Developed Countries
Negative relative sales growth at retail drug stores has caused the S&P retail drug store index to underperform (top and second panels). However, the second derivative of the decline has turned positive, troughing early this year, but the sector's share of the consumer's wallet has barely changed since the share price slide began in 2015. Analysts' top line estimates have largely captured the modest improvements in the sales outlook; these pulled out of deflation last month for the first time since late-2016 (bottom panel). However, valuations have not followed suit, which appears to be the market assigning a too-high risk premium to the operating recovery. If, as we expect, sales at drug retailers have turned a corner, margins and multiples should expand, particularly since the industry has consolidated substantially since 2015. This should allow investors to recoup some of their losses. Stay overweight The ticker symbols for the stocks in this index are: BLBG: S5DRUG - CVS, WBA.
The GAA DM Equity Country Allocation model is updated as of July 31st, 2017. The model has continued to reduce its allocation to the U.S. and now the U.S. allocation is the largest underweight. The funds from the U.S. are largely used to reduce the large underweight in the U.K. such that now the U.K. is in slight overweight. Other changes in the non-U.S. universe are the downgrade of Spain in favor of Germany, Italy and Netherland. These adjustments are mainly due to changes in liquidity indicators, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 88 bps in July, entirely due to the 213 bps outperformance of Level 2 model where the overweight in Italy, Spain , Australia and Netherland vs the underweight in Japan, Germany, Sweden and Switzerland worked very well. Since going live, the overall model has outperformed its benchmark by 257 bps. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of July 31, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continue to be bullish on global growth and hence the cyclical tilt. However, consumer discretionary is the only cyclical sector to have an underweight. This recommendation is mainly driven by the unfavorable liquidity and technical backdrop. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com.
Feature Recommended Allocation When Central Banks Turn Hawkish It seems almost as though, when central bank governors gathered in Portugal for the ECB's annual confab in late June, they agreed to start sounding more hawkish. ECB President Mario Draghi's speech included the line: "The threat of deflation is gone and reflationary forces are at play." Bank of Canada Governor Stephen Poloz went ahead and on July 12 announced Canada's first rate hike in seven years. Indeed, BCA's Central Bank Monitors (Chart 1) suggest that, with the exceptions of Japan and possibly the euro area, all major developed central banks need to tighten monetary policy. Does this matter for risk assets, such as equities? Historical evidence suggests not, as long as the central bank is tightening because it is confident about the outlook for growth and unconcerned about financial risks (rather than, for example, reacting to a sharp rise in inflation). Equity markets typically move up in the early stages of a tightening cycle (Chart 2); it is only when the central bank tightens excessively (usually later in the cycle) that risk assets start to anticipate that this will trigger a recession. Even in the U.S. which, after four rate hikes since December 2015, is the furthest advanced in tightening, the real effective Fed Funds Rate is still -0.3%, below the 0.3% that the Fed believes to be the neutral real rate at the moment (Chart 3). The Fed expects the neutral rate to rise to 1% in the longer run. Chart 1Most Central Banks Need To Tighten Chart 2Equities Usually Rise During Rate Hike Cycle Chart 3Fed Policy Is Still Accommodative But the order in which central banks tighten will be a major driver of currencies (as has been clear with the sharp appreciation of the CAD and AUD in recent weeks). Our current asset recommendations are based on the belief that the market has become too complacent about the speed at which the Fed will tighten (with futures pricing only 26 bp of hikes over the next 12 months), and too nervous about the ECB (Chart 4). As the market starts to understand that the Fed has fallen a little behind the curve, and that the ECB will remain cautious (given continuing weakness in peripheral economies, and a lack of underlying inflationary pressures), we expect to see the dollar begin to appreciate again. A key to all this is whether the recent softness in U.S. inflation data (core PCE inflation has fallen from 1.8% YoY to 1.4% since January) proves to be temporary. A rebound in inflation would allow the Fed to continue to hike without bringing the real rate close to the neutral level yet. It is worth remembering that inflation is a lagging indicator: the recent weakness is largely a reflection of last year's soggy GDP growth (Chart 5), as well as some transitory technical factors (particularly drug and wireless data prices). The recent dollar depreciation should also boost inflation via the import price channel over the coming months (Chart 6). Chart 4Markets Views On Fed And ECB Have Diverged Chart 5Inflation Lags GDP Growth Chart 6Dollar Deprecation Will Raise Prices However, with global equities having produced a total return of 35% since their recent bottom in February last year, and 17% year to date, valuations are unattractive and, on some measures, sentiment is quite optimistic (Chart 7). What catalysts are there left to give risk assets further upside? We see two. First, earnings. The Q2 U.S. results season has seen 77% of S&P 500 companies surprising on the upside at the sales line, with EPS rising 7% compared to the same quarter in 2016. Most of our indicators suggest that earnings have further to rise this year (Chart 8), yet the consensus EPS forecast for 2017 as a whole remains at just over 10%, where it has been since January. Strong earnings momentum is likely to remain a positive at least through the end of the year. Second, tax cuts. Our Geopolitical Strategy service1 remains optimistic that the U.S. Congress will pass tax legislation to come into effect in early 2018. The failure to repeal Obamacare means that the Republican Party will need a big legislative win going into the mid-term elections in November 2017. Tax cuts (which the market is no longer pricing in - Chart 9) is one policy on which there is little disagreement within the GOP. Chart 7Are Investors Getting Too Optimistic? Chart 8Earnings Can Still Surprise On Upside Chart 9No One Expects Tax Cuts Any More None of the recession indicators we highlighted in our most recent Quarterly 2 (global PMIs, the shape of the yield curve, or credit spreads) are pointing to a downturn in the next 12 months. So, given the environment described above, we are happy to remain overweight equities versus bonds, and to maintain our pro-risk and pro-cyclical tilts. But we continue to warn of the risk of a recession in 2019 - probably triggered by the Fed needing to tighten more aggressively - and might look to lower our risk profile in the first half of next year. Equities: We favor DM equities over EM. An appreciating dollar, rising interest rates, weak industrial metals prices this year and uncertain growth prospects for China all represent headwinds for EM equities. Our strong dollar view points to an overweight in U.S. equities in USD terms but, in local currencies, our preference is for euro area and Japanese equities. Both are relatively high-beta, have strongly cyclical earnings momentum, and central banks that are likely to stay dovish. In Japan, the falling popularity rating of the Abe administration might compel it to ramp up fiscal spending to boost the economy, which would help the Bank of Japan in its efforts to rekindle inflation. Chart 10Everyone Has Turned Bullish On The Euro Fixed Income: Our macro outlook, with faster rate hikes and rebounding inflation in the U.S., is very negative for rates. We are underweight government bonds, short duration and prefer inflation-linked bonds to nominal ones. Valuations in credit are no longer particularly attractive but, with a 100 bp spread for U.S. investment grade bonds and a 230 bp default-adjusted spread for high-yield, returns are likely to be satisfactory as long as the economic cycle continues to improve. Currencies: Our fundamental view of the dollar is that relative monetary policy and interest rates point to further appreciation, especially against the yen and euro. The timing of the dollar's rebound, though, is harder to pinpoint. The euro could rise further over the next couple of months. However, given speculators' large net long positions in the euro - a big turnaround from the start of the year (Chart 10) - the likely announcement by the ECB in September or October of a reduction in its asset purchases might be the catalyst for a reversal (as a classic "buy the news, sell the rumor" event), particularly if Mario Draghi dresses it up as a "dovish tapering." Commodities: Oil inventories have begun to draw down in line with our expectations (Chart 11). Continued discipline by OPEC producers until next March, combined with a slowdown in the growth of U.S. shale production (reflecting the weaker crude price this year) should bring inventories down further (despite production increases in such countries as Libya and Iran), and push the price of WTI above $55 a barrel by year end. Industrial commodity prices have rebounded somewhat in the past six weeks, mainly on the back of moderately brighter economic data out of China (Chart 12). But, given uncertain prospects about the sustainability of this growth, especially beyond the Communist Party Congress in the fall, and amid some signs of weakness in Chinese monetary and credit aggregates,3 we remain cautious about the outlook for metals prices over the next 12 months. Chart 11Oil Inventories Will Draw Down Further in Chart 12Tick-Up In Chinese Data? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bca.research.com. 2 Please see BCA Global Asset Allocation, "Quarterly Portfolio Review," dated July 3, 2107, available at gaa.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com. Recommended Asset Allocation
Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. Telecom services stocks are down 9%, while the S&P is up 10% YTD. In fact, in Q1 telecom services stocks were the sole sector to register negative year-over-year EPS growth on trough Q1/2016 earnings comparisons. Nevertheless, we do not want to overstay our welcome and are booking profits of 12% and lifting the S&P telecom services sector to the neutral column. Our Cyclical Macro Indicator (CMI) has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (top panel). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (second panel). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (third panel). Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading (bottom panel) Bottom Line: Lock in gains of 12% in the S&P telecom services sector and lift exposure to neutral. For additional details, please see yesterday's Weekly Report. The ticker symbols for the stocks in this index are: T, VZ, LVLT, CTL.
Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals and both have roughly doubled over the past decade. However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (third panel). If our cautious drug pricing power thesis pans out as we portrayed in this week's Weekly Report, then pharma earnings will suffer and exert downward pressure on relative share prices (top panel). Industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (bottom panel). While this metric does not suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Bottom Line: Trim the S&P pharmaceuticals index to underweight, which takes the S&P health care index to underweight. For additional details, please see yesterday's Weekly Report. The ticker symbols for the stocks in the S&P pharmaceuticals index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO.
Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? Chart 6The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? Chart 6The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Portfolio Strategy Factors are falling into place for an earnings-led underperformance phase in health care stocks. Trim to a below benchmark allocation and execute this downgrade via reducing the heavyweight S&P pharmaceuticals index to a below benchmark allocation. The bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Lift to neutral. Recent Changes S&P Health Care - Downgrade to underweight. S&P Pharmaceuticals - Trim to underweight. S&P Telecom Services - Lift to neutral, lock in gains of 12%. Table 1 Feature Equities stayed well bid last week, trading near all-time highs. Broad-based earnings exuberance buttressed stock prices, trumping political uncertainty. The Fed stood pat and signaled a likely September commencement to a balance sheet wind down. Our fixed income strategists do not expect another hike until the December meeting; a less hawkish Fed augments the goldilocks equities backdrop. Three weeks ago1 we posited that earnings will take center stage and serve as a catalyst to sustain the blow off phase in the S&P 500. A mini profit margin expansion phase is taking root as the most cyclical parts of the SPX are flexing their operating leverage muscle. As long as revenues continue to grow, profit margins and profits will expand, especially given muted wage pressures. The lagged effect from a softening U.S. dollar will also likely underpin EPS in the back half of the year. We are surprised that mentions of the greenback are virtually absent from Q2 conference calls; the domestic market appears front of mind for investors and management teams alike. Globally, the dominant market theme is synchronized global growth paving the way to a coordinated G10 Central Bank tightening cycle. In other words, there is a handoff from liquidity to growth. Charts 1 & 2 highlight this fertile equity backdrop: First BCA's Synchronicity Indicator is as good as it gets. In fact in the G20, only Indonesia and South Africa have a manufacturing PMI below the boom/bust line. Second, our global EPS diffusion index is also at an extreme (diffusion index shown inverted, middle panel, Chart 1). In our sample of 44 EM and DM countries, none have declining year-over-year EPS. Third, global export expectations are recovering smartly, suggesting that global trade is on a solid footing and on track to vault to fresh cyclical highs (bottom panel Chart 2). Chart 1Synchronized Global Growth... Chart 2...Is Bullish For Equities While the IMF recently downplayed the U.S.'s importance as a force in global GDP growth contribution, the resurgent ISM new orders-to-inventories ratio signals that U.S. output will recover in the back half of 2017 (second panel, Chart 2). Importantly, not only are cyclical U.S. businesses vibrant but also the most cyclical corner of U.S. PCE is roaring. As consumers are feeling more flush, they tend to spend more on recreational goods and vice versa. According to the BEA, recreational goods & vehicles outlays are expanding at the fastest clip since 2005, near 10% and 15% per annum in nominal and real terms, respectively. Since 1960, this nominal series has been an excellent predictor of the business cycle. Such discretionary outlays have also been moving in tandem with overall nominal PCE growth, easily surpassing it during expansions, and significantly trailing it in times of distress (Chart 3). Currently, recreational goods spending underscores that overall PCE will likely rebound in the coming quarters. Chart 3The U.S. Consumer Is Alright Resurgent global (including U.S.) growth is unambiguously bullish for U.S. equities. This week we are taking down our overall defensive sector exposure another notch by making an intra-defensive sector switch. Health Care: In The ER The health care reform circus is ongoing in Washington, and such uncertainty will likely cast a shadow on health care stocks and reverse recent euphoria. Year-to-date health care stocks have bested the broad market by over 7%, and have retraced roughly 1/3 of the relative losses from the mid-2016 peak to the end-2016 trough. Technicals are extended, with the six month momentum stalling near the upper band of the past eight year range, and breadth is as good as it gets: 70% of health care sub-groups trade above their 40-week moving average (Chart 4). We are using this opportunity to lighten up exposure on this defensive sector and downgrade to a below benchmark allocation. Drug inflation is the biggest risk for the sector. Relative pricing power contracted for the first time in seven years (top panel, Chart 5), warning that the health care top line contraction phase is far from over. This stands in marked contrast to the broad corporate sector that is growing revenues at a healthy clip. Chart 4Sell Into Strength Chart 5Selling Price Pressures Blues While investors appear content to look through this recent weakness as transitory, our sense is that robust pricing power gains of the past are history. Chart 6 shows that since 1982 drug prices have risen fivefold. In fact, since 2011 they have gone parabolic outpacing overall wholesale price inflation by 50%. Importantly, health care sector profits have skyrocketed alongside drug inflation (bottom panel, Chart 6). Such a breakneck pace is unsustainable, especially given recent intense drug price hike scrutiny. Granted, health care spending in the U.S. comprises over 17% of overall consumer outlays, the highest in the world, but it has also likely plateaued (not shown). Real health care spending is decelerating in absolute terms, and contracting compared with overall PCE. This suggests that selling price blues are demand driven and will likely continue to weigh on health care profits (second & third panels, Chart 7). Chart 6Unsustainable Pace Chart 7Even Demand Is Easing Worrisomely, there is no positive offset from international markets. The U.S. dollar has depreciated since the mid-December peak, but health care export growth is hovering around the zero line (bottom panel, Chart 7). News is also grim on the domestic operating front. Not only are selling prices softening, but also our health care sector wage bill is on fire, pushing multi-year highs. Taken together, operating margins will continue to compress, sustaining the recent down drift (Chart 8). Our newly introduced S&P health care sector profit model does an excellent job in capturing all of these forces. Currently, our relative EPS model suggests that the relative profit contraction phase will last into 2018 (Chart 9). Chart 8Margin Trouble Chart 9Heed The Model's Message Factors are falling into place for an earnings led underperformance phase in health care stocks. Downgrade to a below benchmark allocation. We are executing the health care sector downgrade via the heavyweight S&P pharmaceuticals index. Trim Pharma To Underweight Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals since the mid-1970s, and both have roughly doubled over the past decade (top panel, Chart 10). However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (bottom panel, Chart 10). Is it also notable that relative spending on pharma soars in times of recession, highlighting the non-discretionary aspect of health care spending. If our cautious drug pricing power thesis pans out as we portrayed above, then pharma earnings will suffer and exert downward pressure on relative share prices (Chart 11). Similarly, BCA's view remains that recession is a 2019 story, thus a knee jerk spike in relative pharma spending and relative EPS is unlikely on a cyclical horizon. Chart 10Cresting Chart 11Soft Prices Are Bearish We doubt capital will chase this long duration group with a stable cash flow profile, especially in a synchronized global growth world. The missing ingredient is consumer price inflation, but the depreciating U.S. dollar suggests that the recent disinflationary backdrop will prove transitory. The NFIB survey of small business planned price hikes is still flirting with cyclical highs (shown inverted, middle panel, Chart 12). That helps explain the positive correlation between the greenback and relative pharma profit estimates. Synchronized global growth is giving way to a coordinated tightening Central Bank (CB) backdrop with G10 CBs taking cover now that the Fed has paved the way. As a result, the U.S. dollar may continue to grind lower, to the benefit of cyclical sectors but detriment of defensives such as pharmaceutical stocks (bottom panel, Chart 12). Worrisomely, the export relief valve has not provided any significant offsets, despite the currency's year-to-date losses (top panel, Chart 12). Taking a closer look at domestic operating conditions is revealing. Not only are relative outlays steadily sinking but pharmaceutical production is contracting. True, whittled down inventories partially explain the letdown in industry output, but contrast the climbing pharma labor footprint. The implication is that declining productivity will continue to weigh on relative valuations (Chart 13). Finally, industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (middle panel, Chart 14). Similarly, the pharma interest coverage ratio continues to slide, moving in the opposite direction of the NFC sector (bottom panel, Chart 14). While neither of these metrics suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Chart 12No Export Relief Chart 13Waning Productivity Chart 14Modest B/S Deterioration Bottom Line: Downgrade the S&P health care index to underweight. Trim the S&P pharmaceuticals index to underweight. The ticker symbols for the stocks in the S&P pharmaceuticals index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Book Profits And Upgrade Telecom Services To Neutral Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. Telecom services stocks are down 9%, while the S&P is up 10% YTD. In fact, in Q1 telecom services stocks were the sole sector to register negative year-over-year EPS growth on trough Q1/2016 earnings comparisons. In Q2, it remains at the bottom of the GICS1 sector EPS growth table, trailing the SPX by 500bps. We have been fortunate enough to be underweight this niche sector since late January, adding alpha to our portfolio. Nevertheless, we do not want to overstay our welcome and are booking profits of 12% and lifting the S&P telecom services sector to the neutral column. Relative valuations just breached the one standard deviation below the mean mark according to our Valuation Indicator (VI), signaling that indiscriminate selling is overdone and nearly exhausted. Historically, such a depressed VI reading has led to a playable reversal. Importantly, the relative forward P/E multiple has fallen below the lows hit in the aftermath of the TMT bubble and is clocking all-time lows. Tack on washed out technicals probing a collapse close to two standard deviations below the long-term average and a reflex rebound is likely in the short-term (Chart 15). Extreme bearishness reigns in the sell-side community. Five year forward profit estimates plumbed all-time lows at a 10% decline rate versus the broad market (Chart 16). Surely the bearish story is baked into such glum readings. Chart 15Washed Out Chart 16Too Much Pessimism Meanwhile, our Cyclical Macro Indicator has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (second panel, Chart 15). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (Chart 17). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (Chart 18). Anecdotally, Verizon's first full quarter post the new pricing plans was solid and suggests that the peak deflationary impulse is likely behind the industry. Chart 17Freefalling Chart 18There Is A Ray Of Light Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading. This will also stabilize relative profitability (top and bottom panels, Chart 18). While this sector trades as a fixed income proxy and the recent sell off in the bond market has weighed on relative performance, yield hungry and value investors will start bottom fishing in these stable cash flow, high dividend yielding stocks. However, we refrain from becoming overly bullish. Pricing power is still contracting and the cable industry's veering into wireless phone plan offerings has yet to play out. A more constructive sector view would require the following two developments: a trough in our sales model on the back of firming pricing power and a leveling off in relative consumer outlays signaling that demand for telecom services is on the mend. In sum, the bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Green shoots on the industry's pricing power front and impressive management focus on cost structures argue against being bearish this niche sector. Bottom Line: Lock in gains of 12% in the S&P telecom services sector and lift exposure to neutral. The ticker symbols for the stocks in this index are: T, VZ, LVLT, CTL. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.