Downgrading The U.S. S&P Materials Sector

The rebound in U.S. materials stocks is likely to fizzle, undermined by China’s capital spending slowdown and the surge in natural gas input costs.

Our U.S. equity strategists have been overweight S&P Materials as part of the deep cyclical sector bias, but are losing confidence that the recent uptrend can be sustained.

Technical conditions are overbought. Our Technical Indicator is closing in on previous bullish extremes, and is challenging levels that have previously marked interim relative performance peaks. The advance has also occurred on narrow breadth. The number of groups with a positive 52-week rate of change is lagging behind relative performance, as is the number of groups trading above their 40-week moving average. Spotty participation suggests that the latest advance is not well supported.

Importantly, China is struggling to maintain a high rate of economic growth. Infrastructure spending has slowed significantly, and its currency has begun to decline. Money growth is sinking and loan growth is decelerating, underscoring that a sudden resource-intensive reacceleration in Chinese economic growth is unlikely. This is a headwind for the materials sector.

downgrade materials sector S&P 500

Sluggish Chinese economic data, persistent softness in emerging market leading economic indicators, contracting materials exports and surging natural gas prices, a key input cost, are weighing on our Cyclical Macro Indicator. The message from the CMI is that relative forward earnings estimates are unlikely to sustain upward momentum. Consequently, the prudent portfolio strategy is to pare our materials sector weighting to neutral.

Australia & New Zealand: Firing Up

Bullish currency developments overnight for both Australia and New Zealand:

Australia And New Zealand Firing Up

Australia: The most recent payroll report was very positive. More full-time positions were created in February than in any month since 1991. This is a reversal of the trend of the past year in which part-time positions have been robust, while full-time positions have been were shed. True, it does not pay to extrapolate one month of data, but as highlighted in previous Insights, economic reports from Australia have generally surprised to the upside in recent months.

New Zealand: As predicted, the RBNZ is the first of the G10 central banks to raise its policy rate. If there is a surprise, it is that the RBNZ expects to increase interest rates by 200bps over the next two years and expects to reach the 2% inflation target eighteen months sooner than it early reported. Meanwhile, New Zealand’s terms of trade hit a new secular high. This is pulling the fair value of the kiwi dollar higher.

Our Foreign Exchange Strategy service is bullish on both the New Zealand and Australian dollars relative to USD. In terms of the cross, our strategists see AUD/NZD as a long term value trade: the market has discounted significant rate hikes in New Zealand, but remains much too cautious on the RBA. A convergence in interest rate expectations will support the AUD/NZD cross.

U.S. Bond Strategy: Stick With High-Yield

The option-adjusted spread declined 41 basis points in February and currently rests at 361, just 21 basis points above our multi-year spread target of 340. Our U.S. Bond Strategy service recommends maintaining overweight allocation to high yield bonds.

U.S. Bond Strategy Stick With High-Yield

There are certainly budding signs of deteriorating credit quality in the high-yield space: our Corporate Health Monitor appears poised to cross over into deteriorating health territory, covenant quality remains weak and there has been a surge in payment-in-kind issuance. For now, however, these trends are in their very early stages and corporate balance sheets are starting from a very healthy base.

Moreover, a worsening in credit quality is only one of several conditions usually required to mark the end of a cyclical bull market in spreads. Typically, spreads only begin to widen once the Fed has tightened policy into restrictive territory. An additional catalyst, such as a tightening in lending standards, is then usually required to prompt an upswing in defaults.

The 12-month trailing default rate fell to just 1.78% in January, and our model projects only a slight increase over the first half of this year before it levels-off. Investors remain well compensated for bearing this default risk, as the default-adjusted spread has just recently dipped below its historical average.

Zero-bound rates will continue to make spread product a hot commodity over at least the next year. A more significant undershoot of the historical average default-adjusted spread, down perhaps to the 190 level that prevailed during the latter part of the previous credit cycle, seems entirely possible.

Russia Takes It To Next Level

By invading Ukraine, Putin is putting pressure on the pro-West Yatsenyuk government and sending a strong message to the West that Russia will not tolerate the loss of Ukraine from its sphere of influence. NATO’s response will be critical for gauging the commitment level of the West to challenge Russia.

Russia Takes It To Next Level

In a Daily Insight last week, our Geopolitical strategists highlighted that investors must watch for signs of how committed the U.S. and EU are to wrestling Ukraine from Russia. A serious effort – combining financial aid and blank-check diplomatic support – would force Moscow to respond. However, Russia sent a clear message over the weekend that it is prepared to play hard-ball, before any aid package could be presented to the Ukraine government.

German Chancellor’s weekend phone call with Putin provides some hope. By playing the middle ground between Russia and the U.S., Germany could defuse the situation, at least temporarily. According to news reports, Russian President Vladimir Putin accepted the offer of international monitors, which may calm the situation.

A key risk in the short-term is that Russia decides to invade the rest of Ukraine, following its maneuvers in Crimea. Another risk is that the West responds with more than rhetoric. Our strategists believe that the U.S. does not care enough about Ukraine to directly challenge Russia, and there are no signs that NATO is willing to step up to a military confrontation at the moment. Therefore, the German Chancellor’s offer of monitors in Ukraine may be the beginning of a de-escalation.

Bottom Line: Ukraine should not have major implications for financial markets in the major countries, but much will depend on the response from NATO and, particularly, the U.S. However, Ukraine may degenerate into a Yugoslavia-style civil war regardless of any de-escalation of tension between Russia and the West.

Chinese Slowdown: Lessons From The 1990s

For an economy with constantly increasing underlying demand and high growth potential, a seven-year growth slowdown is rare in China’s post-reform history. History never repeats itself, but our China Investment Strategy service believes that the 1990s credit-driven growth slowdown offers several important messages in understanding the ongoing growth downturn:

Chinese Slowdown - Lessons From The 1990s

First of all, compared with the 1990s, inflation is distinctly absent in the current environment. Headline inflation peaked at 27% in 1994, compared with 2.5% today. Without a major inflation threat, the authorities are unlikely to tighten aggressively in such a way that could lead to an abrupt disruption in credit flows and a sharp growth slowdown.

Second, another major difference is that the economy was dominated by the state sector back in the 1990s and was a lot less efficient than today. Inventory build-up was a major source of GDP growth in the 1990s, a sign that the economy was accumulating debt and producing products simply to keep workers employed. In essence, the growth slowdown in the 1990s was due to a combination of credit tightening and structural cleansing of a socialist state-controlled system to remove idle capacity. China’s economic structure today is drastically different from two decades ago.

Finally, credit tightening was clearly a headwind for growth in the 1990s. However, the sharp credit growth slowdown between 1998 and 2000 did not lead to major growth problems in the broader business activity. In fact, amid the credit crunch, the economy was able to withstand major global shocks such as the Asian financial crisis and the global tech bubble bust, and stayed largely stable without major financial stress. If history is any guide, we expect the economy and financial system to remain resilient in the ongoing tightening cycle, especially as policymakers are in no rush to hasten the “deleveraging” process, and the global business cycle is gradually on the mend.