Overvalued And Overlevered

If we had conviction that the profit contraction was near a reversal, subdued economic activity would be less worrisome. But in this cycle, corporate balance sheets are stuffed with excess leverage, underscoring that the risk of hitting stall speed is elevated.


Without balance sheet flexibility, depressed cash flow generation means that companies could be forced to take growth-sapping retrenchment measures. Seven out of the ten broad sectors are expected to show year-over-year profit contraction in the first quarter, a grim outcome.

Moreover, credit excesses extend beyond the corporate sector to investor positioning. Margin debt is near record levels in absolute terms, and compared with GDP and/or market cap. Market cap itself is extremely stretched relative to GDP. Both are challenging previous secular market peaks.

Moreover, thin individual investor cash holdings are more consistent with a market top than a market trough. At a minimum, these readings warn of paltry long-term returns from current levels. Worse, a low cash cushion combined with hefty margin debt creates an “air pocket” potential, and reinforces our U.S. equity strategists’ commitment to a defensive portfolio structure.

Bottom Line: We expect defensive sectors and industries to maintain their leadership role, even if the broad market stays in overshoot territory for a while longer as a consequence of the search for yield.

U.S. Equity Strategy: Cyclicals Versus Defensives

Renewed strength in the U.S. equity market sponsored by another round of global monetary easing has revived the debate about whether it is finally time to transition out of an alpha-generating U.S. defensive portfolio strategy.


A number of strategists and media outlets have championed the view that yield proxies and non-cyclical sectors are expensive, and no longer offer an attractive reward/risk trade-off, particularly within the context of the recent easing in credit spreads, commodity price relief and the dip in the U.S. dollar.

In absolute terms, nearly every sector and group is expensive, given that the broad market is trading at historically rich multiples. Thus, pointing to rich valuations in absolute terms is not appropriate when gauging potential for relative performance.

Our metrics do not support the notion that defensive sector outperformance has skewed relative valuations. Defensive sector strength has been almost entirely earnings driven, as measured by the steady upward march in relative forward earnings estimates. Our relative valuation gauge for defensives is barely above neutral despite multiyear outperformance. At the same time, cyclical sectors have experienced a steady decline in relative forward profit estimates, which has kept our valuation gauge close to neutral when the energy sector is excluded.

The implication is that forecasting a cyclical sector comeback based on a valuation basis could lead investors down the wrong path. Instead, the lack of a major valuation anomaly means that relative performance should continue to be dictated by relative profit trends. Please see the next Insight, (Part II) U.S. Equity Strategy: Cyclicals Versus Defensives.

Warning Signals For EM Equities

There is no science that helps differentiate between temporary rebounds and lasting bull markets in the early stages of a market upswing. Our EM strategists reviewed several indicators that suggest the current rebound is quite fragile, and that global and EM risk assets will relapse.


  • The relative performance of Swedish industrial companies’ stocks to global nonfinancial equities has in the past led global share prices. At the moment, the relative performance of Swedish industrial stocks has rolled over, pointing to a relapse in global share prices. Why do Swedish industrial stocks tend to lead? The Swedish stock market includes many multinational industrial firms that derive revenues worldwide and, hence, their price fluctuations reflect global business cycle dynamics.
  • The gold-U.S. bond ratio has not yet broken out and appears to be stalling. A reversal in this ratio, if sustained, would signify the resurgence of deflation trades.

Please see the next Insight for several other indicators that warn that the global and EM equity bounce is in a late stage.

Weak Productivity Growth: Don’t Blame The Statisticians

There is little evidence to suggest that the decline in productivity growth in the U.S. and many other countries in recent years is the result of measurement error. While the mismeasurement problem in the IT hardware industry has likely intensified over the past 10 years, this has been offset by the relative decline in the size of that sector.

The unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. The real reason that productivity growth has slowed is that businesses have plucked many of the low-hanging fruits made possible by the IT revolution. Cyclical factors stemming from the Great Recession have also weighed on productivity.

Low productivity growth tends to be deflationary in the short run, but inflationary in the long run. For now, this is good news for bonds, but is likely to become bad news by the end of the decade. Subpar productivity gains could dampen investor sentiment and reduce the growth of economy-wide business profits. However, to the extent that the productivity slowdown is due to diminished “creative destruction”, this could favor firms that already dominate stock market indices.

A Decline In Productivity Growth Is Deflationary In The Short Run,But Inflationary In The Long Run

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To access the Special Report entitled Weak Productivity Growth: Don’t Blame The Statisticians, please click here.

Global Equities In The Fed’s Wake

Global equity and commodity prices have cheered the Fed’s dovish forecasts published last week. Meanwhile, the stability in the yuan is another source of glee for EM and commodity markets. However, we continue to expect the Fed-induced rally to be short-lived.


After a disappointing reaction to the ECB’s policy easing on March 10, global equity and commodity prices have cheered the Fed’s dovish set of forecasts published last week. Also, the recent period of stability in the yuan is defying many market participants’ dire expectations. True, the previous dose of fiscal stimulus undertaken by the Chinese authorities could spell a temporary period of strength in the Chinese economy, which would help the EM and commodity complex for a few months. But the burden of proof remains high for this second scenario.

While a China-induced risk rally could last a few months longer than a strictly Fed-induced one, and hence be more playable for nimble investors, the Chinese economy remains plagued by a massive debt load, excess capacity, and deep deflationary forces, none of which are being fundamentally addressed. This suggests that any improvement will be temporary. Moreover, the longer the rally in commodities lasts, the more aggressive the Fed will get, creating another set of problems for commodities.

There are good odds EM assets will make new lows later this year; DM equities will also continue to face a challenging backdrop this year.