Developed Countries

Special Report

This week's report is guest-authored by my colleague, Marko Papic, BCA's Chief Geopolitical Strategist. In a highly controversial piece, Marko argues that Donald Trump's strategy of focusing on the concerns of white working class voters may represent the GOP's best hope for winning this year's presidential election. As such, we expect the political debate to remain highly charged over the coming months, possibly to the detriment of risk assets.

Special Report

In recent travel, our clients remain focused on downside risks to today's range-bound markets. And for good reason. Uncertainty regarding Chinese reaction function is the biggest source of political risk in today's markets. We discuss it in detail in this month's report, along with an update on our views of Brazil, Russia, and Turkey. In addition, we examine the potential casualties of the European immigration crisis and the likelihood of Donald Trump becoming the president of the United States.

In recent travel, our clients remain focused on downside risks to today's range-bound markets. And for good reason. Uncertainty regarding Chinese reaction function is the biggest source of political risk in today's markets. We discuss it in detail in this month's report, along with an update on our views of Brazil, Russia, and Turkey. In addition, we examine the potential casualties of the European immigration crisis and the likelihood of Donald Trump becoming the president of the United States.

Small caps have enjoyed a modest oversold bounce relative to large caps, but the latest NFIB survey of the small business sector warns that these gains are likely to fully reverse, and more. The tightening in domestic monetary conditions appears to have begun taking a toll on both small business confidence, and access to funding. That is noteworthy, because history shows that small caps underperform large caps when credit tightens (top panel), given that the former rely more heavily on the banking sector for financing than do large caps. Meanwhile, optimism about the economy has tanked, perhaps reflecting the intensification in deflation pressures: the number of companies reporting price increases has plunged. While labor compensation also eased, suggesting increasing overall labor market slack, it was not enough to offset the loss of pricing power. Our small cap profit margin proxy continues to sink. We reiterate our large cap bias.

While high-beta equity areas have rebounded smartly in recent trading sessions, we remain skeptical that earnings-follow through will be forthcoming. Instead, our portfolio remains defensively-geared, where profit support is strongest. For instance, the latest manufacturing data showed that pharmaceutical shipments continue to boom, underscoring that top-line momentum has started on a strong foot in the first quarter. That bodes well for pharmaceutical relative performance. Elsewhere, beverage shipments have also soared on a growth rate basis, sending a similar upbeat message for the S&P soft drink index. Importantly, pricing power remains solid in both industries, underscoring that the surge in manufacturer shipments likely remains demand-driven. We reiterate our overweight position in both indexes.

Fed policymakers will soon shift their focus toward the strong employment and inflation data and stress that further rate hikes this year are likely. This will stem the rally in risk assets and cap the upside in long-dated yields.

Gold and gold stocks have bounced nicely in recent weeks. But from a multiyear perspective, both remain extremely depressed (top panel). While gold has had several false starts in recent years, a number of factors suggest that the latest rally will have durability. Gold raises in stature as policymakers lose efficacy. That is certainly the case now, as incremental QE has done little to foster a return to above-trend growth and a growing number of countries have resorted to negative deposit rates to reinvigorate anemic economic activity. Real interest rates, the opportunity cost of holding gold, which is a zero-yielding asset, are low and falling around the world and may need to fall further to reverse the decline in economic confidence. Importantly, gold has begun to rise in a number of currencies, suggesting that it is no longer just a play on a lower U.S. dollar. From a tactical perspective, sentiment toward the yellow metal is still pessimistic, despite the jump in gold prices in recent weeks. That is a contrary positive. As a result, we recommend an overweight position in gold equities, both as portfolio protection and also as a long-term hedge on monetary policy exhaustion. While the S&P 1500 gold index has only two stocks, the Global Gold Miners ETF (GDX) provides a liquid and diversified proxy for gold equities, which we will use to track gold stock performance. Please see yesterday's Weekly Report for more details.

In yesterday's Weekly Report, we outlined our top ten reasons to underweight the technology sector, an out of consensus call based on the sector's resilience during the past few months' of broad market turmoil. At the root of our concern is that tech sector productivity growth is eroding at the same time that previously bulletproof balance sheets are slowly deteriorating. Declining sector productivity can be remedied through increased capital spending, but the chart shows that tech has underinvested as a share of sales for the better part of a decade. While the latter is slowly creeping higher, it will take time before it feeds into increased efficiency and faster earnings growth. Worse, our overall capital spending model is sinking steadily (bottom panel). In particular, the financial and public sectors have traditionally been large technology spenders. Despite ultra-low borrowing costs, government spending is still politically constrained and thus on a tight leash. Meanwhile, the financial sector has already ramped up its capital spending significantly (middle panel), without a corresponding positive impact on new order growth, signaling that weakness from other end markets has been a large drag. If the financial sector pulls in its horns as overall credit quality sours, it will remove a support for tech capital spending. We are bearish on relative performance prospects, and recommend underweight positions. Please refer to yesterday's report for more details.

We still recommend a cautious stance on portfolio risk, for both credit and duration exposure, given that monetary policy expectations priced into Developed Market yield curves are already extremely dovish.