Sectors
Overweight Consumer finance stocks have been mostly range-bound over the past two years following their significant underperformance in the two years prior. We think the trading range is only a pause as the sector girds itself for another step higher. Unemployment claims, the single largest driver of underlying earnings growth, have diverged from the index's performance in the last five years (top panel). At the same time as unemployment claims have been falling, revolving consumer credit has been expanding at an exceptional rate. Following a lull at the end of last year, growth appears to be reaccelerating (second panel). Meanwhile, the consumer continues to look eminently capable of growing their household balance sheet (third panel). Typically, periods of expanding consumer credit see tightening of credit card interest rate spreads; the opposite has been happening in the most recent period as spreads have widened by 100 basis points from their most recent low in 2014 (bottom panel). Further, according to the Fed's most recent senior loan officer survey, a majority of lenders are willing extenders of credit. The upshot is that consumer finance companies should be able to grow more profitably than in the past. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CFINX - AXP, DFS, SYF, NAVI, COF.
Highlights China's ongoing industrial sector slowdown will not likely lead to a global growth shock, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Feature We have presented the following views about China's economy and its financial markets over the past several months: China's industrial sector is slowing, and is set to slow further based on our proprietary leading indicators for the Li Keqiang index. This will cause a further deceleration in Chinese nominal import growth and suggests that Chinese ex-tech earnings per share growth will soon peak. Residential investment has potential to provide a tailwind to domestic growth if home sales sustainably pick up, but there are no firm signs that this is occurring. Robust export growth will help China's economy from slowing sharply, but there are several risks to the external demand outlook that need to be monitored. Given the poor growth momentum in the industrial sector, fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. China's consumer-oriented tech sector ostensibly stands out as a shelter from an old economy slowdown, but it is extremely expensive, earnings momentum is very stretched, and it may be adversely impacted by the U.S.' section 301 investigation. We have recommended avoiding exposure since mid-February. China's ex-tech equity market is comparatively cheap, high-beta vs the global benchmark, and technically robust. While the risks to the economic outlook are clear, investors should continue to overweight Chinese ex-tech stocks vs their global peers. For global investors who are perennially concerned that a slowdown in China's economy will culminate in a significant shock to the global economy, Chart 1 provides a helpful visual representation of our view. The chart depicts two scenarios: first, the ongoing industrial sector slowdown in China results in an outright subtraction from global growth momentum via a contraction in imports, despite positive growth impulses from the U.S. and euro area. In our view, Chinese import growth is likely to remain positive, but will largely be driven by strong demand in the developed world (scenario 2). Chart 1Two Different Scenarios Concerning China's Contribution To The Global Economy Chart 1 highlights that our view is more positive for the global economy than one might otherwise think, but it is important for investors to understand the nature of China's relative stability in the event that export growth surprises to the downside over the coming months. In fact, Chart 2 highlights that the most salient data development over the past two weeks has been a fairly significant deceleration in smoothed nominal export growth, which is our preferred method of analyzing Chinese trade data. Despite the relative stability of China's PMIs over the past few months, a 3-month moving average of US$ exports decelerated from 17.5% to 7% in May, or from 10% to -1% in RMB-terms. Sequentially, Chinese export growth improved in May (vs April's reading) in both US$ and RMB-terms, and both beat market expectations. As a result, we are sticking with the second scenario depicted in Chart 1 as the more likely of the two for the coming 6-12 months. However, the reliance on strong external demand to prop up China's import growth is somewhat of a "shaky ladder" for global investors to climb, given the clear risks from U.S. protectionist action, the headwinds to Chinese export competitiveness from a strong currency (or, alternatively, the punishing impact of translation effects on exporter revenue), and the potential for robust export growth to embolden Chinese policymakers to push forward with even more aggressive reforms over the coming year. Still, Chart 3 highlights that many investors are perfectly willing to climb this ladder, shaky or otherwise. The chart shows that the relative performance of Chinese ex-tech stocks versus their global peers remains firmly within the ascending trend channel that has been in place since early-2017, despite the ongoing slowdown in the industrial sector. As we noted in our May 30 report,1 this message is consistent with the view that any recent negative relative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. Chart 2A Nontrivial Slowdown In Chinese Export Growth Chart 3Investors Are Fine Climbing A Shaky Ladder We remain nervous bulls concerning Chinese ex-tech stocks, and continue to recommend an overweight stance. But our reading of China's macro dynamics suggests that investors should not be dogmatic about their equity allocation to China, and should be prepared to cut exposure in response to a material shift in sentiment towards the Chinese economy. As a final point, while we have clearly presented our framework over the past several months for thinking about and analyzing China, investors attending BCA's Annual Investment Conference in September will get an opportunity to hear additional perspectives about the cyclical trajectory of its economy. Leland R. Miller, CEO of the China Beige Book, will be presenting his thoughts on the outlook for Chinese growth and risk assets. Based on his firm's unique insights into China's economic and financial market developments, Mr. Miller's panel will certainly be among those not to miss. Bottom Line: China's ongoing industrial sector slowdown will not likely lead to a shock to global demand, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. A-Shares: EM Inclusion, Factor Analysis, And A Contrarian Shadow Trade The beginning of June marked a milestone for Chinese equities, as MSCI added over 226 large-cap A-shares to their Emerging Markets index. Box 1 provides some brief details about the inclusion, and also notes how it affects several of the trades in our trade book. Chart A1A-Share Inclusion Added 10% Market Cap ##br##To The MSCI China Index Box 1 The Inclusion Of Chinese A-Shares In The MSCI Emerging Markets Index On May 31 2018, 226 China large-cap RMB-denominated A-shares were included in the MSCI Emerging Markets Index. The change represented a 1.4% increase in the market capitalization of the MSCI Emerging Markets index, and 10% increase in the MSCI China Index (Chart A1). We have often referred to the MSCI China Index as the "investable" index in previous reports and in our trade table, but this index now includes some domestic stocks as a result of the recent inclusion. We plan to continue to use the MSCI China Index (or its ex-tech equivalent) as the main outlet for our investment recommendations, which means that the benchmark for five of our trades will be re-labeled in our trade table (from China investable to MSCI China Index). One exception is our trade favoring the MSCI China ESG Leaders Index, as MSCI has yet to publish an ESG rating index for Chinese domestic stocks. We last wrote about the outlook for A-shares in our March 14 Weekly Report,2 and noted that the significant underperformance of A-shares relative to global stocks over the past few years was due to the legacy effects of an enormous, policy-driven speculative bubble in 2014-2015. We highlighted that while domestic stocks have worked off some of this bubble and multiples are no longer extreme, that a neutral allocation was still warranted due to an uninspiring earnings outlook and, at best, a very modest valuation discount relative to global stocks. Chart 4 illustrates this latter point; based on all four trailing valuation ratios that we track, ex-tech onshore stocks are either on par or considerably more expensive than global ex-tech stocks. By contrast, the MSCI China Index (excluding technology) is cheaper than their global peers by all measures, in some cases considerably so. Nevertheless, while we continue to recommend that investors maintain a neutral stance towards A-shares within a global equity portfolio, the inclusion of A-shares in the EM index may force some investors to increase their exposure to domestic stocks beyond the level that they otherwise would have maintained. In order to provide some perspective of what domestic stocks to favor, we have taken a quantitative approach to analyzing A-shares that is loosely inspired by the Fama-French three-factor model. More precisely, we have examined the historical relative performance of three separate factor strategies for A-shares and global stocks, both relative to their respective broad market. The three factors tested are as follows: Return On Equity (ROE): Replacing market beta in the F&F model, we have built a historical portfolio for both Chinese domestic and global stocks that favors level 1 GICS sectors with above-median ROE. Within high-ROE sectors, the portfolio allocates to the sectors on a value-weighted basis to maximize the investability of the strategy. Sector Weight: Our second approach favors GICS sectors with a below-median sector weight, which conceptually mimics the firm size factor in the F&F model. In reality, this strategy is selecting among sectors made up of large cap firms, meaning that investors should regard the performance of this strategy as reflecting the success or failure of investing in potentially underowned or unloved sectors. Value: Our third factor is exactly in line with the F&F model, with portfolios using this approach favoring sectors with above-median dividend yields. We have chosen a cash flow-based valuation measure instead of the book value yield to assuage potential investor concerns about accrual quality. Chart 5 presents the cumulative returns of these strategies, for both global and Chinese domestic stocks. Several important observations are noteworthy: Chart 4A-Shares Are Not Cheap Vs##br## Global Stocks In Ex-Tech Terms Chart 5ROE, Sector Weight, and Value Are ##br##All Successful Factors In China's Domestic Market Favoring high-ROE sectors has been a more profitable strategy when allocating among global sectors than those of the domestic Chinese market, but we have seen similar returns from the strategy in both markets since early-2011. This is consistent with an important conclusion that we made in our March report: the perception among some global investors that domestic Chinese stocks are a "casino" market disconnected from fundamentals does not appear to be supported by the data over the past several years. A strategy of favoring sectors with a low market cap weight has fared better for Chinese A-shares than for the global market, albeit with considerable volatility. We suspect that the underperformance of smaller-than-average sectors at the global level has been affected over the past four years by the underperformance of resources, but the outperformance of the strategy in China also makes sense: underowned or unloved sectors should have more abnormal return potential in smaller, less scrutinized markets. Favoring cheap stocks has been an abysmally poor strategy at the global level over the past decade, due to the chronic underperformance of the financial sector. But cheaper sectors have outperformed China's domestic equity market at a modest pace over the past several years, which is good news for value-oriented investors. Chart 6 highlights where each of China's domestic equity sectors currently sits in the ROE/size/value spectrum. There are three sectors exhibiting two of the factors employed in our analysis: health care, financials, and real estate. For now, we would caution investors against buying domestic health care stocks, as Chart 7 shows that the sector has become heavily overbought over the past several months. Domestic financials would appear to be a better bet: despite underperforming financials in the MSCI China Index, domestic financials have outperformed the domestic broad market over the past year and have not broken materially below their trend line despite a recent selloff. Chart 6Health Care, Financials, And Real Estate Are At The Intersection Of Successful Factors Chart 7Financials Are A Better Bet Than Health Care; Watch For A Housing Catalyst To Buy Real Estate Finally, real estate stocks have the potential to become a fantastic contrarian trade if Chinese home sales do sustainably pick up. The sector is cheap, profitable, and highly unloved given the view among many investors that the Chinese government's structural reforms will weigh on performance for some time to come. But as we have noted in previous reports, the persistent gap between home sales and housing construction over the past few years may very well be over, implying that the latter may rise in lockstep with the former if sales begin to trend higher. Chart 7 shows that investors are not even remotely pricing in such a scenario, as domestic real estate companies have underperformed the domestic benchmark since early-2016 and remain in a relative downtrend. We would not recommend fighting negative investor sentiment towards the sector for now, but domestic real estate companies should clearly be on an investor's watch list, alongside the trend in residential sales volume. Bottom Line: The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. An Update On China's Corporate Bond Market China's equity market may not be the only financial market segment to garner more addition from increased index inclusion over the coming year: Bloomberg recently announced that it will add Chinese RMB-denominated government and policy bank bonds to the Bloomberg Barclays Global Aggregate Index over a 20-month period beginning in April 2019, conditional on the implementation of certain "operational enhancements" to the market by the PBOC and Ministry of Finance.3 China's total bond market (government and corporate) is the third-largest in the world, with a record of 79 trillion yuan ($12.7 trillion) outstanding. Yet foreign investors have little exposure to Chinese bonds, due to frictions concerning investability, a lack of transparency on issuers/index components, and concerns about the quality of domestically-issued credit ratings (95% of China's corporate bonds are rated AA- or higher). Chart 8The Recent Uptick In Yields Has Had A Paltry Impact On Total Returns While the proportion of foreign ownership of Chinese bonds may rise slowly over time, our sense is that it will indeed rise. First, there is a clear yield advantage for Chinese relative to global bonds, in a world where high long-term absolute return prospects are scarce. Second, Chinese policymakers continue to (slowly) open China's financial markets to the rest of the world, and global investors can now gain access to China's onshore bond market through four channels without quota: the qualified foreign institutional investors program (QFII), the renminbi qualified foreign institutional investor program (RQFII), the China interbank bond market (CIBM), and the Bond Connect program.4 Third, China's regulators allowed foreign-owned ratings agencies to set up shop in China last year, in an attempt to address the ratings quality issue. BCA's China Investment Strategy service initiated our long China onshore corporate bonds trade on June 22 last year, which has since earned a 3.7% return in spite of widening yield spreads and a spike in default concerns over the past several weeks. Indeed, Chart 8 highlights that the recent rise in corporate yields has had a minimal impact on the index total return profile. There is one critical factor driving this apparent discrepancy that is not well understood by global investors: compared with corporate issues in the developed world, China's corporate bond market has considerably shorter duration. Table 1 highlights that most of the corporate bonds issued in China have a maturity of three years or less, and the duration for the ChinaBond Company Credit Index, the benchmark that we have used for our corporate bond trade, is approximately 2.3 years. By contrast, U.S. investment- and speculative-grade bonds currently have an effective duration of 7.5 and 4 years, respectively. Chart 9 illustrates the 12-month breakeven spread for the Company Credit Index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. The chart shows that Chinese corporate bond yields would have to rise approximately 250 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that is totally inconsistent the PBOC's monetary policy stance. Table 1Maturity Distribution Of China's Bond Market Chart 9A Compelling Cushion Against Potentially Higher Rates Another way to gauge the attractiveness of a corporate bond position is to look at the spread relative to comparable duration government bonds in order to calculate the default loss that would be required to erase the spread (which is also roughly 250 bps today). Using the relatively conservative assumption of a 35% recovery rate, a 2.5% default loss implies a default rate of close to 4%. We noted in our May 23 Special Report that recent corporate defaults in China amounted to only 0.1% of the outstanding corporate bond market,5 implying that the ultimate scope of corporate bond defaults in China would have to be 40 times larger than currently observed to wipe out the spread relative to Chinese government bonds of comparable duration. While we cannot rule such an event from occurring, there is no evidence to suggest that such a dramatic escalation in defaults is about to occur. Bottom Line: Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "11 Charts To Watch", dated May 30, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "A-Shares: Stay Neutral, For Now", dated March 14, 2018, available at cis.bcaresearch.com. 3 These enhancements include the implementation of delivery vs. payment settlement, the ability to allocate block trades across portfolios, and clarification on tax collection policies. 4 The first three programs have a clear statement that no quotas apply, whereas the bond connect program has no specific statement concerning quotas. 5 Pease see China Investment Strategy Special Report "Messages From BCA's China Industry Watch", dated May 23, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Overweight (High Conviction) The S&P air freight index has been on a tear in recent months, after putting in a bottom earlier this year. It appears the market is valuing rising global trade driving a surge in revenues over a run up in fuel costs that will be a headwind for margins. We would concur. Domestic business conditions are nearly as good as they get, which has historically coincided with rising global air freight volumes (second panel). This rising demand, combined with relatively flat capacity growth, puts pricing power squarely in the hands of the logistics providers (third panel). We think the necessary conditions are in place to improve profit despite rising input costs. While the performance of the S&P air freight index has been solid recently, the growth in forward EPS estimates has been stronger, meaning valuations have barely budged from their steep discount to both normal and the market (bottom panel). We expect this situation is unlikely to persist with the most likely scenario being strong stock price performance, particularly if input costs begin to recede. Accordingly, we reiterate our high conviction overweight recommendation on the air freight index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.
Highlights One of Europe's major success stories is the structural and broad-based increase in female labour participation rates. The trend is set to continue for the next decade. Stay overweight the Personal Products sector as a long-term position. Italy's decade-long stagnation is not a deep-seated structural malaise. It is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Buy exposure to Italian real estate as a new long-term position either directly or through Italy's small real estate equity sector. Feature Some analysts persist on comparing economic performances on the basis of real GDP per head of total population. But the total population includes children and the elderly who cannot contribute to economic output. Therefore, a correct assessment of economic performance should look at real GDP per head of working-age population. Chart I-1AWomen Are Powering The European Economy... Chart I-1B ...Less So In The U.S. Admittedly, as the retirement age rises, the definition of 'working-age' will gradually change, but the general principle still holds: only count in the denominator those who can contribute to economic output. GDP per head of working-age population can grow in several ways. One way is to get more output or better output from each hour worked through improvements in efficiency and/or quality. As this improvement is theoretically limitless, it is the main source of productivity gains in the long run. A second way is for each worker to work more hours. But given the physical and legal constraints on productive working time, there is only limited scope to increase output in this way. How Women Are Powering The European Economy There is one other way to increase GDP per head of working-age population: increase the percentage of the working age population that is in the labour force.1 In other words, structurally increase the labour participation rate. If this participation rate is already high - as it is for men - then there is little scope to increase it much further. But if the participation rate is low - as it is for European women - then there is considerable scope to increase it. This brings us to one of Europe's major, and largely untold, success stories - the structural and broad-based increase in female participation rates (Chart I-1-Chart I-5). Over the past twenty years, the EU28 female participation rate has risen from 57% to 68%, with an especially large contribution from the socially conservative southern countries. In Spain, female participation has surged from 47% to 70%. In Italy, it has shot up from 42% to 56% and has clear scope to rise much further. Chart I-2Italy: Labour Force Participation Rate Chart I-3Spain: Labour Force Participation Rate Chart I-4Germany: Labour Force Participation Rate Chart I-5France: Labour Force Participation Rate What is driving this structural trend? Two things. First, the employment sectors that are growing structurally - healthcare, social care, and education - tend to employ more women than men. Second, European countries have legislated a raft of policies encouraging women to join and remain in the labour force: generous paid maternity leave and subsidised childcare. The trend is for further improvements, with the focus now on improving paternity leave. Sharing parental and family responsibilities between mothers and fathers allows more women to enter and stay in the labour force.2 For the ultimate end-point in the trend, look to the Scandinavian countries which started such policies in the early 1970s. In Sweden, labour force participation for women and men is almost identical: 81% versus 84%. If the EU eventually adopts the Scandinavian model, it would mean another 20 million European women in employment and contributing to economic output (Chart I-6). Chart I-6Another 20 Million European Women ##br##Could Join The Labour Force Dispelling Two Myths: The Euro Area And Italy Having established that economic performances should be compared on the basis of GDP per head of working age population, we can now dispel two common myths. The first myth is that the U.S. generates superior productivity growth than the euro area. It is true that the U.S. has been better at getting more output from each hour worked, so on this measure, the U.S. does win. Against this, the euro area has been much better at getting more of its working-age population - albeit mostly women - into employment. So on this measure, the euro area wins (Chart of the Week). The net result is that, over the past twenty years, the U.S and the euro area have generated exactly the same growth in real GDP per working-age population (Chart I-7). Of course, the euro area's structural improvement in female participation rates cannot continue forever, but it can certainly continue for another decade or so, and this is generally the longest time horizon that most investors care about. Chart I-7The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The second myth concerns the subject du jour: Italy. Many people claim that Italy's economic stagnation is due to deep-seated structural problems which differentiate it from other major economies. The problem with this narrative is that from the mid-1990s until 2008 the growth in Italy's real GDP per head of working age population was little different to that in Germany, France or the U.S. (Chart I-8). Chart I-8Italy Performed In Line With Other Major Economies Until 2008 Italy's economic stagnation only started after the 2008 global financial crisis. After a financial crisis which cripples the banking system, there are two golden rules: unleash fiscal stimulus; and repair the banking system as quickly as possible. The U.S. and U.K. followed the golden rules perfectly and immediately; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as the fiscal stimulus kicked in and the banks recuperated. Italy neither unleashed fiscal stimulus, nor repaired its banks - so its economy has stagnated for a decade. Moreover, if output stagnates for a decade, it follows arithmetically that productivity growth will also look poor. In a back-to-front argument, critics have pounced on this as evidence of excessive 'red tape' and 'structural problems'. But this is a misdiagnosis of the malaise. To reiterate, Italy's real GDP per working-age population was growing very respectably before 2008. Italy's misfortune is that its indebtedness has an unusual profile: more public debt than private debt. France and Spain (and other major euro area economies) have the usual profile: less public debt than private debt. So the EU's fiscal rules - which can see only public debt and are blind to private debt - have severely and unfairly constrained Italy's ability to respond to financial crises. While every other major economy followed the golden rules to recover from the 2008 crisis, Italy could neither unleash fiscal stimulus to kick start the economy nor recapitalise its dysfunctional banking system. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Two Structural Investment Conclusions This week's two investment conclusions are both long term, and require a buy and hold mentality. The first conclusion reiterates a structural position: overweight the Personal Products sector. This is based on our expectation that, in Europe, female participation rates will continue their structural uptrend; while in the U.S. we expect female participation rates to continue outperforming male participation rates. Therefore the sales and profits of the Personal Products sector, in which female spending dominates, will benefit from a multi-year tailwind, at least relative to other sectors. And the extent of this tailwind is not fully discounted in valuations. The second conclusion is a new long-term recommendation: buy exposure to Italian real estate. This is based on our assessment that Italy's decade-long stagnation is not a deep-seated structural malaise. Instead, it is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. Removing these shackles will allow a long-term recovery, just as it did for Spain in 2013. If we are right, the best multi-year buy and hold play is Italian real estate which has been in a decade-long bear market (Chart I-9). For those that cannot directly invest in property, Italy has a small real estate equity sector which faithfully tracks the long term profile of real estate prices (Chart I-10), and whose main component is Beni Stabili. The caveat is that the stock has a market cap of just €2 billion; the appeal is that it offers a juicy dividend yield of 4.5%. Chart I-9Italian Real Estate Has Suffered ##br##A Decade-Long Bear Market Chart I-10Italian Real Estate Equities##br## Track Real Estate Prices Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 And in employment. 2 Please see the European Investment Strategy Special Report "Female Participation: Another Mega-Trend" published on April 6, 2017 and available at eis.bcaresearch.com Fractal Trading Model* This week, we note that the 130-day fractal dimension for platinum versus nickel is close to its lower bound, a level which has consistently predicted a tradeable countertrend move over the following 130 days. Hence, this week's trade is long platinum/short nickel on a 130 horizon before expiry. The profit target is 14% with a symmetric stop-loss. Our two other open trades, long SEK/GBP and long PLN/USD, are both in profit. 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. Chart I-11 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. * 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 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
Underweight (Upgrade Alert) It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus, it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (fuel prices shown inverted in top panel). Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations (bottom panel). We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK.
Overweight (High Conviction) The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. Currently, software investment is outpacing overall capital outlays (second panel). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Our S&P software EPS growth model corroborates this encouraging news (third panel), pointing to ongoing exceptionally strong earnings growth. Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt (bottom panel); if our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com.
Highlights Chart 1Risks To The Bond Bear Market Two weeks ago we flagged that large net short positioning and elevated growth expectations left the Treasury market primed to benefit from any disturbance in the economic outlook. Since then the 10-year yield fell from a peak of 3.06% to 2.77%, before climbing back to 2.92%. With positioning still deeply net short and strong odds of a further decline in the economic surprise index (Chart 1), we continue to see an elevated risk that yields move lower on a 0-3 month horizon. But beyond that, less nimble investors should remain positioned for higher yields on a 6-12 month timeframe. The major risks in the global economy - Eurozone sovereign credit concerns and a strong dollar weighing on emerging market demand - are unlikely to put the Fed off its "gradual" pace of one rate hike per quarter unless they lead to a significant risk-off event in U.S. financial markets. Absent that sort of shock, the Fed will continue to lift rates "gradually" toward a neutral level near 3%, and eventually into restrictive territory. This rate hike path is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to -122 bps. Value has improved considerably since the start of the year. The 12-month breakeven spread for a Baa-rated corporate bond is back up to its 29th percentile relative to history (Chart 2). Market-derived inflation expectations also ebbed during the past month, with the 10-year and 5-year/5-year forward TIPS breakeven inflation rates now at 2.09% and 2.12% respectively. This is below the target range of 2.3% to 2.5% that would trigger a downgrade to our corporate bond allocation. The combination of more attractive value and a somewhat more supportive monetary environment (as evidenced by the decline in TIPS breakeven rates) increases the odds of near-term corporate bond outperformance, and we would not be surprised to see spreads tighten during the next few months. However, the longer run outlook for corporates remains negative. First quarter data showed a 5.7% annualized decline in pre-tax corporate profits, dragging the year-over-year growth rate down to 5.8% (bottom panel). As employee compensation costs accelerate in the second half of the year, we expect that corporate profit growth will fall sustainably below the pace of corporate debt growth leading to rising leverage (panel 4). Strong oil prices have caused the energy sector to outperform the overall index considerably since the middle of last year. Now, many energy sub-sectors no longer appear cheap on our model. We take this opportunity to downgrade a few energy sub-sectors from overweight to neutral, and adjust some other sector recommendations as well (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +36 bps. The average index option-adjusted spread widened 24 bps on the month, and currently sits at 356 bps. High-yield spreads are increasingly at odds with Moody's default rate projections. The latter call for the 12-month speculative grade default rate to fall to 1.5% by next April. The current 12-month trailing default rate is 3.7% (Chart 3). Using the Moody's default rate projection, and our own forecast for the recovery rate, we calculate the excess spread available in the Bloomberg Barclays High-Yield index to be 284 bps (after accounting for expected default losses). This is somewhat higher than the historical average of 248 bps. The current excess spread means that in an unchanged spread environment we would expect a High-Yield excess return (relative to duration-matched Treasuries) of +278 bps during the next 12 months. If the index spread were to tighten by 100 bps, we would expect an excess return of +675 bps. If the index spread were to widen by 100 bps we would expect an excess return of -120 bps (panel 3). If the excess spread were to simply revert to its historical average, then it would imply an excess High-Yield return of +427 bps. At the sector level, Moody's expects that most defaults during the next 12 months will come from the Media: Advertising, Printing & Publishing sector, followed closely by the Durable Consumer Goods and Retail sectors. Much of the projected improvement in the overall default rate results from a continued decline in Oil & Gas sector defaults compared to the past few years. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in May, dragging year-to-date excess returns down to -27 bps. The conventional 30-year zero-volatility MBS spread widened 4 bps on the month, driven entirely by a 4 bps increase in the compensation for prepayment risk (option cost). The option-adjusted spread held flat at 32 bps. Value in the MBS sector is by no means exciting. The nominal spread on a conventional 30-year MBS is near its all-time low, the option-adjusted spread is close to one standard deviation below its pre-crisis mean (Chart 4) and MBS no longer look very attractive compared to investment grade corporate credit (panel 3). The most compelling reason to hold agency-backed MBS is that mortgage refinancings are likely to remain very low, owing both to rising interest rates and the large number of homeowners that have already refinanced. Depressed refi activity should keep MBS spreads near historically low levels (bottom panel), even as stresses emerge in other spread product sectors, notably corporate bonds. We recently presented a method for calculating expected total returns for all different bond sectors, only using assumptions for the number of Fed rate hikes during the next 12 months and the expected change in spreads.1 Our results showed an expected total return of 2.9% for conventional 30-year MBS in a scenario where the Fed lifts rates by 100 bps and where spreads remain flat. The same scenario corresponds to 3.4% total return for the investment grade corporate index. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 33 basis points in May, dragging year-to-date excess returns down to -40 bps. Sovereign debt underperformed the Treasury benchmark by 158 bps on the month, dragging year-to-date excess returns down to -242 bps. Foreign Agencies underperformed by 37 bps on the month, dragging year-to-date excess returns down to -56 bps. Local Authorities underperformed by 22 bps on the month, dragging year-to-date excess returns down to +37 bps. Supranationals underperformed by 2 bps on the month, dragging year-to-date excess returns down to +2 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to +7 bps. Global growth divergences and a stronger U.S. dollar weighed on Sovereign bond returns in May (Chart 5). While value in the sector improved somewhat as a result, it remains expensive relative to investment grade corporate credit (panel 2). With dollar strength likely to persist in the near-term, we remain underweight Sovereign bonds. Conversely, we reiterate our overweight recommendations on Foreign Agency and Local Authority bonds. Those sectors still offer compelling valuations and are less sensitive to a strong U.S. dollar than the lower-rated Sovereign sector. Supranationals and Domestic Agency bonds are low risk but do not offer sufficient spread to warrant much attention. Better low-risk spread product opportunities are available in the Agency CMBS and Consumer ABS sectors. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +110 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% on the month and, at 86%, it is very close to its post-crisis low (Chart 6). It remains somewhat elevated compared to the average level of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Technically, yield ratios have been supported by robust fund flows and subdued issuance (panels 2 & 3), while fundamentally our Municipal Health Monitor suggests that ratings upgrades will continue to outpace downgrades for the time being (not shown). The message from our Health Monitor is confirmed by the trend in state & local government net borrowing (bottom panel). First quarter data, released last week, showed a sizeable drop in net borrowing as state & local governments managed to grow revenues by $46 billion while growing expenditures by only $25 billion. This is consistent with governments working hard to repair their budgets, raising taxes and slowing spending growth, as we showed in a recent report.2 Given tight municipal valuations, we continue to see better opportunities in the corporate bond space than in municipal bonds. But we will look to upgrade munis at the expense of corporates as we approach the end of the credit cycle. Hopefully, from a more attractive entry point. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened in May. The 2/10 Treasury slope flattened 3 bps to end the month at 43 bps. The 5/30 slope held steady at 32 bps. The short-end of the Treasury curve is still not adequately priced for the Fed's likely pace of one 25 basis point rate hike per quarter. Such a pace translates to a level of 100 bps on our 12-month discounter, which currently sits at only 73 bps (Chart 7). Similarly, the long-end of the Treasury curve is not adequately priced for the likely trend in inflation. The 10-year TIPS breakeven inflation rate is at only 2.09%, below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. We anticipate that higher TIPS breakevens at the long end of the curve will be roughly offset by loftier rate expectations at the short end of the curve, leaving the slope of the Treasury curve close to current levels during the next few months. In a recent report we introduced a framework for identifying the most attractively valued butterfly trades across the entire yield curve.3 The results, shown in Table 4, identify the 7-year bullet over the 1-year/20-year barbell as the most attractively valued butterfly trade that is geared toward curve steepening. According to our model, that trade is priced for 56 bps of 1/20 flattening during the next six months (panel 4). That seems excessive given the low level of long-maturity TIPS breakevens. Table 4Butterfly Strategy Valuation (As Of June 4, 2018) TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +95 bps. The 10-year TIPS breakeven inflation rate fell 10 bps on the month and currently sits at 2.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 13 bps and currently sits at 2.12%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.4 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. Recent trends show that inflation is steadily making progress toward the Fed's 2% goal. The 12-month rate of change in the core PCE deflator is back up to 1.8%, from 1.5% in February. However, the core PCE deflator has only increased by 0.15% in each of the past two months. Consistent monthly prints above 0.165% are required to reach the Fed's 2% target (Chart 8). We expect tight labor markets and strong pipeline pressures (panel 3) to drive inflation higher in the months ahead. Although, as we discussed last week, the risk of a significant overshoot of the Fed's inflation target during the next 6-12 months is low.5 ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -3 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp on the month and now stands at 41 bps, 7 bps above its pre-crisis low. While consumer ABS offer reasonably attractive expected returns relative to other low-risk spread product (Agency CMBS, Domestic Agency bonds and Supranationals), credit risk is slowly starting to build in the sector. The New York Fed's Household Debt and Credit report showed that the 90+ day credit card delinquency rate rose above 8% in Q1 for the first time since 2015. Meanwhile, the overall consumer credit delinquency rate continues to increase alongside a rising debt service ratio (Chart 9). On the supply side, banks reported tightening credit card lending standards for the fourth consecutive quarter in Q1, while auto loan lending standards were tightened for the eighth consecutive quarter. Periods of tightening lending standards tend to coincide with rising delinquencies and wider spreads (bottom panel). In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect Aaa-rated credit card ABS to return 2.3% and Aaa-rated auto loan ABS to return 2.4%.6 Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month and currently sits at 70 bps, close to one standard deviation below its pre-crisis mean. Banks eased lending standard on nonfarm nonresidential loans in Q1 for the first time since 2015, and continued easing could signal lower delinquencies in the future (Chart 10). Easier lending standards could also support commercial real estate prices, which have decelerated recently and currently pose a risk for spreads (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +13 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 48 bps. In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect non-agency Aaa-rated CMBS to return 2.8% and Agency CMBS to return 2.6%.7 Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.54%. The drop in the model's fair value compared to last month stems from a decline in the global PMI from 53.5 to 53.1, and a rise in dollar bullish sentiment from 60% to 67%. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. As resource slack dissipates, inflationary pressures mount and the same pace of global growth should be associated with a higher Treasury yield. This means that as we approach the end of the cycle, the 2-factor model will start producing fair value readings that are consistently too low. We can attempt to correct for this by incorporating a measure of resource slack into our model, in this case the employment-to-population ratio. A model for the 10-year Treasury yield based on the employment-to-population ratio and the Global PMI produces a fair value of 3.29% (Chart 11). As we move further toward the end of the cycle, and away from the zero-lower bound on the fed funds rate, we expect the regression coefficients shown in the bottom three panels will revert to their pre-crisis levels and Treasury fair value will revert closer to the one shown in the second panel. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
The GAA DM Equity Country Allocation model is updated as of May 31, 2018. No significant changes in the model's allocation this month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 111 bps in May, largely driven by Level 2 model which underperformed by 300 bps. The model's largest overweight, Italy, turned out to be the worst performer in May as a result of Italian politics, an event that is difficult for a quantitative model to capture. Level 1 model outperformed by only 7 bps in May. Consequently, since going live, the outperformance of the Level 2 model, which allocates funds among 11 non-U.S. countries, has reduced to 52 bps, while the overall model has performed in line with the MSCI World benchmark. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. 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 May 31, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The largest shift was a move from underweight to overweight in the materials sector, driven by improving momentum. On the other hand, the overweight in energy was reduced by 1.7 percentage points. The aggregate model now has a small overweight on cyclicals versus defensives, although this is entirely in commodity-related cyclicals. The only other overweight sector is utilities, which saw a small decrease in its weight in the model. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com.