U.S. Equities: The Tone Is Changing

Since late last year, the U.S. stock market has started to favor defensively orientated sectors.

DIN-20170227-160813

Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models. Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal.

These nascent trend changes have developed even though the economic data have generally surprised on the upside. This may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. For instance, the global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive versus cyclical stocks. Keep in mind that the market is priced for a non-inflationary growth nirvana and even modest economic disappointments could short circuit the buying binge.

Moreover, the 2/10-year Treasury yield curve has stopped steepening and financial conditions are no longer easing. This provides additional confirmation that the defensive versus cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend.

Bottom Line: Evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. Our U.S. equity strategists expect a mostly defensive portfolio structure, along with select interest rate-sensitive exposure, to outperform in the next 3-6 months.

The Fed Has An Itchy Trigger Finger

Despite somewhat mixed economic data, Fed officials are clearly prepping investors for a rate hike on March 15.

DIN-20170302-111754

Fed Governor Lael Brainard is the latest official to signal that a rate hike in mid-March has a high probability. What makes Brainard’s hawkish comments particularly noteworthy is that she is well known to have very dovish leanings. She joins Fed Presidents Dudley and Williams, who also raised the prospect of raising rates this month earlier in the week.

The sudden hawkish shift to the Fed’s rhetoric is somewhat at odds with the recent data, which do not call for any increased urgency to raise interest rates. Although the core PCE deflator rose 0.3% m/m in January, our diffusion index fell below zero. This means that the price gains were narrow and it would not be a surprise to see softer price increases in the next few months. Moreover, the annual core PCE inflation rate remained steady at 1.7%, still below the Fed’s 2% target. Meanwhile, a divergence between the “hard” activity data and the “soft” survey data persists. Reflecting the former, real consumer spending contracted in January. Consequently, the Atlanta Fed’s GDPNow model slashed its Q1 growth forecast to just 1.8%. However, the ISM manufacturing survey rose to a boom-like 57.7 in February.

Nevertheless, in light of the recent Fed commentaries, our U.S. bond strategists now believe that a rate hike in March has a high likelihood. It will take a very dovish speech by Fed Chair Janet Yellen tomorrow or a very weak nonfarm payrolls report next Friday to stay the Fed’s hand on March 15.

The U.S. equity market has shrugged off the Fed’s hawkishness. It seems that investors see accelerated rate hikes as a confirmation that the economy is strong. Whether this interpretation is correct or not, investors should keep a close eye on the yield curve. A renewed flattening trend will warn that growth expectations are being marked down, which will make lofty equity valuations more difficult to sustain.