Healthcare Sector Update

 

It’s been an incredibly busy 3 months for the US stock market, bombarded by constant headlines focused on US trade policy, yield curve inversion and a significant amount of attention directed towards the United States Federal Reserve. Despite the consistent noise, the S&P 500 is still up 1.47% for the past three months with utilities, real estate and consumer staples leading the way, showing gains of 5.6%, 4.1% and 3.53% respectively.

This seemingly strong growth is unfortunately not market wide. Over the past 3 months, XLV, the index that tracks the Healthcare industry, has fallen 2.18%, led by declines in drug manufactures Johnson and Johnson and Pfizer, as well as healthcare providers like Anthem and UnitedHealth Group. These sectors have been in the spotlight of American politics for the past year, with President Trump pushing for lower drug prices and many Democratic candidates using universal healthcare as a key talking point in debates. Increasing uncertainty caused by these proposed policy changes and increased regulations are causing many investors to stray away from healthcare companies that have large amounts of revenue concentrated in these areas.

Johnson and Johnson have been facing a large amount of backlash for its predatory marketing strategies for its poppy plant, Norman, used in the production of painkillers used by Purdue Pharma. Oklahoma State is the first state to follow through with a lawsuit targeting the $350 billion drug maker for $572 million, naming it a main cause in the opioid epidemic sweeping across America. This is the third lawsuit for Johnson and Johnson in the past year, highlighting the increased risk that investors are seeing in the industry.

Although equity investors have been reducing exposure to healthcare, acquisition activity in the industry is increasing rapidly as companies try to diversify their pipelines and gain access to new patents rather than investing money into researching and developing new drugs. In 2019 Healthcare has been the second busiest sector in terms of acquisitions, with a total of $362.2 billion worth of deals, the largest being by Bristly Myers Squib for about $74 billion and AbbVie Inc. for $63bn.

Companies like Pfizer have been attempting to diversify their revenues streams via acquisitions. This past June, Pfizer committed to the acquisition of Array Biopharmaceuticals in an $11.8 billion deal. The acquisition of Array deepens Pfizer’s drug portfolio in the cancer space, with two drugs used to target metastatic melanoma, as well as 30 other drugs that are still in the process of development. One of which targets colorectal cancer, last year 140,000 patients were diagnosed with this cancer and 50,000 people are expected to die each year due to their illness. Pfizer’s acquisition of this research could be another addition of a life saving drug to the company’s portfolio. Pfizer’s stock dropped 20% after the announcement.

This will be an interesting sector to watch coming into the 2020 election, with investors bracing for further increased pricing pressure, political risk and a further shift on how pharmaceutical companies are approaching ways to grow revenues.

By Sean O’Dea - Healthcare Sector Director, Baruch IMG

 

TMT Sector Update

 

Technology sector headlines over the summer have been dominated by the trade dispute between the US and China, uncertainty in the semiconductor industry, a large number of tech IPOs, regulatory cases against Big Tech, and the ongoing growth in cloud.

Cloud, data centers, and 5G connectivity remain the largest investment categories spoken about, with cloud growth driving revenue growth across technology companies. Less talked about are cognitive computing and automation tools, which are now under a spotlight for vastly improving customer insights and increased efficiency. The advancement of digital tools has allowed companies to better analyze data and gain insights on not just customers, but competitors. Efficiency is also growing in the bankruptcy process and the restructuring afterwards as tech companies play a larger role in assisting companies. IT strategies around cloud computing and data analytics are being increasingly used to cut costs and streamline processes.

Antitrust investigations continue in the US, with the House Judiciary Committee asking for a variety of documents, including emails between executives, financial statements, and information about competitors, market share, mergers, and key business decisions, from Big Tech executives. These executives include Amazon’s Jeff Bezos, Facebook CEO Mark Zuckerberg, Apple CEO Tim Cook, and Google’s Larry Page, Sergey Brin, and Eric Schmidt. It’s very unlikely these companies will give such access to the House Committee, so negotiations over the documents requested are likely to commence soon.

Several other investigations are underway against Big Tech, including investigations from the Justice Department, the Federal Trade Commission, Texas AG Group, and NY AG Group. However, any US action against Big Tech is likely years away considering the large ramp-up in spending such companies have put in place to influence antitrust discourse and that any sanctions against the companies must be imposed by federal or state law enforcers, not Congress.

Despite that, technology companies might not wait for the US to act. Microsoft CLO Brad Smith recently came out and said: “The laws around the world are going to change, and because technology is so global, American companies will adopt a new approach even if the United States Congress does nothing.” His call for regulation is skeptical as any laws geared to make internet platforms more accountable for their content pose a greater threat to competition than Microsoft

On another note, 2019 has been an extremely active year for tech IPOs. Despite Uber and Lyft’s disappointing performances, top tech IPOs have outperformed the S&P 500 this year at a 67% gain including Cloudfare which jumped 20% on its first trading day this Friday. There are many caveats in this comparison, including the facts that it does not factor in market caps, lock-up expirations, and most notably, the necessity of Beyond Meat in the IPO basket, which is up 524% since its market debut. Following Beyond Meat’s stellar performance is videoconferencing company Zoom, up 120%, and security vendor CrowdStrike, up 91%. The biggest laggard is Lyft, down 36%, followed by Uber, which is down 26%, and e-commerce company RealReal, down 15%.

From a macro viewpoint, technology companies continue to expand into emerging markets, swallowing currency headwinds and highlighting the risks of continued geopolitical uncertainties, including the US-China trade dispute, unpredictability in China, and declining smartphone demand. Cloud computing continues to be the center of attention in the tech industry with significant margin improvements, followed by AI computing, data centers, cybersecurity solutions, 5G connectivity, and IoT. 

By Gloria Ghita - TMT Director, Baruch IMG

 

Consumers Sector Performance Update

 

While the ongoing U.S. – China trade war, slower economic growth, and muted inflation levels have created uncertainty and fallout in the markets in 2019, one area that has seen growth this year is the consumers industry. The industry, which is broken down into two primary sectors – consumer staples and consumer discretionary – have outperformed the overall market performance as a whole so far this year. The S&P 500, which is comprised of 11 sectors, has seen 18.8% growth year-to-date. Consumer discretionary is ranked second, with 23.5% growth, while consumer staples is ranked fourth, with 20.4% growth, according to Yardeni Research.

Those growth numbers should not come as a surprise, since consumer spending is responsible for approximately 65% of the growth in the U.S. economy, as measured by Gross Domestic Product (GDP). Although economic growth is expected to slow in the second half of 2019, the consumer industry continues to outperform.

The consumer has been the primary driver of growth in 2019 so far, since the trade war between the U.S. and China has slowed business investment. Additionally, the Federal Reserve’s willingness to continue to cut rates means consumers will have cheaper borrowing opportunities and more money to spend. As a result, the U.S. will need the consumer industry to remain robust through year-end and deliver solid spending during the holiday shopping season.

The consumer staples sector, which is comprised of companies specializing in typical consumer products, such as food, beverages, home and personal care, and tobacco, has followed a historically consistent trend. It has outperformed during trade-induced volatility, but has underperformed at times when those concerns have eased.

Some of the factors that have impacted the sector this year are the retailers aggressively cutting costs, increased geopolitical tension and increased competition within the low-cost space. The trade disputes are likely the most significant factor since escalating. Long term trade conflicts could increase costs for American producers and increase prices for consumers.

However, due to the increased likeliness of a recession in the near future, consumer staples are a safe haven to continue to outperform the market. Consumers will continue to buy essential goods, such as toiletries, food, water, and clothing, regardless of the economic state. As a result, these businesses are protected from short-term economic-driven demand swings, and they tend to grow steadily, regardless of the status of the economy. That is why stocks in this sector are referred to as "recession-proof."

The consumer discretionary sector, which is made up of goods and services that are considered non-essential items that require extra income, including luxury goods, restaurants, hotels, and casinos, saw a decline in performance at the start of 2019 after the December 2018 market correction. However, some sector companies have recovered nicely in 2019, such as Home Depot (NYSE: HD) and Chipotle Mexican Grill (NYSE: CMG).

Consumer spending continues to reach all-time highs, with spending in the United States surpassing $13.3 trillion in the second quarter of 2019, compared to the $13.1 trillion in the first quarter of 2019. As a result, the sector remains in a position to benefit.

The SPDR Consumer Discretionary Select Sector ETF, which holds 62 of the largest consumer discretionary companies, is up 24% since the start of 2019, proving that there has been a strong rebound from the correction.

Currently, the near-historically low unemployment, still relatively low interest rates, and modestly rising wages are positive signs for the sector, but tends to perform more in line with the market. The way consumers buy products has also affected the sector, since the rise of e-commerce has created a tough environment for many retailers and traditional department stores. Department stores saw a 36.1% decrease in growth year-to-date as a result, but that decline was offset by strong positive growth in every other niche vertical within the discretionary sector this year.

Trade disputes, increased retail competition, and changing consumer habits continue to affect the sector, along with low unemployment, increased wages, and rate cuts.

As of mid-2019, consumer staples stocks accounted for $3.6 trillion of market capitalization, making them sixth in relative size, while consumer discretionary accounted for $5.4 trillion of market capitalization, making them fourth.

John Williams, New York’s Federal Reserve Bank President, said “The consumer is now carrying all of the weight, or much of the weight, for growth going forward.”

Overall, the American consumer’s mood appears positive, as shown by the Consumer Confidence Index, which measures how optimistic or pessimistic consumers are regarding their expected financial situation. The index is currently at 135.1 as of August 2019, which is a very small decline from July’s index of 135.8. Expectations cooled moderately, but overall remain strong. The index has seen a huge spike since the 2008 financial crisis and subsequent recession, while steadily increasing the entire decade, illustrating the increased optimism consumers have about current and prospective businesses, labor market conditions, and their own financial outlook.

It will be interesting to see if that translates into more spending and more pricing power for retailers, especially during ongoing trade tensions and other factors of economic and political uncertainty.

By Felix Malamud - Consumers Sector Director, Baruch IMG

 

Energy Industry Update

 

Throughout the summer, the oil and gas industry has been in a steep decline. Both WTI and Brent have been down since the end of the spring semester, with Brent falling from a high of $74 in April to its current price of $60, and WTI falling from its high of $66 to its current price of $55. The reason behind the drop in oil prices is supply build-up; the US has been ramping up production steadily for all of 2019, which didn’t hurt prices until the US stockpiles began to grow dramatically. Signs of a global demand slowdown in the energy market heightened investor fears of the ever-encroaching plateau of oil and gas.

Political dealings have also played their part in exacerbating the drop in oil prices-- with the first political issue being the heavy tension between the United States and Iran that made headlines over the summer, resulting in higher than usual volatility in the oil market. As the conflict with Iran promised increased scarcity, oil prices continued to drop. This culminated with a sharp sell-out in the market upon the president seemingly forgetting about Iran and all parties just moving on. The second important political issue affecting oil prices would be the heightened fear of both the US and China entering a recession on account of the trade war. Uncertainty about the future of demand from such large players in the oil space has caused investors to be more sensitive to stockpile increases than they would have been given no trade war.

On an industry-specific note, Independent E&Ps are beginning to feel a crunch in the market. Historically, independent E&Ps were viewed as the startups of the energy industry; investors placed little emphasis on the financial health of the company and focused purely on whether or not production was increasing. However, more recent market movements have signaled a move away from that perspective on independents. Contrary to current market trends, whether or not the business had a positive free cash flow was generally ignored, and valuations like NAVs were king as they provided simple predictions for future production. Now as worries of demand slowing grow, the company with the lowest breakeven will be the company that earns the most, and as many Independent E&Ps have breakeven prices over $70 which is highly unsustainable in the current climate.

Interestingly enough, oil indicators seem to point to an upward trend in the near future. WTI has recovered from its price of $51 three weeks ago to its price of $55 now. The WTI futures market has shifted into backwardation, with the difference between the first month and fourth-month contract being positive. This backwardated market shows a tighter and more liquid market for WTI than there has been for the past year. Increased trade activity may be a sign of investors thinking more positively about the commodity. Another driver for future performance is the WTI and Brent differential. The differential has declined rather sharply over the summer from its price of $10 three months ago to its current price of $5. This lessened differential will slow down imports which can be seen in the US crude inventory. This decrease in imports is going to have a larger effect on US inventories once it is combined with the fact that the Permian basin pipeline capacity is set to drastically improve as we head into 2020. This will thus lead to a positive feedback loop, with fewer imports reducing the differential and the reduced differential reducing imports.

To take advantage of this future potential export increase, it would be wise to invest in the leaders in Permian production, such as XOM and CVX, as well as the companies that will be providing the increased pipeline capacity shortly such as TRP. However, it is important to note that while the signs may seem to be overly positive currently, if the differential was to tighten further or possibly reverse to a point before the shale revolution (potentially due in part to many Permian players going out of business in a lower-priced oil environment), then the exports will drop significantly.

By Silvio Pantoja - Energy Sector Director, Baruch IMG

 

Summer 2019 Review

 

The Summer of 2019 has proven to be more eventful than initially anticipated. From puzzling “mid-cycle” interest rate cuts, to escalating trade tensions, a likely no-deal Brexit, and a yield curve inversion, the Fall 2019 semester is starting on the heels of uncertainty and jitteriness.

Rate cuts

Following the sharp December downturn partly caused by their hawkish stance, the Federal Reserve shifted into neutral as it kept the federal funds rate – 2.25%-2.50%– unchanged in June. The following month, Jerome Powel, the Chair of the Federal Reserve, announced a “mid-cycle adjustment”, decreasing the Fed Funds Rate by 25bps to 2.00%-2.25% amid growing fears of a recession. The market did not respond as well with the Fed’s precarious new stance, as the U.S. economy continues to be robust.

The news of rate cuts didn’t stop in July, as Jerome Powell issued a statement claiming that the Fed “will act as appropriate to sustain the expansion” as the trade war worsens. Many took this statement to mean that the Federal Reserve would further lower rates, causing a drop in yield in the fixed income space. Though lower rates would stimulate the economy through cheaper borrowing, how much of an impact can the Fed make with benchmark rate adjustments with an already historically low rate? Is another cycle of easing in store?

Trump Trade War

The once seemingly fruitful negotiations turned sour this Summer as tariffs on Chinese goods increased to 30%, spiking volatility in the markets as companies search for alternatives from tariff-affected Chinese goods . In a recent development, President Trump increased threats on China stating that he could “declare a national emergency”. As tensions continue to increase, markets are on the decline, with stocks such as Apple and Intel underperforming due to their reliance on the Chinese markets. Now, huge speculation lies upon the prospects of an agreement between the world’s largest economies, although the current consensus remains gloomy.

G-7 / Brexit

After failing to execute on her promise for a Brexit deal, Theresa May resigned from the office of Prime Minister of the United Kingdom in June. In a vote held in late July, the Conservative Party elected Boris Johnson as May’s replacement as head of the party and Prime Minister of the United Kingdom. Johnson, the former mayor of London, was catapulted to worldwide fame (or infamy) when he became the loudest voice in the “Vote Leave” campaign during the original Brexit referendum.

More recently, at the G-7 summit, Johnson said he would be willing to take talks on a potential Brexit deal down to the wire– the October 31st deadline set in place by the European Union. Johnson stated that if no deal is reached by that date, the United Kingdom will leave the European Union without a deal . A “no-deal” Brexit could carry some seismic repercussions. Overnight, British products would have tariffs placed on them, and the Office of Budget Responsibility estimates that the British economy could contract by 2%, causing a recession for the UK . As to the likelihood of a Brexit, Johnson is cautiously optimistic that a deal can be reached by the October 31st deadline. However, British consumers are preparing for the possibility of a no deal Brexit, by stockpiling food, medicine, and even clothing, as they fear nationwide shortages and price hikes.

On the other side of Brexit stands Jeremy Corbyn and his Labour Party desiring a no-confidence vote on Johnson’s conservative party. If Corbyn has the votes, a general election will be triggered, and potentially a second Brexit referendum will take place. The situation remains uncertain.

Yield Curve Inversion

Lastly, August saw an inverted yield curve, where shorter-dated treasuries carry a higher yield than their longer-dated counterparts. An inverted yield curve, especially when defined by the difference between the 10-year Treasury note and the 3-month bill, has historically been a trustworthy signal of a recession looming in the future. An inverted yield curve is a representation of inflation expectations for the future. The NY Fed model based on the yield curve puts the risk of a recession in the next 12 months at over 30%, the highest its been since the 2008 recession. The question remains how investors reconcile low unemployment, subdued inflation data, and a robust economy, with a historically reliable warning alarm ringing.

By Paul Menestrier - Chief Investment Officer, Devon Lall and Donny Moskovits - Portfolio Management Analysts, Baruch IMG

 

Semiconductor Industry Overview

 

The information technology sector has been the leading sector year-to-date in the S&P 500 with an average return rate of 24.42%. Within the information technology sector, both the semiconductor and semiconductor equipment industries have been driving this growth in returns with each industry attributing an average return rate of 26.19% and 37.07% respectively. This growth can be credited to the rise in global chip sales. According to the Semiconductor Industry Association global ship sales rose 13.7% to $468.8 billion in 2018. Despite the fact that the market started to weaken late last year, the 2018 figure represented the industry’s highest-ever annual total.

So, what is a semiconductor? Conductors as a whole conduct electricity, insulators help resist electricity and semiconductors fall in between the two. Their level of conductivity and other properties can be changed with the introduction of impurities, to meet the specific needs of the electrical components in which they are installed. Also known as semis, or chips, semiconductors can be found in thousands of electrical products such as computers, smartphones, appliances and even medical equipment. Their actual function includes the amplification of signals, switching, and energy conversion.

The semiconductor industry lives by a simple rule, smaller, faster and cheaper is always better. While some experts believe that Moore’s Law is no longer applicable, chips manufactured today are still increasingly growing smaller in size. It’s quite simple why being smaller is better in the semiconductor industry, finer lines mean more transistors can be packed on a single chip. The more transistors a single chip has, the faster that chip works. Due to the size of competition, and the rate at which new technology is currently developing, the price of a chip can fall up to 50% within months. With this constant pressure on chip makers to come up with something better and cheaper, it is easy to see why only a few companies achieve success in the semiconductor industry.

Semiconductors were invented in the United States, and the US still leads the world in manufacturing, design, and research. The US is currently the worldwide leader in this industry owning nearly half of the global market share. In 2018, the US semiconductor industry made a total $209 billion, with over 80% of US semiconductor company sales being to customers overseas. Semiconductor chips and equipment is also the US fourth largest export, after airplanes, refined oil and automobiles. This highly competitive industry is made up of four main product categories: memory, microprocessors, commodity integrated circuits, and complex SOC’s.

Semiconductor stocks are currently on the rise and many of the industry top players are expecting accelerating demand growth in the next coming months. The VanEck Vectors Semiconductors ETF, which holds 25 of the largest semiconductor companies, is up 28% year to date and trading near historical highs. This sector however has seen some resistance in the past several months. A lot of this resistance comes from the industry’s intrinsic supply and demand dynamics and the current uncertainty of the trade war. With that being said, many of the top players in this sector are seeing signs of a rebound in sales in the coming months.

Even though global semiconductor sales were off to a weak start this year with a broad- based year-over-year decline in January and February, it is expected to improve in the coming months. The rise in demand of cutting-edge technology, including cloud-based computing, autonomous vehicles, augmented reality and artificial intelligence, is one of the main drivers pushing for this expected growth in the industry. Also, the deployment of 5G technology is expected to further increase this growth and create further opportunities.

By Michael Betancur - TMT Analyst, Baruch IMG

 

2019 First Quarter Review

 

US equities market ended the first quarter of 2019 on a very strong note with the S&P500 gaining +13.41%, the best since 1998. It was largely driven by improving trade talks with China, accommodative monetary policy statements coming out of Federal Reserve, and strong economic reports.

The key highlight of the quarter was the yield curve inversion near the end of the quarter when the 10 year treasury note’s yield dipped below the 3-month treasury yield. This cause the market to sell off two days in a row because it has historically preceded an economic recession. But the market recovered back to year-to-date high after the inversion went away before the end of the quarter.

Sector Performance

Information Technology was the best performing sector and it was up +19%. About 11% of the return came from just five companies; AAPL, MSFT, CSCO, V, and MA. The remaining 9% came from semiconductor and software companies. Real Estate was the second best performing sector at +17.51% and four major companies were responsible for ~7% of the return. Though the industrial sector was the best performing sector between February and early March, it ended the quarter in third place at +17%. Boeing stock performance near the end of the quarter played a major role in bringing down sector performance. The company represents a whooping 9% of the sector.

On the other hand, healthcare was the worst performing sector at +6.45% followed up by financials at +8.49%; both sectors underperformed the market. Healthcare underperformance was driven by a negative outlook on some of the major industries. As we head into the 2020 election where healthcare is the number one voter issue, market is bracing for a big shake up as a result of increasing rhetoric from the both sides of political spectrums. Lots of key hot topic issues such as universal healthcare and drug pricing are on the agenda list. While pharmaceutical companies and healthcare provides are getting hurt the most, healthcare equipment makers has been able to stay out of the cross fires.

Looking Ahead

As we enter in to the second quarter with earnings season kicking off at the middle of April, one thing to keep an eye on is for signs regarding corporate earnings recession. The current estimate for S&P500 2019 Q1 EPS growth is at -4.2% according to Factset and if the companies report negative earnings growth, it will the first year-over-year decline in earnings since Q2 2016.

By Baruch IMG’s Portfolio Management Team

 

Oil and Political Unrest in Algeria

 

The energy industry is one of the most volatile sectors you could invest in. One of the most important factors that affect the industry is also one of the most unpredictable: Political unrest. Given the amount of oil that is produced by OPEC of which many members are nations with precarious political positions that are often subject to revolutions or general unrest. Currently, there is one OPEC nation subject to political upheaval that may harm the bottom line of many international energy companies; and that country is Algeria.

Algeria is the largest OPEC member by territory and the largest country within Africa. The country achieved independence from France in 1962 and has since then transitioned into an oil-based economy with $22 billion in oil exports per annum and 12 billion barrels of oil in their proven reserves. The oil produced from the country is notably light and sweet, comparable to the U.S. Eagle Ford crude in its sulfur content and only slightly denser. Algeria is a heavily based on their oil earning, with 30% of their GDP and 95% of their export earnings coming from oil, most of which goes into the EU which has been their largest trading partner since 2002.

To set the stage for the political unraveling of Algeria, it's important to know that it's a socialist country with citizens used to all-encompassing social welfare programs. The issue with having an oil-dependent socialist country became apparent during the oil crash of 2014. When the global price of oil fell dramatically Algeria faced a drastic drop in revenue, and given the expansive and expensive social welfare programs, Algeria found itself struggling to balance its budget. Oil prices remained low for two more years keeping Algeria in strife. There is a historical basis for the assumption that a drop in oil prices will result in political unrest in Algeria. In the 1980s when oil was still at rock bottom due to the oil glut, Algeria faces countless violent protests due to the lack of money for social programs.

In 2019 oil prices had greatly rebounded yet, Algeria found itself in the same situation it was in during the 1980s riots. This is because, although prices have risen OPEC nations have all agreed to cut supply, including Algeria; leaving it with a high enough price to pay for their programs but not enough quantity to sell. Even without the money from their oil exports, the Algerian government declined to shut down the social welfare programs and instead funded them with the money from the country’s foreign exchange reserves. These reserves have since depleted 50% from their 2014 levels; leaving Algeria to begin print money to pay for its social welfare programs. Leading to rampant inflation.

Do to the perceived mismanagement of the budget many grassroots protests have since emerged calling for a change in leadership. Specifically calling for the resignation of President Bouteflika who has been in office for four consecutive five-year terms. As of this week, this has been achieved, President Bouteflika has agreed to resign by April 26th. While this may seem to be an end for the political strife in the nation, it is more likely just the beginning as the president has left a not clear successor to take his place. Leaving political certainty at an all-time high. With expatriation of oil reserves being a significant risk given the country’s outspoken and dissatisfied military elite.

Now how does this effect, the energy market as a whole? Both major and independent Oil and Gas companies have exposure to Algeria, and as political unrest and instability increases the projects likelihood of projects underdevelopment being halted. One example of this would be Exxon’s plan to develop a natural gas field in Algeria which were halted do to the political unrest. Moving forward it would be wise to avoid companies with significant exposure to Algeria, in either current projects or developing ones until the political unrest has been settled.

By the Baruch IMG Energy Team

 

Industrials Sector Update

 

Ethiopian Airlines crash leads to the grounding of Boeing 737 Max 8 worldwide

The March 4th crash of a Boeing 737 Max 8 Ethiopian Airlines flight 6 minutes after takeoff has led to the grounding of the entire 737 Max fleet.  This was the second crash involving the 737 Max 8 in the last 6 months. Lion Air flight 610 crashed into the Java Sea 13 minutes after takeoff from Jakarta on October 29, 2018.  China was the first country to ground all 737 Max aircraft, followed by the UK, Australia, Canada, and the US. An issue relating to an anti-stall device in the nose of the plane has been linked to the Lion Air crash and recently recovered Ethiopian black boxes show the two crashes have a clear similarity.  The 737 Max is a brand new plane and had just been delivered to both airlines just months prior to the crashes. Additionally, a grand jury is looking into safety certifications involving the aircraft. The next few months will be rough for Boeing as the company will be under scrutiny from aviation authorities.   

The Max program is critical to Boeing as it accounts for approximately 590 jets valued at between $27 billion and $30 billion in revenue this year alone, representing 1/3 of total projected 2019 revenues.  A grounding of all 737 Max planes could cost the company between $1 billion and $5 billion, according to estimates from Wall Street firms Melius Research and Jefferies. Shares have dropped 12% since the Ethiopian crash.

Payments Sector Sees Another Mega-Merger

Fidelity National Information Services Inc. (FIS) agreed to acquire Worldpay Inc. (WP)  for roughly $35 billion in cash and stock. The deal will create a global giant with worldwide reach in the payment and back-office financial services sector that will allow the company to reach more customers.

FIS engages in an array of tasks ranging from storing and managing basic account information to complex back-office trading operations. Worldpay connects merchants to the networks that process credit and debit card transactions and other types of payments.

As retail banks have started to get rid of their traditional payment management services, an increasing amount of smaller, technology-driven startups has filled the void.  This has led to an increasing number of new stock-market listings, strategic takeovers and private-equity buyouts in recent years.

The combined company expects to generate $500 million in additional revenue and save roughly $400 million by combining their one-stop shop services to process online and in-store payments and manage transactions in multiple currencies. The new company expects to generate $12.3 billion in revenues.

U.S. Decision On Iran Sanction Waivers will drive oil prices

Recent discussion of oil prices has revolved around OPEC production cuts, record-breaking US output, turmoil in Venezuela, and the U.S.-China trade dispute.  However, U.S. sanctions on Iran’s oil exports will be the key factor that drives the price of oil in the coming months.

After imposing sanctions on oil imports in November 2018, the U.S. granted waivers to eight major Iranian oil clients, including the superpowers China and India, resulting in an increase in supply which drove prices down.  Benchmark Brent crude futures fell 22 percent that month and the waivers influenced an OPEC decision to agree to cuts beginning in 2019.

Looking ahead, analysts believe that the price of oil itself will play a major factor in the decision whether to extend the waivers and demand additional reductions from Iranian oil customers.  If waivers are extended, analysts anticipate that India and China will be receiving the go-ahead to continue buying oil and the US will not renew waivers to Italy, Greece, and Taiwan in order to limit the supply of oil.

Mining company Vale SA dam collapse to have a far-reaching effect on iron ore supplies

The January 25 Brumadinho dam accident in Brazil that left more than 300 people dead or missing on Jan. 25 has resulted in Vale SA cutting production at an iron ore mine in the state of Minas Gerais that has an annual capacity of 12.8 million tons.  It will also suspend operations at its Doutor dam. This is in addition to a temporary closure of its Brucutu mine and other mines in southern states, which were expected to affect 70 million tons a year of production capacity.

The news caused Chinese iron ore futures to rise by more than 3 percent to a two-week high on Monday and pushed shares of Rio Tinto and BHP, rivals of Vale, up by 1.8% pre-market on Monday.  This is Vale’s second dam disaster in the last 5 years, as the Samarco dam collapse in 2015 caused the deaths of 19 people and irreparable pollution of the entire Doce River basin.

By Vikram Chitkara - Industrials Director, Baruch IMG

 

US Economy Update

 

The real Gross Domestic Product (GDP) increased at an annual rate of 2.6 percent in the last quarter of 2018, in accordance with the “initial” estimate released last Thursday, February 28th by the Bureau of Economic Analysis (BEA). This initial estimate replaces the “second” estimate that was supposed to be released last Thursday, while initial reports were intended to be released January 30th, a result of the partial government shutdown. The fourth quarter GDP growth rate was down 0.8 percentage points from the third quarter, due largely in part to decelerations in private inventory investment, personal consumption expenditures (PCE), and downturns in federal and state government spending. However, these movements were partly offset by an increase in exports and an acceleration in nonresidential fixed investment. That being said, the actual fourth quarter GDP report was still stronger than the consensus forecast, which was 2.2 percent.

The Consumer Price Index increased a total of 1.6 percent, the smallest increase seen since the period close of June 2017, as of the 12-month close in January. The index regarding all items rose 2.2 percent over the trailing period of 12 months, while the energy index declined 4.8 percent. The GDP and CPI directly affect one another and are two of the most important aspects of a healthy economy.

The Bureau of Labor Statistics uses the CPI to adjust important economic indicators such as wages, retirement benefits, and tax brackets. While economic growth is preferred, the U.S. Government can only sustain an annual growth rate between 2.5 to 3.5 percent. If growth rate accelerates so does the inflation rate. Calculated using the trailing 12-month CPI, the current inflation rate is 1.55 percent.

U.S. consumer confidence rebounded in February following a tumultuous January. The Conference Board consumer confidence index dropped last month amid worries involving the 35 day-long government shutdown and stock-market volatility, which reflected higher interest rates and paranoia due to trade tensions between the U.S. and China. The consumer confidence index reported by the Conference Board, which measures consumers’ assessment of current economic conditions and forward-looking expectations, rose from 121.7 to 131.4 in February, following a rally in the stock market and a positive outlook regarding current trade talks.

The February Manufacturing ISM report announced a PMI at 54.2 percent. The PMI, or Purchasing Managers’ Index, is an indicator of economic health for manufacturing and service sectors. The PMI is released monthly by the Institute of Supply Management and provides information to company decision makers, analysts, and purchasing managers about current business conditions. It is also based on a survey, consisting five major areas: new orders, inventory levels, production, supplier deliveries and employment, gets sent out to senior executives at over 400 companies.

A PMI reading above 50 percent indicates that the manufacturing economy is generally expanding, while a reading below 50 percent indicates contraction. Typically, a PMI reading above 42.9 percent, over a period of time, indicates expansion of the overall economy. While the February reading was the lowest recorded in the past 12 months, it still represents growth in the manufacturing sector for the 30th consecutive month, and growth in the overall economy for the 113th consecutive month.

Total payroll employment increased by 304,000 in January, while to unemployment rate edged up to 4 percent compared to the previous month’s 3.9 percent. That being said, average hourly earnings of all private-sector employees rose over the month, following a 10-cent gain in December. Over the past 12 months, hourly earnings have risen a total of 3.2 percent. We saw the largest employment increase of 74,000 this past month in the leisure and hospitality industries, with the smallest change seen in government employment, showing an increase of only 8,000.

In brighter news, the employment-population ratio – the proportion of the population that is employed – is now 19.1 percent among those with a disability, as reported by the U.S. Bureau of Labor Statistics. This shows a .4 percent increase from last year’s employment-population ratio among disabled people in the U.S. Among disabled persons aged 16-64, this ratio rose 30.4 percent in total in 2018.

All in all, the health of the U.S. economy is making a steady comeback from the recent lows hit in the last quarter of 2018. Looking ahead, we plan on seeing continuous mature growth throughout the remainder of the year, stabilizing the overall economy. Keep an eye out for updated GDP estimates for the fourth quarter, based on more complete data, being released on March 28th.

By Paige Goulden, Portfolio Management Junior Analyst - Baruch IMG

 

iRobot

 

As students, some of us may be in a constant state of frenzy over whether our careers will be overtaken by robots. Well, the plague has officially began overtaking the healthcare industry as we know it.

Every year more than 4,000 people are injured undergoing surgery due to human error. Surgeries, specifically spinal implant procedures, leave patients with severe bleeding and long recovery times. In fact, post-surgical pain is oftentimes reported as being more severe than it was pre-surgery. But with the assistance of robots, we can actually begin to improve the efficacy of surgeries and post-surgical pain.

Robots are much more precise and require smaller incisions to complete procedures. This does not mean that humans are not involved in the process. Surgeons are sitting behind computer screens and monitoring the procedure using a video camera attached to the robot’s arm, and controlling the robot as needed. Companies such as Intuitive Surgical and Globus Medical are streamlining efforts to be at the forefront of creating robots that aid in such minimally invasive procedures. While procedures such as breast mastectomies (removal of breast tissue) and hysterectomies (removal of the uterus) are still preferred to be done by humans, robots are beginning to take over spinal surgeries entirely.

The spinal surgery market is going to be driven by the fact that people require more spinal implants. As countries are becoming more industrialized, sedentary lifestyles are becoming more prominent due to bad posture from sitting all day. Because of this, 20% of Americans develop scoliosis, which oftentimes requires spinal implant surgeries. Additionally, the world population is aging. The number of people over 65-years-old will exceed the number of people below 18-years-old by 2035, which is truly a never-before-seen feat. Due to the rise in aging population, chronic back pains have risen by 24% in the past decade, as spinal problems are age-related.

As more people are opting for spinal surgeries, the rise in artificial intelligence will aid in broadening the applications of robots for minimally invasive procedures. The $60B artificial intelligence market is the root cause of software developments that allow for a robot to acquire a human-like brain during operations. As of 2017, the number of surgical procedures rose by 15% globally, due to people’s increased trust of and declining fear of surgeries. And for this, we can thank the robots for inducing the minimally invasive procedures.

The main risk factor in the robotic space is the slowing usage of robots due to the lack of surgeons able to be overlook the surgeries. It’s argued that more surgeons will be required to be present at surgeries when robots are handling the procedure, as more human brains need to be attentive to what’s happening behind the robot’s movements. Utilizing such equipment in the surgery room also requires extensive training. However, companies such as Global Medical having simplified training programs in place to make sure that robots really are the face of the future.

By Alice Karetsky - Healthcare Analyst, Baruch IMG and David Jejelava - Healthcare Director, Baruch IMG

 

2019 Q1 Markets Update

 

After the -19.78% correction in the last two months of 2018, market has turned around its performance in the first quarter of 2019. S&P 500 recorded best January performance in history and its year-to-date return stands at 11.26%. The correction that ensued near the end of 2018 was caused by slew of worries. Investors fear over hawkish tone of Federal Reserve monetary policy, escalating trade tensions with China, synchronized global economic slowdown, and concerns over a potential earnings recession in 2019 were some of the suspects behind the panic. The market has regained much of what it lost during the correction in part due to better than expected earnings reports and sudden change in tone of Federal Reserve Chair Jerome Powell during his latest press conference where he backed off from running the balance sheet normalization on autopilot. Even though president Trump recently announced that he is postponing the additional tariff hike by 60 days, the threat of unresolved trade policies still looms large.

Sector Performance Review:

At +17.71%, Industrials (XLI) is the best performing sector. Boeing (BA) is the biggest contributor with the stock up 22.05% after a record Q4 earnings. They beat EPS estimate by 19.9% on the back of $28.30 billion revenue and raised expectations for airplane sales to 905, up from 806 last year. This signals strong growth for air travel, despite the world bank cutting its 2019 growth forecast due to trade tensions and currency woes. Railroads have also been performing incredibly well. CSX, NSC and UNP added a total of 2.3% of XLI’s YTD gains. Although railroads had incredible gains for 2019, they faired poorly in the last quarter of 2018, due to tensions between China and the US. However, recent data shows that rail traffic has held up well, with carloads up 1.7% from January 2018 and intermodal originations up 1.1% showing continued strength in the industry. All three companies have beat Q4 EPS and revenue expectations.

The technology sector, (XLK) is up 13.90% with biggest contribution from Microsoft (MSFT) who reported 76% growth in could service segment, Azure. In the process, Microsoft took over the crown of most valuable publicly traded company on market capitalization basis at $856.1billion. Other big contributors are the payment processors, Mastercard (MA) and Visa, adding a total of 1.36% to XLK. Mastercard reported a gross dollar volume of $1.55T an increase of 14% YoY with Visa reporting a similar outcome with an increase of 11% in payment volume.

Energy (XLE) is up 12.45% for 2019 with Exxon Mobile (XOM), Chevron (CVX) and Phillips 66 (PSX) adding a total value of 6.16% to XLE. These increases are backed by an increase refining margins and and production.

Consumer Staples (XLY) posted a total of 11.38% in gains for 2019, backed by Amazon (AMZN) and home improvement retailers like Home Depot (HD) and Lowes (LOW). Amazon has only returned 8.72% this year underperforming markets, but due to its weighting in the ETF (21.54%), it has added by far the most value to XLY with 1.93%. Much like Microsoft, the most impressive number was the cloud service performance which is up 46% YoY and brought in $7.92 billion in revenue.

Financials (XLF) underperformed the overall market in 2018 and continues to do so, posting only 10.16% YTD. Worries about raising interest rates has plagued the industry but the fundamentals are still strong. Bank of America (BAC) reported strong Q4 earnings with 52% increase in consumer banking net income and 42% increase in global wealth and investment management. Recently BB&T announced that it will merge with SunTrust Banks for a $28.2 billion in an all stock deal to create the sixth largest bank in the United States by deposits. The two Banks were having a difficult time competing with larger banks and also wanted to consolidate their tech spending which they desperately need in order to serve their customer and compete against big national banks. The merger is expected to be completed by Q4 2019 and create an annual cost savings of $1.6bn by 2022.

After stellar performance in 2018 Healthcare (XLV) has lagged behind the market, only posting 8.63% YTD. The company with the largest attribution to XLV is Johnson and Johnson with 6.58%. In recent news General Electric (GE) has agreed to sell its healthcare business to Danaher Corporation (DHR) in a $21 billion all cash deal. Some analysts believe that DHR’s organic growth will increase from 4% to 6% due to this acquisition that will be completed in Q4 2019. Danaher is funding the acquisition with an offering of $1.35 billion worth of common stock and an additional $1.35bn of Series A Mandatory Convertible Preferred Stock.

By Baruch IMG’s Portfolio Management Team

 

Financials Outlook: Banking Industry

 

As the era of historically low rates ends, the Banking sector is now facing geopolitical headwinds, trade uncertainty, and overall market fragmentation. However, despite external pressures, the commercial banking industry maintains a positive outlook as strong fiscal spending and temperate inflation in the current climate will slow down the flattening yield curve and boost demand for credit.

The health of the economy is tied to the performance of the banking sector. While there are concerns about the flattening yield curve, the Fed’s sudden dovish outlook hints at the continued credit growth in 2019. We are also continuing to reap benefits from the recent tax cut in 2018 and President Trump’s increased fiscal spending.

Given the subdued interest rate environment, prudently expanding loan books and establishing a robust digital banking platform are the primary drivers of growth in the banking sector.

Throughout 2018, the rising rates helped banks increase profits in the consumer and commercial banking segment as the spread between the rates they offer to savers and the rate they lend widened. During this period of rising rates, the average net interest margin for all US banks increased by 6% from 3.15% to 3.33%. In conjunction, credit card debt also increased to 19.3% from 18.4%. Although the Fed may hold off raising rates in 2019, the trend of accumulating deposits and increasing loan book size will be fueled by the improved credit demand in the economy.

Another trend that’s fragmenting the entire industry is the rise of FinTech. Early adopters of digital banking such as JP Morgan Chase & Co and Citizen’s Financial Group have been able to penetrate the millennial market and expand their geographical deposit footprint. On the other hand, the majority of full-service banks must now decide between investing in horizontal integrations to strengthen their value chain to combat the new entrants or unbundle their consumer banking services to the new FinTech entrants. At the same time, the FinTech trend has also increased the importance of branding and increased cost savings as brick and mortar locations are slowly phased out.

Geopolitical uncertainty from Brexit and the overall economic instability of the EU’s banking system is another considerable risk to the entire banking sector. While US banks are all unified under the Central Bank, the European banking system lacks a central authority regulatory agency. As a result, Brexit could lead to a free-fall of the British pound and disrupt the entire EU economy. The ongoing trade uncertainties also affect banks with international exposure such as Citi. However, we should keep in mind that external pressure ultimately doesn’t undermine or change the operational structure of a bank.

The biggest problem facing M&A activity and capital markets today is the rising cost of debt. While a quarter point hike here and there won’t drastically lower profit margins, the consistent hikes have threatened the balance between servicing debt and reducing the principal. Banks are now seeking financing from foreign markets, which include Europe and India, and financial sponsors to combat the rising cost of debt.

By Kenny He - Financials Director, Baruch IMG

 

2018 Equity Market Recap

 

Equities were expected to outperform other major asset classes in 2018 as they were to benefit from synchronized global growth and an increase in profits due to the Tax Cuts and Jobs Act passed in 2017. While major U.S. equity indices spent the majority of the year in the green, their gains were erased in December due to a combination of factors. These factors included investor’s expectation of a weakening global macroeconomic backdrop and an unpopular decision by the Federal Reserve to increase their federal funds rate between 2.25% and 2.50%. The federal funds rate is a measure used by the central bank that controls the country’s money supply and in turn, can influence growth. With increasing interest rates, investors were worried that the Federal Reserve was raising rates too quickly and that the economy could overheat. As a result of these developments, major equity indices posted their worst year in ten years with the S&P 500 falling 6.2%, the Dow Jones Industrial Average falling 5.6%, and the NASDAQ falling 4%.  

In comparison to 2018, 2019 is a year in which analysts expect growth in corporate profits to slow as they have reaped the benefits of the tax cut and will continue to suffer from an increase in expenses due to the ongoing U.S.-China trade war. However, with approximately 50% of S&P 500 companies already having reported 2018 fourth-quarter earnings, major U.S. equity indices have been able to bounce back from their December lows as growth in corporate profits have been better than initially expected. For January, the S&P 500 gained 9.16%, the Dow Jones Industrial Average gained 8.11%, and the NASDAQ gained 10.23%. Although each sector had seen certain companies that failed to meet analyst’s earnings expectations, the following two retail companies have posted some of the strongest earnings for the quarter.

Estee Lauder Companies Inc. (NYSE: EL)

Estee Lauder Companies Inc. is one of the world’s leading manufacturers and markets quality skin care, makeup, fragrance and hair care products that are sold in upscale department stores. Currently, Estee Lauder Companies Inc. offer these products under brand names such as Aveda, Bobbi Brown, Jo Malone London, and Tom Ford Beauty. In recent years, Estee Lauder Companies Inc. has been able to benefit from an increase in spending towards discretionary goods as well as an overall trend in which consumers have become more concerned about their image.

On Tuesday, February 5, EL released earnings for the quarter in which investors were reassured that the company continues to benefit from the same trends it did a year ago. For the quarter, EL reported earnings per share of $1.86 which is better than last year’s earnings per share of $1.52 and Wall Street’s estimate of $1.54 for the quarter. Additionally, EL’s revenue was reported to be $4.01 billion for the quarter in comparison to the $3.92 billion expected by analysts. The company’s better-than-expected performance was primarily driven by a strong holiday season, increased sales from premium products, and solid results from its Asia-Pacific operations. As a result of this strong quarter, EL has raised their outlook for the first six months of the year and had experienced a 12% gain on the day.

Clorox Co. (NYSE: CLX)  

Clorox Co. is a $19.6 billion company that manufactures and markets consumer and professional products under notable brand names such as Clorox, Tilex, Glad, Burt’s Bees, and Kingsford. As a company that predominately offers household consumer products, Clorox tends to perform best in times of an economic slowdown as their products are a constant necessity within consumer’s lives.  

On Monday, February 4, Clorox Co. posted better-than-expected earnings for the quarter that resulted in the company’s shares gaining 6% on the day. For the quarter, Clorox Co. reported adjusted earnings per share of $1.40 which beat analyst’s expectations of $1.30. The company’s increase in profitability was driven by a greater-than-expected decrease in costs under the company’s cost-cutting plan. Similar to Estee Lauder Companies, Inc., Clorox Co. increased their guidance for the year as the company expects to continue cutting costs under their current plan.

With Estee Lauder Companies Inc. and Clorox Co. posting better-than-expected earnings for the quarter, investors who are bullish on the retail sector have been provided with a glimpse of what can be expected from future earnings releases in the coming weeks.


By Dominik Sochon - Consumer Goods & Retail Director, Baruch IMG

 

November Update: Another Rough Month for Markets

 

After a turbulent October, investors were hoping for a relief from the sharp selloff as we move into the slow holiday season. There was some initial relief at the beginning of November as markets rebounded but that turned out to be a dead cat bounce when market started selling off again as crude oil price started plunging. All three major indices, S&P 500, NAQSDAQ 100, and Dow 30 year-to-date return turned red for the fourth time this year.

From a sector perspective, Information sector led the selloff mostly driven by Apple as investors process the new quarterly disclosure policy where they will discontinue announcing the unit sale of individual product category. The market viewed this as a big red flag and raised concern over future iPhone sales which is essentially Apple’s primary cash-cow. This fear spilled over into semiconductor names such as Qualcomm and Skyworks because of their exposure to iPhone sales.

Energy was the second worst performing sector as oil price continue to plunge. Within the last seven weeks, U.S. WTI benchmark prices have dropped from the highs around $76 in early October to $52 as of 27 November. As in the case of any commodity, the drop was due to rising inventory levels. The weekly inventory level has been trending up since September and is edging closer to upper end of 5-year range. This 5-year range is an important barometer for gauging the health of physical crude oil market because it gives insight into the demand and supply balance in a historical context. Any deviation from the average will either drive up the price or pull it down. Should we continue on the current path and break above the upper end of 5-year range, we could possibly see a repeat of 2015/2016 sub $30 oil price.

The Weekly EIA Inventory Chart

The Weekly EIA Inventory Chart

On the other end, healthcare and utilities were two best performing sectors as investors move into defensive sectors. Healthcare outperformance has been especially interesting because most of the heavy lifting in the sector were performed by major drug companies. Out of the top five best performer, four were drug companies. This quite puzzling because of the current negative political climate around drug pricing.

By Baruch IMG’s Portfolio Management Team

 

Technology Industry Outlook: E-Sports, Cloud, and Cyber Security

 

According to Aristotle, there is a fundamental irreconcilable split between the world’s process of being and becoming. Being connotes the part of nature that is static while becoming points to the ever-changing fluidity of the world. Today, in the technological era, our process of being, in terms of industrialization, has ended and our process of becoming, in terms of digitalization, has begun and is accelerating faster than ever. The global expansion of the web has flattened our world and made us more connected than before.

This February, during the NFL’s 52nd Super Bowl, the Philadelphia Eagles beat the New England Patriots 41 to 33 in front of 103.4 million viewers from across the globe. American Football is the most viewed sport in the U.S. and has lost 7% of its total average users since 2017. In the meanwhile, the League of Legends World Championship Finals held on October 21st, 2018, was able to garner a total of 200 million viewers worldwide. The up and coming Electronic “Sports” market is taking the world by storm and has already gathered crowds larger than those within some tradition sports leagues. According to Statista, the eSports market is expected to generate $905 million in revenue by the end of 2018 and $1.65 billion by the end of 2021; the sector is expected to grow at a CAGR of 38%. Currently, about 80% of this revenue is coming from sponsorships and advertising and the other 20% is coming from eSports betting, prize pools, tournament ticket sales, and merchandise.

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Companies like Activision has already generated nearly $1 billion in revenue off capitalizing on the eSports trend by selling off 12 Overwatch teams last year to sports team owners/supporters across major cities. This start-up Overwatch league has been a huge success so far, generating lots of money across multiple different tournaments, and will set them up next wave of team sales at higher prices. Take-Two Interactive Software also capitalized on this growing eSports trend by creating an NBA 2K League, where 17 of the 30 NBA teams would be represented.

Aside from the gaming companies, traditional technology giants have also been plotting plans to enter into the lucrative eSports market. Companies like Amazon acquired streaming platforms such as Twitch in 2016 in order to tap into the eSports market. Now, Google and Microsoft have recently announced efforts to let people play big-budget, visually complex games on internet connected devices without them having to spend too much on devices such as Xbox or PCs. The game-software sector revenue rose 59% since last year to $121.7 billion and is expected to reach $134.9 billion by the end of the year.

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Game-Software growth and eSport’s market growth carries huge growth opportunities for other parts of the tech industry as well. Demand for cloud and high-speed internet connection is expected to increase as a result of eSports because of the need to constantly integrate data at lighting speeds. During tournaments, a delay of even a quarter of a second can heavily skew the outcome of a game being players. This will accelerate demand for 5G networks once telecom companies start to role it out. Also, increased demand in gaming and 5G networks will also increase the demand for semiconductors which will benefit companies with Advanced Micro Devices and Nvidia. The semiconductor manufacturing industry is currently generating a revenue of $54.6bn with an annualized projected growth rate of around 2.2% per year over the next 5 years according to IBISWorld Research.


By Waiho Zhang - TMT Director, Baruch IMG

 

Monthly Market Review: Is the Worst Behind Us?

 

October was a turbulent month as the market faced major headwinds that brought down all three major indices for a second time this year. The S&P 500 fell close to 10% correction territory at -9.25% before closing the month at -7.23%. Though some components of the Dow Jones Index such as 3M Company and Caterpillar reported disappointing earnings and gave gloomy guidance, the overall index held up much better than its peers. Strength of the rest of the components such as Unitedhealth Group, McDonald’s, Boeing, and Apple neutralized the weakness. It was down -8.23% before recovering to close the month as -5.77%. The worst performing index was NASDAQ 100 as it crossed below the 10% correction territory at -12.28% before recovering and finishing the month at -8.78%.

We think that the China trade war rhetoric from the Vice President Mike Pence, rising yields, suspected peak earnings growth and profit taking kicked off the initial sell-offs with disappointing earnings report by major technology companies exacerbating it further.

From a macro perspective, the United States posted strong economic report with third quarter initial GDP reading coming in at 3.5% driven by consumption. The unemployment rate hit 49-year low of 3.7% and the monthly YoY wage growth came in nine year high at 3.1% as the labor market continues to tighten. As the economy marches ahead with all 12 cylinders, this raises the fear of an overheated economy and its implication on the federal reserve monetary policy. The fed announced three rate hikes so far this year and if the economic indicator continues to print strong numbers, we could potential get another rate hike announcement during December meeting because of inflation fears. Currently, the CME Fed Funds Future is pricing in a 76.6% probability of a 25-bps rate hike during the December meeting which will raise the federal funds rate range to 2.25% to 2.50%.

Oil prices dropped significantly over the month. The United States WTI benchmark fell 13.27% and the international benchmark Brent, fell 11.19% from an $86 per barrel high at the beginning of the month to a 7-month low of around $75 at the month’s end. This drop was primarily due to U.S. stockpiles increasing for the 6th week straight given the expectation for an inventory drawdown because of falling Iranian crude oil export due to reinstatement of sanctions.

Average Hourly Earnings YoY Change

Average Hourly Earnings YoY Change

Earnings Season Spotlight by Sectors:

Energy: -12.54%

ExxonMobil (XOM) saw its stock price jump after posting its highest Q3 profits in four years, and seeing revues rise 57%. Chevron (CVX) also saw its stock rally after posting positive quarterly results, including setting a new daily barrel production record of about 2.9 barrels, and nearly doubling its production in the Permian Basin.

Healthcare: -7.24%

UnitedHealth Group, one of the largest healthcare providers in the U.S., posted impressive earnings with EPS beating by 3.91% and revenue exceeding consensus expectations by 12%. The Group also raised guidance for Q4 2018, citing synergies in Optium as a primary reason. Despite the positive earnings, the stock dropped down 4.12%, reflecting the cautious attitude currently surrounding the markets.

Johnson and Johnson (JNJ), the largest drug manufacturer in the S&P 500 reported its EPS beating expectations by 0.02, and revenue growth of 3.5%. The company cited robust a pharmaceutical growth of 6.7%, which was slightly offset by the floundering medical device segment shrinking 0.2%.

Industrials: -11.64%

Boeing reported strong EPS and revenue growth which came in above consensus and raised guidance for Q4. Boeing showed 12% growth in its Global Services, and Space & Security segments making up for declining commercial aircraft sales. Boeing’s performance indicated that tariffs have not impacted all manufacturers. This was further supported by the fact that “tariff” was never mentioned during its earnings call.

3M told a very different story with Q3 EPS missing estimates by 4.65%, revenue shrinking by 0.2%, and guidance being lowered for the future. Reportedly, the implementation of tariffs reduced earnings by 15 cents per share, and 3M management stated future product pricing will offset the higher material costs. Despite tariff impacts, 3M’s main setback was the headwinds from currency volatility, which resulted in a 1.7% reduction in revenue.

Communication Services: -8.44%

Facebook report beat EPS by 19.10% but missed on revenue growth. The metrics currently catching investors’ eyes are revenue growth (the slowest to date) and daily/monthly active users (currently stalling). Some see slowing revenue and user growth as an indication of the company reaching maturity which could signal rough roads ahead for the social media giant.

Alphabet, the parent company of Google (GOOG), beat EPS by 25.5%, however like many other companies this earnings season, it fell short on revenue growth. Alphabet cited growing traffic in total searches, Youtube engagement, and cloud services. GOOG reported large growth internationally as well as domestically. U.S. revenues were up 20% year-over-year, EMEA up 20% year-over-year, APAC up 29% versus last year and Other Americas were up 19% year-over-year.

Financials/Real Estate: -5.09%

Blackrock (BLK), the world’s largest asset manager, beat EPS estimates by 10.10%, however missed revenues by $60mm. In Q3 the asset manager posted its first net capital outflow since 2015, announcing a $3.14bn exodus, compared to last quarter’s inflow of $20bn. The vast majority of this outflow was corporate and not individual investors, signaling that companies are reconsidering their cash investments as a rising interest rate environment seemingly approaches. BLK declined 30% from its highs earlier this year.

By Baruch IMG’s Portfolio Management Team

 

Energy Outlook: Looming Fears

 

Overview

The Energy Industry is a multi-factor industry that is not only affected by the performance of companies but the price of the commodity that is used by many companies within the industry. The global benchmark is Brent Crude, and the U.S. benchmark is West Texas Intermediate or WTI.

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Price Build-Up


The price of Brent and WTI have rallied since the crash to $30 a barrel but have recently undergone some strain. The rally was in part due to OPEC’s de-facto leader Saudi-Arabia working with Russia to put supply cuts. That combined with geo-political tensions including the death of Jamal Khashoggi at a Saudi-Arabian embassy in Turkey and sanctions announced on March 12th on Iran who exports nearly 3.5 Million barrels per day, have brought Oil futures to new 4-year highs.


Recent Decline


Oil demand is strongly correlated to GDP as it is inferred that as GDP increases, output has increased meaning a need for oil. We can see GDP globally being threatened specifically with South Korean GDP only expanding by 0.6% missing the expected 0.7% for Q3. The recent slow-down of the global economy has sent shocks to the price of oil. From the beginning of October, Brent is down 10.71% and WTI is down 12.48%. With the Federal Reserve set to raise interest rates again in December and planning three more hikes next year we see that the decade long bull run may be slowing down. There is also a rise in the U.S. dollar index of 1.44% hurting demand for dollar denominated oil futures. Most recently we’ve seen that Russia has weaned off its supply cuts and has no intention of freezing or slowing output levels with fear of undersupply combined with China and India looking to circumvent U.S. sanctions on Iran allowing for higher oil supply and hurting futures.

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U.S. Energy Industry

The U.S. has had a surge in oil production because of their ability to Frack. This allows them to drill multiple wells horizontally instead of one well vertically, allowing for more oil production per well. This practice has enabled the U.S. to surpass Russia as the largest oil producing nation. The largest area for fracking is the Permian Basin, an oil field in West Texas, second only to the Ghawar oil field in Saudi Arabia in production. This has come with some issues. The Permian Basin’s rapid increase of oil production to 3,496,000 barrels per day was not accompanied by an increase in capacity from oil pipelines which move oil to refineries to be turned into usable products. This has caused a supply glut in the Permian Basin forcing Upstream or E&P companies to sell their oil at a discount or transport it by rail hurting earnings. Refineries have benefited from this by acquiring oil at a discount boosting earnings. Refineries in Northern United States are also currently getting their oil at a discount from Canada. As Canada is a large oil producing nation that does not have enough refineries, drillers there sell their oil at huge discounts currently around 60% to American refineries.

By Joseph Vittoriano - Energy Director, Baruch IMG

 

U.S. Homebuilders Facing Onslaught from Higher Rates

 

After the market wide correction towards the beginning of 2018, a majority of the market has been able to recoup its losses, and even extend gains, the story is quite the opposite for homebuilders. ITB, a homebuilder iShares ETF is currently off 33.74% from this year’s highs and continues to edge lower. The decline in homebuilders can be attributed to an amalgam of factors, but the rising of interest rates has been the main driver.

After the fed approved the first interest rate hike of 2018 on March 21st 2018, homebuilders have reacted adversely to the news, and for good reason. As interest rates rise, you see the cost of borrowing follow that as well, causing mortgages to get more expensive and deter homebuyers from bidding on houses. With third rate hike of the year in September and another potential hike during the December meeting, the sentiment surrounding homebuilders will continue to sour. For this sentiment to reverse its path, we need to see moderation in hawkish tone from the FOMC members. 

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Unfortunately for homebuilders, the bad news doesn’t stop at the rate hikes. The current landscape makes for a perfect storm against the industry. The newly imposed 21% tariff on Canadian soft lumber, falling home sales, disappointing earnings/projections and negative analyst sentiment have been weighing down on the sector as well. 

One of the larger emerging threats to the industry is tariffs on Canadian lumber imports. This will cut into margins and adversely affect future growth projections for many companies. This increase in cost will most likely be transferred to the consumer, causing further increases in the cost of building new homes while discouraging even more homebuyers. This is already being shown in the forecasted cost of US homes, with a projected increase of 6.4% for the next 12 months.

The homebuilder industry is incredibly cyclical, and trends are seeming to rhyme with past interest rate hikes in 2007. Once the Fed began raising rates in 2006, the homebuilder etf XHB began its descent, falling 55.4% before the actual market downturn, which started a little more than a year later, in October 2007. The current trend is nearly mirroring the past tightening cycles, slowing projected job growth and the increasing frequency of disappointing earnings by companies within the sector.

 The homebuilding sector may seem relatively isolated, but it is quite the opposite. The industry is vast and has incredible influence over a sizeable amount of companies, including home inputs like Mohawk, Sherwin Williams, Masonite, Scotts Miracle Grow and Home Depot. Companies within XHB or ITB also have a huge impact on many raw material companies across America. A decline in the housing sector could mean trouble ahead for the rest of the markets.

Although the future for the homebuilding sector looks bleak, some analysts believe that there may be a sweet spot in home builders. The super-affordable segment, consisting of LGI Homes (NASDAQ: LGIH) (avg home 220,000-230,000), NVR (NYSE: NVR) and Meritage Homes Corporation (NYSE: MTH) seems like it may have some value left, considering its more affordable price range.

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The bottom line here is that home sales are declining because of rising prices driven by declining inventory of for-sale home due to “mortgage rate lock-in”, rising cost of raw materials due to the trade war, and rising cost of mortgage due to federal reserve rate hikes.

By Baruch IMG’s Portfolio Management Team

 

Industrials Outlook: Aerospace & Defense

 

As the geopolitical landscape continues moving with uncertainty and the world is entering a phase of heightened technological development, a constant focus is on the aerospace and defense sector. As a whole, the A&D (Aerospace and Defense) industry strengthened in 2018 as revenues increased by 7.65%, almost quadrupling last year’s 2.1% growth. Events such as the political dispute between the United States and China pose security threats for many involved governments. In response, the United States government has signed the omnibus spending bill, which set the Department of Defense’s budget at $700 billion, about a 20% increase in two years.

As a whole, Deloitte analysts expect a growth in global defense spending at a CAGR (compounded annual growth rate) of 3.0% from 2017-2022. Tensions in developing countries such as India also factor into this continued growth, which shows little signs of slowing down. As cyber threats continue to evolve, there is also a greater need for cybersecurity to help companies protect their clients' personal information. Therefore, global cyber security spending is expected to grow at an annual rate of 10.2% to $248.26 billion over the next five years.

Aerospace


At the moment, the aerospace market is dominated by large key players, such as Airbus and Boeing, which control a combined 92.4% of the commercial aircraft market. Growth in the aerospace industry is fueled by a rise in the middle class, which is estimated at an additional 140 million individuals annually. This leads to increased capital expenditure in related fields such as air travel, which was accounted for with the record high backlog of commercial aircraft at 14,215 units at the end of 2017.  The industry is facing increased demand and is becoming consolidated and efficient in moving forward.

Increased global fears of warfare and border disputes and increased trade activity are the primary drivers for growth in the aerospace sector. With the Pentagon pivoting its defense focus towards China, Russia, North Korea and Iran there is a renewed market for aerospace presence in these regions. China is also active in land disputes such as that in the South China Sea, which contributes to the overall security threat in the region. As a result, aerospace defense companies with a large government client base have seen a sharp uptick in their contract flow.

Lockheed Martin, with U.S government agencies as its largest client has recently been awarded a $2.9 billion contract for the manufacture of missile warning satellites for the U.S Air Force. This is reflective of the tense political situation worldwide and translates into overall gains for the aerospace defense sector.

On the basis of aerospace manufacturing and transportation, the industry is also showing significant signs of growth. Globalization and an increasing reliance on intellectual capital have resulted in businesses and individuals traveling overseas at one of the highest rates in recent years. In total, revenue passenger miles increased 7% in 2017, which is above 6% annual growth for the third consecutive year. As a result, major aircraft manufacturers are looking internally towards agile growth of their processes, as well as key acquisitions in the M&A space to continue innovating.

Boeing recently acquired a majority stake in the commercial aircraft arm of Brazilian plane maker Embraer SA for $3.8 billion, effectively thrusting the large American maker into the lower end market of aircraft. The expansion of aerospace company operations through M&A opens up the possibility for increased solutions for large-scale institutional clients, such as governments and private contractors.

Furthermore, the opportunity for machine learning and automation in aiding the manufacturing process is a touted possibility in the sector. Drone use for inspection of aircraft wear and tear and inventory management on blockchain systems are just a few examples of the potential for future aircraft production, and these can be potentially implemented into company processes in the coming years. As a whole, the aerospace sector is in the process of entering the next generation of solutions and has a positive forward outlook

Defense


Increasing global tensions are driving growth for the defense industry. The U.S and China have recently taken aggressive stances toward each other. Trump imposed multiple tariffs on Chinese goods, with China responding by imposing their own tariffs on U.S goods. Both countries are increasing their defense spending to prepare for a potential war. There is also increased demand for defense and military products in emerging markets. For example, ISIS is a major threat to countries in Africa, such as Syria, Iraq and Afghanistan. These countries are forced to spend money on defense to protect themselves against terror strikes and cyber-attacks. Due to these global tensions, defense stocks will become hot investments for the next 5 years.

The leaders in defense are the participants of the Pentagon’s MQ-25A “Stingray” competition. This competition was designed to create the U.S Navy’s first carrier-based drone, with Boeing winning the competition and a $805 million contract to produce four naval drones. The competitors also included Lockheed Martin and General Atomics.

Lockheed Martin is the world’s biggest defense contractor and specializes in aerospace defense. General Atomics is a private company that specializes in creating military drones. 

Another driver for the defense industry is the need for cybersecurity. Cyber-attacks, such as data threats, ransomware and malware outbreaks, can cause critical disruption for unprepared countries. Data breaches have surged over the past years, with digital security company Gemalto reporting that 1.38 billion records were breached in 2016 and 1.9 records breached in the first half of 2017. These data breaches can lead to leaked personal data and identify theft, which has affected 15.4 million consumers.

Due to these threats, the cybersecurity market is expected to grow from $138 billion in 2017 to $248.26 billion in 2022. The main attackers are Russia, China, Iran and North Korea, who have been testing destructive cyber-attacks that are aimed toward the U.S and its allies.

To combat this, U.S government has invested much of its spending towards companies that can protect them from these attacks. Companies that the U.S has relied on include Booz Allen Hamilton, Palo Alto Networks and CyberArk. Booz protects the government's information through encryption, which has shown to be the most effective way to protect data. Palo Alto Networks protects its customers through next-gen firewalls, and is best positioned among its competitors to experience robust growth in 2019. CyberArk is unique because it actually protects companies from internal threats such as corporate spies or disgruntled employees. As a whole, the defense sector is in the process of heating up as countries have prioritized spending on defense to protect themselves from other countries and cyber-attacks.

In conclusion, the aerospace and defense (A&D) industry has experienced significant growth in 2018, with expectations of greater growth in 2019.

On the aerospace side, global fears of warfare have caused the government to sign contracts with aerospace securities to protect themselves from outside threats. Due to growing globalization and improved transportation, many middle-classes citizens from emerging markets have travel overseas at a extremely high rate. Finally, major aerospace manufacturers are looking to move into the M&A space in order to attract new clients.

On the defense side, global tensions have resulted in a large amount of countries spending money on defense to protect themselves from cyber-attacks and missile/drone attacks. The U.S government has taken many steps to give defense companies new opportunities, such as increasing the defense spending bill and creating competitions between the defense titans to improve technology. Overall, the A&D industry is anticipating the emergence of conflict and new-age technology, and it is well-positioned to reap its benefits.

By Liam Minerva - Industrials Director, Baruch IMG, Nikhil Kumar and Anqin Chen - Industrials Analysts, Baruch IMG