Is The Industrials Honeymoon Over?

The ISM index offers useful leading information on the relative performance of industrials. Whenever the ISM index sinks below the boom/bust line for five or more consecutive months, it does not pay to underweight industrial stocks as too much bearishness is usually baked in the cake. The opposite is also true. We analyzed relative industrials performance since the early 1990s every time the ISM manufacturing new orders sub-index hit 60. The bottom panel of the above chart shows the median relative performance in the ensuing twelve months. The implication is that industrials stocks will suffer in the coming quarters as too much optimism is already discounted since the post-election reflex advance.

Bottom Line: We reiterate our recent high-conviction underweight stance on the S&P industrials sector.

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Is 2017 The Year Of The Letter “R”?

2017 will be dominated by a four ‘Rs’ theme: Recovery, Rates, Rotation, Re-leveraging, which will eventually lead to two additional ‘Rs’: Risk and Recession.

The global economy is in a modest recovery, whose roots predate the U.S. elections. The chart shows the number of times “reflation” has been mentioned in the news according to Bloomberg data. Such hype has been closely correlated with the extremely economic sensitive copper-to-gold ratio. Moreover, economic exuberance is signaling that global stocks have more room to run (top panel).

The back up in real yields is also noteworthy given the close correlation they enjoy with equities. Importantly, the U.S. 10-year TIPS yield has vaulted 47bps higher since the multi-year low hit just after Brexit, reflecting at the margin an improving economic growth outlook. Indeed, economic surprise indexes have firmed and financial conditions (as per Bloomberg) remain loose in every major region.

Another way to depict the reflationary effect on stocks is via a global equity EPS diffusion index. Using forward EPS data from I/B/E/S, we constructed a diffusion index of countries (both DM and EM) that have negative y/y EPS growth. This index has been steadily sinking since mid-summer with fewer and fewer country EPS in the contraction zone. This is a positive backdrop for global equities.

For additional details on the rest of the ‘Rs’, please refer to the Global Alpha Sector Strategy report titled ‘The Year Of The Letter “R”’, available at gss.bcaresearch.com.

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What Are BCA’s Top Ten High-Conviction Equity Sector Calls For 2017?

Our biggest out of consensus call is to overweight the much maligned consumer staples sector.

One of the most glaring divergences between our macro indicators and relative share price performance exists in the consumer staples sector.

Since the U.S. election, this sector has been used as a source of capital to fund more speculative investments in areas levered to global economic growth, such as industrials. An exploitable undershoot has developed in a sector with one of the best 12 and 24-month track records during Fed tightening cycles. The sector is undervalued, and is resting at an oversold extreme, based on our Technical Indicator.

Our Cyclical Macro Indicator for the sector is grinding higher, Supported by consumers’ persistent preference for saving vs. spending, a plus for retail sales at non-discretionary stores. Tack on a budding recovery in consumer staples exports (bottom panel), and the nascent acceleration in sector sales growth should strengthen further, supporting earnings outperformance.

For our complete list of high-conviction calls, please refer to Monday’s Weekly Report titled “2017 High-Conviction Calls“, available at uses.bcaresearch.com.

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What Are The Equity And Sector Implications Of De-Globalization?

The most profound and simultaneously provocative investment implication from the end of globalization is that real earnings have plateaued and will likely come under pressure. Reconstructed S&P 500 EPS data date back to the mid-1920s. Historically, corporate profits and globalization have been positively correlated. As globalization intensifies, global trade links deepen and “borders fall,” boosting companies’ international revenue exposure. The opposite occurs under de-globalization. Typically, higher top-line growth from foreign markets has also been associated with increasing overall sales and profitability. However, the tide has already started receding. If President-elect Trump’s policies sabotage global trade, then internationally sourced turnover has more room to fall, likely weighing on overall sales and EPS.

On the inflation front, not only is de-globalization inherently inflationary, but most of Trump’s policies also lead to inflation. On a shorter-term basis energy prices will also add fuel to the looming inflationary backdrop. If crude oil prices move sideways from current levels, oil inflation will be up 100% in February 2017, and given the historical correlation with headline and core CPI, some transitory inflation effects will flow through the data.

The inflation-related equity-market investment implications are threefold.

First, the broad equity market’s P/E multiple moves inversely with inflation. The chart shows that since 1926 a rising inflation impulse caps multiple-expansion phases, and a waning impulse leads to an equity market rerating. The link is via the ebbs and flows of the fed funds rate or the discount rate. As the economy gains steam and inflation propagates, the Fed acts belatedly and tightens monetary policy. A higher/rising fed funds rate leads to a multiple contraction phase. Since 1979 (when forward EPS data commence), every time the Fed has embarked on a tightening cycle the forward P/E multiple has been squeezed.

Second, …

For additional details, please access the Special Report titled “How To Profit From De-Globalization” at gss.bcaresearch.com.

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