the top marginal federal corporate income tax rate from 35% to 21% beginning in 2018. We expect no material corporate tax changes if the president wins re-election, while we would expect that an incoming Democratic administration, fortified by House and Senate majorities, would prioritize increasing corporate tax revenues. We expect a modest rise in interest rates over the year, which is unlikely to materially impact firms’ interest expense. We expect that the dollar will weaken in 2020, as incremental growth in the rest of the world exceeds incremental growth in the US, providing the S&P 500 with a modest margin tailwind. Bottom Line: On balance, we expect that the S&P 500 will face modest margin headwinds in 2020. If the Democrats assume control of the White House and both houses of Congress next January, downward pressure on margins could intensify. Investment Implications Falling margins against a backdrop of tepid revenue growth suggest that 2020 S&P 500 earnings growth will be nothing to write home about. Stocks will have to get an assist from multiple expansion if they are to continue producing double-digit annual returns. We do not think multiple expansion is much of a stretch – it would be consistent with the latter stages of previous bull markets – but equities do not need to generate double-digit returns to top the prospective returns on offer from Treasuries, credit-sensitive fixed income or cash. As long as the margin compression unfolds slowly, equities will merit at least an equal-weight allocation in balanced portfolios as will spread product in dedicated fixed income portfolios. Corporate profit margins would quickly feel the burn in a Sanders administration. We expect that profit margins will compress slowly, as it remains our base case (albeit with limited conviction) that the president will win re-election. Under a Democratic regime, however, corporate tax rates would likely rise, anti-trust enforcement would likely unwind some of the buildup in industry concentration, and organized labor would gain a more sympathetic ear in Washington. If Bernie Sanders were to win the presidency instead of one of the Democratic moderates, margin compression would likely unfold much more rapidly (and multiples would be at immediate risk, to boot). The upcoming election is thus approaching something of a binary outcome for equities. We still see monetary policy as the swing factor for the ongoing expansion, and financial market returns, and we therefore remain constructive on the economy and risk assets. The election could upend that framework, however, passing the baton from the Fed to elected officials. We will be tracking the primary and general election ups and downs closely.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the October 2012 Bank Credit Analyst Special Report, "Are US Corporate Profit Margins Really All That High?" available at www.bcaresearch.com. 2 The economic case for the stimulus package rested on the expectation that it would promote investment in the capital stock that would not otherwise occur (via immediate expensing of investments and repatriation of capital held overseas) and facilitate labor force participation. A capex burst that followed its passage quickly fizzled, and we are of the opinion that the minor provisions intended to expand labor force participation have had little effect.