Executive Summary

  • Regional Strategy — Our regional strategy is unchanged, even with a heightened focus on monetary policies and exchange rates in the past month driven, in part, by fears of deflation.  We continue to have a defensive tilt in our regional recommendations, and are Underweight the commodity-rich regions of CEEMEA and Latin America.
  • Sector Strategy — Our sector strategy is also unchanged and remains “less cyclical, more defensive.”  We maintain our relatively defensive posture given pockets of economic weakness globally.  We are Overweight Health Care in North America, the U.K. and Europe ex U.K.  We are Underweight or Neutral Energy in the majority of regions.
  • Food for Thought — Is deflation always “bad” for equities?  History suggests not.
Geraghty_2Feb15_Fig1-2

Regional and Sector Strategy: Monthly Update

This month there are no changes to the recommendations in our regional and sector strategy models.  Our previous regional and sector recommendations were published in the January 2015 edition of the Cornerstone Capital Regional and Sector Strategy: Monthly Update.

Even with a heightened focus on monetary policies and exchange rates in the past month, our regional strategy is unchanged.  We continue to have a defensive tilt in our regional recommendations, and are Underweight the commodity-rich regions of Central and Eastern Europe, Middle East and Africa (CEEMEA) and Latin America.

Our sector strategy is also unchanged and remains “less cyclical, more defensive.”  We maintain our relatively defensive posture given pockets of economic weakness globally.  We are Overweight Health Care in North America, the U.K. and Europe ex U.K.  We are Underweight or Neutral Energy in the majority of regions.

Regional Strategy Update

We have updated the inputs to the Cornerstone Capital Regional Strategy Model in which we rank eight regions/major economies that are included in the MSCI All Country World Index (ACWI).  In terms of valuations, Figure 3 illustrates that the valuation of Emerging Asia, which we are Overweight, has become even more attractive.  Our other Overweight — Japan — continues to look attractive on a relative valuation basis, even though the country has become a little more expensive.

Geraghty_2Feb15_Fig3

Figure 4 illustrates that earnings momentum in Japan and Emerging Asia continues to improve, while earnings momentum in the U.K. (downgraded to Underweight last month) has weakened further.

Geraghty_2Feb15_Fig4

Figure 5 illustrates that the earnings revisions trends in three of our Underweight regions — Latin America, CEEMEA and Europe ex. the U.K. — remain extremely negative i.e., downgrades by far exceed upgrades.

Geraghty_2Feb15_Fig5

Figure 6 illustrates that free cash flow margins in the Underweight CEEMEA region are currently at ten year lows.

Geraghty_2Feb15_Fig6

Figure 7 illustrates that share issuance is relatively high in the U.K., an Underweight region.

Geraghty_2Feb15_Fig7

Figure 8 summarizes the current regional recommendations and Figure 9 illustrates the dispersion of the regional scores.

Geraghty_2Feb15_Fig8-9

Sector Strategy Update

We have updated the inputs to the Cornerstone Capital Sector Strategy Model in which we rank the ten GICs in the MSCI ACWI.

Figure 10 illustrates that, even with the sharp decline in share prices, the Energy sector has actually gotten more expensive on a relative basis suggesting, perhaps, that stock prices in the Energy sector have not fallen as fast as earnings estimates.

Geraghty_2Feb15_Fig10Figure 11 illustrates that earnings momentum in the Health Care, Financials and Information Technology sectors — our three Overweights — improved last month.  Earnings momentum in the Energy and Materials sectors — two of our three Underweights — weakened significantly once again.

Geragthy_2Feb15_Fig11

Figure 12 shows that the Energy sector’s earnings estimate revisions continued to be sharply negative i.e., downward revisions by far outpaced (any) upward revisions.

Geraghty_2Feb15_Fig12

Figure 13 illustrates that free cash flow margins in the Information Technology and Health Care sectors remain materially higher than most other sectors.

Geragthy_2Feb15_Fig13

Figure 14 illustrates that two of our three Underweight sectors — Utilities and Materials — have experienced a significant amount of share issuance over the last twelve months.

Geraghty_2Feb15_Fig14

Figure 15 summarizes the current sector recommendations.

Geraghty_2Feb15_Fig15

Figure 16 illustrates the dispersion of the sector scores.

Geragthy_2Feb15_Fig16

Combining the Regional and Sector Models

Combining our regional and sector models, Figure 17 illustrates sector Over- and Under-weights by region.

  • We are Overweight Health Care in North America, the U.K. and Europe ex U.K.
  • We are Underweight or Neutral Energy in the majority of regions.

Geraghty_2Feb15_Fig17

Food for Thought: Is Deflation Always “Bad” for Equities?

As discussed, our global equity strategy is unchanged, even with a heightened focus on monetary policies and exchange rates in the past month driven, in part, by fears of deflation.  Which raises the question: Is deflation always “bad” for equities?  History suggests not.  In the decades after the U.S. Civil War, a sustained period of deflation was associated with explosive economic growth and a rising stock market.

The completion of a continental railroad network, and the concomitant telegraph system, created a national market that encouraged a spate of technological innovations.  The number of patents issued doubled between the 1860s and 1880s.  Among the specific innovations introduced were:

• Use of electricity in factories;
• The electric streetcar;
• Refrigerated cars for meat-packing;
• The telephone;
• The typewriter;
• The roller mill to process oatmeal and flour; and
• Major advances in making steel, which replaced iron for many uses.

In the last four decades of the 19th century, value added by U.S. manufacturers grew at a pace of 5-7% annually.  From the 1870s to the 1890s — a period of rapid population growth driven by heavy immigration from Europe — national income per capita expanded by a remarkable 88%.  All the same, wholesale prices in the U.S. in 1900 were 56% below their 1865 level — Figure 18.

Geraghty_2Feb15_Fig18

It is quite possible that the deflation of the late 19th century to some degree caused this spate of technological innovations.  Unable to raise prices in order to boost profits, businesses had no choice but to cut costs via innovation — whether that involved using electricity in a factory, replacing clerks’ pens with typewriters, installing labor-saving manufacturing equipment, or using railroads to distribute products more efficiently.  And plenty of capital was available to finance such innovations, because interest rates were declining.

As for equity investors, between 1865 and 1900 the Dow Jones Industrial Average gained 96% — Figure 19.

Geraghty_2Feb15_Fig19 Geraghty_2Feb15_Fig20
 
View or print the complete report along with important disclosures here.
 
Michael Geraghty is the Global Markets Strategist at Cornerstone Capital Inc. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi.