Economy

Highlights Chinese policymakers will deliver more growth-supporting measures in the coming months, but Chinese government bond yields have already priced in a much weaker economic slowdown and a more aggressive policy response. While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. The PBoC’s recent liquidity injections are mostly a preventive measure to avoid an acute cash crunch in the real economy, and the historical path following the 2003 SARS outbreak suggests the additional monetary easing action is unlikely to be sustained over the coming 6-12 months. As such, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. On a cyclical basis, we continue to overweight Chinese equities over government bonds. Feature Chinese bond yields have declined sharply over the past two weeks, as investors weighed both the economic consequences of the Covid-19 outbreak and the likelihood of more accommodative monetary policy. Following the extended Chinese New Year holiday, China’s central bank (PBoC) has carried out five cash injections, pumping nearly 3 trillion yuan into the interbank market (Chart 1). It also lowered the de jure policy rate - the 7-day reverse repo rate - by 10bps to cut the cost of funding for commercial banks. The 3-month SHIBOR (which trades very closely to the 3-month repo rate), which we have long viewed as China’s de facto short-term policy rate, quickly reversed its January rise and fell back to its July-2018 low (Chart 2). Chart 1Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Chart 2Monetary Conditions Turned Much Easier In Just Three Weeks The PBoC’s aggressive easing measures of late have sparked market speculation that China is entering another major monetary and credit easing cycle, and that a government bond rally is well underway with even lower yields to come. Chart 3Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields In our January 29 Special Report1 on China’s government bond market, we discussed how there has been a strong relationship in the past decade between unexpected changes in the 3-month SHIBOR and the long-end of China’s government bond yields. In order for the current rally in government securities to be sustained, investors need to believe that the PBoC’s easing measures are here to stay and that there will be additional policy rate cuts in the months to come (Chart 3). There are indications that Chinese policymakers are looking to deliver more growth-supporting measures over the coming months. However, it is likely that the current bond rally will be a near-term event rather than a cyclical (6-12 months) trend. Therefore, on a cyclical time horizon, we continue to recommend overweighting Chinese stocks versus Chinese government bonds and would advise against an aggressively long duration stance. Has The Covid-19 Epidemic Peaked? The fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained.  Chart 4Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Investors appear to concur with our view that the Covid-19 outbreak has largely become a Hubei-specific crisis.2 Chinese stocks in the onshore and offshore markets have recovered more than half of the losses from their bottom on February 3, when the number of new cases outside of the Hubei epicenter reached a tentative peak. The 12-month change in the yields of Chinese 3 and 10-year government bonds also inched up since then (Chart 4). While the Chinese government’s rollout of supportive measures, including liquidity injections and policy rate cuts since early February might have helped improve market sentiment, the fact the epidemic outside Hubei province seems to be contained also helps explain the bottom in equity prices and bond yields. In addition, the number of new suspected cases outside Hubei province has trended down since February 9 (Chart 5). The diagnosis methodology was recently revised to include suspects with clinical symptoms, regardless of whether they had a history of contact with infected cases from Wuhan. This new methodology has lowered the bar for registering newly suspected cases. While the situation surrounding the Covid-19 outbreak is still fluid, the fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained. Bottom Line: Outside of the epicenter, the Covid-19 outbreak may have peaked. This means the fear element driving down Chinese government bond yields may soon end. Chart 5The Situation Continues To Get Better Outside Of The Epicenter Current Bond Rally Unlikely A Cyclical Play Bond yields now appear to have largely priced in a delayed economic recovery and more aggressive policy response. We think the current rally in Chinese government bonds will thus only be a short-term event rather than a cyclical (6-12 month) play. The rally in China’s government bond market since mid-2018 was largely driven by market expectations of a significant slowdown in the Chinese economy, and a much easier monetary policy in responding to a slowing Chinese domestic demand and a protracted Sino-US trade war. Bond market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. Cyclically, we think both of these factors are absent from the current situation, and a normalization back to the pre-outbreak monetary stance may come earlier than the market expects. In the last two weeks, Chinese government bond markets have discounted a sharp slowdown in economic activity; 10-year Chinese government bond yields are back below 3.0% for the first time since 2016 and the 3-month SHIBOR is now 25bps lower than the bottom in 2015-2016 (Chart 6). This suggests the market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. The nature of the current situation, as we pointed out in our previous reports,3 represents a temporary delay rather than a derailing of an economic recovery in China.  The Covid-19 outbreak and the unprecedented containment measures paused the Chinese economy in the first quarter, just as it was coming off of a two-year soft patch. But domestic demand was not nearly as weak as in 2015-2016 before the outbreak (Chart 7). Chart 6Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Chart 7A Chinese Economic Recovery Was Budding Pre-Outbreak Chart 8The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing If the virus is contained outside of the epicenter in the next couple of weeks and the hit to China’s overall economy is limited to Q1, then the PBoC will likely normalize policy back to its pre-outbreak stance. While the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, it was proactive in normalizing its monetary policy following short-term shocks. Chart 8 shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015.  In all three economic slowdowns, there has not been a significant rise in interbank rates in the first nine months of an economic recovery. Following the SARS outbreak, however, the PBoC reversed its easy stance and significantly tightened liquidity conditions in the banking system only four months after the peak of the SARS outbreak. While we do not expect the PBoC to shift into a tightening mode this year, a shift back to the pre-outbreak policy trajectory sometime in Q2 is highly likely, provided the Covid-19 outbreak is contained outside of Hubei province.  In turn, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. PBoC is also unlikely to open a liquidity floodgate. Despite large liquidity injections in the past two weeks, we are not convinced that the PBoC intends to fully open the liquidity tap in the interbank market.  So far, most of the financial support measures have been a combination of targeted low-cost funding to non-financial corporations and fiscal subsidies to local governments and businesses. This differs from 2015-2016 when the PBoC aggressively cut interbank rates and the 1-year benchmark lending rate, and kept excessive liquidity in the interbank system for a prolonged period (Chart 9). As Chart 9 (bottom panel) shows, PBoC’s net fund injections have been extremely volatile since Covid-19 erupted in January. This suggests that while the PBoC has added large doses of liquidity into the interbank market, demand for financial support in the banking system has mostly matched or even outstripped supply. In other words, the PBoC is not flooding the interbank system with cash, rather it is preventing an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  The PBoC is trying to prevent an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  Chart 9Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Chart 10Private Sector Highly Leveraged... This approach is warranted. Small businesses have been disproportionally hit by the outbreak and are reporting a severe shortage of cash. China’s private sector is particularly vulnerable to cash flow restrictions because many businesses are highly leveraged (Chart 10).  A joint survey of 995 small and mid-size companies by Tsinghua and Peking universities showed that more than 60% of respondents said they can survive for only one to two months with their current savings (Chart 11).   Chart 11…Making Small Businesses Especially Vulnerable To Cash-Flow Constraints Additionally, there is a risk that the PBoC is underestimating the demand for cash in the banking system, particularly from small- and medium-sized banks. This underestimation could lead to a rise in the interbank lending rate. This occurred in 2017 when the crackdown of shadow bank lending caused a funding squeeze for China’s small and mid-sized banks, which led to a material rise in interbank lending rates and government bond yields (shown in Chart 6). It is also the reason that we primarily track the 3-month SHIBOR over the 7-day rate, as the former tends to capture the effects of these funding squeezes whereas the latter does not. The demand for cash in the interbank market in the current quarter will be higher than in the same period last year. The government has announced an additional debt quota of 848 billion yuan, on top of the previously authorized quota of 1 trillion yuan worth of local government bonds that would be frontloaded in Q1. This is a 32% increase from a total of 1400 billion yuan of bonds that local government frontloaded in Q1 2019. This implies the demand for cash in the interbank market will remain high as commercial banks account for about 80% of local government bond purchases.4 A temporary spike in corporate bond defaults leading to a jump in the interbank rate could also push up government bond yields. Additionally, the delayed resumption of work, the loss of production and the cash crunch facing small companies raise the risk of a surge in overdue bank loans and defaults. This could also escalate the demand for cash from smaller banks, because large commercial banks may be unwilling to lend to riskier borrowers in the interbank market. The 3-month SHIBOR has inched up since the takeover of Baoshang Bank in May 2019. Chart 12Average Lending Rates Lag Short-Term Bond Yields We expect the PBoC to lower the loan prime rate (LPR), following the 10bps cut in the medium lending facility rate (MLF) on February 17. As we pointed out in our January 29 Special Report, this easing by the PBoC will reduce corporate lending rates, but not necessarily interbank rates. Chart 12 shows that the change in average lending rates lags the change in Chinese government bond yields. Therefore, the upcoming cuts in the LPR are a result of lowered interbank rates and bond yields, not a cause for changes in government bond yields going forward. Bottom Line: Monetary policy will remain relatively loose this year, but we think the PBoC’s recent aggressive easing will be a temporary event. Any additional easing by the PBoC this year will likely be through providing short-term cash relief and temporarily lowered funding costs to non-financial corporations. There are also near-term risks that interbank rates may be pushed up due to a liquidity crunch.  Hence, yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Investment Conclusions While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. Barring a lasting economic slowdown from the Covid-19 outbreak, the long-end of the curve has the potential to move moderately higher in the second half of the year, as China’s economy recovers from the outbreak-induced shock. Bond yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Given this, we continue to expect Chinese domestic and investable equities to outperform government bonds in the next 6-12 months, and we would advise Chinese fixed-income investors against an aggressively long duration stance. Onshore corporate bonds, while risking a higher default rate in the near term, shares a similar outlook on a cyclical basis: onshore spreads are pricing in (massively) higher default losses than we believe are warranted. This means that onshore corporate bonds will still outperform duration-matched government bonds without any changes in yield, underpinning another year of Chinese corporate bond market outperformance versus government bonds.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Special Report "How To Analyze And Position Towards Chinese Government Bonds," dated January 29, 2020, available at cis.bcaresearch.com 2   Please see China Investment Strategy Weekly Report "The Evolving Crisis," dated February 13, 2020, available at cis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Recovery, Temporarily Interrupted," dated February 5, 2020, available at cis.bcaresearch.com 4   ChinaBond, as of 2019 Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Spread Product: Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for high-yield. Accommodative monetary conditions will ensure that the supply of credit remains ample for some time yet. This will keep defaults low and spreads tight. Monetary Policy: The Fed is in no rush to tighten policy, but has also set a high bar for further cuts. Investors should short August 2020 fed funds futures.  Yields Will Move Higher … But Not Yet Chart 1A Peak In New Cases? Uncertainty about the economic impact of the coronavirus – now officially called COVID-19 – is the cloud that continues to hang over financial markets. Last week, bond yields fell when a change in the definition of what constitutes a confirmed infection caused the number of reported cases to spike. However, even after revisions, the daily number of new cases looks like it may have peaked (Chart 1). The end result is that the 10-year Treasury yield sits at 1.58%, not far from where it was last week (Chart 2). Notably, the 10-year yield continues to shrug off the notable improvement in US economic data (Chart 2, bottom panel), taking its cues instead from COVID-19 headline risk. Even if the downtrend in new COVID-19 cases continues, it is too soon to be looking for higher bond yields. For one thing, the most up-to-date economic data releases were collected during January, before the outbreak. Weaker readings during the next 1-2 months are assured, and investors may not look through the weakness given that many were already skeptical about the prospects for global economic recovery. Our read of the data is that global growth was in the process of bottoming when COVID-19 struck. We therefore expect global growth to move higher once the virus’ impact abates. In terms of timing, using the 2003 SARS outbreak as a comparable, we expect bonds to remain bid until the daily number of new cases falls to zero, at which point a sell-off is likely. Yields continue to shrug off improvements in economic data. It’s not just the long-end of the curve that has responded to COVID-19. The front-end has also moved to price-in high odds of a rate cut in the coming months. Specifically, the overnight index swap curve is priced for a 42 bps decline in the fed funds rate during the next 12 months (Chart 2, panel 2), and the fed funds futures market is pricing a 74% chance of a rate cut by the end of the summer. As we discussed last week, given that any economic impact from COVID-19 will be temporary, we think the bar for a Fed rate cut this year is quite high.1 As such, our Golden Rule of Bond Investing dictates that investors should keep portfolio duration low on a 12-month horizon.2 We also recommend shorting August 2020 fed funds futures, a trade that will earn 23 bps of unlevered return if the Fed stands pat between now and August (Chart 2, panel 3). Turning to corporate credit, we see that, so far, COVID-19’s impact on spreads has been minor. The investment grade corporate bond index spread is only 3 bps wider than at the start of the year, and the junk index spread is only 8 bps wider (Chart 3). Value remains stretched in the investment grade space, but high-yield spreads look quite attractive. The sell-off in the energy sector has boosted the high-yield index spread considerably (Chart 3, bottom 2 panels). We view this as a medium-term buying opportunity for junk. Once the COVID outbreak abates and global growth ticks higher, the oil price is bound to increase, leading to some tightening in energy spreads. Chart 2Bond Yields Driven By COVID Chart 3HY More Attractive Than IG Will Bonds Feel The Bern? Beyond COVID-19, there is one more risk on the horizon this year. Specifically, the risk that Bernie Sanders is elected President in November. This outcome is far from certain. Sanders is currently leading all other candidates in the Democratic Primary, but fivethirtyeight.com’s model puts the odds of a brokered convention at 38%.3 This means that the race is still wide open and might only be settled at the convention in July. But given Sanders’ lead, it is worth considering the bond market implications if he were to become the next President. The most obvious implication is that risk assets (equities and corporate spreads) would respond to Sanders’ agenda of wealth redistribution by selling off. This could spur a flight-to-quality into government bonds, causing Treasury yields to fall. However, that flight-to-quality won’t occur if markets also start to price-in the long-run implications of Sanders’ agenda. I.e. the fact that the redistribution of wealth from capital to labor would lower the economy’s marginal propensity to save, and likely raise inflation expectations, leading to higher interest rates. It’s important to note that there are a lot of hurdles to overcome before Sanders’ full policy agenda is implemented. First he must secure the Democratic nomination, then defeat Donald Trump in the general election. Even after that, he will still need to convince the House and Senate to pass non-watered down versions of his proposals. With such a long road ahead, we don’t think Sanders’ momentum will push bond yields higher in 2020. Rather, the risk is that Sanders’ rise keeps bond yields low in 2020 as risk assets sell off. If Bernie Sanders looks poised to win the nomination, we will consider reducing our 6-12 month allocation to spread product and increasing our recommended portfolio duration. The outlook for the Democratic Primary should become clearer after Super Tuesday on March 3. If Sanders looks poised to win the nomination we will consider reducing our recommended 6-12 month allocation to spread product and increasing our recommended portfolio duration. Bottom Line: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for junk. Though the credit cycle is far from over (see next section), we may reduce our recommended allocation to spread product versus Treasuries if Sanders’ election chances rise.  Bank Lending Standards Won’t Push Credit Spreads Wider In 2020 The net change in commercial & industrial (C&I) bank lending standards, as reported in the Fed’s quarterly Senior Loan Officer Survey, is a vitally important indicator for the credit cycle. Easing lending standards tend to coincide with a low default rate and falling credit spreads, while tightening lending standards usually coincide with spread widening and a rising default rate. With that in mind, it is mildly concerning that bank lending standards have been fluctuating around neutral levels for quite some time, and have in fact tightened in two of the past five quarters (Chart 4). In this week’s report we consider whether tighter bank lending standards could pose a risk to our overweight spread product view in 2020. Chart 4Bank Lending Standards And Monetary Variables Bank lending standards are such an important credit cycle variable because they tell us about the supply of credit. A corporate default only occurs when credit supply is lower than the amount required for that firm’s survival. On a macro scale, we can think of two main reasons why lenders might restrict the credit supply: They perceive the monetary environment as restrictive. That is, they worry about higher interest rates and slower growth in the future. They perceive corporate balance sheets as being in poor health. That is, they worry that firms won’t be sufficiently profitable to make good on their debts. We find that monetary indicators do a very good job of predicting when lending standards will tighten. Looking back at the past two cycles, lending standards didn’t tighten until after: The yield curve inverted (Chart 4, panel 2). The real fed funds rate was above its estimated equilibrium level (Chart 4, panel 3). Inflation expectations were at or above target levels (Chart 4, bottom panel). Presently, all three of these monetary indicators are supportive. Some portions of the yield curve have been inverted at various times during the past year. But in general, the inversion signal from the yield curve has not been as strong as it was when lending standards tightened in prior cycles. For instance, the 3-year/10-year Treasury slope has not inverted this cycle, and it currently sits at +20 bps (Chart 4, panel 2). Further, the real fed funds rate is below most estimates of its neutral level and the Fed is signaling that it will keep it there for a long time yet. This dovish posture is justified by inflation expectations that remain well below target. It is conceivable that, despite the accommodative monetary environment, banks might be so concerned about poor balance sheet health that they are becoming more cautious with their lending. However, a survey of corporate health metrics doesn’t point to an imminent tightening of bank lending standards either (Chart 5). Chart 5Bank Lending Standards And Corporate Balance Sheet Variables In past cycles, tighter bank lending standards were preceded by: A trough in gross leverage (pre-tax profits over total debt) (Chart 5, panel 2). A peak in interest coverage (Chart 5, panel 3). Negative pre-tax profit growth (Chart 5, panel 4). A peak in profit margins (Chart 5, bottom panel). Currently, gross leverage is the only one of the above four variables that is clearly sending a negative signal. As for the other three, interest coverage and profit margins are barely off their cyclical highs, and profit growth has been fluctuating around zero for three years. If global growth rebounds during the next 12 months, as we expect, then profit growth will also move modestly higher. Bottom Line: Neither monetary nor balance sheet variables point to an imminent tightening of bank lending standards. We expect that the supply of credit will remain ample in 2020, keeping the default rate low and credit spreads tight. A Note On Falling C&I Loan Demand In addition to questions about lending standards, the Fed’s Senior Loan Officer Survey also asks banks to report whether they are seeing stronger or weaker demand for C&I loans. In response, banks have reported weaker C&I loan demand for six consecutive quarters, ending in Q4 2019. Historically, it is unusual for C&I loan demand to fall without a concurrent tightening in lending standards (Chart 6). Chart 6Explaining Weakening Loan Demand We also see the impact of weaker loan demand in the hard data. C&I loan growth has been falling since early 2019 (Chart 6, panel 2) and net corporate bond issuance had been on a sharp downtrend since 2015, before moving higher last year (Chart 6, bottom panel). So what’s going on with C&I loan demand? We can think of two reasons why firms might seek out less credit. First, they may face a dearth of investment opportunities, or alternatively, they might perceive some benefit from carrying less debt on their balance sheets. On the first point, we find that new orders for core capital goods do a very good job explaining the swings in C&I lending (Chart 7). Specifically, we see that the global growth slowdown of 2015/16 drove both investment spending and C&I lending lower. Then, both series recovered in 2017/18 before moving down again during last year’s slowdown. Surveys about firms’ capital spending plans also dropped last year, consistent with the deceleration in C&I lending, but remain at high levels (Chart 7, bottom three panels). All of this suggests that C&I loan growth will recover this year as global growth improves and the investment landscape brightens. Capital goods new orders do a good job explaining C&I lending. Corporate bond issuance has followed a different path from C&I lending during the past few years. Specifically, bond issuance slowed in 2015/16 as investment spending dried up. But it did not recover in 2017/18 the way that investment spending and C&I lending did. This appears to be a result of the 2018 corporate tax cuts and repatriation holiday. Chart 8 shows that the Financing Gap – the difference between capex spending and retained earnings – plunged in 2018 because firms suddenly received a huge influx of retained earnings. The influx came in part from the lower tax rate, but mostly from repatriated cash that had been stranded overseas. Simply, firms didn’t need to issue bonds to finance their investment plans in 2018 because they had a lot more cash on hand. Chart 7C&I Lending Follows ##br##Investment Chart 8A Negative Financing Gap Limits The Need For Debt What about the possibility that firms are demanding less debt because they are trying to clean up their balance sheets? Beyond a few anecdotes, we don’t see much support for this idea. In fact, an equity index of firms with low debt/asset ratios has been underperforming an index of firms with high debt/asset ratios (Chart 9). This suggests that there is currently little reward for firms that are paying down debt. Chart 9Firms Not Rewarded For Healthy Balance Sheets Bottom Line: Weaker demand for C&I loans is a result of the recent global growth downturn and decline in investment spending. It is not a harbinger of the end of the credit cycle. Loan demand should improve as global growth rebounds this year. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 2 For further details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 3 https://projects.fivethirtyeight.com/2020-primary-forecast/?ex_cid=rrpromo Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Stay on the sidelines on cyclicals versus defensives. While the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon. Recent Changes There are no changes to our portfolio this week. Table 1 Feature The SPX shrugged off the persistently negative coronavirus epidemic news and made fresh all-time highs last week (top panel, Chart 1). Domestic flush liquidity remains the dominant macro theme coupled with the expectation of a sizable fiscal and monetary easing out of China in the coming months. Importantly, according to the CME there is a 60% chance of a Fed interest rate cut priced in for the July 29, 2020 FOMC meeting which jumps to over 80% probability for the December 16, 2020 meeting. This is sustaining downward pressure on the 10-year Treasury yield, which in turn is boosting equities. A glum JOLTS report along with the 12-month fed funds rate discounter corroborate that additional Fed easing is likely nearing (middle & bottom panels, Chart 1). Chart 1Is A Fed Interest Rate Cut Looming? Chart 2Unsustainable Rise In “Tenuous Trio” The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently. Nevertheless, beneath the surface trouble is brewing. Chart 2 shows three asset classes rising concurrently. The “tenuous trio” as we have called stocks, Treasurys and the greenback in the past, cannot rise in tandem. When all three asset prices appreciate, it typically foreshadows equity market trouble. In this particular iteration, even the VIX is up for the year, representing a big break in historical correlations. Worrisomely, since 2018 every time the VIX and the SPX became positively correlated, the broad market subsequently suffered a setback (Chart 3).  While the SPX is making all-time highs, the VIX is neither making all-time lows nor cyclical lows. Importantly, equity market volatility is staying stubbornly close to 15, slightly below the ten-year average. As a reminder, a “VIX reading of 15 means that in 30 days the S&P 500 is expected to trade between 4.3% lower and 4.3% higher than its current level”.1 Chart 3Watch Out For Vol The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently.2 Chart 4 shows the percentage of GICS2 sectors with negative two-year relative share price momentum. The higher this diffusion rises the fewer the sectors that drive the SPX’s return. Historically, when our diffusion hits the 70% mark, it signals exhaustion in equity market returns. In fact, 70% readings in this diffusion indicator led both the 2000 and 2007 peaks in the SPX. Chart 4Heed The Diffusion Index’s Message This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Meanwhile on the economic front, the JOLTS report made for grim reading. Labor market softness was evident across the board and it was not squarely concentrated in the manufacturing sector. While this indicator only goes back two cycles, it is flashing yellow for the prospects of the broad equity market (top panel, Chart 5). Importantly, we will continue to monitor the job openings numbers as they are sending the exact opposite signal compared with unemployment insurance claims (job openings shown inverted, middle & bottom panels, Chart 5).  This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Chart 5Avoid Getting JOLTed Mixed Signals We have been neutral the cyclicals/defensives ratio for the past 8 months and continue to recommend investors stay on the sidelines for a while longer. It has been particularly difficult to distinguish a clear signal from noise lately for the cyclicals versus defensives ratio. Relevant macro drivers, operating metrics and profit fundamentals, valuations and technicals all have been emitting conflicting messages and the recent coronavirus epidemic will likely make the waters murkier still. US Equity Strategy’s Global Trade Activity Indicator has turned south recently following in the footsteps of the Chinese manufacturing PMI data that ticked down and are slated to drop below the boom/bust line in the current month (top & bottom panels, Chart 6). The bond market also reflects a gloomy global economic backdrop with the global 10-year Treasury yield sinking like a stone. Such a lackluster bond market will likely weigh on relative share prices (middle panel, Chart 6). CEOs remain a depressed bunch and it is all but certain that for, at least, the next three months executives will put capex plans on the backburner. Basic resources are most at risk and keep in mind that relative capex growth was already decelerating prior to the coronavirus epidemic (top & second panels, Chart 7). Chart 6Trade Uncertainty… Chart 7… And Capex Softness Weighs On Cyclicals A soft sales backdrop coupled with inventory accumulation are firing a warning shot. Relative share prices will likely succumb to the still weak total business sales-to-inventories ratio (third panel, Chart 7). Importantly, an inventory liquidation phase will continue to exert downward pressure on relative profit margins (bottom panel, Chart 7). Chart 8Pricing Power Proxy Blues Our simple relative pricing power proxy for the cyclical/defensive ratio best encapsulates these relative selling price pressures. The CRB metals-to-gold price ratio is on the verge of a breakdown and warns that the wide gulf that has opened up between our pricing power proxy and relative share prices will narrow via a sell off in the latter (Chart 8). Nevertheless, this stands in marked contrast to the ISM manufacturing prices paid subcomponent of the Report On Business survey and actual cyclicals/defensives pricing power momentum (bottom panel, Chart 9). Chart 9The US Dollar Holds The Key Were the greenback to depreciate in the coming months as our FX strategists expect, then cyclicals selling prices would definitively regain the upper hand versus their defensives counterparts (top & middle panels, Chart 9). But, the jury is still out. Sell-side analysts remain optimistic that relative profits will stage a significant comeback in the next year, but on a short-term basis have been trimming cyclical versus defensive earnings revisions (middle & bottom panels, Chart 10). While our macro-factor relative profit growth models were staging a comeback all last year, they ticked down last month (second panel, Chart 10). Finally, relative technical and valuation conditions are both tracing out a bottom near the one standard deviation below the historical mean, a level that has marked prior recoveries in relative share prices (Chart 11). Chart 10Mixed Bag Chart 11Unloved & Undervalued Bottom Line: Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Remain on the sidelines on cyclicals versus defensives, but stay tuned. Clipped Wings? Airline stocks have taken it to the chin lately on the back of coronavirus demand destruction fears, but we reiterate our overweight stance as extreme bearishness appears overdone. Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however looking further out such demand destruction will likely prove transitory. Chart 12 shows that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices (bottom panel, Chart 12). US domestic and international passenger enplanements are running near the 5%/annum growth rate and the recent rebound in the global and US services PMIs suggests that any kink in demand will likely prove short-lived (Chart 13). Chart 12Firming Cyclical… Chart 13…Demand Backdrop… Importantly, this firm cyclical demand backdrop is reflected in accelerating airline selling price inflation both on domestic and international routes (second & third panels, Chart 14). However, profit margins have yet to reflect this encouraging top line growth backdrop. The airline load factor spread (calculated as load factor minus break-even load factor) also heralds a profit margin expansion phase (bottom panel, Chart 14). Chart 14…Is A Boon For Selling Prices Chart 15Lower Fuel Costs Should Turbocharge Profit Margins Tack on the roughly 16% year-to-date drubbing in oil prices and airline profit margins will expand in 2020. This is true especially for the bulk of the industry that does not hedge kerosene costs (jet fuel shown inverted, Chart 15). The analyst community has been pessimistic about the prospects of airline stocks. Revenue and profit growth expectations are slated to tail the SPX in the coming twelve months. This sets a low bar for the industry to surpass in coming earnings seasons (Chart 16). Finally, investors have thrown in the towel, pushing relative valuations to extremely depressed levels to the tune of nearly two standard deviations below the historical mean (middle panel, Chart 17). Relative technicals are also washed out and signal that, at least, a reflex rebound is in store in the coming months (bottom panel, Chart 17). Chart 16Low Bar To Surpass Chart 17Contrary Alert: Pessimism Reigns Supreme In sum, while the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon.      Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://us.spindices.com/vix-intro/ 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, and “When The Music Stops…”, dated January 27, 2020, both available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).