Thursday, November 15th, 2018

Simple Explanation

Last week we reported that Industrials had been downgraded to underweight in our US Equity sector model. Industrials is the sector with the lowest frequency of underweight recommendations (only 10% of all readings since 1996) and historically these have been associated with the onset of a bear market or a period of significant market disruption. Given this record, we decided to have a detailed look at the sector in other regions and also in the credit markets of the US and the Eurozone. The good news is US Industrials have bounced back into neutral territory so this may be a false alarm. The bad news is that the downtrend is still intact and the sector is only one bad week away from being downgraded again.

Looking at the Industrials sector across all equity regions, we see relative downtrends in the US, the UK, the Eurozone and Japan. The UK is rated underweight and the Eurozone is rated neutral, while the US and Japan are hovering on the boundary between neutral and underweight. The longest downtrend is in Japan, since February 2018. The US downtrend started in April, followed by the Eurozone in May. Paradoxically the region with the biggest underweight – the UK – had the most recent change of trend, in September. The exception is the Industrials sector in China, which has been in an uptrend since April. This is good news, but there is a catch. The sector tends to do well when investors expect the renminbi to be weak and it underperforms when the currency is strong. A depreciating renminbi is one of the reasons why the sector outside China has started to come under pressure.

So, if we want one single number for the Industrials sector relative to global equities, we have to look at the world ex-China. In aggregate, the sector has been trending lower since February 2018; it was downgraded to neutral in early May and it only just escaped being downgraded to underweight in October. Compared to the other equity sectors, on the same world ex-China basis, Industrials rank #6, which is respectable but not particularly bullish.

If we had no information from the credit markets, there would be no need to write this note. Unfortunately, we do and it is not pleasant reading. All three models show Industrials in a long-term downtrend, dating from late 2016, with an underweight rating. The worst is Euro Investment Grade, where the sector ranks #10 and last; the best is US High Yield where it ranks #7. Looking at the average of all three models, the sector also ranks #10 and has fallen heavily since mid-October, thanks to the impact of General Electric on the US Investment Grade model. Just to round out the litany of gloomy statistics, the combined ranking of equity and fixed income also shows Industrials at #10, ahead of Consumer Staples and Materials.

So far, we are long on diagnosis and short on causation, but that doesn’t bother us. We are used to our models highlighting a problem before we get all the supporting data. The models may be sending us a false alarm, but there is one simple explanation which would fit all these signals and some of the recent hard data such as the Q3 GDP figures out of Germany and Japan. The global economy may be much closer to a significant slowdown than consensus thinks. If the US equity sector model downgrades Industrials to underweight again, we will prepare for a period of market disruption.

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