Developed Countries

With the Fed more sensitive to how its policy affects the global economy, and <i>vice versa</i>, we believe monetary policy will remain accommodative to encourage U.S. and EM growth.

Unlike rails, the S&P industrial machinery index has tested prior relative performance highs even though the global manufacturing sector is still laboring under excess capacity in Asia and weak commodity prices. Relative share price performance has already diverged wildly from oil prices, a rare occurrence, and a re-convergence is probable if profits fall short. While companies have cut inventories and staff to address productivity slippage, there is little top-line relief ahead. U.S. machinery new orders continue to contract and there is no help forthcoming from abroad. Non-U.S. developed economies are struggling. Capital spending is in retreat, based on the contraction in capital goods orders and capital goods imports. Our proxy for global machinery orders, excluding the U.S., is contracting. Consequently, there is little scope for a recovery in machinery output, which is necessary to lift utilization rates and allow the industry to sustainably escape deflation. We put this group on our high-conviction underweight list on Monday. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, SWK, IR, PH, PNR, DOV, SNA, XYL, FLS.

Investors looking for a lower risk vehicle to participate in broad equity market strength than from chasing momentum driven areas with dubious fundamentals need look no further than the S&P rail index. Expectations have been crushed and valuations are on the cheap side of neutral. While rail freight is currently in a funk, leading indicators have perked up, particularly for the largest category, intermodal. The latter largely reflects the transportation of consumer goods. Thus, the surge in personal bank loans, strength in trucking tonnage and port traffic all bode well for a recovery in freight in the coming quarters. Against a backdrop of steep cost cutting, any stabilization in top-line performance should have an immediate positive impact on the bottom line. We upgraded to overweight in Monday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5RAIL: CSX, KSU, NSC, UNP.

We are recommending profit taking in gold shares after a dramatic surge since our overweight call earlier this year. The long-term outlook for gold remains appealing, given the need for low or even negative real interest rates for a prolonged period in order to restore global growth to trend or above-trend levels. Nevertheless, on an intermediate-term basis, we are concerned that a rise in the U.S. dollar could cap the upside in bullion and related-share prices. Evidence of speculative zeal is mounting. ETF gold holdings have skyrocketed since late-2015, reflecting massive inflows into related funds. Net speculative positions have surged as a percent of open interest (third panel), underscoring that momentum and performance-chasing have turbo-charged the yellow metal's advance. Sentiment toward gold has also spiked. Importantly, relative stock price performance has become extremely overbought. The 52-week rate of change has soared to its highest level in decades. While that upsurge partially reflects a lasting cyclical and structural trend change, an intermediate-term digestion phase is inevitable to relieve overbought conditions in the coming months, with a stronger currency the most likely catalyst. Take profits of 45% and downshift to neutral.

Stocks remain well bid despite the questionable fundamental rationale for price gains. The run to new highs has been driven by renewed valuation expansion a dubious trend given the lack of profit growth, the likelihood that the Fed will resume hiking interest rates this autumn and the potential for the U.S. dollar to climb anew. Still, abundant liquidity expectations are trumping earnings risks in the near run. Nominal GDP growth remains above long-term Treasury yields, a simple yet reliable measure of excess liquidity. Meanwhile, money growth is accelerating relative to output growth. When this occurs, history shows that defensive sectors outperform the broad market (top panel). Deep cyclicals underperform until after economic activity picks up enough to drain excess liquidity from the market (deep cyclicals are inversely correlated with our liquidity gauge, bottom panel). Consequently, we continue to emphasize non-cyclical sectors and groups in our portfolio strategy, with a splash of beta coming from the interest rate-sensitive consumer discretionary sector.

Eventually the easing of financial conditions will strengthen the Fed's resolve to lift rates. Rate hike probabilities will rise and risk assets will struggle to cope with higher Treasury yields.

Government bond markets have likely overestimated the degree of policy dovishness that is likely to be delivered by the major central banks in the next few months.

The GAA DM Equity Country Allocation model is updated as of July 29, 2016. The non-U.S. (level 2) model made some changes by increasing the overweight in Sweden and Italy while reducing the overweight in Netherland and Germany such that now Germany is in underweight position.

The odds of an inflation "mini-scare" are rising, although deflationary tail risks from abroad cannot be dismissed.

It is dangerous to equate recent equity strength with economic vitality, as history shows that liquidity-fueled equity advances favor non-cyclicals over deep cyclicals. Take profits in gold, buy rails and sell industrial machinery.