U.S. Equities: Margin Optimism Is Not Justified

U.S. corporate profit margins are already narrowing, but bottom up forecasts are looking for an aggressive move out to new highs in the coming quarters.

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Given U.S. labor cost inflation, revenues need to snapback from their current contraction to achieve even modest margin expansion. The growth backdrop is not conducive to such a development. The yield curve, which is an excellent business cycle indicator and a leading signal for profit margins, continues to flatten relentlessly.

Fewer than 50% of the non-financial and non-utility industry groups are currently expanding profit margins. Yet 8 out of 10 sectors are expected to grow margins according to analyst earnings estimates.

Specifically, cyclical sectors such as industrials, materials, energy and technology are slated to show broad-based improvement in profitability. That would not be farfetched if the world were on the cusp of a V-shaped, post-recession type of acceleration and the U.S. dollar were set to weaken significantly, i.e. more than 10%. After all, cyclical sector profit margins are very depressed.

However, deleveraging and the global credit contraction warn that global growth is not about to rebound. As such, our U.S. equity strategists remain skeptical that the macro backdrop will validate upbeat analyst forecasts, rendering the broad market vulnerable.

Brexit: The Final Days

Our European Investment Strategy service recently published a report entitled “Brexit: The Final Days, Part 1”, which includes discussions that 30% of voters will either make up or change their minds in the last week before the U.K.’s crucial referendum on EU membership, half of them on the final day itself. Ahead of Britain’s most important vote in a generation’, this two-part report discusses what investors should focus on in the last few days, and how to position before and immediately after the vote.

To access the report entitled “Brexit: The Final Days, Part 1”, please click here.

Brexit

Shadow Fed Funds Rate Says Sell U.S. Equities

Investor optimism has been rekindled as weakening U.S. employment has deferred Fed interest rate hike expectations. Nevertheless, the Fed may stay hawkish because the labor market is near full employment, unemployment insurance claims remain below 300K, core inflation is firming and wage inflation is trending higher. Monetary conditions have been tightening ever since the Fed completed its bond purchases in October 2014. Using the Wu-Xia shadow Fed funds rate, it is obvious that a less accommodative Fed at the margin has let the volatility genie out of the bottle and, more importantly, capped equity market returns. Thus, the risk remains that the Fed raises rates and rekindles the loop of a higher U.S. dollar leading to tighter global financial conditions, in turn causing a stock market correction, and forcing the Fed to back off its hawkish rhetoric.

Bottom Line: While a run toward all-time highs is possible leading up to the next Fed hike, the risk/reward tradeoff remains to the downside and our Global Alpha Sector Strategy service cautions investors not to chase equities higher from currently extended valuation levels.

For additional information, please visit our Global Alpha Sector Strategy website at gss.bcaresearch.com.

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Weak Global Vital Signs

According to our U.S. equity strategists, to forecast that a weaker U.S. dollar will revitalize rather than simply stabilize profits on a broad-basis, it is critical for the rest of the world to demonstrate an internal demand impulse. That would signal that other countries can cope with currency strength, otherwise U.S. dollar depreciation would simply redistribute a shrinking global profit pie back to the U.S.

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Profit redistribution may be enough to avert a serious crunch in stocks, but it is hardly fodder for a sustained breakout when P/E multiple compression is already underway.

The contraction in global exports, particularly in Asia, underscores that global final demand is still sub-par. Our global leading economic indicator, excluding the U.S., is still below the boom/bust line. The global ex-U.S. PMI has also sunk below the key expansion/contraction line. These subdued readings suggest that growth outside the U.S. is not yet on the cusp of a reacceleration.

That is consistent with the message from the bond and equity markets. Global stocks outside the U.S. are barely off their lows, suggesting that foreign profits remain weak. Treasury yields and inflation expectations remain historically low, and yield curves continue to flatten.

We remain wary of global deep cyclicals, but selling pressure in the domestic and interest rate-sensitive S&P consumer discretionary sector may have run its course, particularly if the long end of the U.S. yield curve continues to rally. Our U.S. equity strategist recommend lifting this sector to neutral from underweight.

An Update On Global Growth

According to our EM strategists, there is not much evidence to argue that global growth is improving:

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  • Global trade volumes are contracting and EM share prices – advanced by six months – indicate that the pace of global trade volume contraction will escalate.
  • EM import volumes are contracting, and U.S. import volume growth is heading to zero.

Indicators shown in the next Insight also point towards downbeat growth conditions.