Equities

Our sense is that the current reflation trade will extend into the summer, sending stock and commodity prices higher and the U.S. dollar down. Global government bond yields should rise during this phase. Beyond the near term, we expect these reflation trades to go into reverse. Stay defensive.

Policy easing works with a time lag, and the previous easing measures should continue to feed through to business activity. The recent decline in the trade-weighted RMB should lead to continued improvement in the industrial sector's performance for at least the next two quarters.

Asian exports (volumes and prices) have been contracting, as global trade has hit a wall. While this broad deflationary backdrop has taken a toll on Asian DRAM prices (bottom panel), global semiconductor supply/demand imbalances best explain the industry's dwindling pricing power. Not only are global semi sales shrinking, but also BCA's global semi inventory proxy is surging. Taken together, our global semi sales-to-inventories (S/I) ratio is contracting at an accelerating pace, signaling that an inventory liquidation phase is looming. Historically, the S/I ratio has been an excellent leading indicator of semi earnings and the current message is to expect a significant drop in profits (middle panel). Bottom line: Steer clear from the broad tech sector, continue to underweight the tech hardware, storage & peripherals sub-index and we reiterate our high-conviction underweight status for the S&P semis index. The ticker symbols for the stocks in the S&P semis index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, SWKS, XLNX, MU, LLTC, MCHP, QRVO, FSLR. The ticker symbols for the stocks in the S&P technology hardware, storage & peripherals index are: BLBG: S5THSP - AAPL, EMC, HPE, HPQ, SNDK, WDC, STX, NTAP.

In mid-April we cautioned investors not to position for a betterment in tech sector earnings despite the seemingly low sell-side analyst hurdle. A slew of tech heavyweights have come up short this earnings season both on the top and bottom line fronts. More importantly, bellwether Apple struck a cautionary note on consumer electronics end-demand, especially in China and warned that profit would underwhelm in the current quarter. This is disconcerting especially given Apple's global reach, and is signaling that the tech sector tide is likely turning following a nearly uninterrupted decade-long relative share price bull market run. The top & middle panels of the chart show that this outperformance phase is running on empty as relative profit trends have given way. Meanwhile, on the demand side the outlook remains grim. Overall tech new order growth is contracting and the message from weakening Korean and Taiwanese exports is that more pain lies ahead for tech sector profitability. Deflating Asian export prices are underscoring that semis should also be avoided (see the next Insight).

How big a problem are the non-performing loans in Italy and Greece? And what is the solution?

Cyclical sectors are manufacturing-dependent, whereas defensive sectors are services-oriented, highlighting that cyclicals are more levered to the inventory cycle's ebbs and flows. The latest durable goods report made for grim reading. Both the new orders-to-inventories and shipments-to-inventories (S/I) ratios remain tepid. This corroborates the reading from the S/I ratios in the wholesale, retail & manufacturing sectors, where all are steadily sinking, underscoring that forecasting a rise in manufacturing output on the basis of an inventory cycle is overly optimistic. The implication is that additional pain looms for the cyclicals/defensives relative performance (middle panel). Moreover, diverging debt dynamics are weighing on the cyclicals/defensives ratio. Relative interest coverage and net debt-to-EBITDA are sending a distress signal (not shown). Tack on a narrowing in relative profit margins (bottom panel) and the continuing deterioration in relative top-line growth which according to our sales models has more staying power (please see chart 7 from the March 29 Special Report), and the ingredients are in place for a resumption in the downtrend in the relative share price ratio. Relative profit trends will drive the next phase in the cyclicals/defensives ratio and defensives retain the upper hand (top panel). Bottom Line: Continue to favor defensives over deep cyclicals.

The near-term (next month or two) market dynamics in EM risk assets remain a coin toss. Beyond that the outlook for EM risk assets remains downbeat. EM financial markets are complacent and there are many potential negative EM/China developments that could derail the current EM rally. A new trade: go long the KOSPI / short EM overall equity index.

Earlier this month we made a full shift from underweight to overweight in the S&P cable & satellite index, a sub-component of the broader media sector, in response to receding risk that cord cutting and skinnier cable packages would threaten profits. Given that the outlook for the heavyweight S&P movies & entertainment index has improved, it no longer pays to be underweight. This group has underperformed the broad market since early January, savaged by uncertainty about the outlook for key cable networks, particularly ESPN. However, if our cable read is accurate, then material and widespread deterioration in the value of high-quality specialty channels and networks is unlikely. In fact, one of the drivers of higher media spending has been recreational outlays. That improvement may reflect a delayed response to the windfall from lower fuel bills (second panel). Importantly, attendance at theme parks, movie theaters and other attractions has been sufficiently strong to generate increased ticket prices (third panel). That will buffer any advertising slippage from TV to digital. At the same time, wage inflation is non-existent. Against this backdrop, there is less risk of sustained profit margin pressure in the movies & entertainment index. Underperformance has returned valuations to an attractive level, with the relative forward P/E well below the broad market and not far above the Great Recession low (bottom panel). This warrants a lift in our underweight stance. Bottom Line: Lift the S&P movies & entertainment index to neutral, and take the S&P media group off the high-conviction underweight list. For additional details please see yesterday's Weekly publication. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, VIAB, FOX.

We turned more cautious on banks in January, but in hindsight, could have become outright bearish. Banks are headed for a triple whammy of profit trouble. Loan growth is set to cool, the credit cycle has shifted from tailwind to headwind and the yield curve continues to flatten. Moreover, following several years of downsizing, banks are no longer shedding labor. In fact, banks are adding staff, according to BLS data (middle panel). The timing of hiring is questionable, given that our measure of productivity growth, bank loans/bank employment, is now decelerating (bottom panel). That will undermine profitability, particularly against a backdrop of net interest margin compression. Expectations in the swap curve are for an ongoing yield curve flattening (top panel). It will be very difficult for long-term Treasury yields to rise sustainably as long as other global government bond yields are melting, because the divergence will cause outsized U.S. dollar appreciation which transmits deflationary pressure into the U.S. The implication is ongoing net interest margin compression. Bottom Line: Downgrade the S&P banks index to underweight. This also moves our overall financials exposure to below benchmark. For additional details please see yesterday's Weekly publication. The ticker symbols for the stocks in this index are: BLBG: S5BANK - BAC, BBT, C, CFG, CMA, FITB, HBAN, JPM, KEY, MTB, PBCT, PNC, RF, STI, USB, WFC, ZION.