Technology
Highlights Although it is tempting to argue that emerging markets are in a new era where past correlations no longer matter, our belief is that it is only a matter of time until fundamentals reassert themselves. Several measures of equity markets have reached or are close to their previous structural peaks. In the second half of 1990s, booming U.S. and European growth as well as the tech mania, did not preclude a bear market in commodities and EM financial markets. Overall, EM risk assets will not be immune to selling off considerably from the current overbought levels if Chinese growth and commodities prices surprise to the downside, as we expect. Falling commodities prices will weigh on Indonesia's terms of trade. Equity investors should maintain an underweight position in this market and currency traders should continue shorting the rupiah. Feature A New Era? Money has been flowing into EM financial markets, irrespective of the evolution of many economic and financial variables that have in the past shaped markets dynamics. Indeed, EM share prices and currencies have refused rolling over despite a relapse in a number of variables they have historically been correlated with. EM share prices have continued to surge, even though the aggregate EM manufacturing PMI has rolled over (Chart I-1). Chart I-1Unsustainable Decoupling The recent relapse in the EM manufacturing PMI has not hurt EM currencies either (Chart I-2, top panel). In addition, EM currencies have diverged from commodities prices, an unprecedented historical occurrence (Chart I-2, bottom panel). The same applies to EM versus DM relative equity performance. Chart I-3 demonstrates that EM share prices have outperformed their DM counterparts year to date, even though the EM manufacturing PMI considerably underperformed DM's. Chart I-2Untenable Divergence Chart I-3Relative Share Prices And Relative PMIs Notably, EM stock prices have even defied the recent setback in EM net earnings revisions (Chart I-4). Typically, the latter correlate with swings in share prices, but this time both variables have diverged. Finally, it is important to note that this phenomena of decoupling cannot be explained by the performance of technology stocks. EM share prices excluding technology companies have still rallied, albeit much less, despite the decline in EM net earnings revisions and the EM manufacturing PMI. Remarkably, China's H shares - the index that does not include U.S.-listed Chinese internet/social media companies and is instead "heavy" in banks and "old economy" stocks - have still ignored both the drop in China's manufacturing PMI and rising local interest rates (Chart I-5). Chart I-4Even Analysts' Net EPS ##br##Revisions Have Rolled Over Chart I-5Puzzling... One could argue that the dominant macro drivers of EM in recent months have been the U.S. dollar and U.S. bond yields, both of which have downshifted since mid-December 2016. If the greenback and expectations of Federal Reserve policy continue to shape EM performance, the outlook is not much better. The basis is that the Fed will likely continue to hike interest rates if global stocks continue to rally. Notably, U.S. corporate bond yields/spreads are very low, the dollar is already down quite a bit, U.S. asset prices are reflating and U.S. economic growth is decent. If the Fed does not normalize interest rates now, when and under what conditions will it? Similarly, investor sentiment on the U.S. dollar is no longer bullish, and the market expects only 44 basis points in Fed rate hikes over the next 12 months. The latter is a low bar. We maintain that the dollar's selloff - even though it has lasted longer than we previously expected - is late, especially versus EM currencies. Bottom Line: Although it is tempting to argue that emerging markets are in a new era where past correlations no longer matter, our belief is that it is only a matter of time until fundamentals reassert themselves. As and when this happens - our hunch is that it is a matter of weeks not months - EM risk assets will sell off materially and underperform their DM counterparts. Signs Of A Top? Or Is This Time Different? The EM equity rally has been facilitated by the tech mania occurring worldwide as well as by falling financial market volatility and risk premia - leading investors to bet on EM carry trades. A relevant question is whether these trends are close to the end or have much further to go. We have the following observations: EM share prices in local currency terms, as well as the KOSPI and Taiwanese TSE indexes in U.S. dollar terms, all are testing their previous highs which they have never broken out from (Chart I-6). The question we would ask is: Why should this time be different, or why would these indexes break out this time around? In our opinion, EM fundamentals, including the outlook for EPS growth, remain poor. We have elaborated on this issue at length in previous reports1 and stand by our assessment. On many metrics, the U.S. equity market is expensive, and the rally is overstretched (Chart I-7). Chart I-6Facing A Major ##br##Technical Resistance Chart I-7U.S. Stocks Are Expensive ##br##And Overstretched These charts do not provide clues for the timing of a reversal, but when all these ratios reach their previous secular tops, investors should be critically examining the investment outlook. Our take is as follows: Without a broad-based U.S. corporate profit recession, a major bear market in the S&P 500 is not likely, but share prices could soon hit a major resistance and correct meaningfully from the current expensive and overbought levels. While EM stocks are not expensive, the outlook for their share prices is negative because we expect EM earnings to shrink again by early next year1. Finally, not only is U.S. equity market volatility extremely muted but EM equity as well as U.S. bond market volatility are testing their previous lows (Chart I-8). When implied volatility reached these low levels in the past, it marked a major market reversal. Bottom Line: Several measures of equity market performance have reached or are close to their previous structural peaks and financial markets volatility is at record lows. While one can make the case that this time is different and this EM equity rally will persist, we continue to err on the side of caution. Tech Mania And EM In The 1990s A recent narrative in the marketplace has been as follows: given the share of tech stocks' market cap has risen to 26%, and commodities sectors presently account for only 14% of the EM MSCI benchmark, it makes sense that EM equities have decoupled from commodities prices and have become correlated with tech stocks and DM growth. In this respect, it is instrumental to revisit what happened in the second half of the 1990s, when global tech/internet and telecom stocks were in the midst of a mania like social media/tech stocks nowadays. We have the following observations on this matter: EM share prices, currencies, and bonds plunged in the second half of the 1990s, even though U.S. and European real GDP growth was extremely strong - 4.5% and 3% on average, respectively (Chart I-9, top panel) - and the S&P 500 was in a full-fledged bull market. Chart I-8Volatility: As Low As It Gets Chart I-9EM Stocks And DM Growth In The 1990s EM share prices collapsed in 1997-'98, even though U.S. and European import volumes were expanding at a double-digit rates (Chart I-9, middle panel). Furthermore, the crises originated in emerging Asian countries such as Thailand, Korea and Malaysia that were large exporters to advanced economies. Besides, the share and importance of the U.S. and European economies was much larger 20 years ago than it is now. Back then, China was negligible in terms of its impact on EM in general and commodities in particular. The question is, if an economic boom in the U.S., and Europe in the second half of the 1990s did not preclude crises in export-oriented economies in East Asia, why would moderate DM growth today - as well as their much smaller share of global trade - boost EM share prices from already elevated levels. Twenty years ago, EM share prices fell along with declining U.S. bond yields (Chart I-10). The Fed hiked rates only once by 25 basis points in March 1997. In the past 18 months, the Fed has already hiked 3 times. In fact, the U.S. dollar was in a bull market in the second half of the 1990s, despite falling U.S. bond yields during that period. EM stocks collapsed along with falling commodities prices in 1997-'98 (Chart I-11, top panel) even though the S&P 500 was in the midst of a major bull market (Chart I-11, bottom panel). Chart I-10The 1990s: EM Bear Market ##br##Was Not Due To Rising U.S. Bond Yields Chart I-11EM Stocks, Commodities And The S&P 500 Importantly, the mania sectors of the late 1990s - technology and telecom - accounted for approximately 33% of EM market cap in January 2000. Presently, following an exponential rally and outperformance, technology and social media/internet stocks make up 27% of the EM MSCI benchmark. In addition, the market cap of energy and materials companies stood at 19% of the MSCI EM equity benchmark in January 2000, compared with 14% presently (Chart I-12). Hence, the market cap of commodities sectors was not substantially larger in the late 1990s than today. Finally, Korean and Taiwanese bourses have historically had a high positive correlation with both oil and industrial metals prices (Chart I-13). The reason for this relationship is that both economies are leveraged to the global business cycle, and commodities prices are often driven by global trade cycles. Chart I-13Asian Bourses And Commodities Prices Bottom Line: In the late 1990s, EM crises/bear markets occurred despite booming U.S. and European growth, and at a time when these economies were much more important to EM than they are today. The EM bear market also occurred amid the S&P 500 bull market and falling U.S. bond yields. To be sure, we are not suggesting that everything is identical between today and the 1990s, but all the above suggests to us that EM risk assets will not be immune to selling off considerably from the current overbought levels if Chinese growth and commodities prices surprise to the downside, as we expect. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Profits, China And Commodities Redux", dated May 31, 2017, link available on page 16. Indonesia: Facing Commodities Headwinds (Again) Decelerating Chinese growth and falling commodities prices will weigh on Indonesia's exchange rate (Chart II-1). In turn, not only will the currency depreciation undermine foreign currency returns to investors in stocks and local bonds, but it will also exert upward pressure on local rates. The latter will extend the credit downturn and weigh on domestic demand. Chinese imports of Indonesian coal have begun falling in volume terms (Chart II-2). Consistently, Chinese thermal coal prices - the type of coal that China buys from Indonesia - have also rolled over decisively after rallying sharply in 2016. Chart II-1Indonesia Currency ##br##And Commodities Prices Chart II-2Indonesia's Coal Exports ##br##To China And Coal Prices Indonesia's exports of base metals and oil/gas to China are also declining in U.S. dollar terms. Commodities exports account for around 30% of Indonesia's total exports. As such, falling commodities prices will lead to negative terms of trade for this nation. On the domestic front, consumer demand remains sluggish. Although auto sales have revived, motorcycles sales are still declining for a fourth consecutive year (Chart II-3). Meanwhile, capital expenditures are tame. Capital goods imports are no longer contracting, but there has been no recovery so far (Chart II-4). Chart II-3Consumer Spending: ##br##Auto And Motorcycle Sales Chart II-4Indonesia: Capex Is Sluggish Bank loan growth has not recovered much (Chart II-5) despite low interest rates and a benign external backdrop since early 2016, specifically the revival in commodities prices and large foreign portfolio inflows. NPLs on banks' balance sheet will rise further due to weak growth and lower commodities prices. That, in turn, will dent banks' willingness to grow their loan book. In regard to the credit cycle, Indonesia might be following India's example with a several year lag. In India's banking system, high NPLs have curtailed public banks' desire to lend and, consequently, capital spending has been in disarray. Similarly, Indonesia's credit-sensitive consumer spending and investment expenditure growth will disappoint in the next 12 months as credit growth slows anew. Finally, at a trailing price-earnings ratio of 19.6, equity valuations are not attractive. The poor growth outlook that we foresee does not justify such high multiples. Besides, relative performance of this bourse versus the overall EM equity benchmark is stuck between technical support and resistance (Chart II-6). We are biased to believe that it will relapse from the current juncture. Chart II-5Indonesia's Credit Cycle Is Not Out Of The Woods Chart II-6Indonesian Equity Relative Performance Bottom Line: Weaker commodities prices emanating from slower Chinese growth will hurt Indonesia's currency. We recommend equity investors to keep an underweight position in this bourse. Also, we remain short IDR versus the U.S. dollar and underweight local currency bonds within the EM universe. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Communications equipment stocks have diverged negatively from the broad tech sector and now trade broadly in line with telecom carrier stocks - a key end-market, with a slight lag. The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While valuations look compelling, the risk of further near-term losses and a longer-term value trap remains high; all three key communications equipment end-markets point to additional demand weakness ahead. First, a full blown price war has engulfed the telecom services industry, driving outright deflation. In the absence of revenue growth, telecom capex is unlikely to reaccelerate. Secondly, delays/uncertainty with regard to U.S. fiscal policy and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time, representing another source of drag. Finally, export markets are unlikely to offset domestic cooling, as soaring Chinese & European telecom equipment exports suggest that U.S. manufacturers are losing competitiveness, and market share. Meanwhile, deflationary industry specific forces such as virtual networking will also contribute to margin pressure. We recommend shifting to underweight. Please see yesterday's Weekly Report for more details. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV.
Highlights Portfolio Strategy Downgrade communications equipment stocks to underweight. All three end-markets are weak and signal that profits will continue to surprise to the downside. Continue to avoid the electrical components & equipment index. Deficient demand warns that the profit down cycle is far from over. Recent Changes S&P Communications Equipment - Downgrade to underweight. Table 1Sector Performance Returns (%) Feature Equities broke out to new highs last week. The minutes from the latest FOMC meeting implied that it would take considerable economic strength for the Fed to tighten more than markets currently forecast. A reactive rather than proactive Fed raises the odds that the equity overshoot will persist, because it means monetary conditions will still support profits. A good part of this year's market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery. Net analyst earnings revisions have hit their highest level since the initial post-GFC surge. The number of S&P industry groups with rising earnings estimates has climbed above 80%, reflecting broad-based earnings upgrades. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates (Chart 1). Evidence of a healthy earnings recovery is supported by our own Indicators. Of our ten sector pricing power gauges, seven are in positive territory. On a more granular basis, the majority of our 64 industry group pricing power proxies is also rising. This reflects increased global business activity and U.S. dollar depreciation. In terms of costs, six out of ten wage inflation proxies are decelerating, and more than 50% of our industry labor expense gauges are falling. As a result, seven out of ten of our broad sector profit margin proxies are in positive territory, i.e. pricing power is rising at a faster pace than wage inflation. Of the three in negative territory, two are easing in intensity, i.e. margin pressures are diminishing. These profit trends will support stocks, at least until they generate economic overheating and by extension, a more restrictive Fed. Thus, the good news for bulls is that financial conditions will remain sufficiently easy to sustain a durable profit recovery (see Chart 1 from last week's Report), so much so that investors are lengthening their time horizons. Evidence of the first synchronized global expansion in years and the ability of regional economies to bounce back from a headline risk, such as Brexit, have boosted conviction in the sustainability and strength of long-term earnings growth: analyst 5-year earnings growth forecasts are being steadily upgraded. History shows that as long as economic tail risk remains on the back burner, then valuations can camp out in overshoot territory, as occurred in the second half of the 1990s (Chart 2). To be sure, nosebleed valuation levels underscore that the rally is in a high risk phase and virtually guarantee paltry long-term returns. Still, timing pullbacks is notoriously difficult. We follow a checklist of five reliable indicators that should provide a helpful timing tool. Emerging market currencies have weakened prior to or coincident with U.S. stock market corrections (Chart 3). Exchange rate depreciation in these high beta economies is emblematic of growth disappointment, fears of capital flight and/or risk aversion. At the moment, our proxy of EM currencies is accelerating. Chart 1Buoyant Breadth Bodes Well Chart 2Long-Term Profit Conviction Is Driving Multiples Chart 34/5 Lights Flash Green Corporate bond spreads, both in the U.S. and emerging markets, have also widened coincident with, or in advance of, meaningful equity setbacks (Chart 3). So far, spreads remain tight in both regions, suggesting minimal concerns about debt servicing capabilities. In addition, bullish individual investor sentiment has also eclipsed the 60% zone in advance of the two largest post-GFC drawdowns. Individual investors are currently upbeat, but are not yet frothing bulls, according to the latest survey data (Chart 3). Of the five checklist items, the behavior of the yield curve is the most disconcerting. The curve has narrowed considerably in recent weeks, and is closing in on the pre-U.S. election lows as inflation expectations recede (Chart 3). If real long-term yields do not soon advance and confirm the profit/economic recovery narrative, then the odds of an imminent corrective phase will ratchet higher. In sum, the overshoot should remain intact for a while longer. But we continue to recommend a barbell portfolio rather than one with excessive beta, favoring select defensives and early cyclical sectors such as consumer discretionary and financials given the lack of economic confirmation from the bond market. This week we highlight two exceptions to the generally bullish profit backdrop, which reinforces that selectivity remains critical to portfolio construction. A Weak Signal From Communications Equipment: Downgrade To Underweight Communications equipment stocks have diverged negatively from the broad tech sector and have also trailed the broad market. Instead, this small corner of the tech industry moves with the ebb and flow of telecom carrier stocks - a key end-market, with a slight lag (top panel, Chart 4). The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While the share price ratio has lost ground and valuations look compelling (Chart 4), the risks of further near-term losses and a longer-term value trap remain high. Technical conditions are still far from previously extreme washed out levels. In fact, the overbought conditions' unwind is recent and there is ample downside left before a full capitulation materializes (middle panel, Chart 4). Worryingly, all three key communications equipment end-markets point to additional weakness in the coming months. Telecom carrier outlays have hit a wall. Telecom providers are at each other's throats and a full blown price war has engulfed the industry. This is outright deflationary, and telecom services pricing power has contracted at a double-digit rate during the past three months (bottom panel, Chart 5). In the absence of revenue growth, telecom capex is unlikely to reaccelerate. U.S. telecom facilities construction and communications equipment new order growth move in lockstep (second panel, Chart 5). Both have collapsed on a short-term rate of change basis, warning that communications equipment demand is soggy. Tack on the quickest industry inventory accumulation since 2011 (third panel, Chart 5), a soft order backlog (not shown), and the industry sales growth outlook has darkened even further. Overall corporate outlays are also soft. While a capex upcycle looms and some capital will inevitably flow to the communication equipment industry (middle panel, Chart 6), anemic C&I loan growth (an excellent proxy for broad corporate health, not shown) is a yellow flag. Chart 4Value Trap Chart 5Weak Telecom Segment Capex... Chart 6...Aggravates The Sales Risk Moreover, enterprise spending has not been concentrated on communications equipment gear for years, as the industry has been unable to gain any share of total corporate investment. The implication is that any business sector uptick is unlikely to match the pressure stemming from the telecom services sector. The government segment represents another source of drag. True, a global move away from austerity is a plus, but delays/uncertainty with regard to U.S. fiscal policy is a sizeable offset. In fact, U.S. government spending as a percentage of output is in decline (not shown) and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time. Finally, export markets are unlikely to offset domestic cooling. While the cheapened U.S. dollar should boost U.S. communication equipment manufacturers' competitiveness, China's global networking ascendancy and Europe's recent V-shaped export recovery suggest that U.S. gear providers are losing market share (Chart 7). All of this paints a grim picture for communications equipment sales. As such, cyclically stretched operating margins are at risk (Chart 8). Industry productivity growth has crested, and is likely to recede because slowing new orders and rising inventories imply reduced output. The implication will be profit margin pressure and a return on equity squeeze (middle panel, Chart 8). While the industry constantly realigns headcount to the challenging operating environment, a sustainable profit turnaround requires a demand driven rebound. Chart 7U.S. Manufacturers Are Losing Market Share Chart 8Beware A Margin Squeeze Meanwhile, industry specific forces will also contribute to margin pressure. Five years ago, Cisco's CEO dismissed the nascent virtual networking threat. However, today, virtual networking is a deflationary reality. Such intense deflationary pressure is a clear profit negative and warns that relative EPS are headed south (Chart 8). Bottom Line: The S&P communications equipment index is breaking down. Trim exposure to below benchmark. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV. Electrical Components & Equipment Are Out Of Power The niche S&P electrical components & equipment (ECE) industrials sub-index has marked time since our late-November downgrade to underweight. Our bearish thesis remains intact. Cyclical momentum has sputtered after the relative share price ratio failed to sustain its post-U.S. election euphoria. Valuations remain dear, with the forward P/E ratio trading at a 15% premium to the broad market (bottom panel, Chart 9). If profits continue to disappoint, as we expect, then a de-rating phase is inevitable. ECE companies garner roughly half of their sales from abroad. Thus, the U.S. dollar's fluctuations are inversely correlated with relative share prices. Delayed translation effects from the U.S. dollar's large run-up last year should continue to weigh on profits, and offset the European and emerging market economic recoveries. Worrisomely, there is a wide gap between relative performance and the greenback. If history rhymes, then a convergence phase is likely with the relative share price ratio deflating closer to the level predicted by the U.S. dollar (currency shown inverted, top panel, Chart 9). Domestically, news is equally grim. Investment spending on electrical equipment remains moribund: outlays are contracting in absolute terms and continue to trail overall investment. Historically, the industry's new orders-to-inventories ratio has been closely correlated with relative outlays and the current message is bleak (bottom panel, Chart 10). Chart 9No Reasons To Pay For Premium Valuations Chart 10No Reasons To Pay For Premium Valuations Importantly, the surge in ECE inventory growth and deceleration in backlog growth point to pricing power pressure in the coming months. Chart 11 shows that a rising wage bill and anemic pricing power have squeezed our industry margin proxy. In terms of industry productivity, gains have given way to losses, according to our gauge. This suggests that profits will continue to languish (middle panel, Chart 10). Tack on the slump in weekly hours worked, and there is cause to doubt recent sell side analyst optimism (bottom panel, Chart 11). A demand-driven increase in revenues/backlogs is needed to reverse the industry's profit fortunes. However, our relative EPS model is forecasting the opposite: profits will continue to underwhelm and trail the broad market into the back half of the year (Chart 12). Chart 11Lean Against Analysts' Exuberance Chart 12EPS Model Says Sell Against this backdrop, we remain reluctant to pay a premium valuation to own an industry with an uncertain, at best, earnings profile. Bottom Line: While we are neutral on the broad industrials sector, we continue to recommend underweight exposure in the S&P electrical components & equipment index. The ticker symbols for the stocks in this index are: BLBG: S5ELCO - EMR, ETN, ROK, AME, AYI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights The structural theme of overweighting technology stocks within the overall equity benchmark, and relative to other cyclical sectors such as commodities and machinery stocks, remains intact. However, in absolute terms, EM tech/semi share prices have become overbought and have already priced in a lot of good news. They will likely sell off soon due to the potential slowdown in the pace of semiconductor demand. Continue overweighting EM tech stocks, Taiwanese and Korean bourses within EM equity portfolios. We also reiterate our long-standing long tech / short materials strategy. Feature EM technology stocks have surged to all-time highs (Chart I-1, top panel), contributing significantly to the ongoing EM rally. In fact, excluding tech stocks, EM share prices have not yet surpassed a major technical hurdle, as shown in the bottom panel of Chart I-1. BCA's Emerging Markets Strategy (EMS) team has been recommending that investors overweight tech stocks since June 8, 2010. In our report titled, How To Play EM Growth In The Coming Decade,1 we contended that the structural bull market in commodities was over, and that in the coming decade (2010-2019) the winners would be health care and technology (Chart I-2). We also identified a potential mania candidate - i.e., a segment that was poised for exponential price gains. We reasoned that the fusion between technology and health care - health care equipment stocks - could experience exponential price moves. This strategy has paid off exceptionally well. Consistently, within the EM equity benchmark, we have been overweighting Taiwanese and Korean tech stocks since 2007 and 2010, respectively (Chart I-3). Chart I-1EM Tech Stocks Have ##br##Surged To All Time Highs Chart I-2EMS Strategy Since 2010: ##br##Long Tech / Short Materials Chart I-3Taiwanese & Korean Tech ##br##Stocks Relative To Overall EM After such enormous gains, a relevant question is whether technology share prices will continue to rally in absolute terms, boosting the EM equity benchmark, or whether their absolute performance and/or relative performance will roll over. Chart I-4EM Tech Stocks Are Overbought Before we proceed in laying out our analysis, a caveat is in order: we can offer thematic long-term views on various sectors, but investors should realize the investment calls on many technology, internet and social media companies are driven by bottom-up - not macro - views. From a top-down perspective, we can offer little insight on whether EM internet and social media stocks such as Alibaba, Tencent and Baidu are cheap or expensive, whether their business models are or are not proficient, or what their profit outlooks might be. The reason is that these and other global internet/social media companies' revenues are not driven by business cycle dynamics and top-down analysis is less imperative in forecasting their performance. In this report we will shed some light on the business cycle in the global/Asian semiconductor industry. The latter is subject to both business cycle swings as well as sector-specific factors. Again, sector-unique factors for the semi industry are also beyond our top-down approach. The five largest constituents of the EM MSCI tech sector are Samsung (4.3% of EM MSCI market cap), Tencent (4.0%), Taiwan Semiconductor Manufacturing Company (3.5%), Alibaba (3.0%), and Baidu (1.0%). Chart I-4 shows their share prices. In short, they have become a large part of the EM benchmark and are also extremely overbought, increasing the risk of correction. Technology's Structural Bull Market Is Intact... Even though EM tech prices have skyrocketed in both absolute and relative terms, odds are that the structural bull market has further to run. There are no structural excesses in the technology sector that would warrant a bust for now. Even in China, credit/leverage excesses are concentrated in the old industries, not among the tech and new economy segments. Demand for tech products in general and semiconductors in particular is not very dependent on the credit cycle in EM. In both developed market (DM) and EM economies, spending on many tech gadgets is contingent on income gains rather than credit growth. Our bearish view on EM/China growth is primarily due to our expectations of a credit downturn that will affect spending that is financed by credit. Investment expenditures driven by credit are much more important for commodities and industrial goods than technology products. While the share prices of technology and new economy companies are overbought and may be expensive, global/EM economic demand growth will be skewed toward new industries and technologies rather than commodities. In brief, the outlook for global tech spending remains positive, both cyclically and structurally. Having outperformed all other sectors by a large margin, the EM technology sector presently accounts for 26% of the EM MSCI benchmark, while at its previous structural peak in 2000 its market share stood at 22% (Chart I-5, top panel). During the 1999-2000 tech bubble, the U.S. and DM tech sector’s share of market cap reached 34% and 24% of the U.S. MSCI and DM MSCI benchmark market caps, respectively (Chart I-5, middle and bottom panels). Despite being stretched, it is possible that the technology sector's market cap will rise further before another structural top transpires. Hence, we are not yet ready to call the top in the tech's share of the overall market cap either in EM or DM. From a very long-term perspective (since 1960), the relative performance of the U.S. technology sector against the S&P 500 has not yet reached two standard deviations above its time trend, as it did in the year 2000 during the tech bubble. Conversely, the same measure for energy, materials and machinery stocks is not yet depressed enough to warrant a mean reversion bet (Chart I-6). Chart I-5Tech Stocks Market Cap Share ##br##Of Overall Equity Benchmarks Chart I-6Relative Performance Of ##br##U.S. Sectors Vs. S&P 500 Finally, secular leadership rotations within global equities typically occur during market downturns. Chart I-7 shows that commodities stocks and tech leadership changed in 2001 and 2008. It is possible that new sectoral leadership will emerge in global equities during the next bear market/severe selloff. However, it is too early to bet on it now. The current character of equity markets - which favors technology over commodities - will persist. Bottom Line: The structural theme of overweighting technology stocks within the overall equity benchmark and relative to other cyclical sectors such as resources/commodities and machinery stocks remains intact. ...But The Semi Cycle Upswing Is Advanced The semiconductors industry is cyclical, and as such business cycle analysis is pertinent here. The rest of the technology sector, however, is not correlated with overall business cycles. Therefore, there is little value that macro analysis can deliver on the outlook for non-semi tech areas. This is why this section is focused on semiconductors rather than the overall tech sector. There is no basis as to why semiconductor/tech cycles should correlate with commodities cycles. However, when they do, the amplitude of global business cycle fluctuations rises. Indeed, Asian exports and global trade tumbled in 2015 and have subsequently improved over the past 12 months for the following reason: the 2015 downturn and the ensuing recovery in the semiconductor cycle overlapped with similar swings in commodities and Chinese capital goods demand (Chart I-8). This has increased the amplitude of the global business cycle's swings in the past two years. Chart I-7Secular Leadership ##br##Rotation: Tech Vs. Energy Chart I-8Chinese Capital Goods Imports & ##br##Global Semiconductor Cycle We remain bearish on Chinese capital spending in general and construction in particular. This entails weaker demand for commodities and industrial goods. Yet we are not bearish on Chinese demand for semiconductors and tech devices. The semiconductor cycle has experienced a mini boom in the past 12-18 months. Demand for electronic products in the U.S. has been exceptionally strong (Chart I-9, top panel). Moreover, European production and sale of overall high-tech products as well as computer and electronic products have been robust (Chart I-9, bottom panel). In China, retail sales of communication appliances have also been extremely healthy (Chart I-10, top panel). By extension, the mainland's production of electronics has also boomed (Chart I-10, bottom panel). Chart I-9DM Demand For Tech Is Strong... Chart I-10...And So Is China's One soft spot for semi demand, however, could emanate from the global auto sector. U.S. auto sales have begun to contract, and auto production will likely shrink as well (Chart I-11, top panel). In addition, the growth rate of auto sales in both China and Europe may have reached a peak (Chart I-11, middle and bottom panels). Annual vehicle sales have reached 25 million units in China, and 17 million vehicles in both the U.S. and euro area. Overall global auto production is set to decelerate and this will weigh on semiconductor demand given that autos consume a lot of electronics. In addition, there are several other indications that suggest a mini-slowdown will likely transpire in the global semiconductor sector later this year: Taiwan's narrow money (M1) growth impulse has historically been correlated with the tech-heavy TSE index and has led export cycles (Chart I-12). This money impulse currently heralds a major top and relapse in both share prices and exports. Chart I-11Global Auto Production Chart I-12Taiwanese M1 Money Impulse Is Signaling A ##br##Growth Slowdown And Risk To Stocks The semiconductor shipments-to-inventory ratio has peaked in Korea and Taiwan (Chart I-13). This indicates that the best of the semi upswing may be behind us. Consistently, both global semiconductor producers' and semiconductor equipment stocks' forward EPS net revisions have already surged, and are elevated. This implies that a lot of earnings optimism has been priced in. Historically, when forward earning net revisions have reached these levels, global semi share prices have rolled over or entered a consolidation period (Chart I-14). Chart I-13Korea's & Taiwan's Semi ##br##Cycle Is Topping Out Chart I-14Semiconductors' Forward EPS ##br##Revisions Are Elevated Bottom Line: We expect a moderation in semi demand, but not recession. Semi share prices may react negatively to slower demand growth as the former have become extremely overbought and have already priced in a lot of good news. Investment Conclusions Semiconductor stocks have become overbought and a marginal slowdown in demand might be enough to cause a shake-out. The same is true for the overall tech sector. That said, we continue to recommend that investors overweight EM tech stocks, Taiwanese and Korean bourses within the EM equity portfolios. We also reiterate our long-standing long tech / short materials strategy. Remarkably, the KOSPI and Taiwanese TSE indexes - highly leveraged to semiconductors - have rallied to their previous highs (Chart I-15). In the past, they failed to break above these levels and we expect them to struggle again. If these equity indexes pull back and tech stocks correct, the overall EM stock index will roll over too. The rest of EM equity universe has much poorer fundamentals than tech companies. Financials and commodities sectors make 25% and 7% of the EM MSCI benchmark's market cap, respectively. The former is at risk from credit slowdown in EM and the latter is at a risk from lower commodities prices (Chart I-16). Chart I-15KOSPI & TSE Have Reached ##br##Major Resistances Chart I-16Industrial Metals ##br##Prices To Head Lower On the whole, we believe the recent divergence of EM risk assets from commodities prices and the EM/China credit cycles does not represent a structural regime shift in EM fundamentals, it rather reflects complacency in the marketplace. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor aymank@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "How The Play Emerging Market Growth In The Coming Decade", dated June 8, 2010, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Eurostoxx50 versus S&P500 boils down to a simple choice: Banco Santander, BNP Paribas and ING; or Apple, Microsoft and Google? Right now, we would rather own the three tech stocks than the three banks - which necessarily means underweighting the Eurostoxx50 versus the S&P500. Eurostoxx50 performance relative to the FTSE100 boils down to the inverse direction of euro/pound. Right now, we expect euro/pound to strengthen - which necessarily means underweighting the Eurostoxx50 versus the FTSE100. Stay overweight Spanish Bonos versus French OATs as a structural position. Feature Which would you rather own: Banco Santander, BNP Paribas and ING; or Apple, Microsoft and Google?1 Surprising as it may seem, the all-important allocation decision between the Eurostoxx50 and the S&P500 boils down to this simple choice. The Chart of the Week should leave no doubt that everything else is largely irrelevant. Chart of the WeekEurostoxx50 Vs. S&P500 = Santander, BNP & ING Vs. Apple, Microsoft & Google Right now, we would rather own the top three U.S. tech stocks rather than the top three euro area banks - which necessarily means underweighting the Eurostoxx50 versus the S&P500. The Fallacy Of Division For Equities The fallacy of division is a logical fallacy. It occurs when somebody falsely infers that what is true for the whole is also true for the parts that make up the whole. As a simple example, somebody might infer that because their computer screen appears purple, the pixels that make up the screen are also purple. In fact, the pixels are not purple. They are either red or blue. The fallacy of division is that the property of the whole - purpleness - does not translate to the property of the constituent parts - redness or blueness. As investment strategists, we hear a common fallacy of division. Since global equities are a play on the global economy, it might seem that national equity markets - like Ireland's ISEQ or Denmark's OMX - are plays on their national economies. In fact, nothing could be further from the truth. The property of the equity market as a global aggregate does not translate to the property of equity markets as national parts. The equity markets in Ireland and Denmark are each dominated by one stock which accounts for almost a quarter of national market capitalization - in Ireland, Ryanair, the pan-European budget airline, and in Denmark, Novo Nordisk, the global pharmaceutical company. Therefore, the relative performance of Ireland's ISEQ has almost no connection with Ireland's economy; rather, it is a just a play on airlines. And given budget airlines' sensitivity to fuel costs, Ireland's ISEQ is counterintuitively an inverse play on the oil price (Chart I-2). Likewise, the relative performance of Denmark's OMX has no connection with Denmark's economy; it is just a strong play on global pharma (Chart I-3). Chart I-2Ireland = Short Oil Chart I-3Denmark = Long Pharma In a similar vein, the relative performance of Switzerland's SME is also a play on global pharma - via Novartis and Roche (Chart I-4); Norway's OBX is a play on global energy - via Statoil (Chart I-5); and Italy's MIB and Spain's IBEX are plays on banks (Chart I-6 and Chart I-7). We could continue, but you get our drift... Chart I-4Switzerland = Long Pharma / Short Oil Chart I-5Norway = Long Oil Chart I-6Italy = Long Banks Chart I-7Spain = Long Banks But what about a regional index like the Eurostoxx50 or Eurostoxx600: surely, with the broader exposure, there must be a strong connection with the euro area economy? Unfortunately not - at least, not when it comes to relative performance. Consider that for the past few years, the euro area economy has actually outperformed the U.S. economy2 (Chart I-8). Yet the Eurostoxx50 has substantially underperformed the S&P500 (Chart I-9). What's going on? The answer is that the Eurostoxx50 has a major 15% weighting to banks and a minor 7% weighting to tech. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 22% weighting to tech. Chart I-8The Euro Area Economy ##br##Has Outperformed... Chart I-9...But The Eurostoxx50##br## Has Underperformed For the Eurostoxx50 the distinguishing property is 'bank'; for the S&P500 it is 'tech'. And as we saw earlier, these distinguishing properties are captured by just three large euro area banks and three large U.S tech stocks. So index relative performance simply boils down to whether the three euro area banks outperform the three U.S. tech stocks, or vice-versa. Everything else is largely irrelevant. Equities' Connection With Economies Is Often Counterintuitive When it comes to the FTSE100, it turns out that it is not more bank or tech than the Eurostoxx50. Major sector weightings across the two indexes are broadly similar. Hence, relative performance is more connected to relative economic performance. But there is a catch - the connection is not as intuitive as you might first think. You see, both major indexes are made up of dollar-earning multinational companies. Yet the index value and earnings are quoted in pounds and euros respectively. If the home currency appreciates, index earnings - translated from dollars into home currency - go down, depressing index relative performance with it. And the opposite happens if the home currency depreciates. So the counterintuitive thing is that a relatively strengthening home economy does not result in index outperformance. Quite the opposite, it normally means a relatively more hawkish central bank, and an appreciating currency (Chart I-10). Thereby it causes index underperformance. Hence, Eurostoxx50 performance relative to the FTSE100 boils down to the inverse direction of euro/pound. Once again, Chart I-11 should leave readers in no doubt. Chart I-10A Relatively More Hawkish Central Bank =##br## A Stronger Currency Chart I-11A Stronger Currency = ##br##Equity Index Underperformance Which neatly brings us to today's ECB meeting. The ECB is a tunnel-vision 2% inflation-targeting central bank. Any upgrade to its inflation forecast, as seems likely, would imply less need for its extreme and experimental monetary easing. Once digested by the market, this would support the euro. Meanwhile, on the other side of the Channel, the U.K. Government is preparing to trigger Article 50 of the Lisbon Treaty and start its formal divorce from the EU within a couple of weeks. Expect the EU's immediate response to cast long shadows across Theresa May's vision of a future in sunlit uplands. Once digested by the market, this would further weigh down the pound. A stronger euro/pound necessarily means underweighting the Eurostoxx50 versus the FTSE100. The Fallacy Of Division For Bonds The fallacy of division also applies to euro area sovereign bonds. The aggregate euro area sovereign yield just equals the average ECB policy rate anticipated over the lifetime of the bond (Chart I-12). This is directly analogous to the relationship between the U.K. gilt yield and the anticipated path of the BoE base rate, and the relationship between the U.S. T-bond yield and the anticipated path of the Fed funds rate (Chart I-13). Chart I-12The Aggregate Euro Area Bond Yield = ##br##The Average ECB Policy Rate Expected Chart I-13The U.S. T-Bond Yield = ##br##The Average Fed Funds Rate Expected But what is true for the whole is not necessarily true for the parts that make up the whole. Individual euro area sovereign bond yields carry a second component which can override everything else. This second component is a redenomination premium as compensation for the expected loss if the bond redenominates out of euros. For example, the redenomination premium on a Spanish Bono versus a French OAT equals: The annual probability of euro breakup Multiplied by The expected undervaluation of a new peseta versus a new franc. However, the ECB's own analysis shows that Spain is now as competitive as France (Chart I-14), meaning that a new peseta ultimately should not lose value versus a new franc. So irrespective of the probability of euro breakup, the second item of the multiplication should be zero. Meaning that the redenomination premium should also be zero, rather than today's 75 bps (on 10-year Bonos over OATs). Bear in mind that Spain's housing bust and subsequent recapitalisation of its banks has followed Ireland's template - just with a two year lag. And observe that the redenomination premium on Irish 10-year bonds over OATs, which once stood at a remarkable 1100 bps, has now completely vanished. We expect Spain to continue following in the footsteps of Ireland (Chart I-15). As a structural position, stay long Spanish Bonos versus French OATs. Chart I-14Spain Has Dramatically Improved##br## Its Competitiveness Chart I-15Spain Is Following In The##br## Footsteps Of Ireland Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Listed as Alphabet. 2 On a per capita basis. Fractal Trading Model* Long tin / short copper hit its 5% profit target, while short MSCI AC World hit its 2.5% stop-loss. This week's recommendation is to short ruble / dollar. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-16 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
After an M&A driven outperformance phase, semiconductor stocks appear to be putting in a major top. M&A activity has plunged, warning that deal premiums are likely to be removed from valuations. The recovery in global chip sales growth also looks to be at risk. Our global chip sales model has rolled over, reflecting softening new order growth in a number of chip-intensive industries. If top-line growth begins to recede, then the tentative trough in chip inventories is likely to turn into a full blown rebound. History shows that the highly anticipatory chip index fares poorly when chip supply accelerates. The latter signals that future chip output will decelerate, revealing the downside of a cyclical business with high operating leverage. Our Chip Stock Timing Model, a combination of technical and fundamental forces, has dropped sharply in recent weeks, reinforcing that relative performance is at serious risk. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, MU, SWKS, LLTC, MCHP, XLNX, QRVO, FSLR.
Data processing stocks have been in a consolidation phase, but this increasingly appears to be a trend change rather than a continuation pattern. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue but have lower economic leverage than much of the corporate sector. As such, when growth and inflation expectations climb, capital inflows tend to wane (inflation expectations shown inverted, middle panel). Meanwhile, top-line growth has been in a funk of late, even though companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. We shifted from overweight to underweight in yesterday's Weekly Report. The ticker symbols for the stocks in this index are: V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS.
Highlights Portfolio Strategy The market has quietly adopted a less cyclical sectoral tone since yearend, a trend that could amplify over the coming months, even if overall appreciation persists. Defense stocks have grown into previously extended valuations, warranting ongoing above-benchmark exposure. The opposite is true for aerospace equities. Data processing shares are more likely to roll over than break out and we recommend paring positions to underweight. Recent Changes S&P Data Processing - Downgrade to underweight from overweight. Table 1 Feature The stock market has cheered the broad-based rebound in earnings and improvement in corporate sector pricing power (Chart 1). Unbridled optimism about growth friendly policy tilts including potential tax reform and select regulatory relief combined with an easing in financial conditions have encouraged investors to make large down payments against expected future profit gains. Indeed, extreme economic and earnings bullishness is evident in record setting price/sales (P/S) multiples: Chart 1 shows that on a median basis, the industry group (P/S) ratio is far above the 2000 peak, providing yet another metric in a long list of yardsticks signaling that greed is the overriding market emotion. Nosebleed valuation levels are cause for significant cyclical concern, but as discussed last week, momentum and a valuation-agnostic transition from fixed income to equities are the dominant tactical forces at the moment. Since it is difficult to reconcile valuations at odds with realistic expectations about future earnings growth, we remain focused on sub-surface positioning to indemnify against disappointment. Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models (Chart 2). Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal (Chart 2). Chart 1Future Growth Has Been Paid For Already Chart 2The Market Tone Is Changing Contrarians should take note. These nascent trend changes have developed even though economic data have generally surprised on the upside, which may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. The global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks (Chart 3). The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (Chart 3), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing (Chart 3), providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. A trend change is also consistent with the relentless downgrading in emerging market vs. developed country GDP growth expectations (Chart 4). Chart 3Forward Looking Yellow Flags Chart 4No EM Confirmation For Cyclicals The lack of a durable and credible growth thrust in EM is confirmed by regional share price performance, as EM equities have significantly lagged their developed country counterparts (Chart 4). Now that China's fiscal stimulus impulse has rolled over amidst ongoing currency depreciation, EM lacks a catalyst for incremental growth outperformance vs. developed markets. Adding it up, evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. We expect a mostly defensive along with select interest rate-sensitive exposure to provide optimal portfolio performance in the next 3-6 months. Defense Stocks Will Continue To Protect Portfolios... A Special Report sent to clients on October 31 outlined the long-term appeal of defense stocks, prior to the installment of a new, bellicose U.S. Administration. If anything, the latter threatens to exacerbate the decline in globalization that was already in progress (as discussed since 2014 by BCA's Geopolitical Strategy Service), potentially creating a leadership vacuum that will raise the specter of open military conflict. More nationalistic foreign policies in a number of countries, i.e. moving away from collaboration and cooperation and toward isolationism and self-sufficiency, is a recipe for increased geopolitical instability. China's challenge to the status quo is also likely to motivate a boost to defense spending globally. The recent World Economic Forum estimates of global military spending by 2030 cite both China and India planning to quadruple military outlays over this time frame (Table 2). The U.S. Administration is already pressuring other NATO members to boost defense spending after a long contraction (Chart 5), which should eventually spillover into rising defense contractor sales. Reportedly, only 5 out of 28 NATO members reached the targeted goal of spending 2% of GDP on defense. Ergo, there is room for an increase, especially in some larger countries with fiscal room to maneuver. More imminently, the conditions that have created the gap between aerospace and defense relative performance are growing even stronger (Chart 6). Table 2A New Arms Race Underway Chart 5Lots Of Upside Chart 6A Growing Gap While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (Chart 6). The unfortunate reality is that the incentive to boost defense and security spending has never been higher. Terrorist activity continues to proliferate around the world (Chart 7), raising a sense of geopolitical uncertainty and mistrust. With defense new orders continuing to make new cyclical highs, factory output should run at levels flattering operating margins. Shipments of defense goods are outpacing inventories by a wide margin, which is consistent with solid pricing power. Even exports of military goods are booming (Chart 7), despite the strong U.S. dollar, reflecting a strong undercurrent of global demand. Domestic defense spending has room to expand. Real defense outlays are only just starting to recover (Chart 8). President Trump ran on a campaign to protect the U.S. from terrorism. That should make it comparatively easy to increase defense spending in the years to come. It is normal for defense stocks to retain momentum as defense spending growth accelerates (Chart 8, top panel). Increased staffing at the U.S. Department of Defense (DOD) implies that purse strings may already be loosening in anticipation of heightened activity. DOD employment growth often provides a good leading indication for real defensive spending trends (Chart 8, bottom panel). Thus, while share prices have been on a tear and valuations are not cheap, rapid earnings growth has pushed down forward multiples to manageable, below-market, levels (Chart 9, shown as an average of the companies in the BCA Defense Index). Chart 7Powerful Momentum... Chart 8... With Long-Term Durability Chart 9Growing Into Valuations Prospects for strong multiyear growth should support a move to a premium valuation as margins expand (Chart 9), similar to what occurred during past defense spending booms, as chronicled in our October 31 Special Report. ...But Aerospace Stocks Are Out Of Fuel In terms of aerospace equities, the outlook is more challenging. New orders have been sinking steadily, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Chart 10 shows that aerospace unfilled orders are contracting, an environment typically associated with share price underperformance, or at least elevated volatility. Shipments of aerospace goods are falling, a rare occurrence (Chart 10). The implication is that aerospace industrial production is also shrinking (Chart 10). With a heavily unionized labor force, it will be difficult to maintain profitability. Will increased global growth translate into a recovery in aerospace new orders? Doubtful. Aerospace cycles tend to be long and are not always correlated with the business cycle. Aerospace new order growth has little correlation with the global leading economic indicator. In fact, if anything, it is more countercyclical. Ominously, there are signs of excess capacity. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders (Chart 11). Chart 10Running On Empty Chart 11Too Much Capacity Against this backdrop, aerospace profits will become increasingly reliant on maintenance, repair and consumables activity. However, weak pricing power suggests that this source of revenue is soft (Chart 11). Aerospace valuations are close to a par with those of defense stocks. Divergent profit outlooks imply that the latter should expand while the former get squeezed. Bottom Line: We remain confident that the BCA defense index (LMT, GD, RTN, NOC, LLL) will continue to generate above market returns, whereas the BCA aerospace index (BA, UTX, HON, TXT) exhibits asymmetric downside risk. Data Processors Are Losing Their Allure After a consolidation phase that restored value to a more neutral level, we upgraded the S&P data processing index to overweight in late-September, because it fit into our consumption vs. capital spending theme, outperforms in disinflationary environments and would benefit from a recovery in industry sales growth. While several of those factors still exist, the share price ratio has been unable to gain traction and the window for outperformance may be closing. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue and high returns on equity, warranting persistent above market valuations (Chart 12). However, the flipside of predictability is lower operating leverage than many other industries and a pattern of underperformance during periods of rising inflation expectations. Indeed, cyclical share price momentum tends to take its cue, inversely, from inflation expectations (inflation expectations shown inverted, middle panel, Chart 12). Renewed traction in global economic growth, as evidenced by the upturn in the global leading economic indicator (GLEI, shown inverted, top panel, Chart 13), represents a headwind to capital inflows and relative multiple expansion. The improvement in business sentiment has also boosted our capital spending model, albeit we are doubtful as to whether increased animal spirits will translate into much of a capital spending cycle in a world of deficient final demand and soft free cash flow. Still, any rise in capital spending would put the services-based data processing group at a disadvantage, in relative terms. The downturn in the ISM services index compared with the ISM manufacturing index reinforces that the external environment has become more challenging (Chart 13). All of these factors could be overcome if operating trends were set to improve. Data processing revenue trends are tightly linked with consumer spending (Chart 14). The personal savings rate has room to fall, facilitating an increase in outlays, particularly now that the labor market has tightened. Rising job security has buoyed consumer confidence, which has historically augured well for data processing sales growth. Chart 12The Window Has Closed Chart 13Sell Signals Chart 14Margin Squeeze But top-line growth has been in a funk of late, even with firming pricing power (second panel, Chart 14). Companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. Thus, we are reluctant to embrace the jump in the producer price index, as future readings could be much weaker. The implication is that operating performance will not overcome macro hurdles. Bottom Line: Reduce the S&P data processing index (V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS) from overweight to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).
Highlights Portfolio Strategy Add the S&P asset manager & custody banks index to the high-conviction overweight list. Prospects for higher interest rates bode well for a catch up phase with the rest of the financials sector. Initiate a long S&P consumer staples/short S&P technology pair trade, a truly out of consensus call. Housing-related equities are likely to gain ground as housing activity should stay resilient amidst rising borrowing costs. Recent Changes S&P Asset Managers & Custody Banks - Added to our high-conviction overweight list on February 16th. Long S&P Consumer Staples/Short S&P Technology - Initiate this pair trade today. Table 1Sector Performance Returns (%) Feature Momentum continues to drive the broad market trend. The drag from a reduction in global liquidity courtesy of depleting foreign exchange reserves continues to be overwhelmed by economic optimism. The latter is fueling a major rotation from bonds to stocks, which is the dominant market force. Valuations have taken a backseat, emblematic of blow-off phases. Two weeks ago we introduced our Complacency-Anxiety Indicator, which hit a new high. Another way to measure greed overwhelming fear is the relentless rise of the forward P/E over the VIX. The spread between these two measures can also gauge complacency. This Indicator has also soared to an all-time high (Chart 1). Chart 2 applies this methodology for the broad S&P sectors, using forward P/E and implied equity volatility, and then standardizes the result to remove biases from perennially low and high P/E sectors. A low reading suggests lower risk, and vice versa. Chart 1Buy At Your Own Risk Chart 2Sector Vulnerabilities And Opportunities At the moment, financials, telecom, utilities, REITs and health care have the lowest implicit vulnerability, while cyclical sectors carry the most risk. How long can this overshoot phase last? There are obviously no easy answers. However, from a purely technical perspective and in the absence of any major monetary, economic and/or geopolitical shocks, an examination of our Composite Technical Indicator (CTI) suggests some running room remains. Our CTI is driven primarily by momentum components. Overbought conditions are signaled once it hits one standard deviation above the mean. Currently, the TI remains slightly below this threshold (Chart 3). Even then, it can cross decisively into the danger zone before the S&P 500 eventually sells off in a meaningful fashion. Chart 3Overbought Conditions Can Persist Importantly, when the CTI swings quickly from deeply oversold to overbought levels, there can be a multi month lead before the broad market crests or suffers a sustained setback (Chart 3), and the bulk of those moves are associated with economic recessions and/or growth disappointments. The implication is that even though extended broad market valuations virtually guarantee paltry long-term returns and economic expectations are now sky-high, technical conditions suggest that momentum may continue to carry the day for a while longer. That does not mean investors should abandon a largely defensive portfolio structure, given that this is where the reward/risk tradeoff is most attractive and timing corrections is inherently difficult. Two weeks ago we recommended buying both gold and packaging stocks. As part of our ongoing rebalancing, this week we are further tweaking our portfolio. We recommend a pair trade to position for the inevitable sub-surface mean reversion heralded by our Indicators in the coming 3-6 months. Asset Managers: Shifting To High-Conviction Status The interest rate and market-sensitive S&P asset managers & custody banks index (AMCB) has lagged most other financials sub-indexes at a time when macro forces are lining up bullishly, particularly in view of the sector's attractive ranking on a forward P/E to volatility basis. While the capital markets and banks groups are seen as having higher torque to these positive forces, these three groups tend to move together. Lately, a divergence has opened, but a number of factors point to an imminent AMCB catch up phase (Chart 4), especially given that AMCB is not levered to overall credit growth, which has dried up. Fed Chair Yellen's testimony last week was interpreted to be slightly more on the hawkish side. That, coupled with the recent upside surprise in core inflation, raises the possibility of more 2017 tightening than currently discounted. That would provide further relief for custody banks, as ultra-low interest rates have been an anchor on this group's profitability as fees earned on funds held in trust have been minimal. The increase in short-term Treasury yields heralds a share price rally (Chart 5, top panel). Chart 4Catch Up Ahead Chart 5Time To Rally Moreover, the boost in economic expectations signals scope for an increase in fee generating activity, such as M&A, stock issuance and even stock lending. BCA's Global Economic Sentiment Index also indicates that the share price ratio has undershot (Chart 5). Most importantly, the asset preference shift from bonds to stocks reverses another major drag on profitability (Chart 5, third panel). Fixed income products carry lower margins than equity products, so as equity assets under management grow, profit margins should expand. If so, then we would anticipate a relative valuation re-rating, especially if the pace and scale of financial sector deregulation disappoints. The latter has been a key factor propelling capital markets and banks, and any disappointment could cause a capital rotation into the lagging AMCB index. Bottom Line: We are already overweight the S&P asset management & custody banks index, and added it to our high-conviction list in a daily Sector Insight on February 16th. New Pair Trade This week we are recommending what can be considered a highly contrarian pair trade: long the S&P consumer staples sector and short the S&P technology sector. It may be difficult to swallow executing such a non-consensus position while the broad market is going gangbusters. However, the objective message from our Indicators and increasing odds of a vicious, un-telegraphed correction, argue that the reward/risk trade-off is too attractive to ignore. As outlined in last week's Cyclical Indicator Update, the technology sector's relative earnings profile has deteriorated, because the corporate sector is not spending much yet and tech companies have suffered a serious loss of pricing power. Conversely, the consumer staples sector has a better chance of earnings outperformance, according to our model (Chart 6). Both sectors appear to have discounted the opposite outcome. Moreover, from a technical perspective, tech stocks are overbought and consumer staples are extremely oversold (Chart 6). Even a simple technical/momentum renormalization would imply a sharp jump in the share price ratio. Both sectors lose competitiveness when the U.S. dollar rise, but given that the technology sector's share of foreign sales (58%) is much higher than that of consumer staples (28%), the pain is disproportional. Importantly, consumer staples exports are accelerating, whereas tech exports are shrinking (Chart 7). Chart 6Contrasting Profiles Chart 7The Strong Dollar Is Worse For Tech Non-durable consumer goods are less sensitive to emerging market prospects, and thus when their currencies weaken, momentum in the consumer staples/tech share price ratio tends to accelerate (EM currencies shown inverted and advanced, bottom panel, Chart 7). Moreover, a strong U.S. dollar tends to reduce input costs for many consumer staples vendors, both through lower commodity prices and a reduced cost of imported goods sold. We have shown that tech stocks fare poorly toward the latter stages of a U.S. dollar bull market, when consumer staples start to shine. This dynamic reflects the economic fallout abroad from a strong U.S. dollar, particularly on developing economies, as well as the drag on U.S. corporate profits, and by extension, capital spending. While the U.S. dollar and stocks have risen in tandem in recent months, that cannot continue indefinitely, and when the correlation breaks down, the defensive consumer staples sector should outperform. In terms of economic dynamics, this share price ratio tends to accelerate when consumer spending outperforms capital spending. Consumer confidence is outpacing business confidence (Chart 8, top panel), signaling such an environment ahead. That sentiment mismatch has already translated into faster consumption than business investment on tech goods (Chart 8, second panel). Unless the gap between the return on and cost of capital reverses course and widens anew, then this trend is likely to persist. As a result, the surge in consumer staples vs. technology pricing power will continue, ultimately flattering the share price ratio through relative profit performance (Chart 8, bottom panel). The message is that consumer staples profits can have the upper hand over tech even when overall GDP growth is positive, provided the underlying driver is consumption rather than capital spending. From an external standpoint, it is notable that consumer staples have a better track record than tech stocks during inflationary periods. Chart 9 shows that the uptrend in long-term inflation expectations and increase in actual inflation both forecast a revival in this pair trade. Chart 8Unsustainable Divergences Chart 9Inflation Pressures? Buy This Ratio Rising inflation ultimately heralds tighter monetary policy, which is a precursor to elevated broad market volatility and a rise in the discount rate, to the detriment of long duration sectors. History shows that the high priced tech sector is more vulnerable than the safe haven staples sector in such an environment. In sum, the time is ripe for a contrary pair trade favoring consumer staples vs. technology. Notable risks to this trade are that the U.S. dollar weakens meaningfully and/or global capital spending re-accelerates decisively, relative to consumer spending. Bottom Line: We recommend a market neutral long consumer staples/short technology pair trade. The time horizon for this trade is 3-6 months. Will Housing Stocks Go Through The Roof? Housing-related stocks have delivered positive earnings surprises, but anxiety about rising mortgage rates challenges the outlook. While the latter is a risk, cheap valuations and consumers' underappreciated ability to absorb rising borrowing costs offset these concerns. Sensitivity analysis shows that even a 200 basis point (bps) spike in interest rates from current levels would fail to push housing affordability back to the long-term average (Chart 10). Moreover, mortgage payments as a percentage of incomes and effective borrowing costs would also remain below their respective historic means even with such a spike. Importantly, housing market fundamentals are improving. Lumber prices are on fire. Lumber has been the best performing commodity year-to-date. This is a real time indicator of housing demand (Chart 11). Similarly, railroad carloads of lumber are also firming, signaling that the price rise is demand-driven rather than a speculative bet in the trading pits. Sustained house price inflation, solid housing turnover and the acceleration in building permits reinforce that housing activity remains robust (Chart 11). Chart 10Higher Rates Are Not A Show Stopper Chart 11Lumber Strength Is Housing Bullish The credit tap to sustain strong activity is still open. According to the latest Fed Senior Bank Loan Officer Survey, banks are willing and able to extend residential mortgage credit (bottom panel, Chart 11). This contrasts with many other credit categories, where banks are tightening the screws and credit demand is faltering: C&I loans have shrunk over the past three months, as has total bank credit. First time home buyers are also reappearing and anecdotes of increased house flipping activity signal a vibrant market with unobstructed access to credit. All of this should continue to support earnings-led outperformance from both homebuilders and home improvement retailers (HIR). The bullish outlook for the S&P homebuilding index rests on four pillars. The latest National Association of Home Builders (NAHB) survey revealed that sales expectations remain over 20 points above the boom/bust line and just shy of recent cyclical highs (Chart 12). Homebuilders are clearly still seeing strong traffic. New home prices are still expanding at a healthy clip (Chart 12). Sales growth and new home price inflation are tightly linked. The mortgage application purchase index has picked up steam despite the mortgage rate increase, confirming that first time homebuyers are entering the market after a long hiatus as the financial motivation to buy vs. rent has improved. This optimism is causing an aggressive re-rating in earnings estimates from chronically bearish levels (Chart 12), a harbinger of further gains in relative share prices. The S&P HIR index also has a concrete foundation. Higher lumber prices flow straight to the bottom line, because HIR companies typically earn a set margin on lumber-related sales. Moreover, higher housing turnover is a boon for industry sales volumes (Chart 13). Historically, home sales momentum has been an excellent leading indicator of renovation activity. Chart 12Buy Homebuilders... Chart 13... And Building Supply Retailers Encouragingly, the NAHB remodeling survey is still in expansion territory, and tends to follow the trend in home sales, underscoring that home renovation activity is set to improve (Chart 13). Our HIR model encapsulates many of these key drivers, and has climbed anew (Chart 13). The message is that profits, and share prices, are on track to outperform. Adding it all up, the housing backdrop remains attractive, and even a steady increase in borrowing costs should not disrupt momentum. The time to become concerned will be if inflation becomes a serious risk, causing the Fed to get 'tight' and credit availability to dry up. The next few interest rate hikes won't move the monetary settings to that phase yet. Until then, we recommend erring on the bullish side. Bottom Line: We reiterate our high-conviction overweight in the S&P home improvement retail index (HD, LOW) and continue to recommend an above benchmark allocation in the S&P homebuilding index (PHM, DHI, LEN). Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).