Developed Countries
2017 has been a tough year for movies & entertainment. The index has been in a steady downdraft and is now probing 5 year lows. Yesterday's U.S. consumer confidence number could presage an inflection point. Consumers are feeling ebullient (second panel), which typically heralds increased discretionary spending, particularly on media services. While cord cutting and concerns about TV ad spending have undermined the index of late, if cable spending continues to accelerate, then these concerns should fade. The sector enjoys high operating leverage, implying strong EPS gains from a sales lift (third panel). This rosy outlook is not yet reflected in valuations which are well below their long-term average (bottom panel). This offers investors a double feature of valuation rerating and significant earnings growth. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB.
Highlights Trade 1: An unwinding of the Trump reflation trade... has worked exactly as expected. Take profits and switch into Trade 5. Trade 2: Short pound/euro at €1.18 and simultaneously buy call options at €1.30... is up 4%. Take profits and add to long euro/dollar. Trade 3: Underweight French OATS... has worked well both in a European bond portfolio and in a global bond portfolio. Stick with this trade. Trade 4: Long euro/yuan... is up 6%. Stick with this trade. Trade 5 (New): Underweight emerging market equities. European equity investors should underweight Poland. Feature At the mid-point of the year, we are devoting this report to appraise our top investment ideas for 2017 - as recommended in our December 22 report Five Pressing Questions (And Four Trades) For 2017. Half-time is a good moment to review the thoughts we had at the start of 2017, establish how the ideas have performed in the first half, and assess whether to stick with them or make some changes in the second half. Chart of the WeekFor EM Equities, Excessive Groupthink Is Hitting Its Natural Limit Trade 1: An Unwinding Of The Trump Reflation Trade Chart I-2The Trump Reflation Trade Has Unwound Our thoughts at the start of 2017: "Can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? This publication believes that the tide has not turned... Rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now." How has the trade performed in the first half? Exactly as scripted, the Trump reflation trade - in its various guises - has unwound. Since our original report, the trade-weighted dollar is down 5%; the global bond yield is down 15bps (the 10-year T-bond yield is down 40bps); and banks have underperformed the market by 5% (Chart I-2). Our thoughts for the second half of 2017: Never forget that the financial markets are a complex ecosystem in which long-term investors jostle with short-term traders. The equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. In February, our prescient warning in The Contrarian Case For Bonds was that as emotional and impulsive short-term traders had been left unchecked to drive markets, excessive groupthink was hitting its natural technical limit. The 6-month sell-off in bonds had reached a point of instability. And sure enough, the trend broke (Chart I-3). Chart I-3For Bonds, Excessive Groupthink Hit Its Natural Limit In February At such tipping points of excessive groupthink, a good benchmark is that the preceding trend will reverse by one third. On this basis, a large part of the gains in the Trump trade unwind have now been made. Take profits and switch into new trade 5. Trade 2: Short Pound/Euro At €1.18 And Simultaneously Buy Call Options At €1.30 Our thoughts at the start of 2017: "2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive... The pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other." How has the trade performed in the first half? For U.K. politics, "especially unpredictable" could be the understatement of the year! An unpredicted general election generated an even more unpredicted result. With pound/euro now below €1.13, the directional position is up 5% in gross terms, and up around 4% in net terms allowing for the cost of the call options (Chart I-4). Chart I-4Pound / Euro Has Underperformed In 2017 Our thoughts for the second half of 2017: In a hung parliament, the minority Conservative government does not have the parliamentary maths to legislate for a hard Brexit in either the House of Commons or the House of Lords. Significantly, the so-called 'Salisbury Convention' - in which the House of Lords does not oppose the second or third reading of any government legislation promised in its election manifesto - does not necessarily apply in a hung parliament. This is because, by definition, the minority Conservative government's manifesto did not secure a majority in the House of Commons. With the hard Brexit tail-risk diminished, our current preference for currencies is euro first, pound second, dollar third, based on the evolution of interest rate expectations explained below. Hence, take profits in short pound/euro and add to long euro/dollar. Trade 3: Underweight French OATS Our thoughts at the start of 2017: "2016 was the year when QE peaked... The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero." How has the trade performed in the first half? French OATS have substantially underperformed both U.K. gilts (Chart I-5) and U.S. T-bonds (Chart I-6). So it has been correct to underweight French government bonds both in a European bond portfolio and in a global bond portfolio. Chart I-5French OATs Have Underperformed In##br## A European Bond Portfolio... Chart I-6...And A Global ##br##Bond Portfolio Our thoughts for the second half of 2017: Central banks' professed commitment to data-dependency means that their words - and ultimately actions - must acknowledge the hard data. No ifs, buts or maybes. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses, which lead activity, euro area hard data will continue to be among the best among the major economies. Combined with the supply shortages the ECB is now facing in buying German bunds, expect the ECB's words to continue becoming more hawkish. The recent relatively smooth winding down of three failing banks - Spain's Banco Popolare and Italy's Banca Popolare di Vicenza and Veneto Banca - will also hearten the ECB that the strategy for resolving its undercapitalised banks does not pose a systemic risk to the economy or markets. Hence, expect euro area interest rate expectations to continue converging with other developed economies. And stick with the underweight French OATS (or German Bunds) trade, especially in a global bond portfolio. Chart I-7Euro / Yuan Is Up 6% Trade 4: Long Euro/Yuan Our thoughts at the start of 2017: "The debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation... China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses." How has the trade performed in the first half? Euro/yuan is up 6% (Chart I-7). Our thoughts for the second half of 2017: The thoughts we expressed at the start of 2017 are still entirely valid and supported by the argument for trade 5 below. Stick with long euro/yuan. Trade 5 (New): Underweight Emerging Market Equities Just as we presciently warned of excessive negative groupthink towards bonds in February, we are now seeing similarly excessive positive groupthink towards EM equities hitting its natural technical limit. This is a strong warning that the first half 15% rally risks reversing, or fizzling, in the second half (Chart of the Week). Chart I-8If EM Underperforms DM, Poland ##br##Underperforms Europe For the detailed fundamental analysis, I refer you to the latest reports penned by my colleague, BCA's Chief Emerging Markets Strategist, Arthur Budaghyan. But in summary, Arthur says: "China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth... the outlook for EM risk assets is extremely poor... and we continue to recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies."2 For European equity investors, this means underweighting Poland, whose relative performance tracks EM versus DM equities (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Please see the Emerging Markets Strategy Weekly Report "EM: Contradictions And A Resolution" published on June 14, 2017 and available at ems.bcaresearch.com Fractal Trading Model* As shown on page 1, this week's trade is to go short emerging markets with a corresponding long in developed markets. In this case, the trade duration is up to 6 months with a profit target and stop-loss of 3%. Amongst our other open trades, long FTSE100 / short IBEX35 is approaching its 4% profit target. 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-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Fractal Trading Model 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 Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel). The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (bottom panel), such that even a modest shift in sentiment would drive a large relative price swing. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. For additional details, please see Monday's Weekly Report.
Feature The BCA Corporate Health Monitor (CHM) - designed to assess the financial well-being of companies - is one of our most reliable indicators that is also extremely popular with our clients. That is no surprise, as the CHMs have a solid track record in signaling broad turning points in company credit quality. This makes them useful in determining asset allocation recommendations on Investment Grade (IG) and High-Yield (HY) corporate bonds. Chart 1U.S. Corporates Outperforming, ##br##Despite Worsening Credit Quality In this Weekly Report, we present the "top-down" CHMs based on corporate data from national income (i.e. "GDP") accounts for the U.S., Euro Area and the U.K. We also show the "bottom-up" CHMs constructed using the actual reported financial data of individual companies in the U.S., Euro Area and Emerging Markets (EM). The CHMs are shown in a chartbook format that allows for quick visual analysis and comparisons. Going forward, we will publish this CHM Chartbook on a quarterly basis as a regular part of Global Fixed Income Strategy. The broad conclusion from looking at the CHMs is that corporate credit quality has been steadily improving in Europe, the U.K. and in the EM universe over the past couple of years, in sharp contrast to the worsening financial health of highly-levered U.S. companies. Bond investors seem to be ignoring the relative message sent by our CHMs, however, as U.S. corporate debt has outperformed other developed credit markets since the beginning of 2016 (Chart 1). An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is an indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios similar to those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the metrics used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.1 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team last September, which extends the CHM analysis to EM hard-currency corporate debt.2 Table 1Definitions Of Ratios That Go Into The CHMs U.S. Corporate Health Monitors: Still Deteriorating Chart 2Top-Down U.S. CHM: Still Deteriorating Our top-down CHM for the U.S. has been flashing a deteriorating state of corporate health since mid-2014 (Chart 2). That trend had been showing signs of stabilization last year, but the Q1/2017 data worsened on the back of lower profit margins and returns on capital. The latter now sits just above 5% - a level last seen during the 2009 recession. Corporate leverage, as measured in our top-down CHM using the value of debt versus equity, does not look to be a problem. The story is quite different when using alternative measures like net debt/EBITDA, however, with U.S. leverage exceeding the highs from the Telecom bubble of the early 2000s. While booming equity values certainly flatter the leverage ratio in our top-down CHM, a strong stock market should, to some degree, reflect a better backdrop for growth in corporate profits and creditworthiness. Even against this positive backdrop, however, other credit indicators are flashing some warning signs that leave our top-down CHM in the "deteriorating health" zone. Interest coverage and debt coverage ratios, while still above the lows seen during past recessions, are steadily falling. This does raise concerns for U.S. corporate health if U.S. bond yields begin to climb again, as we expect. However, given the historically low interest rate backdrop for corporate debt, a bigger threat to interest coverage ratios and overall credit quality would come from an economic slump that damages company profits. That is not going to be a problem for the rest of this year, but weaker growth is a more likely outcome in 2018 as the Fed continues its monetary tightening cycle. Our bottom-up CHMs for U.S. IG (Chart 3) and U.S. HY (Chart 4) have shown a bit of improvement in recent quarters relative to the signal from our top-down CHM. This is likely related to the growing gap between corporate profits as reported in the U.S. national accounts data, which are slowing, compared to the reported earnings of publicly traded companies, which are accelerating. Also, leverage in the bottom-up CHMs uses the book value of equity, which is more readily reported by individual companies, and is thus much higher than the measure used in our top-down CHM. Return on capital is at multi-decade lows for both IG and HY corporates, although profit margins look to be in much better shape for IG names relative to HY issuers. HY margins have enjoyed a cyclical improvement, however, largely due to better earnings from HY energy companies (Chart 4, panel 4). Interest coverage and debt coverage are depressed, with HY issuers in much worse shape than IG. Chart 3Bottom-Up U.S. Investment Grade CHM: ##br##Deteriorating Chart 4Bottom-Up U.S. High-Yield CHM: ##br##Some Cyclical Improvement The cumulative message from our top-down and bottom-up U.S. CHMs is that U.S. corporate health has enjoyed some cyclical improvement over the past few quarters, but the state of balance sheets is slowly-but-steadily worsening. High corporate leverage will become a major problem during the next U.S. recession, but is not a major factor weighing on credit spreads at the moment (Chart 5). We are maintaining our overweight stance on U.S. IG and higher-rated U.S. HY, both of which should continue to outperform Treasuries over the next few months, but a repeat performance is far less likely next year. Chart 5No Signs Of Concern##br## In U.S. Corporate Credit Spreads Chart 6Top-Down Euro Area CHM:##br## Improving Euro Area Corporate Health Monitors: Solid Improvement Our top-down Euro Area CHM has been showing steady improvement since 2013, driven by strong profit margins and rising interest and debt coverage ratios (Chart 6). The ultra-stimulative monetary policies of the European Central Bank (ECB) have likely played a large role in helping lower corporate borrowing costs and boosting the interest coverage ratio. The average coupon on bonds in the Bloomberg Barclays Euro-Aggregate Investment Grade corporate index is now down to a mere 2.3% - a far cry from the 5% level that prevailed during the peak of the 2011 Euro Debt crisis or the 3.5% level just before the ECB began its asset purchase program in 2015. Return on capital has fallen over the past decade and now sits at 8%, although profit margins remain quite strong on our top-down CHM measure. Short-term liquidity is at a record high, suggesting no imminent problems for European corporate borrowers. Our bottom-up CHMs for Euro Area IG (Chart 7) and HY (Chart 8) are telling a broadly similar story to the top-down CHM. The bottom-up CHMs have steadily improved in the past couple of years, most notably for domestic issuers of Euro-denominated debt.3 Some improvement in the bottom-up aggregates for operating margins and interest coverage ratios is providing a boost to European credit quality. Chart 7Bottom-Up Euro Area Investment Grade CHMs Chart 8Bottom-Up Euro Area High-Yield CHMs The bottom-up measure of leverage for domestic IG issuers has been steadily declining since the 2009 recession, a sign that European companies have been much more cautious in managing their balance sheet risk than their U.S. counterparts. The same cannot be said for Euro Area domestic HY issuers, where all the individual ratios are at weak absolute levels. When splitting our bottom-up Euro Area IG company list into issuers from core Europe versus countries on the Periphery (Chart 9), the "regional" European CHMs tell broadly similar stories of improving credit quality. The fact that even Peripheral issuers are seeing rising interest coverage and liquidity ratios, despite much higher levels of leverage than in the core, is an indication of how the ECB's low interest rate policies and asset purchase programs (which include buying corporate debt) have helped support the European corporate sector. Net-net, our Euro Area CHMs are sending a signal that there are no immediate stresses on corporate balance sheets or profitability. This is already reflected in the current low level of corporate bond yields and spreads, though (Chart 10). A bigger threat to Euro Area corporates comes from monetary policy. The ECB is under increasing pressure to consider announcing a tapering of its asset purchases - likely to include slower buying of corporates - starting in 2018. There is a risk of a negative market reaction that could undermine future Euro Area corporate bond performance. Because of this, we continue to prefer U.S. corporate debt over Euro Area equivalents, despite the large gap between the U.S. and European top-down CHMs (Chart 11). Chart 9Bottom-Up Euro Area IG CHMs: ##br##Core Vs. Periphery Chart 10Euro Area Corporate Bonds ##br## Have Had A Great Run Chart 11Relative CHMs Starting ##br##To Turn Less Favorable For U.S. Credit U.K. Corporate Health Monitor: Solid Balance Sheet Fundamentals The top-down U.K. CHM has steadily improved over the past couple of years, led by rising profit margins, higher interest coverage and very robust liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop. Fundamental analysis of U.K. corporates may not be of much use at the moment given the extremely accommodative monetary policy environment provided by the Bank of England (BoE). Low interest rates, combined with BoE asset purchases (which include a small amount of corporate debt) and a steep fall in the Pound in the aftermath of the Brexit-driven political uncertainty, are all helping keep the U.K. economy afloat. The BoE is now having to deal with a currency-driven climb in U.K. inflation, with three members of the BoE policy committee even calling for a rate hike at the latest policy meeting. The political backdrop after last year's Brexit vote and this month's closer-than-expected U.K. election result remains too volatile for the BoE to seriously consider any imminent tightening of monetary policy. While it can be debated how much the Brexit uncertainty is truly weighing on the U.K. economy, the BoE is unlikely to take any risks on triggering a growth slowdown by becoming too hawkish, too soon - even with the relatively high level of currency-driven inflation. A combination of a strong CHM and a dovish BoE will allow U.K. corporate debt, both IG and HY, to continue to outperform Gilts. We continue to recommend an overweight allocation to U.K. corporates even though, as in the other countries shown in this report, valuations are not cheap (Chart 13). We have not yet constructed bottom-up versions of the CHM for U.K. corporates to allow us to make any additional comments on the relative merits of U.K. IG and HY debt. This is something we intend to look into for future reports. Chart 12U.K. Corporate Balance Sheets ##br##Are In Good Shape... Chart 13...Which Is Already Reflected In ##br##Tight Credit Spreads Emerging Market Corporate Health Monitor: Cyclically Strong, Structurally Weak The CHM for EM corporates built by our Emerging Markets Strategy team is purely a bottom-up measure. The financial data from 220 EM companies in over 30 countries is used to construct the EM CHM. Only firms that issue U.S. dollar-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs for the developed economies. A shorter list of financial ratios is used in the EM CHM than the developed CHMs, including: Profit margins Free cash flow to total debt: Liquidity Leverage Unlike the developed CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and cash flow/debt combined represent 75% of the EM CHM. The weightings are designed to optimize the performance of the EM CHM versus the actual spread movements in the J.P. Morgan CEMBI benchmark index for EM corporate debt. Chart 14EM Corporate Health: Cyclically Solid... The EM CHM is currently pointing to very strong fundamental underpinnings for EM corporates with the indicator at the most credit-positive level in a decade (Chart 14). That recent strength is a modest cyclical improvement after a multi-year deterioration in all the individual EM CHM components (Chart 15). The uptick in global commodity prices in 2016 played a major role in the improvement in the growth-sensitive components (top two panels). However, the biggest structural headwind for EM corporates is the unrelenting rise in balance sheet leverage (bottom panel) - a problem that could come to the forefront if the recent slump in commodity prices persists or developed market interest rates begin to rise more sharply as central banks become marginally less accommodative. For now, we continue to recommend only a neutral allocation to EM hard currency debt, as the positive message sent by the EM CHM appears fully priced into the current low level of EM yields and spreads (Chart 16). Chart 15...But Structurally More Challenged Chart 16EM Corporate Debt Is Not Cheap Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. 3 Given the large share of non-European issuers in the Euro-denominated corporate debt market, we have split our sample set of companies in our bottom-up Euro Area CHMs into "domestic" and "foreign" issuer groups. This allows a more precise analysis of the corporate health of European-domiciled companies. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
We raised the S&P air freight & logistics group to overweight two months ago, because the budding revival in global trade was not reflected in either valuations or earnings estimates. Looking ahead, firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail. Yet buoyant global trade expectations are still not baked into tumbling relative sales expectations and deeply discounted valuations remain in place. Consequently, there is scope for a dual increase in valuations and profit estimates, warranting a bump up to our high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.
Highlights Fed Policy Loop: Low inflation is preventing rate hike expectations from being revised higher, prolonging the current rally in spread product. We expect rate hike expectations to move up as inflation recovers, eventually leading to a correction in spread product. Such a correction will prove fleeting as long as inflation stays below target. High-Yield: High-yield valuation is consistent with its historical average, after accounting for expected default losses. Current valuation levels should translate into excess returns of just over 200 bps during the next 12 months. Aaa Spread Product: Non-agency CMBS offer the most spread pick-up of any Aaa-rated sector. However, we prefer to focus our Aaa-rated spread product allocation in Agency CMBS and credit card backed consumer ABS. Feature Chart 1The Fed Policy Loop In Action One of this publication's main themes during the past few years has been the Fed Policy Loop.1 In essence, the Loop describes the feedback mechanism between monetary policy and financial markets, a relationship that results from both investors' sensitivity to the Fed's policy stance and the Fed's reliance on financial conditions as a predictor of economic growth. In practice, the Loop works as follows: Easier Fed policy causes spread product to outperform Treasuries. Tighter credit spreads lead to easier financial conditions, which the Fed interprets as a sign that economic growth will accelerate. An improved economic outlook causes the Fed to step up the pace of tightening. Tighter Fed policy causes spread product to underperform Treasuries. Wider credit spreads lead to tighter financial conditions, which the Fed interprets as a sign that economic growth will moderate. A worse economic outlook causes the Fed to slow its expected pace of tightening. Rinse, repeat. Chart 2 provides a graphical description of the Loop, and its most recent iteration can be seen in Chart 1 above. Chart 1 shows that corporate bonds outperformed Treasuries leading up to the March rate hike, but then rate expectations rose too far. In mid-March the market was discounting a fed funds rate of 1.86% by the end of 2018. These overly stringent rate hike expectations caused corporate bonds to underperform, and this underperformance led rate hike expectations to be revised lower. The market now expects a fed funds rate of only 1.47% by the end of 2018, and these depressed rate expectations have fueled the rally in corporate bonds that started in mid-April. Normally at this stage of the Fed Policy Loop we would expect rate hike expectations to move higher until they eventually prompt a correction in corporate spreads. However, extremely disappointing core inflation prints during the past three months have caused the market to keep its rate hike expectations depressed. This has extended the most recent rally in spread product. This is why we have consistently pointed to core inflation and the cost of inflation protection embedded in long-maturity bond yields as the main factors to watch to determine how much life is left in the corporate bond trade. As long as inflation stays below target, the Fed absolutely needs it to rise. It will therefore be quick to respond to any tightening of financial conditions/widening of credit spreads. Table 1 shows average monthly excess returns for investment grade corporate bonds relative to duration-matched Treasuries. These returns are split into buckets based on the reading from the St. Louis Fed's Price Pressures Measure (PPM). The PPM is a composite of 104 economic indicators designed to measure the probability that inflation will exceed 2.5% during the next 12 months. As can be seen, average monthly excess returns are strongest when inflation pressures are low, but they gradually decline as inflation heats up and the Fed's reaction function becomes less supportive for markets. At present, the PPM gives a reading of only 4.8%. Table 1Investment Grade Corporate Bond Excess Returns* Under Different ##br## Ranges Of Price Pressures Measure** (January 1990 To Present) Similarly, Table 2 shows that it is difficult to get a long-lasting correction in an environment with low inflation pressures and a responsive Fed. This table shows the results of a "buy the dips" trading strategy where if the average junk spread widens by 20 basis points we buy the junk index versus duration-matched Treasuries and hold it for a period of 1, 2 or 3 months. Just as in Table 1, this strategy works well when inflation pressures are muted, but starts to fail as inflation ramps up. Table 2High-Yield Corporate Bond Returns* Achieved By Holding The Junk Index ##br## Following A 20 BPs Widening In High-Yield Corporate OAS** Under Different Ranges Of ##br## The St. Louis Fed Price Pressures Measure*** (February 1994 To Present) Beatings Will Continue Until Morale Improves So when will the Fed staunch the current rally? That depends on how quickly inflation rebounds,2 and also on how much emphasis Fed policymakers place on financial conditions versus the actual inflation data. At the moment, most indexes are sending the message that financial conditions are easier than average and that the Fed should continue to tighten (Chart 3). However, as was noted above, inflation gauges are sending the opposite signal (Chart 3, panel 2). For now, the Fed is downplaying low inflation as transitory. It decided to leave its median projected rate hike path unchanged at the June FOMC meeting. But the Fed's refusal to capitulate in the face of weaker inflation has caused the yield curve to flatten, the cost of inflation protection to plummet (Chart 3, bottom panel) and investors to grow increasingly concerned about a policy mistake (Chart 4). Chart 3Financial Conditions Are Supportive Chart 4Should The Fed Keep Tightening? This brings up an interesting flaw in the financial conditions approach to policymaking. Most indexes of financial conditions are at least partially driven by long-maturity Treasury yields (lower yields = easier financial conditions, and vice-versa). This makes some sense. Lower yields do in fact indicate that the financing back-drop is more supportive and tend to translate into higher growth in the future (Chart 5). Chart 5Financial Conditions Lead Economic Growth However, what if lower long-maturity Treasury yields are the result of excessively tight Fed policy? This would appear to be the case at the moment. Investors are revising their long-run inflation forecasts lower on the view that the Fed is not doing enough to allow prices to rise. In such a situation it would be incorrect to interpret lower Treasury yields as a signal that policy needs to tighten further. On the contrary, tighter policy would only exacerbate the downtrend in yields. For this reason we do not include the level of yields in the financial conditions component of our Fed Monitor (Chart 3, top panel). As a result, this financial conditions indicator is not as deep in "easing territory" as most other indicators. However, it is still above the zero line, suggesting that policy should be biased tighter at the margin. Bottom Line: Low inflation is preventing rate hike expectations from being revised higher, prolonging the current rally in spread product. We expect rate hike expectations to move up as inflation recovers, eventually leading to a correction in spread product. Such a correction will prove fleeting as long as inflation remains below the Fed's target. The key risk is that inflation stays low but the Fed continues to focus exclusively on "easy" readings from financial conditions indexes, and proceeds on its current tightening path. In that scenario cries of "policy mistake" will grow louder and spread product will sell off, converging with lower rate hike expectations. We view this scenario as a low-probability tail risk. Junk Valuation Update At 378 bps, the average spread on the Bloomberg Barclays High-Yield index is only 55 bps above its post-crisis low, but still more than 100 bps above the level where it tends to settle in the late stages of the economic cycle when the Fed is tightening policy (Chart 6, top panel). Higher debt levels than are typical for this stage of the cycle suggest that somewhat wider spreads are justified,3 but the idea that junk spreads are extremely tight compared to history does not hold up to scrutiny. Chart 6High-Yield Default-Adjusted Spread Our preferred measure of junk valuation, the default-adjusted high-yield spread, paints an even rosier picture. The second panel of Chart 6 shows an ex-post measure of the default-adjusted spread (the option-adjusted spread of the high-yield index less actual default losses over the subsequent 12 months). The most recent reading from this indicator is based on our forecast of default losses for the next 12 months, and is shown as a dashed line. The message from the default-adjusted spread is that, assuming our default loss forecast is correct, junk bonds currently offer compensation for default risk that is in line with the historical average. That level of compensation would be consistent with an excess return of just over 200 bps during the next 12 months (Chart 6, panel 3), and is contingent on the speculative grade default rate falling to 2.68%, in line with Moody's baseline forecast (Chart 6, bottom panel). We expect a decline in the default rate to materialize in the coming months as commodity sector defaults continue to work their way out of the data. Moody's did not record any commodity-related defaults in May, the first month this has occurred since January 2015. The risk going forward is that defaults start to emerge in the increasingly stressed retail sector. So far, Moody's has recorded two retail defaults this year. However, more are probably on the way. This will be especially true if inflationary pressures start to mount and the Fed tightens policy, giving banks less incentive to extend credit. We will be monitoring the situation in retail closely going forward. Bottom Line: High-yield valuation is consistent with its historical average, after accounting for expected default losses. Current valuation levels should translate into excess returns of just over 200 bps during the next 12 months. Aaa Roundup As can be inferred from the previous two sections, we are still reasonably comfortable taking credit risk in U.S. bond portfolios. However, this week we also look at the compensation offered by Aaa-rated spread product. For investors who desire some Aaa-rated allocation outside of the Treasury market, Chart 7 provides a snapshot of where the most additional spread is available. The first thing that jumps out is that Agency bonds offer very little spread compared to other Aaa-rated instruments. Agency residential mortgage-backed securities also offer relatively little compensation, unless one is willing to extend into premium coupons (4% and above). Agency CMBS, auto ABS and credit card ABS all offer more spread than Aaa-rated corporate bonds. Non-agency CMBS offer much more attractive spreads than the other Aaa sectors, but we see potential for capital losses in that segment, as is discussed below. Agency MBS Only agency MBS carrying coupons of 4% or above offer interesting compensation relative to other Aaa-rated sectors, and even there we see potential for spread widening in the coming months. Nominal MBS spreads are already very tight compared to history (Chart 8) and appear even tighter relative to trends in net issuance (Chart 8, panel 2). While refinancing activity will likely stay depressed (Chart 8, panel 3), we see potential for option-adjusted spreads to follow net issuance higher, even as the compensation for prepayment risk (option cost) remains low. A similar scenario played out in 2007 (Chart 8, bottom panel). The Fed's exit from the MBS market, which could occur as early as September, represents an additional upside risk for spreads. Chart 8MBS Spreads Biased Wider Chart 9Avoid Non-Agency CMBS CMBS As noted above, non-agency CMBS look very attractive compared to other Aaa-rated spread products. But we see potential for spread widening in this sector. Commercial real estate lending standards are tightening and property prices are decelerating, both should pressure non-agency CMBS spreads wider (Chart 9). Agency CMBS offer somewhat lower spreads than their non-agency counterparts. But this sector should be more insulated from spread widening. For one thing, Agency CMBS are mostly backed by multi-family loans. Multi-family property prices have been stronger than those in the retail or office segments (Chart 9, panel 3), and multi-family properties have also experienced much lower delinquencies (Chart 9, bottom panel). Consumer ABS Chart 10Credit Cards Greater Than Autos While Chart 7 shows that Aaa-rated auto ABS offer a slight spread advantage over Aaa-rated credit card ABS, we are inclined to view credit card ABS more favorably. Rising auto loan net loss rates pose a risk for auto ABS spreads, while credit card charge-offs remain historically low (Chart 10). Auto lending standards have also moved deep into "net tightening" territory, while credit card lending standards have dipped back into "net easing" territory. The small extra compensation available in auto ABS relative to credit card ABS does not seem to be worth the extra risk. Bottom Line: Non-agency CMBS offer the most spread pick-up of any Aaa-rated sector. However, we view the risk of a further widening in non-agency CMBS spreads as substantial. We prefer to focus our Aaa-rated spread product exposure in Agency CMBS and credit card backed consumer ABS. Both sectors offer reasonably attractive spreads, and should remain insulated from capital losses going forward. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Our view is that core inflation will rebound fairly quickly. For further details please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 For further details please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The rollover in the economic surprise index is not sending a near-term recession signal and should trough in the next month or so, as decent economic data begins to surpass now lowered expectations. Investors should be prepared for a mild recession in 2019, but odds of a recession are low in the next 12-18 months. Oil prices will move higher from the mid $40s per barrel as investors start to see the inventory drawdowns we expect in the coming months. We expect that the Fed will stick to its plan to begin shrinking its balance sheet in September and hike rates again in December. Still, a stubbornly low inflation rate in the next few months would likely see the Fed postpone any further tightening until early 2018. Small cap stocks have underperformed large caps this year, but investors should not interpret this as a sign of that start of sell-off in risk assets. Feature The Citi Economic Surprise Index (CESI) is not sending a near-term recession signal and should trough in the next month as decent economic data begin to surpass lowered economic expectations. The index is nearly two standard deviations below its mean after peaking in early March in the wake of the election and has been falling for 71 days. It typically takes 90 days for the surprise index to find a footing after readings above 40. Moreover, the mean reverting nature of the index suggests a rebound at two standard deviations, absent a recession that we do not foresee (Chart 1). Chart 1Economic Surprise Index Approaching A Turning Point CESI is composed of two components, whose composition and recent behavior are crucial to interpreting the weakness in the overall surprise metric. A positive reading on the "consensus change" index, which tracks economists' forecasts, means that expectations have improved relative to their one-year average. A positive reading on the "data change" component suggests that economic releases have been stronger than their one-year average. The overall surprise index combines these two elements/factors (Chart 2). Chart 2Post Election, Economic Expectations For Soft Data Hit An Eight Year High Lofty expectations, rather than poor data, account for much of CESI's weakness in the past three months. This is most pronounced in the soft economic surprise index, where outlooks moved sharply in the wake of the U.S. election when forecasters were swept up in Trump euphoria. By early March 2017, the economic consensus index for soft data was at its highest in seven years, topping out just shy of the all-time record set in late 2009. Prognosticators also ratcheted up their forecasts for the hard data, but not by nearly as much. The inevitable result of elevated expectations, combined with economic reports that signaled that overall growth remained close to 2%, was a prolonged spell of economic disappointment. This type of divergence between heightened expectations and weakness in the overall surprise index has occurred several times in the past 13 years (2004, 2010, 2011, 2012 and 2017). Each episode took place before a bottom in the economic surprise index and our view is that this time is no different (Chart 2). Despite the dismal surprise index, forecasts for U.S. and global GDP in 2017 and 2018 have held up, which is a positive sign for profits (Chart 3). The stability of these forecasts is in sharp contrast to 2012, 2013, 2015 and 2016 when global growth estimates sunk at the same time as the economic surprise index. As we stated in our recent report,1 GDP growth in 1H 2017 in the U.S. is on track to match the Fed's modest 2.1% target for the year. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time. Chart 3U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well Falling oil prices are another worry for investors concerned that global growth is on the wane. We take a different view and expect oil prices to increase in the coming months. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue should prevail (Chart 4). Investors are cautious amid the uncertainty. We view the investment environment as overly pessimistic and anticipate that oil prices (and oil-focused upstream equities) will improve as inventory withdrawals escalate in the coming months. The latest 3.5% year-over-year reading on LEI for May points to low odds of a near-term recession (Chart 2, panel 3). However, BCA's Global Investment Strategy service has raised the possibility of a U.S. recession commencing in 2019. Financial markets would move ahead of a recession, thus investors should begin to adjust their portfolios3 for a recession scenario in the latter half of 2018, as economic and profit growth begins to weaken. Until then, we favor stocks over bonds, but we remain vigilant for any signs of imbalances that typically precipitate a recession. Our Global Investment Strategy service points out that in the post-war era the unemployment rate's three-month moving average has never risen by more than one-third of a percentage point without a recession. A good leading indicator of the unemployment rate is the weekly unemployment claims data, and they suggest continued tightening in the labor market (Chart 5). Chart 4We Expect The Oil Balance To Tighten Later This Year Chart 5Claims Not Even Close To Sending A Recession Signal A tighter labor market will lead to the familiar vicious cycle of a more aggressive Fed, a margin squeeze, slower and eventually falling profits, rising corporate defaults and layoffs. The resulting economic downturn would be mild compared with the 2007-2009 recession because the current imbalances are not as severe as those in 2007. Even so, with valuations stretched, the pain of the recession may be most felt in the financial markets, with a likelihood of a 20-30% equity bear market. Bottom Line: Despite signs to the contrary, the sweet spot that has buoyed risk assets remains in place: a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins, low inflation and a Fed prepared to only gradually hike rates. We remain overweight stocks versus bonds in the next 6-12 months. Threats to this risk-asset friendly environment include a further drop in core inflation, an over-aggressive central bank, and signs that negative economic shocks are leading to a significant markdown of global growth prospects. Is The Fed's Inflation Target Credible? The recent drop in oil prices has undermined our short-duration recommendation. But more than that, investors are questioning whether the Fed even has the ability to reach its inflation goals, following the surprising May CPI report and the softening in some of the wage data. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? The sharp flattening of the Treasury curve indicates that the bond market has already rendered its judgement. As we noted last week, the energy component pulled down the headline CPI rate again in May, but the softening of inflation this year is widespread in the index. This is contrary to Fed Chair Yellen's assertion that recent weak readings are due largely to special factors, such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The 3-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial, 2.8 percentage points. Table 1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table 1Key Drivers Of Core Inflation Deceleration In 2017 Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the weak dollar or on-line shopping, is startling. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data lag the CPI by roughly a month. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart 6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart 7). The slowdown has been fairly widespread across manufacturing and services. The good news is that the soft patch appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). Chart 6CPI, PCE Diffusion##BR##Indices Are Mixed Chart 7Wages Have Accelerated##BR##Over Past Three Months There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart 8). The related diffusion indexes also remain constructive. The ECI is adjusted to avoid compositional effects that can distort the aggregate index. We conclude from these and other wage measures that the Phillips curve is still operating. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even when the labor market overheats. Nonetheless, the relationship between the ECI and measures of labor market tightness, such as the quit rate, the "jobs plentiful" index and NFIB compensation plans, does not appear to have broken down (Chart 9). The percentage of U.S. states with unemployment below the Fed's estimate of full employment is above 70%. Anything over 60% in the past has been associated with wage pressure (Chart 10). The percentage jumped from 58% in March to 71% in April, blasting through the 60% threshold. Chart 8No Slowdown##BR##In ECI Data Chart 9Labor Market Tight Enough##BR##To Push Up Inflation The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart 11). The PPI for services and for core goods are not suggesting there is deflationary pressure in the pipeline (Chart 8). Chart 10Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Chart 11Inflation Lags Economic Growth By 18 Months What Will The Fed Do? The CPI data have rattled some on the FOMC. Federal Reserve Bank of Dallas President Kaplan, for example, believes that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. FOMC Vice Chairman Dudley echoed this view in comments he made last week to the press. The Fed has been quick to ease or back away from planned rate hikes at the first hint of trouble since the Lehman shock. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further since the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the economy. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve inflation pressure and achieve a soft landing; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will rise if the low-rate environment extends much further. The bottom line is that we expect the Fed will stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? Our fixed-income strategists see three possible scenarios for the bond market:4 Base Case: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of likelihoods, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a tail risk. The bottom line is that short-duration positions have been a "pain trade" in recent weeks, but it appears to us that the rally is overdone. We remain short-duration. No Signal From Small Caps Chart 12Small Caps Are No Longer Expensive The underperformance of small cap stocks since December is not sending a signal about the broader equity market. In fact, small cap relative performance has a mixed track record calling the peak in large cap equities. We maintain our view from a 2014 report:5 There is no basis for concluding that small cap underperformance heralds a fragile economy, stock market weakness or heightened risk aversion. Investors should note the sector/compositional, domestic/international, cyclical/defensive, and valuation discrepancies between small and large cap stocks before drawing any conclusions about the signals from small caps. The S&P 500 small cap index has more exposure to financials, industrials and materials than its large cap cousins, and has lower weights in energy, staples and healthcare. This mix makes small caps more cyclically oriented. Moreover, small caps have less exposure to overseas economies and, therefore, less sensitivity to fluctuations in the U.S. dollar. Plus, our small cap valuation indicator has moved even further into undervalued territory since our discussion of small cap equities in this publication on April 246 (Chart 12). Chart 13Small Caps Are Not Great##BR##Market Prognosticators Small-cap stocks outperformed large cap by 12% from November 8 through December 8, 2016, but have lagged since, as investors unwound the Trump trade. The implication is that the recent sell-off in small caps is not a signal that the broader market is poised for a downturn. Instead, it reflects the market's view that Trump's pro-small business agenda has stalled. Moreover, history shows that the relative performance of small caps versus large caps is not a good predictor of the future performance of risk assets versus bonds. The small-to-large ratio sent plenty of mixed signals in the '80s and '90s when the economy was in a long expansion, fostered by low inflation and a gradualist Fed (Chart 13, panels 1 and 2). On the other hand, local peaks and troughs in small cap performance provided solid signals for turns in stock versus bond performance from the early '70s through the mid-80s, a period characterized by soaring inflation that is not present today (Chart 13, panel 1). Small-cap outperformance starting in late 2008 did presage an upturn in the stock-to-bond total return ratio in 2009, and captured a few of the risk on/risk off periods from 2010 through 2012, while the Fed engineered QE2, Operation Twist and QE3. More recently, the relative performance of small versus large has been range-bound and has not provided a consistent signal for turns in the overall market (Chart 13, panel 3). Bottom Line: The underperformance of small caps to large is a reaction to the market's perception that Trump's pro-small business agenda will disappoint, not a sign that U.S. growth is waning. While several planned policies of the Trump administration have been delayed, a legislative agenda that appears to be pro-business is in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation noted above. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Can The Service Sector Save The Day?", June 5, 2017, available at usis.bcaresearch.com. 2 Please see Energy Sector Strategy Weekly Report, "Views From The Road", June 21, 2017, available at nrg.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report "The Timing Of The Next Recession", June 16, 2017, available at gis.bcaresearch.com. 4 Please see U.S. Bond Strategy Weekly Report "Three Scenarios For Treasury Yields In 2017", June 20, 2017, available at usbs.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report "On The Road Again", June 2, 2014, available at usis.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report "Spring Snapback", April 24, 2017, available at usis.bcaresearch.com.
Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Chart 2Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Chart 5Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Chart 7Financials Have##br## The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS Chart 12Margin Expansion##br##Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.