Equities
Highlights Global growth has peaked, but will remain firmly above trend for the remainder of the year. The composition of global growth is shifting back towards the U.S. As often happens in the late stages of business-cycle expansions, asset markets have entered a more volatile phase. A global recession is likely in 2020. Equities: The correction is nearing an end, which will set the stage for a blow-off rally into year-end. For the time being, favor DM over EM stocks, Europe over the U.S., and value over growth. The "real" bear market will start next year. Government bonds: Global bond yields will trend higher over the next 12 months, but will begin moving lower by the middle of next year as recession risks mount. Over the long haul, yields are going higher - much higher. Credit: Spread product will eke out small gains relative to government bonds over the next 12 months. Spreads will blow out as the recession approaches. Investors will be shocked to learn that a lot of what they thought is investment-grade debt is really junk (or worse). Currencies: The U.S. dollar will bounce before resuming its bear market next year. The yen could weaken slightly against the dollar in 2018, but will hold its own against most other currencies. Energy-sensitive currencies such as the CAD will outperform other commodity currencies. Feature Booyah Writing frantically on October 8, 1998, CNBC commentator and former hedge fund manager Jim Cramer entitled his TheStreet.com piece with the indelible words "Get Out Now". Long-Term Capital Management had just imploded. Emerging Markets were crashing. Coming off the heels of a stratospheric ascent, the S&P 500 was down 22% from its highs. The tech-heavy NASDAQ had swooned 33%. The equity bull market had finally ended. Or so he thought. As fate would have it, the S&P 500 bottomed literally the very same minute that Cramer's piece came out.1 It went on to rise 68% before ultimately peaking in March 2000. Cramer would go on to avenge his 1998 call, wisely counseling his readers on October 6, 2008 to "take your money out of the stock market right now, this week." But on that fateful day in 1998, he was wrong. There are many differences in the economic environment between now and then, but on the crucial question of which way global equities are heading, history is likely to rhyme. As was the case in the late 1990s, the shakeout this year may be a prelude to a blow-off rally that takes stocks to new highs. Historically, equity bear markets and recessions almost always overlap (Chart 1). In fact, the most useful lesson I have learned over the past 25 years studying macro and markets is that unless you think a recession is around the corner, you should overweight stocks. It's as simple as that. Chart 1Recessions And Bear Markets Usually Overlap Fortunately, another recession is not around the corner. Interest rates are rising but are not yet in restrictive territory. Fiscal policy is being loosened, particularly in the U.S. Easy fiscal policy and still-accommodative monetary policy rarely produce recessions. As we discuss below, a global recession will eventually arrive - probably in 2020 - but that is still two years away. Stocks normally sniff out recessions before they start. However, the lead time is usually about six months. As Table 1 illustrates, equities typically do well in the second-to-last year of business-cycle expansions. We are probably in that window now. Table 1Too Soon To Get Out A Whiff Of Stagflation So why the newfound angst? Partly, it is because markets were technically overbought and due for a correction. We warned clients as much in a report entitled "Take Out Some Insurance", published on February 2nd, one day before the VIX spike began.2 Fears of stagflation are also escalating. Inflation appears to be rising at the same time as global growth is slowing. Real potential GDP has increased at a snail's pace in the G7 economies over the past decade, the result of disappointing productivity gains and sluggish labor force growth (Chart 2). If the world is running out of spare capacity - and GDP growth is forced to climb down towards what many fear is an anemic trendline - then revenue and earnings growth are apt to decelerate. Chart 2Lackluster Productivity Gains And Anemic Labor##br## Force Growth Have Weighed On Potential GDP Escalating protectionism has further exacerbated anxieties about stagflation. President Trump has threatened to hike tariffs on steel and aluminum, go after China for allegedly stealing U.S. intellectual property, and pull out of NAFTA if a new deal is not negotiated in America's favor. An all-out global trade war would raise consumer prices and reduce output by impairing the efficient allocation of resources across countries. Investors have taken notice. None of these stagflationary concerns can be summarily dismissed, but they are less worrisome than they might appear. Let's start with trade wars. A Trade Spat, Not A Trade War We have long thought that we are in a secular bull market in populism. This is why we argued that investors were greatly understating the risks of Brexit in the weeks leading up to the referendum. It is also why we ignored the derision of others and predicted that Trumpism would prevail back in 2015 and that Trump himself would win the presidency by securing a larger-than-expected share of disgruntled white blue-collar workers in the Midwest.3 Trade protectionism, of course, is a major part of most populist agendas. However, the attractiveness of protectionism tends to ebb and flow depending on the state of the business cycle. There is a reason why the Smoot-Hawley tariff act was introduced during the Great Depression and not the Roaring Twenties. Both economically and politically, beggar-thy-neighbor policies are more appealing when unemployment is high and one more job abroad means one less job at home. That is not the case today, at least not in the U.S. Moreover, while the U.S. legal system gives the president free rein to impose tariffs and other trade barriers, Donald Trump is still constrained by the reaction of the business community and financial markets. After all, this is a president who likes to measure his self-worth by the value of the S&P 500. Needless to say, investors do not like protectionism. It is not surprising, therefore, that Trump has watered down his tariff rhetoric every time the stock market has sold off. It also not surprising that Trump has increasingly focused his wrath on China, a country with which the U.S. business community has had a love-hate relationship. A blue-ribbon commission recently estimated that intellectual property theft - most of it originating from China - costs the U.S. $225 billion-to-$600 billion per year.4 That is a lot of money that American companies could be making but aren't. China will undoubtedly complain that it is being unfairly singled out. It will also threaten retaliatory measures if the Trump administration imposes trade barriers on Chinese imports. In the end, those threats are likely to ring hollow. A war is only worth fighting if you think you can win. China has a very asymmetric trading relationship with the U.S., and one that gives it very little leverage. U.S. exports to China amount to less than one percent of U.S. GDP. That's peanuts - in some cases literally: Nearly half of U.S. goods exports to China consist of soybeans, wheat, cotton, nuts, and other agricultural products and raw materials. It would be difficult to tax them without hurting Chinese consumers. Of course, China could try to punish the U.S. by dumping Treasurys. But why would it? This would only drive down the value of the dollar, giving U.S. exporters a greater advantage. Trump wants that! Saying that you will retaliate against Trump's tariffs by no longer manipulating your currency is not exactly a credible threat.5 In the end, far from retaliating, China will try to placate Trump by easing restrictions on trade and foreign investment and making some politically-calculated purchases of U.S.-made goods. Boeing's stock sold off in the wake of escalating trade tensions. It probably should have risen. Peak Growth? In contrast to last year, global growth is no longer accelerating. Our Global Leading Economic Indicator is still rising, but the diffusion index, which measures the proportion of countries with rising LEIs, is down from its October 2017 high (Chart 3). Changes in the diffusion index have often foreshadowed changes in the composite LEI. An even more worrisome picture is painted by the OECD's LEI, which has actually dipped slightly over the past two months. The OECD's LEI diffusion index has also fallen below 50%. The Chinese economy appears to be slowing on the back of tighter monetary conditions (Chart 4). The Keqiang index, which combines data on electricity production, freight traffic, and bank lending, has come off its highs and our leading indicator for the index is pointing to further weakness. Property price inflation in tier 1 cities has fallen to zero. A number of clients noted during my visit to China last week that a wave of supply has hit the market over the past month following President Xi's warning that homes are for living and for not investing. A weaker Chinese property market could drag down construction spending, with adverse knock-on effects to commodity prices. Slower Chinese growth is rippling across the global economy (Chart 5). Korean exports - a bellwether for global trade - have decelerated. Japanese machinery orders have rolled over. The Baltic dry index has plunged by 40% from its December highs. The expectations component of the German IFO index has fallen to its lowest level since January 2017. Chart 3Global Growth Will Remain Above Trend,##br## But Has Probably Peaked For This Cycle Chart 4China's Industrial Sector Is Set ##br##To Slow Further China Is Slowing Chart 5Signs Of Slowing##br## Global Growth So far, the slowdown in global growth has been fairly modest. Goldman's global Current Activity Indicator (CAI), which combines both soft and hard data to gauge underlying economic momentum, was still up 4.9% in March, only slightly below recent cycle highs (Chart 6). The deterioration in a number of leading economic indicators suggests that the slowdown may have further to run. However, we would be surprised if it proves to be especially deep or long-lasting. Global financial conditions are still quite accommodative (Chart 7). Bank balance sheets are in good shape and rising capex intentions should support credit demand over the coming months, even in the face of somewhat higher borrowing costs. Improving labor markets should also bolster consumer confidence. Chart 6But Global Slowdown Has Been Fairly Modest Chart 7Global Financial Conditions Are Still Fairly Easy Back To The USA If global growth were decelerating because capacity constraints were starting to bite, this would be more worrying because it would mean any effort to stimulate demand would simply lead to more inflation rather than stronger economic growth. Reassuringly, that does not appear to be the case. The U.S. has slowed less than other large economies, even though it is closer to full employment. Notably, the manufacturing PMI has continued to rise in the U.S., but has dipped most everywhere else. Both Citigroup's and Goldman's economic surprise indices are still positive for the U.S., but have fallen into negative territory in Europe and Japan (Chart 8). Granted, Bloomberg consensus estimates suggest that U.S. growth will edge down to 2.5% in the first quarter. However, this may reflect ongoing seasonal adjustment problems. First quarter growth has averaged 1.7 percentage points less over the past decade than in the rest of the year. We are particularly skeptical of recent data showing that consumer spending has slowed, which is completely at odds with strong employment growth, rising home prices, and near record-high levels of consumer confidence. Looking out, U.S. demand growth should benefit from all the fiscal stimulus coming down the pike. We expect the fiscal impulse to rise from 0.3% of GDP in 2017 to 0.8% of GDP in 2018, and 1.3% of GDP in 2019 (Chart 9). The actual numbers could be even higher as our estimates do not include any additional expenditures on infrastructure, the possible restoration of earmarks (which could inflate pork-barrel spending), or the high likelihood that recent changes to the tax code will spawn all sorts of unforeseen loopholes, leading to lower-than-expected tax receipts. Chart 8U.S. Is The Standout Chart 9Fiscal Stimulus Bode Well For Growth Unfortunately, all this fiscal stimulus is coming at a time when the economy does not need it (Chart 10). The U.S. unemployment rate currently stands at 4.1%, 0.4 percentage points below the Fed's estimate of NAIRU. Given the prospect of continued above-trend growth, the unemployment rate is likely to be close to 3.5% by early next year, which would be below the 2000 low of 3.8%. Chart 10Now Is Not The Time For Fiscal Profligacy Rebalancing Global Demand: The Role Of The Dollar What happens when fiscal stimulus pushes aggregate demand beyond an economy's productive capacity? One possibility is that imports go up, thereby allowing the additional demand to be satiated with increased production from the rest of the world. For this to happen, however, the prices of foreign-made goods sold in the U.S. need to decline relative to the prices of domestically-produced goods. U.S. imports account for only 15% of GDP. Thus, if the prices of U.S.-made goods do not change relative to the prices of foreign-made goods, only 15 cents or so of every additional dollar of income will fall on imports. After all, consumers do not care about the intricacies of balance of payments statistics when they are deciding whether to buy a foreign or domestic automobile. They care about relative prices. This means that either the nominal trade-weighted dollar must appreciate or the U.S. price level must rise relative to foreign prices. Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.6 In theory, one can envision a scenario where the nominal dollar exchange rate depreciates while the real exchange rate appreciates over the long haul because inflation rises significantly in the U.S. relative to its trading partners. Much of the market commentary has implicitly focused on just such an outcome. Massive fiscal stimulus, as the story goes, will lift U.S. inflation by so much that the dollar will fall over time. The problem with this narrative is that it is difficult to square with the facts. Long-term inflation expectations have actually risen more in the euro area and Japan since Trump got elected (Chart 11). The true puzzle is that rising U.S. real yields have not translated into a stronger dollar (Chart 12). Chart 11Long-Term Inflation Expectations Have ##br##Risen More In Japan And The Euro Area##br## Than The U.S. Since Trump Took Over Chart 12The Dollar Has ##br##Decoupled From Interest##br## Rate Differentials A Trump Risk Premium? What happened, as Hillary Clinton might ask? One answer is that Trump happened. Larry Summers has argued that political uncertainty around Trump's antics (protectionism, the Mueller probe, the porn stars, etc.) has made holding U.S. assets more risky.7 This risk has been exacerbated by the prospect of large current account and fiscal deficits - the so-called "twin deficits" - stretching for as far as the eye can see. If this theory is correct, the increase in U.S. real bond yields may be less the result of better growth expectations and more the consequence of a rising risk premium on long-term government debt. It's an intriguing hypothesis, but it cannot explain why business confidence is near all-time highs or why the S&P 500, despite this year's selloff, has risen by 23% since the U.S. presidential election. It also cannot explain why the yield curve has flattened recently, which is not what you would expect if investors were shunning long-term bonds. Perhaps it is best not to overthink things. The dollar is a high-momentum currency (Chart 13). At the start of 2017, the greenback was overbought (Chart 14). Then global growth began to accelerate, which has historically has been bad news for the dollar (Chart 15). The lion's share of that growth also came from outside the U.S. None of this is true today, but the downward trend in the dollar has remained intact, and that is proving hard to break. Chart 13USD Is A Momentum Winner Chart 14USD Was Overbought At The Start Of 2017 Hard but not impossible. The dollar could get a bit of a reprieve. USD Libor has broken out recently (See Box 1 for details). As Chart 16 illustrates, there has been an extremely close relationship between the dollar index and the 3-month lagged value of the Libor-OIS spread. The cost of shorting the dollar is about to spike as borrowing rates linked to Libor reset over the next few weeks. The Libor spread will eventually come down, but perhaps not before the negative momentum against the dollar has turned into positive momentum. Chart 15Slowing Global Growth Tends##br## To Be Bullish For The Dollar Chart 16Shorting The Dollar Is About##br##To Get A Lot More Expensive Fixed-Income: Hedged Or Unhedged? Chart 17Bond Yields, Currency-Hedged When European investors buy U.S. bonds, they take on exposure to both the value of the bond and what happens to the euro-dollar exchange rate. If they do not want to assume the currency risk, they can sell the dollar forward, effectively locking in the number of euros they will receive for every dollar sold. The purchase of the bond increases the demand for dollars, while the commitment to sell the dollar increases the supply of dollars. For the value of the dollar, it is largely a wash.8 Likewise, if U.S. investors do not want to bear currency risk when purchasing German bunds, they can sell the euro forward. This also entails two offsetting transactions: One that boosts the demand for euros and one that raises the supply of euros. The spike in USD Libor has increased the currency-hedged return of non-U.S. bonds relative to U.S. bonds. Chart 17 shows that the yield on 10-year Treasurys, hedged into euros, has fallen to 0.06%, which is below the 0.5% yield offered by German bunds. In contrast, the 10-year bund yield, hedged into dollars, has risen to 3.16% - which is above the 2.78% yield offered by Treasurys. All things equal, it becomes less attractive for foreign investors who wish to buy U.S. bonds to hedge currency risk as USD Libor rises. In contrast, it becomes more attractive for U.S. investors to currency-hedge their overseas bond purchases when USD Libor goes up. Unhedged bond purchases bid up the currency of the issuer, but hedged purchases do not. If a smaller share of foreign investors decide to hedge currency risk when buying Treasurys, while a larger share of U.S. investors decide to hedge currency risk when purchasing foreign bonds, the net demand for dollars will rise. This could help the dollar over the coming months. Go Long Treasurys/Short German Bunds, Currency-Unhedged The correlation between the German-U.S. 30-year bond spread and EUR/USD was extremely tight in 2017 but has completely broken down this year (Chart 18). At this juncture, betting on a normalization of this correlation - effectively, a bet that U.S. Treasurys will outperform bunds in currency-unhedged terms - has become too good to resist. In fact, it is almost a "can't lose" wager. Consider the fact that 30-year Treasurys are yielding 182 basis points above comparable-maturity bunds. The euro would have to rise to 1.23*(1.0182)^30=2.11 against the dollar over the next 30 years for investors to lose money on this investment. Chart 18Unsustainable Divergence? Granted, inflation is likely to be lower in the euro area. CPI swaps are forecasting that euro area inflation will be roughly 40 bps lower compared to the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.49. In other words, long-term investors betting on the euro are effectively betting on a major euro overshoot. The discussion above raises a more fundamental point. Investors often equate their view about the direction in which a currency is heading with whether to be bullish or bearish on it. We completely agree that the trade-weighted dollar will weaken over the long haul because most valuation metrics suggest that the greenback is still expensive. However, given the carry advantage the U.S. enjoys, long-term investors would still be better off overweighting U.S. fixed-income assets. Regional Equity Allocation U.S. equities have outperformed their global peers since the start of 2017 in local-currency terms but have underperformed in common-currency terms (Chart 19). If the dollar rebounds over the next few months, as we expect, this should boost the local-currency value of European stocks since many large multinational European companies generate sales in dollars. Sector skews should also work in Europe's favor. Financials are the largest overweight in euro area bourses, while technology is the biggest overweight in the U.S. (Table 2). Chart 19U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency Table 2Global Sector Skews: Tech Resides In The U.S. And Growth Indexes,##br## Financials Live In The Eurozone And Value Indexes While global growth has peaked, it will remain firmly above trend. This will ensure that spare capacity continues to shrink, taking global bond yields higher. Since the ECB will not raise rates for at least another year, the yield curve in the euro area will steepen, boosting the profitability of European banks (Chart 20). Tech companies are particularly sensitive to changes in discount rates since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening (more than 50% of U.S. tech sales are derived from abroad). Recent concerns over the way Facebook and other tech companies have handled privacy issues could further sour sentiment towards the sector. The outlook for Japanese stocks is a tough call. Japan, like Europe, is trading at a discount relative to the U.S. based on our in-house valuation metrics (Chart 21). However, we do not see much downside for the yen, even after its recent appreciation. The currency remains very cheap by historic standards, Japan's current account surplus has widened to 4% of GDP, and unlike the euro, speculative positioning is short. While Japanese corporate earnings have been able to expand rapidly over the past 16 months without the support of a weaker currency, now that profit margins are near record highs (Chart 22), further gains in profits and equity prices are likely to be limited. Chart 20Euro Area Yield Curve ##br##Steepening Will Boost Banks Chart 21Japanese And Euro Area##br##Stocks Are Relatively Cheap The combination of higher U.S. rates, a stronger dollar, and weaker Chinese growth will weigh on EM equities over the coming months. There is $17 trillion in U.S. dollar-denominated debt held outside the U.S., most of it in emerging markets. Ironically, weaker Chinese growth will hurt other EMs more than it hurts China. China accounts for more than 50% of base metal demand compared to only 13.5% for oil (Chart 23). This means that the outlook for metal producers such as Brazil, South Africa, Chile, and Australia is more challenging than for energy producers such as Canada and Norway. Chart 22Global Profit ##br##Margin Picture Chart 23Base Metals Are More Sensitive##br## To Slower Chinese Growth Favor Value Over Growth We expect global value stocks to start outperforming growth stocks after more than a decade of deep underperformance (Chart 24). The valuation measures constructed by Anastasios Avgeriou and his global equity sector strategy team suggest that value stocks are trading more than two standard deviations cheap relative to growth stocks. Earnings revisions are also starting to move in favor of value names9. Similar to the U.S./euro area equity split, financials are overrepresented in value indices, while technology is overrepresented in growth indices. The weights of the energy and consumer discretionary sectors in the U.S. index are roughly the same as the weights of those two sectors in the euro area index. However, energy is overrepresented in global value indices while consumer discretionary is overrepresented in growth indices. Despite our outlook for a somewhat stronger dollar, our commodity strategists see upside for oil prices this year thanks to continued discipline by OPEC 2.0. This should help energy stocks. On the flipside, consumer discretionary stocks often struggle in a rising rate environment, so this should tilt the playing field in favor of value (Chart 25). Chart 24Value Versus Growth: ##br##Compelling Entry Point Chart 25Consumer Discretionary Stocks Do##br## Poorly In A Rising Rate Environment With all this in mind, we are initiating a trade recommendation to go long the All-Country World Value Index relative to the corresponding Growth Index starting today. Investment Conclusions Volatility typically rises in the late stages of business-cycle expansions, as inflation picks up and monetary policy becomes progressively less accommodative (Chart 26). We have entered such a phase. This does not mean that equities cannot go higher. Chart 27 shows that the VIX rose in the late 1990s, even as stocks zoomed to new highs. We are probably at the tail end of an equity correction now. A blow-off rally into year-end is likely. Chart 26A More Hawkish Fed Usually Means A Higher VIX Chart 27Volatility Can Increase As Stock Prices Rise We expect the fed funds rate to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, the U.S. fiscal impulse will have dropped back to zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to increasingly binding supply-side constraints, the economy could easily stall out in 2020. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller PE ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 3% over the next decade (Chart 28). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault investors for taking some money off the table now. A somewhat more defensive posture would certainly be warranted. Recall that the NASDAQ bubble burst in March 2000, but the S&P 500, excluding the technology sector, did not peak until May 2001. During the intervening period, S&P tech stocks underperformed the rest of the market by 70% (Chart 29). As was the case back then, a shift away from tech leadership may be afoot. This would support our value over growth, and euro area over the U.S., recommendations. Chart 28Demanding U.S. Valuations Point##br## To Low Long-Term Returns Chart 29The Force Of Tech At ##br##The Turn Of The Century Spread product should be able to eke out small gains relative to government bonds over the next 12 months. Ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 30). Spreads will blow out as the recession approaches. In this month's issue of The Bank Credit Analyst, my colleague Mark McClellan simulated the effect on investment grade credit from: 1) A 100 basis-point increase in interest rates across the curve; and (2) A more severe scenario where interest rates rise by 100 basis points and corporate profits fall by 25% peak- to-trough. Mark's calculations suggest that the next recession will see the interest coverage ratio drop more than in previous downturns (Chart 31).10 Investors may be shocked to discover that a lot of what they thought is investment-grade debt is really junk (or worse). Chart 30Ratings Migration Is Supportive For Credit But... Chart 31...Corporate Leverage Will Take Its Toll We suggested going long the dollar in August 2014. This view worked well for a while but struggled mightily last year. However, the broad trade-weighted dollar index has been fairly stable since September, and is actually up 2.3% since its January lows (Chart 32). The greenback is due for another rally, one that no doubt would catch many traders by surprise. After a heated internal debate, BCA shifted its house view on bonds towards a more bearish stance in July 2016. As fate would have it, our note entitled "The End Of The 35-Year Bond Bull Market" came out on the same day that the U.S. 10-year yield reached an all-time closing low of 1.37%.11 We observed in February that bond positioning had become extremely short and, thus, tactically, yields could come down a bit. This has indeed happened. Over a 12-month horizon, however, we continue to see yields rising more than what is currently priced in. Both the TIPS 10-year and 5-year/5-year forward breakeven rates are 20-40 basis point below the 2.3%-to-2.5% range that prevailed in the pre-recession period (Chart 33). Somewhat higher oil prices should also boost inflation expectations. Chart 32Up Then##br## Down Chart 33Breakevens Still Below Levels Consistent##br## With 2% Inflation Mandate In addition, the real yield component could rise as the market revises up its expectation of the terminal rate. Revealingly, the mean and median terminal dots in the Fed's Summary of Economic Projections increased by 8.3 and 12.5 bps, respectively, in March, but are still more than 100 bps below where they were five years ago. Bond yields will increase in the euro area, as the ECB continues to taper asset purchases. We see less scope for yields to rise in the U.K., as the Brexit hangover continues to weigh on growth. Yields in Japan will remain repressed due to the continuation of the Bank of Japan's Yield Curve Control regime. As the next recession approaches, global bond yields will fall, but are unlikely to take out their 2016 lows. As we discussed in a series of recent reports, both yields and inflation will make a series of "higher highs" and "higher lows" in the U.S. and most other countries over the next decade and beyond.12 Appendix B shows stylistic diagrams of how we expect returns across the major asset classes to evolve over the next decade. The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Box 1 What's Up With Libor? The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. 1 In his book, Confessions Of A Street Addict, which I highly recommend, Cramer wrote: On October 8, a dreary, chilly rainy Thursday in New York ... the stock market bottomed. At eighteen minutes after 12:00 P.M. I ought to know. I caused it. At 12:18 P.M. I capitulated. I couldn't take it anymore. I gave up both literally, at my fund, and virtually, on my website, TheStreet.com, where I penned a piece entitled "Get Out Now". And the prop wash from that article marked the low point in the most vicious bear market of the last century. 2 Please see BCA Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com. 3 Please see BCA Global Investment Strategy reports, "Trumponomics: What Investors Need To Know," dated September 4, 2015; "Worry About Brexit, Not Payrolls", dated June 10, 2016; "Three (New) Controversial Calls", dated September 30, 2016, available at gis.bcaresearch.com. Also see BCA New York Investment Conference presentations: "Five Controversial Calls - Call #5: The Trumpists Will Win" (September 2015), and "Three Controversial Calls - Call #1: Trump Wins And The Dollar Rallies" (September 2016). 4 Please see "Update To The IP Commission Report - The Theft Of American intellectual Property: Reassessments Of The Challenge And United States Policy," The Commission on the Theft of American Intellectual Property (The National Bureau of Asian Research), (2017). 5 The fact that China's foreign exchange reserves have been trending sideways since early last year does not mean that past interventions should be disregarded. Just as both theory and evidence suggest that quantitative easing affects bond yields primarily through the "stock channel" (how many bonds central banks own) rather than the "flow channel" (the purchase or sales of bonds in any given period), the yuan's value is also more affected by the stock of foreign assets the PBOC controls rather than its recent interventions. This makes intuitive sense. If a central bank drives down its currency by buying a lot of foreign assets, and then suspends further purchases, one might expect the currency to stop falling, but one would not expect it strengthen to where it was before the intervention began. 6 Expressed mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 7 Larry Summers, "Currency Markets Send A Warning On The US Economy," March 5, 2018. 8 We say "largely" a wash because while selling the dollar forward is not exactly the same as short-selling it in the spot market due to the presence of the so-called currency basis swap spread, it is economically similar. When European investors short-sell the dollar, they are effectively borrowing dollars at Libor, selling them for euros, and parking the proceeds in a short-term account that pays Euribor. Three-month U.S. Libor is 230 bps these days, while three-month Euribor is -33 bps. Thus, European investors lose 263 bps by currency-hedging their U.S. bond purchases. Conversely, when U.S. investors go short the euro, they are effectively borrowing euros, selling them for dollars, and then parking the proceeds in a short-term account paying Libor. Thus, they gain the equivalent amount from the decision to currency-hedge purchases of euro area bonds. 9 Please see BCA Global Alpha Sector Strategy Weekly Report, "Global Size And Style Update," dated March 9, 2018, available at gss.bcaresearch.com. 10 Please see BCA The Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?" dated March 29, 2018, available at bca.bcaresearch.com. 11 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 12 Please see BCA Global Investment Strategy Weekly Report, "What Central Bankers Don't Know: A Rumsfeldian Taxonomy," dated March 16, 2018; Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. Appendix A APPENDIX A CHART 1Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 2Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 3Long-Term Return Prospects Are Slightly Better Outside The U.S. APPENDIX A CHART 4Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B APPENDIX B CHART 1Market Outlook: Bonds APPENDIX B CHART 2Market Outlook: Equities APPENDIX B CHART 3Market Outlook: Currencies APPENDIX B CHART 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow Chart I-4A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Continue to underweight the most cyclical sectors - Banks, Basic Materials, and Energy. As predicted, global growth is losing steam. This implies that the Eurostoxx50 will struggle to outperform the S&P500. Continue with a currency pecking order of "yen first, euro second, pound third, dollar fourth." The sell-off in bonds is due a retracement, or at least a respite. Stock markets' rich valuations are contingent on low bond yields. Feature The views in this report do not necessarily align with the BCA House View Matrix. Chart I-2Cyclicals Were Underperforming##br## Long Before The Trade Skirmishes Stock markets have experienced turbulence this year, and it would be very simple to blame the first skirmishes of a global trade war. It would also be simplistic. The sharp underperformance of cyclical stocks started in January, well before any inkling of the Trump tariffs (Chart I-2). The trade skirmishes have merely accelerated a process that was already underway. In this week's report, we make sense of the market turbulence from three broad perspectives: the global economic mini-cycle; market technicals; and valuation. The Economic Mini-Cycle Has Likely Turned Down When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but this headwind is felt with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but the tailwind is felt with a delay. This delay occurs because credit supply lags credit demand by several months. But if credit supply lags demand, an economic theory called the Cobweb Theorem1 points out that both the quantity of credit supplied and its price (the bond yield) must undergo 'mini-cycle' oscillations. The theory is supported by compelling empirical evidence (Chart I-3). Furthermore, as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same mini-cycle oscillations (Chart I-4). Chart I-3Compelling Evidence For Mini-Cycles In##br## Credit Supply And The Bond Yield... Chart I-4...And ##br##Economic Activity These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months. Their regularity creates predictability. And as most investors are unaware of these cycles, the next turn is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. Mini half-cycles average eight months, and the latest mini-upswing started last April. Hence, on January 4 we predicted that "contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018." The predicted deceleration is precisely what we are now witnessing, and we expect this to continue through the summer months. From an equity sector perspective, the relative performance of the most cyclical sectors - Banks, Basic Materials, and Energy - very closely tracks the regular mini-cycles in global growth. In a mini-downswing these cyclical sectors always underperform (Chart of the week). Accordingly, continue to underweight these sectors through the summer months. Chart of the weekCyclicals Always Underperform In An Economic Mini-Downswing For the time being, this implies that the Eurostoxx50 will struggle to outperform the S&P500 - because euro area bourses have an outsize exposure to the most cyclical sectors. From a currency perspective, the stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. In essence, as the ECB and BoJ are at the realistic limit of ultra-loose policy, long-term expectations for their policy rates possess an asymmetry: they cannot go significantly lower, but they can go significantly higher. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they can go either way, lower or higher. Hence, on January 18 we advised a currency pecking order of "yen first, euro second, pound third, dollar fourth." This currency pecking order has also worked perfectly this year, and we expect it to continue working through the summer months. Cyclical Sectors Had Bullish Groupthink Groupthink in any investment is a warning sign that the investment's trend is approaching exhaustion, because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when market participants disagree with each other. Consider a stock whose price is rising strongly: a momentum trader wants to buy it, while a value investor wants to sell it. Hence, the market participants trade with each other with plentiful liquidity. Liquidity starts to evaporate when too many market participants agree with each other. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders fuel the trend. But when all the value investors have become momentum traders, the trend reaches a tipping point. If a value investor suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, our proprietary fractal analysis measures whether groupthink in a specific investment has become excessive, signalling the end of its price trend. Furthermore, using a 130-day groupthink indicator (fractal dimension), the fractal framework provides a powerful and independent reinforcement of our mini-cycle framework. This is because 130 (business) days broadly aligns with the mini half-cycle length. Fractal analysis reinforces our decision to underweight cyclical sectors, because it shows excessive (bullish) 130-day groupthink in these economically sensitive sectors (Chart I-5). Chart I-5Excessive Bullish Groupthink In Cyclical Sectors It also shows excessive (bearish) 130-day groupthink in government bonds, suggesting that the sell-off in bonds is due a retracement, or at least a respite (Chart I-6). Chart I-6Excessive Bearish Groupthink In Government Bonds Rich Valuations Are Contingent On Low Bond Yields On price to sales, world equities are as richly valued as they were at the peak of the dot com boom in 2000. The observation is important because price to sales has proved to be a near-perfect predictor of future 10-year returns. It shows that in 2010, world equities were priced to generate 8% a year compared with 4% a year available from global bonds. Today, richer valuations mean that both world equities and global bonds are priced to generate a paltry 2% a year (Chart I-7). Chart I-7World Equities As Richly Valued As At The Peak Of The Dot Com Boom Nevertheless, this makes perfect sense, because when bond yields are at 2%, bonds and equities are equally risky as each other. It follows that they must offer the same return as each other. One of the biggest errors in finance is to define an investment's risk in terms of its (root mean squared) volatility. This is incorrect because nobody fears sharp gains, they only fear sharp losses. Consider an investment whose price goes up sharply one day and then sideways the next day ad infinitum. The investment has a very high volatility, but it has no risk. You can never lose money, you can only make money. This leads us to the correct definition of risk, as defined by Professor Daniel Kahneman. He proved that investors are not concerned about volatility per se, they are concerned about the ratio of potential short-term losses versus short-term gains, a measure known as 'negative skew'. The important point is that at low bond yields, bond returns start to exhibit negative skew. Intuitively, this is because the lower bound to yields forces an unattractive asymmetry on bond returns: prices can fall a lot, but they cannot rise a lot. Specifically, at a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-8). And as the two asset classes are equally risky, they must offer the same return, 2% (Chart I-9). Chart I-8At A 2% Bond Yield, 10-Year Bonds##br## Have The Same Negative Skew As Equities... Chart I-9...So At A 2% Bond Yield, ##br##Equities Must Also Offer A 2% Return Therefore, equities find themselves in a precarious equilibrium. Rich valuations are justified if bond yields remain at low levels or fall, but rich valuations become increasingly hard to justify if bond yields march higher. Seen through this lens, the rise in bond yields at the start of the year is one important reason why equities have experienced a turbulent 2018 so far. What lies ahead? The combination of our economic mini-cycle, market technicals and valuation perspectives suggests that the equity sector and currency trends established since the start of the year should persist into the summer. As for equities in aggregate, the greatest structural threat would arise if bond yields gapped upwards. But for the time being, this is not our expectation. Happy Easter! Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model Given the Easter holidays, there are no new trades this week. But we are pleased to report that our long global utilities versus market trade achieved its 3.5% profit target and is now closed. Out of our four open trades, three are in profit with the short nickel / long lead trade already up sharply in its first week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations
Highlights The China-specific tariffs proposed by the Trump administration last week represent a great escalation in U.S. protectionism, but the actual measures may be smaller than what was initially announced. The proposed tariffs, if applied as stated, would likely shave 2% off of China's export growth over the coming 6-12 months. This would prevent an acceleration that we would have otherwise expected given the strength of the global economy. A 2% deceleration in export growth is not in and of itself a significantly negative event for China's economy, but the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We recommend that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. The recent weakness in the Hong Kong dollar is not a sign of any major economic weakness or financial market instability that should concern investors. However, the prospect of tighter monetary policy is a potential threat to the highly leveraged Hong Kong economy that needs to be monitored. Feature The Trump administration doubled down on its protectionist agenda last week, by announcing its intention to levy US$50 billion in tariffs against a variety of imports from China. This follows the administration's decision earlier in the month to impose a tariff on all steel and aluminum imports, which we discussed at length in our March 7 Weekly Report.1 While the China-specific tariffs represent a great escalation in protectionism relative to those on steel and aluminum imports, there are several important factors for investors to take into consideration: Chart 1President Trump Can Ill-Afford ##br##Any Major Economic Turmoil The decision on Chinese import tariffs is not yet final, as the White House will propose a list of Chinese goods potentially subject to tariffs for public comment and consultations. This opens the door for an enormous lobbying effort from U.S. retailers and negotiations with Chinese officials, signaling that the end result is not set in stone. China's very muted retaliation (so far) increases the odds of a benign, negotiated outcome. Following the initial announcement of the steel and aluminum tariffs, the Trump administration significantly watered down the measures by granting Canada and Mexico an exemption and allowing exemption applications from other countries. This could suggest that the final tariffs to be applied against Chinese imports will be considerably smaller than what the administration signaled last week. Finally, given that the U.S. midterm election will be occurring later this year and that the administration can ill-afford to lose control of the legislative process, President Trump's actions on trade may be designed to maximize the perception of serious trade reform without threatening to substantially impact U.S. or global ex-U.S. economic momentum (Chart 1). This perspective would further support the notion that the bark of China-specific tariffs will be worse than the ultimate bite. The Impact Of Proposed Tariffs On Growth Still, investors cannot assume that the tariffs will be significantly watered down, meaning that it is important to have a forecast for the impact of the proposed tariffs on Chinese growth. We take a simple approach to judging the economic impact on nominal export growth, by calculating an aggregate tariff rate as if the amount of proposed tariffs applied equally across all Chinese exports to the U.S. We then multiply that rate by an estimate of U.S. import price elasticity, and again by the weight of U.S. exports as a share of total Chinese exports. Table 1 presents a list of import elasticity estimates for the G7 countries, both over the short- and long-term. Given that the short-run is our primary concern when modeling the likely cyclical impact on Chinese exports, we use the 0.6 elasticity estimate for the U.S. as a starting point for our analysis. We shock this estimate upwards to 0.8, for two reasons: To generate a relatively conservative estimate of the impact on Chinese export growth It is not clear whether the demand for goods from China is more or less price elastic than goods from other countries. However, given that the majority of Chinese exports to the U.S. are consumer-oriented (and thus less differentiated than highly specialized industrial goods), it is plausible that the price elasticity of Chinese imports is higher than it is on average. Table 1U.S. Short-Run Import Price Elasticity Is Not Trivial Given that US$50 billion is roughly 10% of annual U.S. imports from China, our simple approach suggests that the proposed tariffs would cause China's total export growth to decelerate about 1.6% (10% effective tariff rate times -0.8 import price elasticity times 20% export weight). Including the effect of Chinese re-exports to the U.S. via other major trading partners would slightly increase this estimate, meaning that 1.5 - 2.0% is a conservative range of estimates for the tariff impact. When applied to the current growth rate of Chinese exports, the impact of this estimate would be minimal. Chart 2 shows that Chinese nominal export growth recently accelerated to 22% even when shown as a 3-month moving average, suggesting that a U.S. import tariff would be coming at a time of considerably strong export momentum. In fact, China's February export data was so positive that it raised the Citigroup economic surprise index for China to a 9-year high (Chart 3). Chart 2At First Blush, Chinese Export Growth ##br##Has Accelerated Significantly Chart 3The Pop In Export Growth Has##br## Turbocharged The Surprise Index However, our view is that the growth rates of China's nominal imports and exports do not currently reflect the underlying pace of trade, with both series likely overstating the recent pace of growth. On the import side, we have highlighted in previous reports that import demand has recently outpaced what the Li Keqiang index would suggest. On the export side, a model of global US$ imports from China regressed against extrapolated global industrial production growth has an extremely strong fit over the past several years, and implies that the underlying pace of Chinese export growth is closer to 10%. Chart 4 illustrates this estimate of underlying export growth (based on global imports from China) along with the impact of the proposed tariffs, and highlights that a 2% export growth shock would simply prevent the 2% acceleration in underlying growth that we would normally expect over the coming months given the recent pickup in our global LEI. Chart 4If Enacted, The Proposed Tariffs Will ##br##Prevent An Acceleration In Export Growth Bottom Line: The import tariffs proposed by the Trump administration, if applied as stated, would likely shave about 2% off of China's export growth over the coming 6-12 months. This would prevent an acceleration that we would have otherwise expected given the strength of the global economy. The Implications For Chinese Stock Prices A 2% deceleration in export growth is not a significantly negative event for China's economy, especially if underlying export growth was set to trend higher due to strong global activity. But it does have the strong potential to mute a source of positive economic momentum, at a time when the industrial sector is clearly slowing. We presented our decision tree for Chinese stocks (Chart 5) in our first report of the year,2 and referenced it again in our March 7th report. The decision tree lays out four key questions for investors to answer over the coming 6-12 months in order to decide on the ideal allocation to Chinese equities within a global portfolio: Is The Global Economy Slowing Significantly? Is Significant Further Monetary Policy Tightening Likely? Is The Pace Of Renewed Structural Reforms Likely To Be Too Aggressive? Is The Existing Slowdown In China's Growth Momentum Metastasizing? Chart 5The Chinese Equity 'Decision Tree' While the answer to questions 2 and 3 remains "no", Trump's shift towards protectionism certainly raises the risk of an eventual "yes" to the first question, especially given that our analysis has assumed no retaliation or counter-retaliation. Regarding the issue of China's industrial sector slowdown, the Li Keqiang index is not falling sharply, but it remains in a downtrend and is set to decline further according to our BCA Li Keqiang Leading Indicator (Chart 6). At best, the answer to question 4 is a lukewarm "no". We have previously noted that the uptrend in Chinese ex-tech stock prices vs their global peers over the past two years suggests that investors should have a high threshold for reducing exposure to China. We continue to agree with that assessment, but we must also acknowledge that the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We are not yet changing our investment recommendations, but we are putting Chinese ex-tech stocks on downgrade watch for Q2. An outright recommendation to cut exposure to neutral will likely occur in response to a technical breakdown which, for now, does not appear to be imminent (Chart 7). Chart 6China's Industrial Sector Is Set To Slow Further Chart 7Still In An Uptrend, For Now Bottom Line: A 2% deceleration in export growth is not in and of itself a significantly negative event for China's economy, but the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We recommend that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. An Update On The Hong Kong Dollar The Hong Kong dollar (HKD) has been weakening for the better part of a year, but recently it has fallen quite sharply relative to its history and now trades very close to the weak side of the peg (7.85 Hong Kong dollars to 1 U.S. dollar). The pace of recent weakness has caught the attention of investors and market participants, in part because it would be the first time in 12 years since the HKD threatened to decline below the lower end of the peg. In our view, both the HKD's weakness over the past year and the recent slide have been caused largely by technical factors, and are not in and of themselves signs of any major economic weakness or financial market instability that should concern investors. As highlighted in Chart 8, the significant rise in USD/HKD (a depreciation in the Hong Kong dollar) can be explained by a sizeable rise in the 3-month U.S. LIBOR / Hong Kong HIBOR spread. Panel 2 shows that the first portion of the rise in LIBOR vs HIBOR can be explained on the Hong Kong side. 3-month HIBOR itself has fallen quite substantially relative to the base rate, which has risen in lockstep with the Fed funds rate. This decline in 3-month HIBOR suggests that there is a supply-demand imbalance in the Hong Kong interbank market (in favor of excess supply), and that the Hong Kong Monetary Authority (HKMA) is likely to reduce the aggregate balance maintained by commercial banks in the days and weeks ahead (after having reduced it by HKD 80 billion in the second half of 2017; Chart 9) in order to defend the peg. Chart 8HKD Weakness Caused By Factors##br## On Both Sides Of The Pacific Chart 9To Raise 3-Month HIBOR, ##br##The HKMA Has To Tighten Interbank Liquidity Panel 3 of Chart 8 highlights that the second portion of the LIBOR/HIBOR spike is due to events completely unconnected with Hong Kong's monetary policy or its banking system. As discussed in detail in last week's U.S. Bond Strategy,3 the sharp rise in 3-month LIBOR relative to the Fed funds rate (the opposite of what is occurring in Hong Kong) appears to be driven by the U.S. Treasury rebuilding its cash balance following the recent extension of the debt ceiling, the money market effect of U.S. corporations repatriating U.S. dollars, and the Fed's ongoing balance sheet contraction. The combination of these two factors has created incentives for investors to sell the Hong Kong dollar and buy the U.S. dollar, which explains the weakness of the former. While these factors are technical in nature and are likely to dissipate over time, they are both significantly rooted in the fact that the U.S. is tightening its monetary policy. This will be discussed in more depth in next week's report, as the combination of tighter monetary conditions, the ongoing slowdown in China's industrial sector, and the extremely high levels of leverage in Hong Kong's private sector legitimately raises the odds of a smashup over the coming 1-2 years. We will gauge how bearish investors should be on Hong Kong and will present a new indicator that investors can use to monitor whether tighter monetary policy is likely to tip the economy into a debt-driven downturn. Stay tuned. Bottom Line: The recent weakness in the Hong Kong dollar is not a sign of any major economic weakness or financial market instability that should concern investors. However, the prospect of tighter monetary policy is a potential threat to the Hong Kong economy that needs to be monitored. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation," dated March 7, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The "Decision Tree" For Chinese Stocks," dated January 4, 2018, available at cis.bcaresearch.com. 3 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR," dated March 20, 2018, available at usbs.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Portfolio Strategy The reward/risk profile of air freight & logistics is extremely attractive. Synchronized global growth, the capex upcycle, a falling dollar and secular advance in e-commerce compel us to add this unloved transportation sub-index to our high-conviction overweight list. Prepare to lock in gains in managed health care. The positive demand and pricing backdrops are already reflected in perky valuations. While homebuilders still have to contend with rising lumber prices and interest rates and the partial elimination of mortgage interest deductibility, the near 20% peak-to-trough drawdown suggests that all of the bad news is baked in relative share prices, warranting an upgrade alert. Recent Changes Add the S&P air freight & logistics index to the high-conviction overweight list. Put the S&P managed care index on downgrade alert. Set an upgrade alert on the S&P homebuilding index. Table 1 Feature Equities lost ground last week and flirted with the bottom part of the trading range established during the past two months, but held the 200-day moving average. Our view remains that the SPX is digesting the early-February swoon, and the buy-the-dip strategy is still appropriate for capital with a cyclical (9-12 month) time horizon as the probability of a recession this year is close to nil. Nevertheless, the recent doubling in the TED spread and simultaneous spike in financials investment grade bond spreads is slightly unnerving (second panel, Chart 1). Junk spreads also widened as investors sought the safety of the risk-free asset. What is behind this fear flare up propagating in risk sensitive assets? First, the Fed continued its tightening cycle last week, raising the fed funds rate another 25bps. As we have been writing in recent research Weekly Reports, rising interest rates go hand-in-hand with increasing volatility (please see Chart 1 from the March 5th Special Report on banks). Thus, as the Fed tightens monetary policy and continues to unwind its balance sheet, the return of volatility will become a key market theme (bottom panel, Chart 1). The implication is that a bumpier ride looms for equities, and the smooth and nearly uninterrupted rise that market participants have been conditioned to expect is now a thing of the past. With regard to the composition of equity returns in the coming year, rising interest rates and volatility signal that the forward P/E multiple has likely crested for the cycle, leaving profits to do all the heavy lifting (Chart 2). Second, rising policy uncertainty (trade and Administration personnel related, please see Chart 1 from last week's publication) is muddying the short-term equity market outlook at the current juncture, and fueling the risk-off phase. However, synchronized global growth, a muted U.S. dollar and easy fiscal policy are a boon to EPS and signal that profit growth will reclaim the driver's seat in coming weeks. Stocks and EPS are joined at the hip and there are good odds that equities will vault to fresh all-time highs on the back of earnings validation as the year unfolds (Chart 3). Chart 1Closely Monitor These Spreads Chart 2EPS Doing The Heavy Lifting Chart 3Profits And Cash Flow Underpin Stocks Importantly, comparing net profit growth to cash flow growth rates is instructive, as SPX EBITDA is not affected by the new tax law. While EPS are slated to grow close to 20% in calendar 2018, the respective forward SPX EBITDA growth rate (based on IBES data) sports a more muted 10% per annum rate (second panel, Chart 4). Similarly, sell side analysts pencil in a visible jump in forward net profit margins, whereas the forward EBITDA margin estimate is stable (middle panel, Chart 4). The recent tax-related benefit is a one-time dividend to profits that will not repeat in 2019. Thus, the market will likely look through this one time effect and start to focus on the calendar 2019 EPS growth number that is a more reasonable 10%, and also similar to next year's EBITDA growth rate. Our sense is that this transition will also be prone to turbulence. Our EPS growth model corroborates this profit euphoria and is topping out near the 20% growth rate (Chart 5). While it will most likely decelerate in the back half of the year, as long as there is no relapse near the contraction zone à la late-2015/early 2016, the equity bull market will remain intact. Chart 4Investors Will See Through The Tax Cut Chart 5EPS Model Flashing Green As we showcased in the early February Weekly Report, four key macro variables are behaving as they have in four prior 20% EPS growth phases since the 1980s excluding the post-recession recoveries (please see the Appendix of the February 5th "Acrophobia" Weekly Report). Therefore, if history at least rhymes, the equity overshoot phase will resume. This week we add a neglected transportation group to the high-conviction overweight list, put a defensive index on the downgrade watch list and set an upgrade alert on a niche early cyclical group. Air Freight & Logistics: Prepare For Takeoff Last week we reiterated our overweight stance in the broad transportation space and today we are compelled to add the undervalued and unloved S&P air freight & logistics index to the high-conviction overweight list. Air freight services are levered to global growth. Currently, synchronized global growth remains the dominant macro theme. Firming export expectations suggest that global trade volumes will get a bump in the coming months (second panel, Chart 6). Importantly, U.S. manufacturers are also excited about exports; the latest ISM manufacturing export subcomponent hit a three decade high. While the specter of a global trade spat is disconcerting, our sense is that a generalized trade war will most likely be averted or, if the current executive Administration is to be believed, short-lived. The upshot is that air freight & logistics sales momentum will gain steam in the coming months (second panel, Chart 7). Chart 6Heed The Signals From Global Growth,##br## Capex And The Greenback Chart 7Domestic Demand##br## Is Also Firm Beyond euphoric survey data readings, hard economic data also corroborate the soft data message. G3 (U.S., the Eurozone and Japan) capital goods orders are firing on all cylinders and probing multi-year highs, underscoring that rising animal spirits are translating into real economic activity (third panel, Chart 6). Chart 8Mistakenly Unloved And Undervalued Tack on the near uninterrupted depreciation of the trade-weighted U.S. dollar and factors are falling into place for a relative EPS overshoot, given the large foreign sales component of this key transportation sub-group (bottom panel, Chart 6). Not only are air freight stocks' fortunes tied to the state of global trade, but this industry is also sensitive to capital outlays. A synchronized global capex cycle is one of the key themes we are exploring in 2018. The third panel of Chart 7 shows that our capex indicator points to a reacceleration in the corporate sales-to-inventories ratio. This virtuous capital spending upcycle, that would get a further lift were an infrastructure bill to be signed into law, is a boon to air cargo services. In addition, as the secular advance in e-commerce continues to make inroads in the bricks-and-mortar share of total retail dollars spent, demand for delivery services will continue to grow smartly, underpinning industry selling prices (bottom panel, Chart 7). As a result, we would look through recent softness in industry pricing power that has weighed on relative performance. Indeed, transportation & warehousing hours worked have recently spiked, corroborating the message from global revenue ton miles (not shown), rekindling industry net earnings revisions (second panel, Chart 8). Importantly, relative valuations are discounting a significantly negative profit backdrop, with the relative price/sales ratio at its lowest level since 2002 (third panel, Chart 8). Similarly, the index is trading at a 10% discount to the broad market's forward P/E multiple or the lowest level since the turn of the century (not shown). Finally, technical conditions are washed out offering a compelling entry point for fresh capital (bottom panel, Chart 8). The implication is that the group is well positioned to positively surprise. Bottom Line: The S&P air freight & logistics index has a very attractive reward/risk profile and if we were not already overweight, we would take advantage of recent underperformance to go overweight now. Therefore, we are adding it to our high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Downgrade Alert: Managed Health Care Managed health care stocks have been stellar outperformers not only versus the overall market, but also compared with the broad S&P health care sector. Since the April 2016 inception of our overweight recommendation, they have added considerable alpha to our portfolio to the tune of 21 percentage points above and beyond the SPX's rise (Chart 9). While most of the factors underpinning our sanguine view for health insurers remain intact, from a risk management perspective we are compelled to put them on downgrade alert. Most of the good news is likely baked into relative prices and valuations (bottom panel, Chart 9). In the coming weeks, we will be on the lookout for an opportunity to pull the trigger and crystalize gains and downgrade to a benchmark allocation, especially if defensive equities catch a bid on the back of the current mini risk off phase. Namely, recent inter-industry M&A euphoria is a key catalyst to lighten up on this health care services sub-sector (Chart 10). While regulators have disallowed intra-industry consolidation over the past few years, the M&A premia remained and now the proposed CVS/AET and CI/EXPR deals could be a harbinger of petering out relative valuations and share prices. Chart 9Prepare To Book Gains Chart 10M&A Frenzy True, melting health care inflation is likely a secular theme that is in the processes of reversing three decades worth of health care industry, in general and pharma in particular, pricing power gains. While this is a dire backdrop for drug manufacturers - which remains a high-conviction underweight - it is a clear benefit to HMOs (Chart 11). Health insurance labor costs are also well contained: the employment cost index for this industry is probing multi-year lows (bottom panel, Chart 12). The upshot is that profit margins are on a solid footing. Chart 11Operating Metrics Suggest... Chart 12...To Stay Overweight A While Longer Meanwhile, the overall U.S. labor market is on fire. Last month NFPs registered a month-over-month increase of 300K for the first time in four years and unemployment insurance claims are perched near five decade lows. This represents an enticing demand backdrop for managed health care companies, especially when the economy is at full employment and the government is easing fiscal policy (bottom panel, Chart 11). Despite the still appealing demand and pricing backdrop, the flurry of M&A deals will likely serve as a catalyst to lock in gains and move to a benchmark allocation in the coming weeks as this health care sub-index is priced for perfection. Bottom Line: Stay overweight the S&P managed health care index, but it is now on downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Upgrade Alert: Homebuilders Showing Resiliency In late-November 2017 when we launched our 2018 high-conviction call list, we downgraded the niche S&P homebuilding index to underweight (Chart 13). Our thesis was that the trifecta of rising lumber prices, mortgage interest deductibility blues and rising interest rate backdrop, a key 2018 BCA theme, would weigh on profit margins and, thus, profits would underwhelm. Since then we have monetized gains of 10% versus the SPX and removed this early-cyclical index from the high-conviction underweight list.1 Today we are putting it on upgrade alert. As a reminder, this was not a call based on a souring residential housing view. In fact, we remain housing bulls and expect more gains for the still recovering residential housing market that moves in steady prolonged multi-year cycles (Chart 14). Keep in mind that housing starts are still running below household formation and the job market is heating up. The implication is that the U.S. housing market rests on solid foundations. Chart 13Bounced Off Support Line Chart 14Housing Fundamentals Are Upbeat While interest rates and rising house prices are denting affordability (second and fourth panels, Chart 15), homebuilders share prices have been resilient recently and have smartly bounced off their upward sloping support trend line (Chart 13). Indeed, interest rates may continue to rise from current levels, but as we have highlighted in recent research, there is a self-limiting aspect to the year-over-year rise in the 10-year yield near the 100bps mark. Put differently, any rise above 3.05% on the 10-year Treasury yield in a short time frame would likely prove restrictive for the U.S. economy.2 Encouragingly, the mortgage application purchase index has well absorbed the selloff in the bond market, unlike its sibling mortgage application refinance index, signaling that there is pent up housing demand (second panel, Chart 16). New home sales are expanding anew as price concessions have likely been sufficient to compete with existing homes for sale (top panel, Chart 16). Chart 15Get Ready To Upgrade... Chart 16...Given Receding Profit Margin Risks On the lumber front, prices have gone parabolic year-to-date courtesy of trade war talk and a softening U.S. dollar. However, lumber inflation cannot continue at a 50%/annum pace indefinitely (third panel, Chart 16). While higher lumber prices are a de facto negative for homebuilding profit margins, we deem they are now well reflected in compelling relative valuations (bottom panel, Chart 15). In addition, if we are correct in assessing that housing demand remains upbeat, this will give some breathing room to homebuilders to partly pass on some of this input cost inflation to the consumer. Bottom Line: The S&P homebuilding index remains an underweight, but it is now on our upgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "Housekeeping In Turbulent Times," dated February 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).
Overweight The S&P containers & packaging index has been underperforming since the beginning of the year as the spiking input costs of last year materialized in soft Q4 earnings, compounded by fears over a trade war. However, those costs have fallen substantially since the end of the year (second panel) and gross margins should eventually return to normal; trade fears have moderated. In the longer term, we think the focus should remain on the drivers of demand, namely global growth (a key BCA theme for this year). Both volumes and prices have maintained a steady uptrend (third panel) and the sell side has taken notice as relative forward EPS are climbing at the fastest pace in a decade (bottom panel). Combined with the index's weak performance YTD, a sizeable buying opportunity is taking shape; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY.
Underweight Last week we downgraded the S&P consumer discretionary index to a below benchmark allocation on the back of three key factors: a rising fed funds rate, quantitative tightening and higher prices at the pump. One of the charts we published, and are reprinting today, caught the attention of our good friend, who I refer to as the "smartest man in California", and he suggested a few of interesting tweaks to drive a point home. First, he recommended to switch the fed funds rate to the shadow fed funds rate, or the Wu-Xia model, in order to better capture the fact that the Fed was still easing monetary policy below the zero line post December, 2008 and until December, 2015 via QE (top panel). Second, if we were to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the chart would highlight that the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (top panel). Finally, while AMZN has a heavy weight in the broad consumer discretionary index (21%), its earnings weight is quite low (1.5%). Thus, overall consumer discretionary profits are indeed following the Fed's historical tightening path (second panel). Bottom line: We reiterate our underweight stance in the S&P consumer discretionary sector. Category: Consumer Discretionar
Highlights Portfolio Strategy Synchronized global growth, a soft U.S. dollar, our resurgent Boom/Bust Indicator and avoidance of a Chinese economic hard landing, are all signaling that it still pays to overweight cyclicals at the expense of defensives. Economically hyper-sensitive transports also benefit from synchronous global growth and capex. We expect a rerating phase in the coming months. Within transports, we reiterate our overweight stance in the key railroads sub-index as enticing macro tailwinds along with firming operating metrics underscore that profits will exit deflation in calendar 2018. Recent Changes There are no portfolio changes this week. Table 1 Feature The S&P 500 continued to consolidate last week, still digesting the early February tremor. Policy uncertainty is slowly returning and sustained Administration reshufflings are becoming slightly unnerving (bottom panel, Chart 1). Nevertheless, the dual themes of synchronized global growth and budding evidence of coordinated tightening in global monetary policy, i.e. rising interest rate backdrop, continue to dominate and remain intact. Importantly in the U.S., the latest non-farm payrolls (NFP) report was a goldilocks one. Month-over-month NFPs surpassed the 300K hurdle for the first time since late-2014, on an as-reported-basis, while wage inflation settled back down. The middle panel of Chart 2 shows that both in the 1980s and 1990s expansions, NFPs were growing briskly, easily clearing the 300K mark. The 2000s was the "jobless recovery" expansion and likely the exception to the rule. In all three business cycle expansions wage growth touched the 4%/annum rate before the recession hit. The yield curve slope also supports this empirical evidence, forecasting that wage inflation will likely attain 4%/annum before this cycle ends (wages shown inverted, Chart 3). Chart 1Watch Policy Uncertainty Chart 2Goldilocks NFP Report... Chart 3...But Wage Growth Pickup Looms One key element in the current cycle is that the government is easing fiscal policy to the point where both NFPs and wages will likely surge in the coming months as the fiscal thrust gains steam, likely extending the business cycle. This is an inherently inflationary environment, especially when the economy is at full employment and the Fed in slow and steady tightening mode. Last autumn, we showed that the SPX performs well in times of easy fiscal and tight money iterations, rising on average 16.7% with these episodes, lasting on average 16 months (Table 2).1 The latest flagship BCA monthly publication forecasts that the current fiscal impulse will last at least until year-end 2019, contributing positively to real GDP growth. Thus, if history at least rhymes, SPX returns will be positive and likely significant for the next couple of years (Chart 4). With regard to the composition of the equity market's return, we reiterate our view - backed by empirical evidence - that EPS will do the heavy lifting whereas the forward P/E multiple will continue to drift sideways to lower.2 Not only will rising fiscal deficits cause the Fed to remain vigilant and continue to raise interest rates and weigh on the equity market multiple (Chart 5), but also heightened volatility will likely suppress the forward P/E multiple. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Chart 4Stimulative Fiscal Policy##br## Extends The Business Cycle... Chart 5...But Weighs On ##br##The Multiple This week we revisit our cyclical versus defensive portfolio bent and update the key transportation overweight view. Cyclicals Thrive When Global Growth Is Alive And Well... While retaliatory tariff wars are dominating the media headlines, global growth is still resilient. Our view remains that the odds of a generalized trade war engulfing the globe are low, and in that light we reiterate our cyclical over defensive portfolio positioning, in place since early October.3 Global growth is firing on all cylinders. Our Global Trade Indicator is probing levels last hit in 2008, underscoring that cyclicals will continue to have the upper hand versus defensives (Chart 6). Synonymous with global growth is the softness in the U.S. dollar. In fact, the two are in a self-feeding loop where synchronized global growth pushes the greenback lower, which in turn fuels further global output growth. Tack on the rising likelihood that the trade-weighted dollar has crested from a structural perspective, according to the 16-year peak-to-peak cycle4 (Chart 7) and the news is great for cyclicals versus defensives (Chart 8). Chart 6Global Trade Is Alright Chart 7Dollar The Great Reflator... Chart 8...Is A Boon For Cyclicals Vs. Defensives Related to the greenback's likely secular peak is the booming commodity complex, as the two are nearly perfectly inversely correlated. Commodity exposure is running very high in the deep cyclical sectors and thus any sustained commodity price inflation gains will continue to underpin the cyclicals/defensives share price ratio. BCA's Boom/Bust Indicator (BBI) corroborates this upbeat message for cyclicals versus defensives. The BBI is on the verge of hitting an all-time high and, while this could serve as a contrary signal, there are high odds of a breakout in the coming months if synchronized global growth stays intact as BCA expects, rekindling cyclicals/defensives share prices (Chart 9). Finally, if China avoids a hard landing, and barring an EM accident, the cyclicals/defensives ratio will remain upbeat. Chart 10 shows that China's LEI is recovering smartly from the late-2015/early-2016 manufacturing recession trough, and the roaring Chinese stock market - the ultimate leading indicator - confirms that the path of least resistance for the U.S. cyclicals/defensive share price ratio is higher still. Chart 9Boom/Bust indicator Is Flashing Green Chart 10China Is Also Stealthily Firming Bottom Line: Stick with a cyclical over defensive portfolio bent. ...As Do Transports, Thus... Transportation stocks have taken a breather recently on the back of escalating global trade war fears. But, we are looking through this soft-patch and reiterate our barbell portfolio approach: overweight the global growth-levered railroads and air freight & logistics stocks at the expense of airlines that are bogged down by rising capacity and deflating airfare prices (Chart 11). Leading indicators of transportation activity are all flashing green. Transportation relative share prices and manufacturing export expectations are joined at the hip, and the current message is to expect a reacceleration in the former (top panel, Chart 12). Similarly, capital expenditures, one of the key themes we are exploring this year, are as good as they can be according to the regional Fed surveys, and signal that transportation profits will rev up in the coming months (middle panel, Chart 12). The possibility of an infrastructure bill becoming law later this year or in 2019 would also represent a tailwind for transportation EPS. Not only is U.S. trade activity humming, but also global trade remains on a solid footing. The global manufacturing PMI is resilient and sustaining recent gains, suggesting that global export volumes will resume their ascent. This global manufacturing euphoria is welcome news for extremely economically sensitive transportation profits (Chart 13). All of this heralds an enticing transportation services end-demand outlook. In fact, industry pricing power is gaining steam of late and confirms that relative EPS will continue to expand (Chart 12). Under such a backdrop, a rerating phase looms in still depressed relative valuations (bottom panel, Chart 13). Chart 11Stick With Transports Exposure Chart 12Domestic... Chart 13...And Global Growth/Capex Beneficiary ...Stay On Board The Rails Railroad stocks have worked off the overbought conditions prevalent all of last year, and momentum is now back at zero. In addition, forward EPS have spiked, eliminating the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (Chart 14). The track is now clear and more gains are in store for relative share prices in the coming quarters. Despite trade war jitters, we are looking through the recent turbulence. If the synchronized global growth phase endures, as we expect, then rail profits will remain on track. In fact, BCA's measure of global industrial production (hard economic data) is confirming the euphoric message from the global manufacturing PMI (soft economic data) and suggests that rails profits will overwhelm (Chart 15). Our S&P rails profit model also corroborates this positive global trade message and forecasts that rail profit deflation will end in 2018 (bottom panel, Chart 15). Beyond these macro tailwinds, operating industry metrics also point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (second panel, Chart 15). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (second panel, Chart 16). Chart 14Unwound Both Overbought Conditions And Overvaluation Chart 15EPS On Track To Outperform Chart 16Intermodal Resilience The significant intermodal segment that comprises roughly half of all shipments is on the cusp of a breakout. The retail sales-to-inventories ratio is probing multi-year highs on the back of the increase in the consumer confidence impulse and both are harbingers of a reacceleration in intermodal shipments (Chart 16). Coal is another significant category that takes up just under a fifth of rail carload volumes and bears close attention. While natural gas prices have fallen near the lower part of the trading range in place since mid-2016 and momentum is back at neutral, any spike in nat gas prices will boost the allure of coal as a competing fuel for energy generation (middle panel, Chart 17). Keep in mind that coal usage is highly correlated with electricity demand and the industrial business cycle, and the current ISM manufacturing survey message is upbeat for coal demand. Tack on the whittling down in coal inventories at utilities and there is scope for a tick up in coal demand (third panel, Chart 18). Finally, the export relief valve has reopened for coal with the aid of the depreciating U.S. dollar, and momentum in net exports has soared to all-time highs, even surpassing the mid-1982 peak (bottom panel, Chart 18). Chart 17Key Coal Shipments Underpin Selling Prices Chart 18Upbeat Leading Indicators Of Coal Demand All of this suggests that coal shipments will make a comeback later in 2018, and continue to underpin industry pricing power, which in turn boost rail profit prospects (bottom panel, Chart 17). Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).