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Key themes: how to invest for 2019?

Respect the cycle: ISM as a guidepost for rotations

Based on our analysis, we break sectors/IGs into 4 groups based on where we are in the ISM cycle (Fig 60). The X-axis is average relative returns when the ISM is high (above 52.5) and falling, the current phase. The Y-axis is average relative returns when the ISM is below the midpoint and falling, the weakest part of the cycle.

Through cycle outperformers: Healthcare, Consumer Svcs, Communication Svcs, Software and Svcs, Utilities. The top right quadrant shows sectors and IGs that have outperformed on average from an ISM peak through to the trough.

Through cycle underperformers: Materials, Autos & Comp. The bottom left quadrant shows those that have underperformed from an ISM peak to a trough.

Mid-cycle upside, late-cycle downside: Tech (Hdwr, Equip), Industrials (Cap Goods), Financials (Diversified), REITS.

Mid-cycle laggards, late-cycle leaders: Semis, HH & Personal Prod, Telecom, Consumer Durables & Apparel, Transports.

We calculate an ISM cycle score. We use the average relative sector and IG returns, discussed above, as the basis for estimating potential performance through the current phase of the cycle (ISM high/falling) and the last phase (ISM low/falling). An average cycle would point to the ISM hitting 52.5 in October, so we assign the respective time weight to returns during the peak to mid-trough phase (~75%) and the rest to relative returns as the ISM falls toward a trough.

We would look to stay long and add to these sectors and IGs as the ISM is still high but falling.

We stay underweight these areas. Banks and Energy are mixed.

We would look to tactically rotate amongst those sectors and IGs that are more cycle dependent, with the notion that fundamental momentum tends to persist.

For the ISM cycle component in our 2019 composite score, we assign a 75% weight to returns during the high/falling ISM stage and 25% to low/falling.

Figure 60: Sector and IG average relative returns when ISM is high/falling (x) and low/falling (y)

		16%
		14%
		12%
		10%
	Low/falling	8%
		4%
		6%
	- ISM	2%
	(avg)	0%
	returns	-2%
	Relative	-4%
		-6%
		-8%

-10%

-12%

-14% -10%

						Food Bev & Tob				Pharma Biotech & LS
					Cons Staples
		HH & Personal Prod						Food & Stap Retail
					Outperform from ISM					Health Care
						peak to trough
					Retailing			Consumer Svcs
				Telecom
					Software & Svcs			HC Equip & Svcs
					Cons Disc				Comm Svcs
Semis & Equip				TransportationInsurance						Utilities
			Cons Dur & App							Media & Entertain
				Banks	Industrials	Capital Goods
					Financials			Technology		Div Financials
			Com & Prof Svcs
Materials				Energy						Tech Hdwr & Equip
	Underperform from ISM peak to
		trough							Real Estate
Autos & Comp
-8%	-6%	-4%	-2%		0%		2%			4%	6%
		Relative returns (avg) - ISM high/falling

Source: FactSet, Haver, UBS

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Margins will diverge: where are the relative opportunities?

In our earnings model, the level of GDP growth (relative to an intercept/fixed costs) and the change in GDP growth are essentially margin drivers. In addition, we found that margin momentum tends to persist (link). Accordingly, for sectors and IGs, we estimate an implied EBIT margin change in 2019 based on 1) expected sales growth in 2019, 2) the change in the pace of sales growth (2019 vs. 2018), and 3) the change in EBIT margins in 2018 – using a cross sectional multivariate regression to estimate the respective beta sensitivities. We then compare that estimated margin change based on the drivers to the consensus expected EBIT margin change for 2019. The more negative the score (z-score), the greater the potential risk to margins.

Figure 61: EBIT margin chg vs. sales growth chg (2019 consensus expectations)

	2.0
			EBIT margins expectated to expand					Banks
			despite slowing sales growth
	1.5							Com & Prof Svcs
expect			Energy
						Software & Svcs
- 2019	1.0				Financials Cons Dur & App Insurance
					Industrials	Telecom		Utilities
change	0.5					Capital Goods		Food Bev & Tob
					Div Financials	Transportation
					Comm Svcs			Consumer Svcs
			Real Estate
margin						HH & Personal Prod
			Media & Entertain		Technology	Cons Disc
						Pharma Biotech &
		Materials				RetailingLS
EBIT					Autos & Comp		HC Equip & Svcs
	0.0						Cons Staples
						Health Care
					Tech Hdwr & Equip		Food & Stap Retail
		Semis & Equip
		(-11%, -70bp)
	-0.5
	-12%	-10%	-8%	-6%	-4%	-2%	0%	2%	4%
			Sales growth		in 2019 - chg in y/y%

Source: FactSet, UBS

For the margin risk component to our 2019 composite score, we estimate the risk to consensus EBIT margin estimates based on the key drivers of margins.

Materials stand out as having notable risks to margin estimates for 2019, as margins are expected to expand even as sales growth decelerates dramatically.

On the other hand, we think Semis' assumed margin decline (one of the few) may be a reasonably conservative estimate.

Figure 62: Potential margin upside (downside) vs. consensus based on drivers

	2.0					EBIT margin risk (z score, fitted vs consensus)
	1.5
	1.0
	0.5
	0.0
	-0.5
	-1.0
	-1.5
	-2.0						Food & Stap Retail HC Equip & Svcs Semis & Equip Consumer Svcs Retailing Tech Hdwr & Equip Food Bev & Tob Pharma Biotech & LS Insurance HH & Personal Prod Transportation Autos & Comp Media & Entertain Telecom Cons Dur & App Capital Goods Software & Svcs Com & Prof Svcs Div Financials Banks
			Health Care Cons Staples Cons Disc	Technology Utilities Comm Svcs Industrials Materials Financials Real Estate Energy

Source: FactSet, UBS

Financials and Energy stand out as having margin expansion expectations that may be too high amid flat/slowing revenue growth.

Healthcare and Staples margin expectations look relatively conservative compared to other sectors.

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Pricing & wage signal: retail seeing pressure, most margin trends positive.

We derive a margin signal for industries by comparing pricing and wages, and adjust for compensation share (link). Food+Staples Retail has had the most negative margin trends, with pricing slowing by 0.1%, wage growth accelerating by 2.5%, resulting in a 90bp y/y margin headwind given ~40% labor share. The signal also shows negative trends for Materials, Durables and Apparel, as well as Multiline Retail, Distributors, and Textiles at the industry level. On the other hand, margins trends are positive in Transports, where wage growth slowed 60bp and pricing accelerated to 6.4% y/y. Pharma/biotech margins are also up, with a 4% increase in prices and a 4%+ decrease in wages.

Figure 63: S&P 500 margin trends by sector and industry group

We utilize our proprietary measures of pricing across industries and compare it to wage growth to assess potential margin dynamics. We look at both y/y growth and 3m acceleration.

		Pricing (Sep 18)		Wages/hr (All, Sep18)		Compensation	Margin signal		Sales	Change in
						as % of output			growth	Net Margin
	Sectors	Change y/y	3m accel	Change y/y	3m accel	2016	Change y/y	3m accel	Current y/y	Current (pp,
		%		% (3m avg)			%		%	y/y)
	Cons Disc	3.1%	0.9%	2.7%	1.2%	25.4%	2.4%	0.6%	7.9%	0.9%
	Financials	6.5%	1.5%	8.2%	1.1%	31.7%	3.9%	1.1%	9.0%	4.0%
	Technology	-0.1%	1.1%	2.0%	2.5%	27.1%	-0.6%	0.4%	10.4%	2.6%
	Industrials	3.1%	0.5%	2.4%	0.6%	22.2%	2.5%	0.4%	6.8%	0.8%
	Energy	16.4%	-8.1%	0.7%	1.1%	17.0%	16.3%	-8.3%	20.6%	3.3%
	Materials	5.5%	-0.5%	-1.1%	-1.0%	12.0%	5.6%	-0.4%	10.5%	1.5%
	Health Care	3.2%	0.6%	-2.2%	-1.0%	18.5%	3.6%	0.7%	6.7%	0.8%
	Cons Staples	2.2%	0.1%	1.2%	0.1%	17.1%	2.0%	0.1%	2.9%	0.3%
	Real Estate	5.2%	-1.0%						13.9%	-2.3%
	Comm Svcs	1.3%	1.3%	5.2%	4.1%	25.2%	0.0%	0.2%	12.2%	2.4%
	Utilities	1.5%	-1.8%	4.3%	1.1%	18.3%	0.7%	-2.0%	2.1%	1.6%
	S&P 500	3.5%	0.2%	2.6%	1.2%	23.7%	2.9%	-0.1%	8.6%	1.7%
	S&P 500 ex Energy	2.7%	0.7%	2.7%	1.3%	24.1%	2.1%	0.4%	7.5%	1.6%
	Industry Groups
	Autos & Comp	1.6%	0.4%	2.6%	1.1%	9.2%	1.3%	0.3%	3.3%	0.0%
	Cons Dur & App	0.9%	-0.7%	6.3%	-3.7%	15.6%	0.0%	-0.1%	7.0%	0.7%
	Retailing	3.8%	1.3%	1.9%	2.3%	26.4%	3.3%	0.7%	11.3%	1.3%
	Consumer Svcs	2.3%	0.1%	3.2%	0.1%	31.9%	1.3%	0.1%	1.9%	1.6%
	Media & Entertain	1.1%	1.3%	4.3%	4.3%	25.5%	0.0%	0.2%	12.6%	2.2%
	Banks	7.4%	2.3%	12.8%	1.8%	31.5%	3.4%	1.7%	3.3%	5.5%
	Div Financials	6.9%	1.1%	5.4%	0.7%	31.3%	5.2%	0.9%	15.8%	2.5%
	Insurance	3.2%	0.4%	2.7%	0.5%	32.9%	2.3%	0.3%	6.6%	4.7%
	Semis & Equip	-0.3%	2.0%	1.0%	1.2%	20.3%	-0.5%	1.8%	13.4%	4.0%
	Software & Svcs	0.3%	1.1%	2.7%	3.4%	32.8%	-0.6%	0.0%	7.3%	2.8%
	Tech Hdwr & Equip	-0.5%	0.4%	1.2%	1.7%	21.6%	-0.8%	0.0%	12.1%	1.6%
	Capital Goods	2.0%	0.2%	2.7%	1.0%	18.9%	1.5%	0.1%	5.9%	0.6%
	Com & Prof Svcs	3.0%	0.3%	3.1%	0.2%	26.6%	2.2%	0.3%	3.2%	0.7%
	Transportation	6.4%	1.3%	1.2%	-0.6%	31.2%	6.0%	1.5%	9.7%	1.2%
	Energy	16.4%	-8.1%	0.7%	1.1%	17.0%	16.3%	-8.3%	20.6%	3.3%
	Materials	5.5%	-0.5%	-1.1%	-1.0%	12.0%	5.6%	-0.4%	10.5%	1.5%
	Pharma Biotech & LS	4.0%	1.0%	-4.9%	-2.0%	11.2%	4.5%	1.2%	5.4%	1.6%
	HC Equip & Svcs	2.2%	0.0%	1.3%	0.2%	27.7%	1.8%	-0.1%	7.1%	0.6%
	Food & Stap Retail	1.5%	-0.1%	6.2%	2.5%	39.0%	-0.9%	-1.0%	3.5%	0.0%
	Food Bev & Tob	2.5%	0.3%	-2.3%	-0.4%	9.2%	2.7%	0.3%	2.4%	1.2%
	HH & Personal Prod	2.4%	0.0%	1.7%	-2.2%	9.1%	2.3%	0.2%	0.1%	0.3%
	Real Estate	5.2%	-1.0%						13.9%	-2.3%
	Telecom	2.1%	1.1%	9.0%	3.1%	23.7%	-0.1%	0.4%	11.5%	2.6%
	Utilities	1.5%	-1.8%	4.3%	1.1%	18.3%	0.7%	-2.0%	2.1%	1.6%

Source: S&P, FactSet, IBES, UBS Note: aggregate wage excludes Real Estate.

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Dividend growth to rise: look for high DPS growth, low payouts

We believe that dividend growth is likely to outstrip earnings growth in 2019 as corporates decide to hike dividends in early 2019 after 20%+ profit growth. Dividend growth tends to persist and firms that increase dividends the most in one year, tend to also be among those that increase dividends the most the following year. Additionally, firms with lower dividend payout ratios have the potential to increase dividends the most. We look for the combination of dividend growth momentum and lower payout ratios across sectors and stocks as an investable theme in 2019. We also compare current payout ratios to the 5-year average to assess how much dividend upside there may be. For sectors and IGs, we calculate cross sectional z-scores for dividend growth, dividend payout ratios (current and vs. avg); we take the average of the three to get a composite dividend upside score.

Banks, Semis, Tech Hdwr, Retail, Transports and Media stand out as having above average dividend growth and lower payout ratios.

Figure 64: Dividend growth versus dividend payout ratios for sectors and industry groups

Dividend growth % (NTM)

25

20

15

10

5

0

(5)

(10)

Look for high dividend

growth and lower Banks payout ratios

		Financials
		Semis & Equip		Tech Hdwr & Equip
					Consumer Svcs
	Media & Entertain	Retailing		Transportation			Food Bev & Tob
				Insurance	Pharma Biotech & LS
		Health Care
				Cons Disc			Cons Staples Energy
	Div Financials		Software & Svcs
	HC Equip & Svcs		Cons Dur & App		Materials		Utilities	Real Estate
			Comm Svcs				HH & Personal Prod
					Food & Stap Retail
							Telecom
					Industrials
					Capital Goods
					Autos & Comp
10		20		30	40	50		60
					Dividend payout ratio

Source: FactSet, IBES, UBS

Trade risks remain: account for potential impacts

We use our proprietary mapping of harmonized tariff schedule codes to NAICS industry codes to assess the magnitude of the tariffs relative to the respective industry's US business output (i.e. sales). We do that for imports from China and exports to China, and we estimate the impact for both implemented ($250bn imports) and the $267bn overhang. We also account for China revenue exposure. We calculate cross-sectional z-scores for import tariff impact, export tariff impact and China sales and take a weighted average.

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