U.S. Equity Strategy 2015 High Conviction Calls

Each year in January, our U.S. Equity Strategy publishes a list of their top ten high conviction calls for the year ahead. The objective is to highlight calls with staying power, rather than simply chasing short-term momentum.

In today’s Inside BCA, we are pleased to share these top ten 2015 high-conviction calls along with the main factors influencing our U.S. cyclical views.

Health Care Facilities – Overweight

• This domestic and defensive group provides an increasingly rare opportunity to harvest prospective profit margin expansion.
• Operating margins are already climbing, driven by pricing power gains and diminishing labor cost inflation (middle panel). Other costs, such as equipment and supplies, are rising anew, but labor is the largest expense.
• Importantly, capital spending is low and falling as a share of sales, reflecting a profit margin preservation mindset.
• Provisions for doubtful accounts have also abruptly reversed course (fourth panel of the chart). The percentage of uninsured U.S. adults has dropped to 12.9%, down from 17.1% a year ago. Broadening health insurance coverage and rising job growth should ensure that this previous major margin drag continues to move bullishly.
• Consumer spending at hospitals is growing much faster than overall spending. Outlays for physician services have rebounded smartly in line with the declining unemployment rate, consistent with rising facility utilization rates.
• Relative valuations do not reflect this upbeat backdrop (bottom panel).

Hypermarkets – Overweight

• After a painfully long malaise, macro conditions have become outright bullish for hypermarkets.
• Dollar strength is boosting consumer purchasing power and lowering the import bill for retailers. As channel captains, hypermarkets have a chance to meaningfully improve profitability this year (second and fifth panels of the chart below).
• Relief at the pumps is a bullish share price catalyst (top panel). The steep drop in fuel prices is freeing up disposable income for U.S. consumers, which is likely to be spent immediately on higher margin impulse purchases.
• Signs of life in overall wage growth will also boost top line performance beyond the impetus from pump price relief. Anemic job and wage growth had challenged hypermarkets’ ability to deliver retail sales outperformance.
• Growth in the employment cost index signals higher take home pay, which will boost hypermarket retail sales (fourth panel).
• There is ample room for relative valuations to rerate on the back of sales and margin improvement.

Financials – Overweight

• The S&P financials sector is a core portfolio overweight and it is time to elevate our conviction status. While financial strains overseas (and parts of the domestic energy sector) may raise doubts about this call, we expect financials to climb a wall of worry in 2015.
• A number of catalysts can restore investor confidence in financial sector earnings power. The output gap is steadily closing (second panel). Excess resource slack is being mopped up, a sign that credit quality and financial intermediation are both running at a robust rate.
• Share prices don’t reflect the recent acceleration in credit creation (third panel). At the current pace of loan growth, relative valuations are typically 30% higher than at present.
• Consumer borrowing should lead the credit growth charge, as a stronger dollar and cheaper oil bolster real income growth (bottom panel).
• Relative performance has consistently accelerated when oil prices dive into a bear market (oil prices shown inverted, fourth panel).
• Volatility associated with concerns about global economic health should be used to add exposure to this undervalued, domestically-geared sector.

Homebuilding – Overweight

• Homebuilding stocks are poised for a breakout year, after last year’s lull in new home construction and home price appreciation (top panel).
• Mortgage rates are back to cycle lows on global deflationary pressure without a concurrent collapse in domestic nominal income growth.
• That dynamic should be a direct stimulus to the housing market. The improving labor market will help affordability as well as support lender confidence, increasing mortgage accessibility.
• There has already been a decisive shift toward easier mortgage lending standards, the best since prior to the housing crisis (fourth panel). The FHA is planning to reduce fees charged to guarantee mortgages, which will lower mortgage costs further.
• The homeownership rate overshoot has fully unwound after four years of household formation rising faster than housing starts. The pool of potential new home buyers is high and rising, as the percentage of young adults living with their parents is at a record high.
• Homebuilder confidence is booming. Sales expectations matter because they lead the trend in homebuilder new orders and backlogs (second panel).
• The supply of new homes for sale remains near post-war lows, and foreclosures are dwindling thanks to buoyant labor markets.
• Time and consolidation have removed the valuation overhang. An eventual rise in housing starts to the 1.5M level is plausible at an unemployment rate of 5.5%, which would be more than sufficient to support renewed valuation expansion.

Software – Overweight

• Software remains on our high-conviction list, as it still regaining lost ground from the last decade.
• In fact, the share price ratio has not yet even rallied back to its long-term upward sloping trend-line (top panel), even though prospects for business investment are clearly improving.
• Our Capital Spending Model is still strong (third panel). The corporate sector is highly incented to boost investment given sagging productivity growth and a very low cost of capital. Soaring business loans suggest that businesses are already loosening their purse strings.
• Outlays on software stand to gain disproportionately, as the average age of the private software capital stock continues to climb from already historical elevated levels.
• Software investment is already contributing positively to GDP growth, heralding a reacceleration in EPS growth (fourth panel).
• Relative valuations are still far below their long-term average, even excluding the tech bubble, and M&A activity is heating up (bottom panel), and occurring at an average deal premium of roughly 40%. Not only does consolidation help valuations, but it should also shore up pricing power as competitive pressures diminish.

Construction & Engineering – Overweight

• This contrarian call sets up for a potentially strong rebound from deeply oversold and extremely undervalued levels.
• Construction & engineering stocks have been decimated alongside oil prices. Projects are heavily, but not exclusively, energy-related (accounting for roughly 50%). Relative valuations are back to 2009 lows, underscoring that the commodity price plunge is already heavily discounted.
• There are positive offsets. Fiscal austerity needs to fall out of favor, and record low government bond yields should help rekindle public sector projects. U.S. state and local hiring is already improving, consistent with rising backlogs (second panel).
• The group also provides a derivative play on private sector construction. The Architectural Billings Index remains robust, heralding bullish relative earnings performance (fourth panel). Even pricing power is accelerating in the engineering space (middle panel).
• This services-based industry often leads the industrial sector when overall manufacturing activity cools. Sales cycles are long, insulating the group from sudden earnings swings.
• The surge in the non-manufacturing ISM business activity index implies that valuations discount an overly pessimistic collapse in profits.

Semiconductors – Underweight

• The semiconductor group has already discounted an oil-induced surge in consumer electronics spending, making the risk of disappointment acute. Global deflation pressures are likely to contaminate the chip industry.
• Relative sales growth expectations have climbed to the top end of their range. However, the soaring U.S. dollar is anti-reflationary. U.S. dollar strength often leads to weaker chip sales (fourth panel).
• Our composite global chip sales model is not forecasting an imminent sales reacceleration (middle panel). Chips figure early in the supply chain, and this model contains new orders and sales data for the bulk of the major chip end markets. The current message is that revenue growth rates may grind to a halt.
• As a commodity industry, chip sales can only grow so fast relative to the broader economy. Chip sales are now extended as a share of global GDP growth, suggesting saturation has occurred.
• Ominously, global semi producers are still ramping up output even though manufacturers’ chip inventories are growing and semi equipment makers are experiencing a marked deterioration in equipment new orders.
• U.S. chip operating margins are near cyclical peaks. Rising inventories amidst a cooling in leading demand indicators suggest that production is likely to decelerate, hurting margins. Growth in our chip industry productivity proxy is weak (second panel), warning that margins are vulnerable to a squeeze. It usually pays to sell semis when margins are peaking.

Auto Components – Underweight

• Underweighting the S&P auto components index may seem to be at odds with our homebuilding overweight. Both are interest rate-sensitive. But, the two groups have followed very different post-Great Recession paths.
• The powerful thrust in new vehicle sales has absorbed pent-up demand and is thus likely to peter out. New light vehicle sales are back to pre-crisis run rates. The new car purchase rate, measured as the number of new cars per household per year, has also climbed above its long-term average. Consumer plans to buy a new car have rolled over (third panel), even with the plunge in fuel prices. All of this contrasts with the new homes market, where pent-up demand has increased.
• Banks had been very willing to extend auto credit when the rest of the economy was soft, but now that C&I loans are accelerating and housing activity is perking back up, there is less incentive to make high-risk vehicle loans. Anecdotal evidence suggests that loan quality is also fraying around the edges.
• Auto parts manufacturers have considerable global operations and are heavily influenced by global demand trends, as well as the U.S. dollar. The latter is sending a warning signal (dollar shown inverted, top panel). Deflation pressures in the euro area are constraining credit demand. Rising interest rates in the emerging world are already undermining auto sales.
• Ominously, capacity has expanded alongside the rebound in auto demand. Upward pressure on labor costs could become problematic even if vehicle sales move laterally at current levels. Pricing power for components suppliers is close to the deflation zone, consistent with soaring parts inventories (bottom panel).

Industrial Machinery – Underweight

• We added industrial machinery to our high-conviction underweight list in November, and are holding it over into 2015 because profit conditions are bearish.
• U.S. dollar strength, the commodity price plunge and global manufacturing weakness are the primary negative influences.
• U.S. machinery capacity has grown significantly in recent years (middle panel), reflecting misplaced optimism toward global growth and commodity markets, as well as expectations for perennial currency weakness.
• Energy-related capital spending accounts for over 30% of the global total, according S&P Capital IQ. Ongoing supply shocks warn that machinery demand from resource-driven clientele will dry up (top panel).
• Machinery new orders are already falling in nearly every region. Both our global machinery new order and export proxies are now contracting (second panel).
• Incremental foreign central bank stimulus is unlikely to reinvigorate final demand as much as it promotes currency weakness vs. the U.S. dollar. Machinery earnings perform poorly when the greenback is strong (fourth panel).
• The U.S. machinery trade balance is already in deep deficit (bottom panel). The soaring currency and deflation abroad will make matters worse, and more earnings downgrades loom.

Small Caps Vs. Large Caps

• The high-beta small cap asset class will underperform large caps for as long as defensive sectors retain an overall equity market leadership role (top panel).
• Small company wages are accelerating quickly, and faster than pricing power (third and fourth panels). Multinationals have the option of finding cheaper labor abroad where resource slack is abundant.
• Operating margins at large firms are much wider than at small businesses (second panel), consistent with our view of relative wage trends. Typically, higher margin businesses should be awarded higher multiples, but the opposite situation currently exists.
• As the Fed moves closer to draining excess liquidity, small caps naturally face a stiffer headwind given their high-octane status.
• The strong U.S. dollar won’t help despite hefty domestic exposure. Small caps have been a ‘risk on’ play since the Great Recession, outperforming as the greenback weakened. That pushed valuations to unsustainable levels and a renormalization is inevitable as the currency strengthens.