This research note was prepared on December 12, 2012
US materials stocks have been underperforming the S&P 500 for the better part of this year. The latest reporting season (Q3 2012) exacerbated an already heightened sense of pessimism toward the sector, with negative y-o-y earnings (-23.6%) and sales (-6.4%) growth that broadly trailed consensus expectations. Predominantly negative guidance compounded the adverse reaction to earnings misses, with most companies citing a challenging commodity pricing environment as their key concern[1]. Analysts have thus proceeded to revise estimates sharply downward for the upcoming quarters.
US materials stocks have been underperforming the S&P 500 for the better part of this year. The latest reporting season (Q3 2012) exacerbated an already heightened sense of pessimism toward the sector, with negative y-o-y earnings (-23.6%) and sales (-6.4%) growth that broadly trailed consensus expectations. Predominantly negative guidance compounded the adverse reaction to earnings misses, with most companies citing a challenging commodity pricing environment as their key concern[1]. Analysts have thus proceeded to revise estimates sharply downward for the upcoming quarters.
However, a closer look at global macro,
earnings, valuation and technical considerations currently calls for reviewing the
investment case for US materials stocks versus the S&P 500. Looking ahead,
the path of least resistance is higher for materials equities relative to the
broad market.
Gloomy sentiment is not without
grounding
The trajectory of global economic growth certainly
leaves a lot to be desired, implying relatively weak prospects for deep
cyclical sectors (US materials included), which are intimately tied to
commodities and sensitive to shifts in global trade dynamics. Global demand for basic resources has not been
as robust as in previous years. At the same time, more ‘structural’ supply has been steadily flowing into base
metal markets, chiefly in response to China’s rapid growth during the last
decade; the fact that major global mining players (e.g. BHP, Rio Tinto) have been
shelving or trimming down capital expenditures signals that this supply/demand
imbalance is starting to ‘bite’.
Macro considerations
While the Eurozone crisis’ ramifications have gradually come to be ‘digested’ (for the time being), the current policy mix implies that the region is slowly, but surely, heading deeper into recession. The US economy has been showing relative resilience, but real GDP growth is expected to remain sluggish (yet positive) and the looming ‘fiscal cliff’ brings back memories of summer 2011 (is politically-induced uncertainty of the ‘Knightian’ type, after all?). Meanwhile, debate about which variety China’s landing will take (‘soft’ or ‘hard’) has been rampant. Still, what most investors agree on is that there is a landing; China’s commodity-intensive growth has taken on a slower pace over the last eighteen months—not least a corollary of the central government’s emphasis on arresting (socially destabilizing) inflationary pressures.
While the Eurozone crisis’ ramifications have gradually come to be ‘digested’ (for the time being), the current policy mix implies that the region is slowly, but surely, heading deeper into recession. The US economy has been showing relative resilience, but real GDP growth is expected to remain sluggish (yet positive) and the looming ‘fiscal cliff’ brings back memories of summer 2011 (is politically-induced uncertainty of the ‘Knightian’ type, after all?). Meanwhile, debate about which variety China’s landing will take (‘soft’ or ‘hard’) has been rampant. Still, what most investors agree on is that there is a landing; China’s commodity-intensive growth has taken on a slower pace over the last eighteen months—not least a corollary of the central government’s emphasis on arresting (socially destabilizing) inflationary pressures.
However, the skies may be getting clearer. There are signs Chinese economic activity is bouncing off a cyclical bottom. Infrastructure project spending has been picking up (with the blessing of the authorities), so the fiscal tap is getting ‘looser’. Monetary policy indicators are also suggestive of easing financial conditions, with broad money and credit growth aggregates showing improvement (chart 1). In addition, a wide array of data has started to surprise on the upside (e.g. November industrial production +10.1% y-o-y, the best reading since March) and important leading indicators point to ‘expansionary’ territory (e.g. official PMI manufacturing at 50.6 for November; chart 2), signaling that the economy may be turning the corner.
Chart
1
Source: The Australian Economy and Financial Markets, Reserve
Bank of Australia,
December 2012.
Chart
2
Source: ft.com
A
crosscheck with non-Chinese statistical data seems to confirm this positive
momentum. The commodity-heavy Australian stock market remains on a rising trend
versus global equities since the summer correction (in USD terms; chart 3 on the next page), the CAD and
AUD remain resilient (while the RBA reduced its policy rate to 3% last week, the
AUD/USD actually moved higher on the news, with investors likely pricing in a
pause in coming months) and select commodities are picking up steam.
Chart
3
Indeed,
segments of the commodity market whose terms China ‘dictates’, such as iron ore
(chart 4), have rebounded
considerably since bottoming out in September. Copper, which correlates well
with trends in global growth, has also rallied significantly (up 7.3% since the
November lows; chart 5 on the next
page).
Chart
4
Source: macroinvestor.com.au
Chart
5
Turning
to the US, improving (albeit slowly) labor market conditions, a recovery in housing
trends (e.g. housing starts) and a relatively strong auto sales dynamic (replacement
demand) lend support to GDP growth going forward—notwithstanding persistently weak
real household income growth and nascent corporate capital expenditures (the
latter could see a rebound in 2013, provided the ‘fiscal cliff’ is averted thus
reducing policy uncertainty).
Meanwhile, the US dollar is expected to
remain under pressure on the back of the Fed’s ‘open-ended’ accommodative
stance, acting as a tailwind for commodity prices.
In sum, key macro variables—improving
leading indicators, recovering commodity prices, bright spots in US economic
activity and a supportive currency regime—seem to be turning up, giving reason
for optimism.
Fundamentals
Earnings fundamentals also point to a better
outlook for the US materials sector.
As discussed above, global cyclical conditions,
positively correlated with important earnings growth drivers for the US
materials sector, currently bode well for profitability. The pending
re-acceleration in Chinese output should buoy end-demand for basic materials.
Furthermore, higher commodity prices are expected to enhance pricing power,
while ample global liquidity and a favorable (policy-driven) USD bias should
provide a boost to sales and the bottom line, as long as the industry’s cost
structure remains in check.
In this respect, gauging the health of
the US chemicals industry is crucial to understanding the overall sector’s
prospects, as it comprises around 70% of total market capitalization. These
companies enjoy a competitive operating cost advantage arising from the use of
natural gas in production, benefiting from the sizeable differential in US prices
versus the rest of the world[2].
The shale gas ‘glut’ has pushed US natural gas prices dramatically lower and
this ‘game-changing’ theme is likely to persist for the foreseeable future.
Valuations
Relative
valuations for the US materials sector are compelling—the 12-month forward price-to-earnings
ratio trades at a modest premium to the broad market, while its dividend yield
at 2.5% (fourth highest among the ten major S&P 500 sectors) remains above that
of the S&P 500 (chart 6). Moreover,
analyst earnings revisions have arguably discounted a lot of negativity—certainly
a notable contrast with consensus in early 2012 (chart 8 on the next page). Adoption of a contrarian stance may be
getting increasingly appropriate for investors at this juncture, as the
combination of a low relative P/E ratio and depressed relative 12-month forward
EPS expectations suggests a good amount of pessimism may already be priced in.
Chart
6
Source: Goldman Sachs 2013 Equity Outlook,
November 28, 2012.
Chart
7
Source: Goldman Sachs 2013 Equity Outlook,
November 28, 2012.
Chart
8
Source: Goldman Sachs 2013 Equity Outlook,
November 28, 2012.
In contrast, the relative valuation
metrics for domestically oriented industries such as utilities, consumer
staples and telecom services have become ‘rich’ (charts 6 and 7 above).
These sectors’ ‘low-beta’ nature and relative cash flow stability (attractive in an environment of lackluster economic growth), coupled with strong investor demand for dividend income (‘search for yield’ theme) have led to substantial investor inflows.
These sectors’ ‘low-beta’ nature and relative cash flow stability (attractive in an environment of lackluster economic growth), coupled with strong investor demand for dividend income (‘search for yield’ theme) have led to substantial investor inflows.
The
looming risk of higher dividend taxation in 2013 could, at the margin, bring
about a short-term negative impact, but ‘repressed’ bond rates (and negative
real yields globally) render this trend unlikely to meaningfully reverse any
time soon. Successively lower bond yield levels have made equities an
increasingly attractive ‘income’ play. Chart
9 illustrates this point, showing the clear downward trend—interrupted by
‘risk off’ periods—in a ‘bond/dividend stock’ ratio proxy[3]
(IEF/DVY; plotted against the 10-year Treasury yield[4]).
Chart
9
Still, from an overall valuation
perspective the risk/reward tradeoff favors a gradual rotation away from
defensive sectors and toward more cyclically exposed industries.
Market signals / technicals
Finally, what is the message from the
market? Price action across asset classes following the much-anticipated launch
of QE3 speaks volumes: the S&P 500 failed to stage a sustainable rally (‘buy
on rumor, sell the news’?), while the USD strengthened, the 30-year Treasury yield
moved lower and market-implied inflation expectations actually declined after a
short-lived spike. This could be signaling ‘reflation failure’ (maybe it is not
the markets that react to central bank action these days, but the other way
around…)
Indeed,
gold mining stocks (GDX), a useful gauge of the market’s reflationary pulse, have
underperformed the S&P 500 (SPY) by 14% since the Fed’s QE3 announcement (chart 10). This could be taken as another
manifestation of ‘exhaustion’ in the stock market, notwithstanding idiosyncratic
factors that are weighing on this particular industry (e.g. relating to operating
cost pressures, writedowns, et al.)
Chart
10
Importantly, the implicit message from the US equity
market—reinforced by relatively ‘stretched’ valuations in domestically exposed
sectors—seems to be that, for a move toward new highs to materialize, it is the deep cyclical sectors that need to
‘pick up the baton’.
Interestingly,
the underperformance of Emerging Market equities (EEM) versus the S&P 500 (SPY)
since Q4 2010 appears to be running out of steam, lending credence to this
view. This can be seen in conjunction with the observation that US economic
resilience has by now largely become consensus among investors (unlike 12-18
months ago), whereas perceptions of (China-led) improvement in Emerging Markets’
growth prospects continue to be dominated by skepticism. Resolution of this
‘divergence’ could provide the fuel for a continuation in the EEM/SPY ratio’s recent
positive turn, potentially foreshadowing outperformance for the US materials
sector (XLB) versus the S&P 500 (charts
11 and 12).
Chart
12
Looking at technicals, the XLB/SPY ratio has traded in a
tight range since Q2 2012 and seems likely to ‘exit’ sooner rather than later;
a move higher in the EEM/SPY ratio augurs well for this breakout to occur to
the upside. What is more, the 50-day moving average is on the cusp of crossing
the 200-day moving average line from below (‘golden cross’), for both ratios
(EEM/SPY as well as XLB/SPY), a positive near-term signal.
Also, Chinese property stocks have been
on the rise (+20% year-to-date), significantly outperforming the (rebounding) broad
Shanghai Composite index (chart 13
on the next page). This is potentially a bullish development for the relative
performance of US materials stocks, as it tends to correlate quite closely with
the relative performance of the Shanghai Property index. This ‘link’ likely reflects
the influence of Chinese real estate trends on commodity demand and perceptions
thereof.
Source: Bloomberg.com.
Risks
The main risks to this analysis arise
from potential failure in ‘fiscal cliff’ negotiations (hence likelihood of a US
‘growth scare’ and ensuing global risk aversion), disappointment coming out of
China (e.g. the new leadership does not provide enough stimulus, cyclical
growth indicators roll over, there is an outburst of inflation, et al.) or a
flare-up in the Eurozone’s sovereign debt crisis that may lead to a global
‘risk off’ phase.
In addition, one needs to remember that
China’s aspirations for economic rebalancing are unlikely to be a ‘free lunch’ (as
is true of any adjustment) and should, in all probability, lead to a lower real
growth rate along the process (the exact timing/specifics are admittedly a
political decision). Nevertheless, the cyclical backdrop currently suggests that
there is scope for near-term growth acceleration in China.
Conclusion
A case can be made based on a combination of macro, fundamental and technical factors for viewing the US materials sector through a more positive prism in terms of relative risk/reward. From a contrarian standpoint, the current divergence between the Street’s negative consensus stance, on the one hand, and this analysis’ more constructive tone, on the other, suggests that it may be prudent to book profits in domestic/defensive US sector positions and gradually rotate toward more globally exposed, deep cyclical sectors—particularly US materials equities.
[1] Source: Factset Earnings Insight, November 30,
2012.
[3] Not intended to
represent the stock-bond ratio, which is calculated on a total return basis,
but to reflect investors’ attitudes toward the relative attractiveness of US
Treasury bonds versus (dividend-paying) equities.
[4] TNX is an index
tracking the 10-year nominal Treasury yield.
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