Equities
Highlights Chinese policymakers are walking a tightrope, attempting to balance contradictory objectives. While their task is not impossible, we find that financial markets are overly complacent. Recent price action in EM risk assets resembles a final bear capitulation phase, and a classic top formation. Currency appreciation and moderation in export growth will damp corporate profits of exporters in Korea and Taiwan. Stay short KRW versus THB and short MYR versus RUB and USD. Feature "...at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks." Irving Fisher, The Debt-Deflation Theory of Great Depressions (1933) China continues to tighten financial regulations1 and onshore corporate bond yields keep marching higher. Yet EM and China-related financial markets have been extremely buoyant, completely ignoring the tightening dynamics underway. This reminds us of the above quote from Irving Fisher. The Chinese economy has been able to "...bend under strain, ready all the time to bend back..." In other words, growth has so far done well, despite ongoing liquidity and regulatory tightening (Chart I-1). This has led many investors and commentators to proclaim that the economy is healthy and will slow only a bit, or not at all. Chart I-1China: Will Economy Continue ##br##Defying Weak Credit Impulse? Yet, financial market risks linger. At a certain point, cumulative pressure from policy tightening will cause China's recovery to falter - "break," as per Fisher's quote above - impacting the rest of the world in general and EM in particular. This precept is pertinent to China at present because its money, credit and property markets are frothy, as we have written repeatedly in recent years, making them especially vulnerable to tightening. We thought such a deceleration in China's business cycle would occur in 2017, but it has not yet transpired. Forward-looking indicators such as money supply growth and the yield curve have been heralding a growth slowdown for many months (see Chart I-1). Nevertheless, this recovery has proved to be enduring; even though some segments have slowed, overall nominal growth, corporate pricing power and profits have done well. Does such growth resilience warrant an upgrade on China's outlook? An economy's past performance does not guarantee its future performance. This is relevant to China now, especially given the cumulative impact of the ongoing triple policy tightening - liquidity, regulatory and anti-corruption efforts in the financial industry2 - which will likely be substantial. Walking A Tightrope China's policymakers are walking a tightrope trying to balance contradictory objectives such as curbing financial speculation and credit excesses, capping inflation and maintaining a stable currency on the one hand, and maintaining robust growth on the other. Inflationary pressures are escalating in the mainland economy. Chart I-2 demonstrates that pricing power for 5,000 industrial companies - a diffusion index for producer prices compiled by the People's Bank of China - is approaching its 2007 and 2010 highs, while nominal interest rates are currently much lower than they were in 2007 and 2010 (Chart I-2, bottom panel). Notably, most of China's nominal recovery in the past two years has been due to prices, not volumes (Chart I-3). Given that rising prices benefit corporate profits much more than rising volumes, Chinese corporate profits have surged. Yet, the flip side of these dynamics is rising inflation. Chart I-2China: Inflationary Pressure Are Rising, ##br##While Interest Rates Are Low Chart I-3China: It Has Been Nominal (Price) Not ##br##Volume Manufacturing Recovery Mounting inflation amid enormous money excesses - the Chinese banking system has originated RMB 142 trillion (equivalent to $22 trillion) since January 20093 - risks triggering rising inflation expectations, which would then feed back into inflation. With real interest rates already extremely low (Chart I-4), increasing inflation expectations could lead to growing demand for foreign currency, in turn exerting downward pressure on the RMB exchange rate. Chart I-4China: Inflation-Adjusted ##br##Interest Rates Are Low Chinese households have been uneasy about the real (inflation-adjusted) value of their deposits, and have been opting for speculative investments that promise higher yields than bank deposits. Hence, policymakers cannot ignore households' desire for higher real interest rates if they aim to cool down speculative investment activities and contain systemic risks in the system. Overall, the authorities need to tread carefully, balancing between the need to preserve decent growth while keeping inflation at bay. Falling behind the inflation curve is as dangerous as being too aggressive in tightening. For now, rising domestic inflationary pressures, robust DM growth and the resilience of financial markets will justify further policy tightening in China. Controlling leverage, curbing financial market excesses and limiting speculation in the real estate market are all major components of the structural reforms agenda that China's top policymakers committed to at the Party Congress in October. Bottom Line: Chinese policymakers are walking a tightrope, trying to balance contradictory objectives. While their task is not impossible, we find that financial markets are overly complacent. The odds of successfully navigating these contradictory objectives amid lingering money, credit and property market imbalances are 30% or lower. In the meantime, financial markets seem priced for perfection. This gap between the market's views and our perception of risks leads us to maintain a negative investment stance. EM's Blow-Out Phase EM stocks and currencies have gone vertical in recent weeks, despite being overbought and not cheap. The recent price actions in EM and global risk assets looks like a final bear capitulation phase and a classic top formation. The EM overall equity and small-cap indexes have reached their 2011 high (Chart I-5, top and middle panels). Meanwhile, EM high-yield (junk) corporate and quasi-sovereign bond yields are at their historical lows (Chart I-5, bottom panel). Economic data, corporate profits and news flows are typically extremely positive at tops of cycles, and very negative at bottoms. Given that share prices have surged and credit spreads are extremely low, a lot of good news has already been discounted. In particular, EM long-term EPS growth expectations have shot up above their previous highs (Chart I-6). This indicator can serve as a proxy for investor sentiment on EM stocks, at the moment suggesting extreme bullishness. EM stocks topped out in the past when this indicator reached the current levels. Chart I-5Are EM At Their Zenith? Chart I-6Analysts Are Super Bullish On EM Profits Growth Needless to say, global investors' positioning is stretched in favor of risk assets. Chart I-7 entails that U.S. individual investors' holdings of cash was at a record low as of December, while their exposure to equities was not far from record highs. Apart from China-related risks, a potential rise in U.S. bond yields and/or the U.S. dollar, could spoil the EM party. Many investors have invested in EM on the assumption of continued weakness in the greenback and subdued U.S. bond yields. It would be unusual if this current robust global growth does not lead to higher inflation expectations or higher bond yields. With respect to market signals, Chart I-8 illustrates that global steel stocks in absolute terms, and the relative performance of emerging Asian stocks versus DM equities have approached their very long-term moving averages. The latter might become a major technical resistance. Failure to break above this resistance level would be consistent with EM share prices rolling over at their 2011 highs (see Chart I-7). Altogether, this could signal a major top in EM risk assets. Chart I-7Asset Allocation Of ##br##U.S. Individual Investors Chart I-8Select Segments Are At Their ##br##Long-Term Technical Resistances Bottom Line: The EM rally has endured much longer and has gone much farther than we envisioned. However, we maintain our cautious stance, and recommend underweighting EM stocks, currencies and credit versus their DM counterparts. Emerging Asia: Currencies And Business Cycle Chart I-9Geopolitics And Asian Currencies Emerging Asian currencies have recently been on the fly, surging versus the U.S. dollar. Apart from strong global manufacturing, one reason behind the emerging Asian currency appreciation has been geopolitics. We suspect political leaders in Taiwan and Korea have instructed their central banks to allow their currencies to appreciate to gratify the Trump administration's aspirations of a weaker greenback. The top panel of Chart I-9 shows that the Taiwanese dollar's sharp appreciation coincided with Trump's controversial phone call with the Taiwanese president on December 3rd, 2016. Similarly, Trump's visit to South Korea on November 7th, 2017 jives with the latest up leg in the Korean won (Chart I-9, bottom panel). It seems President Trump's geopolitical assurances to Taiwan and Korea are somewhat tied to these policymakers' increased tolerance for currency appreciation. Notably, foreign exchange reserves in both Taiwan and Korea have risen little, despite their strong trade surpluses and foreign capital inflows over the past year. This confirms that their central banks have been reluctant to purchase U.S. dollars and in turn cap their currencies' appreciation. In addition to the political context, there are a number of other important drivers of Asian exchange rates and the region's business cycle: The growth rate of Korean and Taiwanese total exports in U.S. dollars has moderated (Chart I-10). This, along with KRW and TWD appreciation, implies a meaningful deceleration in exporters' revenue growth in local currency terms. Besides, China's container freight index - the price to ship containers worldwide - has relapsed and it correlates well with Asia's export cycle (Chart I-11). Chart I-10Moderation In Asian Exports Growth Chart I-11A Negative Signal For Asian Exports Even though DRAM prices are rising, other semiconductor prices have rolled over (Chart I-12). Semiconductor prices and volumes are vital for the tech-heavy Taiwanese and Korean manufacturing sectors. The RMB rally is also late. Enormous pent-up demand for foreign assets from Chinese residents due to low mainland real interest rates creates the potential for capital outflows to cap RMB strength. This would weigh on the ongoing Asian currency rally. Finally, net EPS revisions of Korean and Taiwanese technology companies' have rolled over (Chart I-13), probably reflecting a dampening effect of currency appreciation. This could in turn lead to foreign capital outflows from their equity markets causing currency selloffs. Chart I-12Divergence In Semiconductor Prices Chart I-13Asia Tech Companies: Net EPS Revisions Corroborating budding signs of a slowdown in exports and corporate profits, emerging Asian stocks have begun underperforming DM equities, as shown in Chart I-8 on page 7. The deceleration in export revenues and currency appreciation are adverse developments for share prices in export-related sectors of Korea and Taiwan. Nevertheless, for dedicated EM equity portfolios, we recommend overweighting the Taiwanese bourse and Korean technology stocks (and being neutral on the rest of KOSPI). The basis is that share prices of hardware tech manufacturers have less downside than other EM sectors. Their attractive relative valuations combined with prospects for robust growth in DM warrant their outperformance against the overall EM equity index in common currency terms. As to exchange rates, the Trump factor will delay and mitigate Asian currency depreciation, but will not preclude it if export growth slows, as we expect. In such a scenario, policymakers in Asia will opt for modest currency depreciation, reversing their recent gains. In terms of investment strategy, we have been shorting the Korean won versus the Thai baht. This trade has so far been flat, but we are maintaining it because the won is a higher-beta currency than the baht, and the former will underperform the latter as Asia's business cycle eventually slows. In addition, we are also shorting the Malaysian ringgit versus the U.S. dollar and the Russian ruble due to weak domestic fundamentals in Malaysia. Bottom Line: Currency appreciation will damp corporate profits of exporters in Korea and Taiwan. This will weigh on EM share prices in aggregate, given that the Korean and Taiwanese markets together account for 27% of the MSCI EM market cap, compared with an 12% share of the entire Latin American region. The 12-month outlook for Asian currencies is downbeat: continue shorting the MYR versus both the U.S. dollar and the RUB, and stay long the THB versus the KRW. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 This week the China Banking Regulatory Commission (CBRC) announced a set of sweeping new rules to control banks' entrusted lending (Source: Caixin). This is in addition to a slew of regulatory measures for financial institutions that have been introduced over the past year. 2 We discussed these in details in Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, a link available on page 13. 3 Please see Emerging Markets Strategy Special Report, titled "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, a link available on page 13. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Upbeat economic reports for December set the stage for a solid 2018. The FOMC minutes acknowledged the flatter curve and only a minority of members discounted the signal from the curve. A majority thought that a tighter labor market would lead to higher inflation. The Citi Economic Surprise Index is peaking, but risk assets should hold up as the Index rolls over. Feature The first week of 2018 brought more good news for risk assets. U.S. stocks beat bonds, oil prices rose, and credit spreads narrowed amid a solid set of economic data. Several high-profile U.S. companies announced share buybacks, and/or one-time bonuses or wage increases linked to the tax cut plan passed by Congress at the end of 2017. Moreover, there were hints of further economic stimulus as lawmakers from both sides of the aisle discussed relaxing the sequester rules that would lift federal spending this year. Markets shrugged off a fresh round of saber rattling between the U.S. and North Korea. Gold prices nudged higher and the U.S. dollar fell despite the upbeat economic news. December's reports on manufacturing and service sector ISM, vehicle sales and the labor market, along with November's numbers on construction spending, trade and factory orders, all lifted estimates for Q4 GDP and boosted the prospects for corporate earnings in Q4 2017 and beyond. Chart 1 shows that the elevated ISM figures provide a favorable backdrop for earnings and sales in 2018. Moreover, Chart 2 indicates that IP, a proxy for S&P 500 sales, is poised to advance in 2018 and provide a lift to corporate profits. We will preview the S&P 500's Q4 2017 earnings reports in next week's U.S. Investment Strategy. Chart 1Favorable Macro Backdrop For Earnings And Sales Chart 2ISM Components Suggest IP Poised To Accelerate The Atlanta Fed GDP Now estimate stood at 2.7% on January 5, while the New York Fed's Nowcast for Q4 GDP was a healthy 4% (Chart 3). Both soundings are well above the FOMC's assessment of the economy's long-term potential growth rate (1.8%) and puts GDP growth in 2017 above the Fed's forecast. The implication is that the output gap pushed deeper into positive territory as 2017 ended, setting the stage for higher inflation in 2018. The December 2017 jobs report, released last Friday, January 5, does not change BCA's outlook for the U.S. economy or the Fed. The U.S. economy added a lower than expected 148,000 new jobs in December, which left the unemployment rate unchanged at 4.1%. Despite the softer than anticipated data, the 3-month average of payrolls growth is still a very healthy 204,000. The monthly increase in wages quickened to 0.3% m/m in December, up from 0.1% m/m last month. However, annual wage inflation remains modest at just 2.5% (Chart 4). Chart 3U.S. Economic Growth Well##BR##Ahead Of Potential In Q4 Chart 4Labor Market Still Tightening Despite##BR##Soft December Report The indications for Q4 GDP growth are solid. Aggregate hours worked rose 2.5% at an annualized rate in Q4 2017. Assuming modest growth in productivity, the payrolls data are consistent with over 3% GDP growth in Q4. There is nothing in the December payroll data to suggest that the underlying trajectory in the U.S. economy has changed. The economy continues to grow above trend. Wage gains are modest at the moment, but should accelerate as the labor market keeps tightening with above-trend GDP growth. This upbeat economic outlook is also supported the December 2017 non-manufacturing ISM survey, also released last Friday. While the overall index fell from 57.4 to 55.9, it is still consistent with solid GDP growth. Moreover, the employment index rose from 55.3 to 56.3, which signals firm job gains, and the prices paid index held steady at a fairly elevated level of 60.8. Bottom Line: It's been solid start to 2018 and it's steady as she goes for the U.S. economy and the Fed. FOMC Minutes: A Rubric BCA's U.S. Bond Strategy service expects that the 2/10 yield curve will languish between 0 and 50 bps in 2018. The curve will steepen from 51 bps at the end of 2017 through mid-year 2018, and then flatten into year-end (Chart 5). Which asset classes would benefit if our curve call is accurate? BCA's "The Bucket List"1 explains our view of the curve in 2018 and details the past performance of various U.S. assets in differing yield curve environments. Chart 5A Flat Yield Curve Is OK For Most Risk Assets BCA expects that the yield curve will first steepen in 2018, then become flatter, ultimately spending most of the year between 0 and 50 bps. A flat curve is the ideal environment for the S&P 500 and the stock-to-bond ratio. However, small cap stocks struggle when the curve is flat; BCA's view is that small caps will outperform large caps in 2018. A flat yield curve raises the risk of a sell-off in high yield, but provides a favorable grounding for oil, which is in line with BCA's fundamental view. BCA expects EPS growth will be positive this year; earnings growth is higher 75% of the time when the curve is flat. The yield curve's slope was a focus of debate at the FOMC's December 12-13, 2017 meeting. Participants cited several reasons for the flat curve2: recent increases in the target range for the federal funds rate; reductions in investors' estimates of the longer-run, neutral real interest rate; lower longer-term inflation expectations; lower term premiums Fed economists recently updated their quantitative assessments of the FOMC's minutes. The note provides a guide (Table 1 in the Fed paper3 and Tables 1 and 2 below) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the committee's latest views on the yield curve and inflation. Table 1FOMC Assessment Of The Yield Curve Table 2FOMC Assessment Of Inflation In short, the FOMC acknowledged the flatter curve and only a minority of members discounted the signal from the curve. Moreover, a majority thought that a tighter labor market would lead to higher inflation. Only one participant held the view that secular trends were muting inflation. Bottom Line: BCA expects the Fed to deliver 3 to 4 rate hikes in 2018, which is still not fully priced in by the market. Investors should maintain below-benchmark duration in fixed income portfolios. Asset allocators should remain overweight stocks versus bonds. Growth is strong and the yield curve is not inverted yet. Therefore, it is still early to de-risk portfolios. Is Economic Surprise Peaking? The Citigroup (Citi) Economic Surprise Index is elevated relative to its recent history, but it may have further to run. Economic prospects were cheery following the 2016 presidential election and the economic data exceeded those lofty projections, aided by a warmer than usual winter. However, the temperate conditions borrowed activity from the spring, which was cooler and wetter than normal, and the combination of lofty expectations and seasonal distortions sent the Citi Economic Surprise Index spiraling lower through mid-year 2017. Since its bottom in June 2017 at -78.6%, the index climbed for 135 days before its peak in late December 2017 (Chart 6, panel 1). On average since 2010, the Citi Index moved from trough-to-peak in 96 days, which means the recent run-up was much longer than usual. However, that phenomenon may have been due to the raised economic expectations and variable weather patterns at the start of 2017. Chart 6Economic Surprise Index Has Surged, But Expectations Remain Muted At 80.7%, the Index has been above zero for 68 days (Chart 6, panel 1). It typically takes 46 days for it to climb from zero to its zenith. Table 3 shows the performance of financial markets and other assets after the Index moves from zero to the peak. The most recent episode (October through December 2017) matched historical averages across most asset classes, although the underperformance of small caps versus large ran counter to the past as the Surprise Index climbed from zero. Table 3Risk Assets Perform Well As Surprise Index Climbs Since 2010, the Index has stayed above 40 for an average of 51 days (Chart 6, panel 1). The Index has been over 40 since November 16, 2017, or 35 days. This suggests that it can remain elevated for another month or so before it again moves lower. However, the Index is mean reverting and investors wonder what will happen to risk assets after economic surprise rolls over. Table 4 and Chart 7 shows the performance of key financial markets and commodities when the Citi Index returned to zero from 40-plus. There have been six such intervals since 2010. On average, gold and oil perform well as the surprise index dips to zero. Stocks and credit outperform Treasuries during these episodes, and small caps beat large caps. Rising economic surprise (Table 3) is a more favorable environment for stocks, credit and oil than when the surprise index is rolling over. However, the performance of gold and small caps is better after the Citi Surprise Index peaks (Table 4). Table 4Risk Assets Hold Up When Citi Surprise Index Rolls Over Chart 7U.S. Assets As Economic Surprise Rolls Over Nonetheless, muted economic expectations will limit the downside in the Index in the coming months. Panel 3 of Chart 6 shows that the outlook for both hard and soft economic data remained muted through the end of November 2017, especially when compared with the significant improvement in economic prospects in late 2016 and early 2017. Bottom Line: Risk assets outperformed as the Citi Economic Surprise Index climbed in the second half of 2017. The Index can stay near recent peaks for several more months thanks to subdued economic forecasts, but it will roll over eventually. However, the elevated level of the Index suggests that there are near-term risks for equities and credit because a lot of good economic news is already priced in. Still, we recommend that investors ride out the volatility given our view that stocks will outperform bonds in the next 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Bucket List", published December 18, 2017. Available at usis.bcaresearch.com. 2 https://www.federalreserve.gov/monetarypolicy/fomcminutes20171213.htm 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm
Highlights Question #1: Will global growth remain above trend? Yes. Question #2: Will growth continue to outperform outside the U.S.? No. Question #3: Will productivity growth pick up? Yes, but only cyclically. The structural outlook remains bleak. Question #4: Will continued strong global growth finally deliver higher inflation? Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Feature Global Growth In Focus We wish all our readers a joyous and prosperous 2018. As the new year begins, four questions about the global growth outlook loom large. Question #1: Will global growth remain above trend? Our answer: Yes. It is likely that global growth will come down a notch from its current elevated pace. However, it should remain firmly above trend. For one thing, the global economy continues to exhibit a lot of positive momentum. Real-time measures of economic activity, such as the Goldman Sachs Current Activity Indicator (CAI), highlight that global real GDP is rising at a robust pace (Chart 1). Our global leading indicator, as well as a wide swath of PMI data, suggest that this trend has legs (Chart 2). Chart 1APositive Global Growth Momentum Can Be Seen Here Chart 1BPositive Global Growth Momentum Can Be Seen Here Since 1980, above-trend global growth in one year has been accompanied by above-trend growth in the following year nearly three-quarters of the time. This bodes well for 2018. Chart 2... And Here Too Chart 3Financial Conditions Tend To Lead Growth By Six-To-Nine Months Global financial conditions eased significantly in 2017, thanks mainly to higher equity prices and narrower credit spreads. Easier financial conditions tend to benefit growth with a 6-to-9 month lag (Chart 3). The 6-month global credit impulse, which tends to lead activity, is also positive (Chart 4). Fiscal policy should remain stimulative. The fiscal thrust moved into positive territory in advanced economies in 2016-17 and this should remain the case in 2018 (Chart 5). Tax cuts will add about 0.3 percentage points to U.S. growth, while hurricane reconstruction spending and a likely congressional agreement to raise the cap on federal discretionary spending will add another 0.2 points. Chart 4Positive Credit Impulse Is Another Tailwind For Growth Chart 5Fiscal Policy Has Turned More Stimulative Our political strategists expect further fiscal easing in Japan this year. They also believe that German coalition talks will produce more government spending, with the SDP extracting concessions from Merkel on public investment and the CSU securing a commitment for more defense expenditure. On the flipside, our strategists expect some fiscal tightening in France as President Macron takes steps to trim France's bloated welfare state. Question #2: Will growth continue to outperform outside the U.S.? Our answer: No. Global revisions were more favorable outside the U.S. in the first nine months of 2017, which helps explain why the dollar came under downward pressure (Chart 6). More recently, U.S. growth estimates have begun to drift higher. As a result, the U.S. surprise index has surged relative to those of other economies (Chart 7). Chart 6U.S. Growth Expectations Were Lagging... ##br## But Not Anymore Chart 7U.S. Economic Surprise Index Increased ##br## Relative To Those Of Other Countries We expect the data to continue to favor the U.S. Aggregate U.S. hours worked in November was up 3.4% at an annualized rate over Q3 levels. If we add in productivity growth, Q4 GDP growth was probably in excess of 4% - well above current consensus estimates. Financial conditions have eased a lot more in the U.S. than in the rest of the world. Fiscal policy is also set to loosen relatively more in the U.S. Euro area growth is likely to tick lower next year from its current stellar pace, as the impact of a stronger euro begins to bite. The 6-month credit impulse has already turned negative there. Japanese growth should also cool somewhat from the heady pace of 2.7% seen over the past two quarters. The Chinese economy will decelerate modestly in 2018. The authorities are tightening the screws on the shadow banking system, expediting efforts to reduce excess capacity in the industrial sector, and clamping down on corruption. All of these reforms will pay off in the long run, but they could dent growth in the short run. Question #3: Will productivity growth pick up? Our Answer: Yes, but only cyclically. The structural outlook remains bleak. U.S. nonfarm productivity rose by 1.5% over the prior year in Q3, well above the post-2010 average of 0.8%. This improvement occurred despite the fact that low-skilled workers continue to re-enter the labor market - dragging down output-per-hour in the process - a phenomenon that is not well captured by the official productivity data. Productivity growth elsewhere in the world also appears to be on the upswing (Chart 8). Increased business investment should support productivity in 2018. Corporate surveys indicate that a rising percentage of companies anticipate boosting capital budgets (Chart 9). This often happens in the last few innings of business-cycle expansions, as more companies begin to experience capacity constraints. Chart 8Productivity Growth Showing Signs Of ##br## A Tentative Recovery Chart 9Surveys Are Signaling Acceleration ##br## In Capex Unfortunately, while the cyclical outlook for productivity is improving, the structural backdrop remains downbeat. As we have discussed in the past, flagging educational achievement, decreased creative destruction, and a shift in technological innovation towards consumers and away from businesses all augur poorly for future productivity trends.1 The much-hyped Amazon effect makes for good news stories, but is not borne out by the data.2 Question #4: Will continued strong global growth finally deliver higher inflation? Our answer: Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Chart 10A Pick-Up In Wage Growth Would Put Upward Pressure ##br## On Service Inflation Going into 2017, the Fed had expected core PCE inflation to end the year at 1.9%. It is likely to have finished the year at only 1.5%. We expect core PCE inflation to move toward 2% by the end of 2018. Wage growth should accelerate as the labor market continues to tighten. This should put upward pressure on service inflation (Chart 10). Goods price inflation should also recover due to the lagged effects of a weaker dollar and the bleed-through of higher energy prices into several core components of the CPI (airline fares being a notable example). Slower rent growth will dampen inflation. However, this will be partially offset by higher health care prices. The cost control measures introduced in the Affordable Care Act helped push down PCE health care services inflation from 3% in late 2010 to less than 0.5% in early 2016 (Chart 11). Many of these measures have been realized, and as a consequence, health care inflation has begun to revert to its long-term trend (though in level terms, the savings to consumers remain). The Republican tax bill could put some upward pressure on health care costs. The Congressional Budget Office estimates that the repeal of the Individual Mandate will raise premiums on health care exchanges by 10% because a larger share of healthy individuals will decide to forgo buying health insurance.3 Japanese inflation should move modestly higher in 2018, but from extremely depressed levels. The Japanese unemployment rate is now a full percentage point lower than in 2007 and the ratio of job opening-to-applicants has reached the highest level since 1974 (Chart 12). Chart 11U.S. Inflation Breakdown Chart 12Japan's Tightening Labor Market Euro area inflation will be held down by the lagged effects of a stronger euro and continued high levels of slack across southern Europe. Outside Germany, labor market underutilization is still 6.3 percentage points higher than it was in 2008 (Chart 13). U.K. inflation should edge lower as the spike in import prices stemming from the post-Brexit pound depreciation dissipates. Chart 13There Is Still Labor Market Slack Outside Of Germany Investment Conclusions A shift in global growth leadership back towards the U.S. would benefit the beleaguered U.S. dollar. Higher U.S. inflation will prompt the Fed to raise rates four times in 2018, one more hike than implied by the dots and two more hikes than implied by current market expectations. Rising inflation should also keep Treasury yields on an upward trajectory. We expect the 10-year yield to finish 2018 at around 3%. As long as inflation is rising in response to stronger growth, and from below-target levels, both U.S. and global risk assets should continue to rally. Only once U.S. inflation rises above 2% in 2019, and growth begins to slow on the back of binding supply-side constraints, will equities flounder. Stay long stocks for now, but look to significantly trim exposure towards the end of the year. Regionally, we favor euro area and Japanese equities over U.S. stocks for the next 12 months on a currency-hedged basis. Both the euro area and Japanese stock markets are dominated by large multinational companies whose prospects are geared more towards global growth than demand in their own regions. Above-trend global growth and rising capital spending should disproportionately benefit European and Japanese bourses, given that they have a greater tilt towards cyclically-sensitive companies. Valuations also tend to favor non-U.S. stocks. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?," dated May 31, 2017; Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 3 Please see "Repealing the Individual Health Insurance Mandate: An Updated Estimate," Congressional Budget Office, dated November 8, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights A "decision tree" for the allocation to Chinese stocks highlights several key questions for investors over the coming year. The equity allocation decision hinges on the condition of the global economy, the stance of monetary policy, the pace of structural reforms, and the character of the ongoing economic slowdown. Despite several identifiable risks, our "decision tree" suggests that investors should be overweight Chinese vs global stocks. Feature Unlike in past years, BCA's China Investment Strategy service published its 2018 themes report in December, as an addendum to BCA's special year end Outlook report.1 Our final report for 2017 echoed our key themes by recapping some of the most important developments in China last year, as well as their longer-term implications.2 These reports outline our framework for evaluating China's economy in 2018, and will serve as an important reference point over the coming months relating to the pace of China's economic slowdown, policymakers' actions and priorities, and investor attitudes toward Chinese assets. In today's brief report, we begin the New Year by walking through the Chinese equity "decision tree" that flows from the framework that we detailed in our themes piece noted above (Chart 1). The chart presents a set of questions that should be answered over the coming 6-12 months in order to decide on the ideal allocation to Chinese equities within a global portfolio. We elaborate on the decision tree below. Chart 1The Chinese Equity "Decision Tree" Is The Global Economy Slowing Significantly?: Developments in China need to be considered within a global context. We have noted in previous reports that a synchronized global economic slowdown was a key factor behind China's economic slowdown in 2015.3 If global growth were to slow significantly this year, it would bode poorly for the relative performance of Chinese stocks. Next week's report will discuss the evolution of the alpha and beta characteristics of China's investable stock market; while our research is still ongoing, the evidence suggests that Chinese equities in US$ terms have become a high-beta market that would likely suffer in relative terms if the global equity market stumbles. Chart 1 highlights that the appropriate allocation to Chinese equities vs global stocks is underweight if the answer to this first question is yes, with the upgrade/downgrade bias determined simply by whether there has been an appropriate response from Chinese and global policymakers. Is Significant Further Monetary Policy Tightening Likely?: Overly tight monetary policy was the second ingredient that contributed to the 2015 slowdown. Monetary conditions tightened somewhat in the first half of 2017 (Chart 2), but the overall stance is not restrictive. Taken alone, hawkish rhetoric from the PBOC would imply that significant further tightening is imminent. However our sense is that the bark of monetary authorities will be worse than their bite over the coming months, especially since growth momentum and house price appreciation has already peaked. Is The Pace Of Renewed Structural Reforms Likely To Be Aggressive?: October's Party Congress heralded stepped-up reform efforts in 2018 and beyond, which we have highlighted is a risk to a constructive stance towards Chinese stocks. While the "status quo" scenario of no significant reforms is highly unlikely, the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers to avoid a repeat of the 2015 experience. Even if policymakers feel that their threshold for pain will be higher in 2018 than has previously been the case, they are very likely to avoid a significant slowdown as it would raise the risk of returning to the exact set policies that they are trying to turn away from. In other words, an intense pace of reform would risk turning a "two steps forward, one back" situation into a full-blown retreat from structural reform momentum. For now, our China Reform Monitor continues to suggest that reform intensity will be consistent with a rising equity market (Chart 3). Chart 2Chinese Monetary Conditions ##br##Have Tightened Chart 3Investors Don't Believe That Reforms##br## Will Upset The Apple Cart Is The Existing Slowdown In China's Growth Momentum Metastasizing? Our view of China's significant growth slowdown in 2015 suggests that the end of the recent economic "mini-cycle" is likely to be benign and controlled, absent a policy mistake or a major global shock. However, it is possible that the lagged effect of a deceleration in export growth and tighter monetary policy, both of which have already occurred, could cause a broader or deeper slowdown in economic growth beyond what we have already observed. In order to gauge this risk, we tested a wide range of commonly-watched macro data series for signs that they reliably lead economic activity in China,4 using the Li Keqiang index as our proxy for the business cycle. We concluded that measures of money & credit are among the most important predictors, and presented a composite leading indicator of the Li Keqiang index based on six series that passed our test criteria (Chart 4). For now, our indicator suggests that the Chinese economy will continue to slow over the coming months, but that the pace and magnitude of the decline will be benign and controlled. The first question in our decision tree is the easiest to answer: The highly synchronized nature of global economic growth suggests that a significant slowdown is not imminent, even if the pace of growth becomes narrower or slows modestly (Chart 5). While our decision tree highlights that answering "yes" to any of the last three questions means that investors should have a negative bias towards Chinese investable stocks (and should downgrade them in response to a technical breakdown), these questions are still addressing risks rather than probable events. This supports our current recommendation of being overweight Chinese investable equities with a positive bias. Chart 4The Chinese Economy##br## Will Gradually Slow Chart 5No Sign Of A Significant ##br##Global Economic Slowdown As a final point, some investors and market participants have noted that investable Chinese stocks experienced a non-trivial selloff at the end of 2017, with some questioning whether it is a harbinger of a more pronounced economic slowdown. Our answer is no, for two reasons. First, there is some evidence to suggest that the selloff was technical in nature, as the sectors that had experienced the largest gains prior to the selloff also experienced the largest declines (Chart 6). Second, the timing of the relative selloff in Chinese stocks coincided exactly with a relative selloff in the global tech sector (Chart 7), which is strongly indicative of a common, global, factor. But given the underlying strength in the global economy, we regard this event as idiosyncratic and do not view it as a threat to the relative performance of Chinese vs global stocks over the coming year. Chart 6The Late-Year Selloff Was Partially ##br##Driven By Technical Conditions Chart 7Global Tech Also Drove The Selloff##br## In Chinese Relative Performance Bottom Line: While there are several identifiable risks that need to be monitored in 2018, for now our "decision tree" for the relative allocation to Chinese equities suggests that investors should be overweight within a global equity portfolio. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, and Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Legacies Of 2017", dated December 21, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, and "China's Economy - 2015 vs Today (Part 1): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Feature Chilean stocks have surged recently following the victory of conservative businessman Sebastian Pinera in the presidential elections. Odds are that we could be witnessing the beginning of a period of Chilean outperformance against the EM equity benchmark, rather than just a short-term political relief rally. Pieces have fallen into place to produce a re-rating in Chilean equities relative to other emerging markets, as illustrated by the top panel of Chart I-1. The cyclically adjusted P/E ratio shows that Chilean stocks are cheap relative to their EM peers. Furthermore, Chilean stocks in common currency terms are presently near a 20-year bottom relative to EM equities (Chart I-1, bottom panel). Hence, just from a mean reversion perspective, Chile's performance relative to EM stocks has the potential to rise. Besides the above points, Chile's business cycle and monetary policy also warrant this bourse's outperformance versus the EM benchmark. A Sweet Spot For Equities There are several signs that the business cycle has passed its bottom and is slowly recovering (Chart I-2). Chart I-1Chilean Stocks Relative To EM Chart I-2Chilean Economy Is Reviving... Moreover, there are also several factors that will lead the Central Bank of Chile (CBC) to keep monetary policy easy for the coming 6-12 months. This will create a sweet spot for share prices where economic growth starts to pick up but the central bank does not tighten. Capital expenditures in real terms and the bank loan impulse to corporations - the second derivative of outstanding commercial loans - might have bottomed although they are still very weak (Chart I-3, top panel). Furthermore, residential and non-residential construction starts are still shrinking while the improvement in the housing loan impulse seems to be stalling (Chart I-3, bottom panel). This suggests that the capex and credit cycles - the two most interest rate-sensitive segments of the economy - remain feeble, justifying low interest rates for a while. Most importantly, there are no signs of inflationary pressures: the output gap is negative and widening, which historically has led to falling core inflation (Chart I-4). Chart I-3...But Interest Rate Sensitive Sectors Are Still Weak Chart I-4Chile: The Output Gap And Inflation A wide range of inflation measures - consumer services and trimmed mean inflation rates - are low and remain in a downtrend (Chart I-5). The key driver and measure of underlying genuine inflation is wages. Overall and key sectors' wage growth are either slowing or muted (Chart I-6). Chart I-5Chile: Inflation Is Low Chart I-6Chile: Wage Growth Is Tame Notably, the number of unemployed people is still rising while the number of job vacancies has plummeted to very low levels (Chart I-7). This heralds low wage growth and disinflationary pressures ahead. Chilean local rates, unlike high-yielding EM local fixed-income markets, will not rise if commodities prices relapse and the Chilean peso depreciates. On the contrary, the CBC can and probably will cut interest rates if the economic recovery is endangered. Therefore, we expect money supply in Chile to continue outgrowing the same measure for aggregate EM. This tends to help Chilean stocks outperform the EM equity benchmark (Chart I-8). Chart I-7Chile: A Lot Of Slack In Labor Market Chart I-8Upgrade Chilean Stocks Versus EM Finally, the health of the Chilean banking system is better than that of some other EM peers as the former is well provisioned and not exposed to foreign currency risk. This will also help this equity market to outperform. As to absolute performance in U.S. dollar terms, it depends on copper prices and the trend in EM absolute performance. Our base case remains that copper prices will relapse due to a deceleration in Chinese capital expenditures in general and construction (both infrastructure and property development) in particular (Chart I-9). This will drive both the Chilean peso (and probably equity prices) down. In a nutshell, the equity valuations in absolute terms are neutral. Chart I-10 illustrates that the cyclically adjusted P/E ratio for the MSCI Chile index is 21, around its fair value. Barring a reversal in EM risk assets (which we expect to start sooner rather than later), share prices could rise further. Chart I-9Downside Risks To Copper Prices Chart I-10Chile: Cyclically-Adjusted P/E Ratio Investment Conclusions We recommend EM dedicated equity investors to upgrade their allocation to Chile from neutral to overweight. The macro backdrop favors Chilean assets over their emerging markets peers. As such we recommend an overweight allocation in equity and corporate credit portfolios within their respective EM benchmarks. Can Chilean stocks outperform EM when copper prices fall? Chart I-11 suggests yes: historically there were periods when copper prices and Chile's relative equity performance versus EM were not correlated or even negatively correlated. Hence, our decision to upgrade Chilean stocks to an overweight while being negative on copper prices is not inconsistent. Chart I-11Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated For absolute return investors, the risk-reward profile for Chilean assets is not attractive if our baseline negative view on EM and industrial commodities prices plays out. Finally, we have been recommending to complement a short position in copper with a long leg in the Chilean peso. This allows traders to earn a bit of carry while waiting for copper prices to gap down. The CLP has lagged the recent spike in copper prices but we reiterate this position as risks to copper prices remain to the downside over the next six months. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2017. The model's allocation to Australia has proven to be quite volatile as evidenced by the large increase to Australia this month to 7% from 1.7% in last month. As a result, the other commodity country, Canada, is now back to underweight from neutral last month. There are no significant large adjustments in other countries, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 80 bps in December as the model was underweight the U.K. versus EMU, yet the U.K. was the best performer in the month while EMU underperformed. Since going live in January 2016, the overall model has outperformed the benchmark by 47 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 265 bps. The Level 1 model outperformed the MSCI World benchmark by 19 bps. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) 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 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 2, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model has turned more bullish on global growth as seen by a 2% increase in aggregate cyclical overweight. However, the model continues to reduce its overweight in the resources-based sectors, and has upgraded financials to overweight on the back of improving momentum. Finally, both utilities and telecom stocks have been moved further into underweight territory. 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.
