Sectors
Overweight (High Conviction) As highlighted in this week's Weekly Report, we are moving to a benchmark allocation in the S&P information technology sector. The way we are executing the upgrade is by lifting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. We are also adding this index to our high conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel). Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (third panel). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (bottom panel) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Bottom Line: Boost the S&P THSP index to an overweight stance and add it to the high-conviction overweight list. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.
Neutral We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral. The core driver of our upgrade is to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel). There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel). Despite the good news, crucial sector risks, including a bounce in the U.S. dollar, higher interest rates (another key BCA theme for 2018) and regulatory/political risks (the source of the recent tech sector wobble) prevent us from turning outright positive. Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral; see yesterday's Weekly Report for more details.
Highlights Portfolio Strategy The capex upcycle, a soft U.S. dollar and improving end demand signal that it no longer pays to underweight the S&P tech sector. Lift exposure to neutral. Firming domestic and global final demand, the synchronized global capex upcycle, an overly pessimistic sell-side analyst community and cheap valuations compel us to upgrade the S&P tech hardware, storage & peripherals index to overweight. Recent Changes S&P Technology - Upgrade to neutral today. S&P Tech Hardware, Storage & Peripherals - Boost to overweight and add to the high-conviction overweight list today. Table 1 Feature The S&P 500 seesawed last week, and continues to absorb the early February drawdown. While global growth cannot continue its breakneck pace indefinitely and a soft patch is inevitable, global output growth remains significant and above trend. Our constructive cyclical equity market view remains intact, premised upon the longevity of the business cycle, at least for the next 9-12 months. In the U.S. specifically, the ISM manufacturing survey is perched closer to 60 than to 50, unemployment insurance claims hover near 50-year lows and the muted 10-year Treasury yield moves all signal that generalized fear has yet to grip markets (Chart 1). In fact, if one looks back at the 2015, 2011 and 2010 global growth scares, investors took shelter in U.S. Treasuries as the SPX sold off, sending the 10-year UST yield lower by 50, 70 and 70 bps respectively in a very short time span. The fact that the 10-year yield is only 15 bps below its peak should cause us to question whether the recent equity drawdown is really about slowing global growth. On the monetary policy front, while the Fed is increasing the fed funds rate and decreasing the size of its balance sheet and volatility is making a comeback (please see Chart 1 from the March 5th Special Report), the real fed funds rate remains below the zero line and the real 10-year UST yield is also close to nil (Chart 2). Economic slack measures confirm that the Fed remains behind the curve. The output and unemployment gaps have been closed for a while now, and BCA's unemployment diffusion index and the Taylor rule both signal that monetary policy is extremely accommodative (Chart 3). Chart 1Macro Conditions... Chart 2...Remain Conducive... Chart 3...To A Rising SPX The implication is that macro conditions remain conducive to a rising equity market from a cyclical time horizon perspective. Meanwhile, sifting through the noise reveals that the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, as we highlighted in recent research, will be turbulent,1 and likely an earnings validation phase will pave the way higher for the broad equity market. In fact, dissecting the tax relief impact on different sectors is in order. Charts 4 & 5 show the calendar 2018 forward estimates on December 31st, 2017 and what analysts pencil in today, respectively. Charts 6 & 7 highlight the delta in absolute terms and percentage change terms. Chart 42018 EPS Growth On March 30, 2018 Chart 52018 EPS Growth On December 31, 2017 Chart 6Delta Chart 7Delta % Change Telecom services will likely benefit tenfold from the lower corporate tax rate (shown truncated, Chart 7), and consumer discretionary stocks are also prime beneficiaries. But this also means that 2018 after-tax profit data are masking the negative underlying trend growth rate for both of these sectors which also sport grim operating metrics. The S&P telecom services sector is a high-conviction underweight,2 and we reiterate our recent downgrade to a below benchmark allocation in the S&P consumer discretionary sector.3 Industrials, energy and financials, also benefit greatly from tax relief (Chart 7), but higher commodity prices along with improving industry operating metrics contribute to the EPS euphoria for these sectors. Nevertheless, we have identified three key risks to our sanguine equity market view: Escalating geopolitical/regulatory uncertainty Severe global growth slowdown U.S. dollar surge All three risks are intertwined and could infiltrate profit growth in the coming months. As we have posited in recent research, U.S. dollar softness begets higher global growth and the two feed off of each other in a virtuous cycle. A depreciating currency is a profit fillip for SPX constituents with heavy export exposure, the opposite is also true (Chart 8). Chart 8S&P 500: Aggregate Sector International Revenue Exposure (%) If the Trump Administration continues to slap on tariffs with China retaliating, as we experienced last week, eventually triggering a global trade war, then all bets are off on the sustainability of global growth (Chart 9). Such an outcome would weigh heavily on both market sentiment and profits, as our Geopolitical Strategists argued last week.4 Chart 9Don't Throw In The Towel On Global Growth Yet Finally, regulatory clampdown on the tech sector specifically is also on our radar screen, especially given the monopolistic powers that a handful of U.S. tech titans command. This is not only a U.S. risk, but also a global one. However, the 2000s Microsoft and recent Google precedents suggest that a corporate breakup is a low probability event à la "Ma Bell" in 1983, and heavy fines are the most likely outcome (we will be covering this regulatory risk in an upcoming Special Report in conjunction with our sister Geopolitical Strategy publication, stay tuned). Adding it up, we assign low probabilities to all three risks. This week we are taking advantage of recent market weakness and adding some cyclical exposure to our portfolio. Lift Tech To Neutral... We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral.5 Before exploring our thesis on why we are becoming more constructive on the largest S&P sector in terms of market capitalization weight, it is instructive to look back and identify what we missed. Two reasons for the tech sector's outperformance stand out. First, BCA's constructive view on the U.S. dollar has weighed heavily on our underweight positioning in the tech sector, especially since the greenback's peak in level terms in December 2016. U.S. tech firms garner 60% of their total revenues from abroad - the highest among the GICS1 sectors (Chart 8) - and the positive P&L translation gain effects have been a tonic to EPS. Irrespective of where the dollar will end 2018, due to lagged effects, the U.S. dollar's significant depreciation will continue to boost tech sector EPS. Second, the lack of inflation at this stage of the cycle has perplexed economists and presented a goldilocks macro backdrop for the tech sector that thrives in deflation/disinflation. This benign inflation backdrop has also coincided with the V-shaped global growth recovery following the late-2015/early-2016 global manufacturing recession and propelled technology stocks. Nevertheless, in mid-September we lifted the S&P software index to a benchmark allocation and subsequently to a high-conviction overweight in late-November in order to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle. Building on this thesis, the broad tech sector also benefits from rising capex (Chart 10). In fact, there is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. Not only is the tech sector gaining capex market share, largely at the expense of basic resources (Chart 11), but also in absolute terms tech spending is on fire and vaulting to fresh all-time highs (Chart 10). Chart 10Prime Capex Beneficiary Chart 11Sector Capex % Of Total National accounts confirm the stock market-reported capital outlays data and tech investment is firing on all cylinders (middle panel, Chart 12). In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end-demand is upbeat (fourth panel, Chart 12). The San Francisco Fed's Tech Pulse Index encapsulates all this tech optimism underpinning tech stocks (second panel Chart 12).6 On the global demand front, EM Asian exports are climbing at the fastest clip in ten years, despite the smart rebound in the ADXY. Historically, tech sales and EM Asian exports are joined at the hip and the current message is positive (bottom panel, Chart 12). Importantly, a rising revenue backdrop is necessary, especially in the context of rising capital outlays, as they sustain the virtuous upcycle. A simple final demand indicator combining tech exports and new orders is also flashing green (Chart 13). Tack on the sizable losses in the U.S. dollar over the past year and resurgent tech exports will be a boon to tech EPS (bottom panel, Chart 13). Chart 12Firm End-Demand Chart 13Soft U.S. Dollar Helps Our tech profit model does an excellent job capturing all of these positive forces and is pointing to healthy growth for the rest of 2018 (second panel, Chart 14). However, there are also a few headwinds that the tech sector has to contend with and that prevent us from lifting exposure all the way to overweight. First, any knee-jerk bounce in the U.S. dollar is a clear negative for technology stocks. Second, BCA's second key theme we are exploring calls for higher interest rates in 2018 on the back of rising inflation (Chart 15). Were the selloff in the bond market to gain steam in the coming months as inflation rears its ugly head, then tech stocks would come under intense pressure. Third, as we highlighted above, regulatory/political risks have been at the epicenter of the recent tech sector wobble, and heightened regulatory uncertainty will continue to muddy the tech waters. Finally, while tech stocks are nowhere near as overvalued as in late-1999/early 2000, they are more expensive than the broad market on a number of valuation measures (third panel, Chart 14). Chart 14Our Tech Profit Model Flashes Green... Chart 15...But Interest Rates Are A Big Headwind Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral, by augmenting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. ...Via Boosting Tech Hardware To Overweight The way we are executing the upgrade to neutral on the broad S&P tech sector is by lifting the S&P THSP index to an overweight stance. We are also adding this index to our high-conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel, Chart 16). Already, U.S. factories are humming trying to fulfill perky end-demand. Industry production is far outpacing capacity growth and this represents a boon to pricing power that has exited deflation for the first time ever (bottom panel, Chart 16). The implication is that S&P THSP profits will overwhelm. Beyond U.S. shores, global fixed capital formation is also climbing sharply. This synchronized global capex upcycle represents a tailwind for this industry and will continue to underpin U.S. computer exports (Chart 17). Add on the depreciating greenback and U.S. manufacturers are well positioned for export market share gains (third panel, Chart 17). Chart 16Capex To The Rescue Chart 17Enticing Global ... Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. In particular, EM Asian exports are expanding at a healthy clip, in spite of rising EM currencies, underpinning S&P THSP net earnings revisions (middle panel, Chart 18). The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (Chart 18). All of this suggests that S&P THSP sales and profits will shine in 2018, easily surpassing the extremely low relative hurdles that sell-side analysts are penciling in for the coming 12 months (second & third panels, Chart 19). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (Chart 20) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Return on equity is also probing all-time highs. Chart 18...Demand Backdrop Chart 19Unwarranted Pessimism... Chart 20...Given Pristine B/S And Sky-High ROE Finally on the relative valuation front, this tech sub-index trades at a 20% discount to the broad market (and below the S&P tech sector) both on a forward P/E and EV/EBITDA basis, offering an appealing entry point. Bottom Line: Boost the S&P THSP index to an overweight stance for a loss of 16% since inception, and add it to the high-conviction overweight list. This shift also lifts the overall S&P tech sector to a benchmark allocation for a loss of 18% since inception. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com. 6 "The Tech Pulse Index is an index of coincident indicators of activity in the U.S. information technology sector. It can be interpreted as a summary statistic that tracks the health of the tech sector in a timely manner. The indicators used to compute the index are investment in IT goods, consumption of personal computers and software, employment in the IT sector, as well as industrial production of and shipments by the technology sector. The index extracts the common trend that drives these series." https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).
Neutral The S&P health care equipment (HCE) index has caught a bid recently, reflecting the sector's strong profit momentum, following nearly a decade of decline (second panel). We fear, however, that investors have become somewhat overzealous as the run up in stock prices has dramatically outpaced earnings expectations, pushing the forward price/earnings multiple to its highest level since the GFC (third panel). Such excitement, particularly when industry pricing power is lagging far behind the rest of the broad corporate sector (bottom panel) seems misplaced. Net, we continue to think the catalyst for a sustainable move higher in the index will be a recovery in pricing power and, in the absence of evidence of this, we reiterate our benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMB, VAR, HOLX.
Overweight (High-Conviction) The S&P software index caught a bid last week, led by heavyweight Microsoft (representing a bit more than 50% of the index) following a positive sell-side report that put a one-year price target implying a $1 trillion market cap. The basis for the (very) high expectations was Microsoft's dominant position in cloud computing and its rapid adoption in the marketplace; we are very much in agreement as we believe software spending is in the early days of an acceleration. CEO confidence, despite having peaked, remains near decade-highs, typically a precursor of greater software spending (second panel). Bank loan growth, another leading indicator of loosening purse strings, has just turned a corner (third panel). Our optimism is clearly shared by the analyst consensus view as earnings revisions have reached a seven-year high (bottom panel). Adding it up, we think more outperformance is in store for this technology subsector; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, TTWO, CA, CDNS.
Feature Japan's economic experience in the post bubble era is often described as a fate to avoid at all costs. We would like to turn this common notion on its head. Rather than something to avoid, Japan's post bubble experience is a fate that other major economies should actively try to emulate, at least in parts. This report focusses on three specific lessons for European investors. Japan's so-called 'lost decades' describe the weak growth in its nominal GDP since the mid-1990s. But this emphasis on aggregate nominal income is grossly misleading. Standards of living do not depend on nominal GDP. What matters is real GDP per head combined with the absence of extreme income inequality. Real income must grow and this growth must benefit the majority, rather than a small minority. Since the late 1990s, the growth in Japan's real GDP per head has outperformed every other major economy (Chart Of The Week). And unlike other major economies, income inequality in Japan has not increased, remaining amongst the lowest in the developed world (Chart I-2). This is not surprising. Credit booms inflate bubbles in financial assets, which exacerbate income and wealth inequalities. Chart Of The WeekJapan Has Outperformed Everybody Chart I-2Income Inequality In Japan Has Not Increased Admittedly, the government has been running persistent deficits, but this is to counterbalance private sector de-levering. Total indebtedness as a share of GDP has not been rising. In the post credit boom era, Japan's real growth has come entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Unlike the unsustainable growth that is fuelled by credit booms and asset bubbles, real growth that comes from productivity improvements is sustainable. Genuine Price Stability: Something To Celebrate, Not Fear Japanese consumer prices are at the same level today as they were in 1992, meaning that Japan has experienced genuine price stability for two and a half decades (Chart I-3). But this is neither new, nor alarming - Britain enjoyed genuine price stability for two and a half centuries! At the height of the British Empire in 1914, consumer prices were little different to where they stood at the end of the English Civil War in 1651 (Chart I-4). Chart I-3Japan Has Experienced Genuine Price ##br## Stability For Two And A Half Decades... Chart I-4...But Britain Experienced Genuine Price Stability For Two And A Half Centuries! Nevertheless, central banks continue with the deception that price stability means an inflation rate of 2%. This is clearly nonsense. Think about it - if prices rise by 2% a year, then your money will lose a quarter of its purchasing power every decade. And after a typical working life, your money will have lost two-thirds of its value.1 How exactly does that qualify as price stability?2 Still, we frequently hear a strong counterargument - in a highly indebted economy, inflation and growth in nominal GDP do matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% rather than at zero; and nominal GDP growth at 3.5% rather than at 1.5%. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point target. As we explained a while back in The Case Against Helicopters, inflation is a non-linear phenomenon which is extremely difficult, if not impossible, to point target.3 Look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. Chart I-5The Money Multiplier Is Non-Linear M is non-linear because the commercial banking system money multiplier - the ratio of loans to bank reserves - is non-linear. At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible (Chart I-5). Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At this point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. What is the Japanese lesson for Europeans? Simply that just like the BoJ, the ECB will keep moving the 2% inflation goalpost further and further into the future, as it realises the impossibility of achieving and sustaining the 2% point target. So even with inflation in the 1-2% channel, the ECB will create a loophole to exit NIRP and ZIRP very soon after it exits QE. This will structurally support the euro. Do Not Own Banks For The Long Term (Or Now) Japanese financial sector profits stand at less than half their peak level in 1990. For euro area financial sector profits which peaked in 2007, the interesting thing is that they are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth through the next 17 years (Chart I-6). Chart I-6Euro Area Financial Profits May Experience No Sustained Growth In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage - the amount of equity held against the balance sheet. More stringent European regulation will make this a headwind too. Banks will have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin - the difference between rates received on loans and rates paid on deposits, effectively a function of the yield curve slope. However, this is a cyclical driver, and as explained last week in Market Turbulence: What Lies Ahead? this driver is unlikely to be positive in the coming months.4 What is the Japanese lesson for Europeans? Simply that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play during periodic strong countertrend rallies, albeit now is not the time for such a cyclical play. A Surge In Female Participation Chart I-7Sales Of Personal Products Have Boomed Over the past twenty years, Japanese sales of skin cosmetics and beauty products have almost tripled (Chart I-7). This has helped the personal products sector to outperform very strongly. The personal products sector is dominated by female spending. So it is significant that in 1995, the Japanese government introduced a raft of policies to encourage women to join the labour force: paid maternity leave, subsidised childcare, and paid parental leave for both parents. Today in Japan, both mothers and fathers can take more than a year of paid parental leave at an average rate of 60% of earnings. The policies had their desired effect. The proportion of Japanese women in the labour force has surged from 57% to 67%, while the male labour participation rate has held at 85%. Therefore, all of the growth in the Japanese labour force through the past twenty years has come from women. Europe tells a similar tale. Through the past couple of decades, parental leave policies have become steadily more generous. Unsurprisingly, the proportion of European women in the labour force has also surged from 57% to 67%, while the male labour participation rate has held at 78%. So just as in Japan, all of the growth in European labour force participation through the past twenty years has come from women (Chart I-8). But for the ultimate end-point in the European trend, look to the Scandinavian countries which have had generous parental leave policies since the 1970s. As a result, labour force participation for Swedish women is almost identical to that for men: 80% versus 83%. If the EU eventually reaches the Scandinavian end-point, it would mean another 20 million women in the EU labour force. What is the Japanese lesson for Europeans? While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled. Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17-year lag (Chart I-9). If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years. Stay overweight the European personal products sector. Chart I-8A Surge In Female Participation Chart I-9Personal Products Profits Set To Grow Very Strongly Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming you work for 50 years. 2 Admittedly, measured inflation probably overstates true inflation. However, estimates put this measurement error at no more than 0.3-0.5 percentage points. 3 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5 2016 and available at eis.bcaresearch.com 4 Please see the European Investment Strategy Weekly Report 'Market Turbulence: What Lies Ahead?' published on March 29 2018 and available at eis.bcaresearch.com Fractal Trading Model* This week’s trade recommendation is to go long the Australian dollar versus the Norwegian krone. The profit target is 2% with a symmetrical stop-loss. 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-10 * 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 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Key Portfolio Highlights Our portfolio positioning remains firmly behind cyclicals over defensives, driven principally by our key 2018 investment themes: synchronized global capex growth (Chart 1A) and higher interest rates on the back of a pickup in inflation (Chart 1B). The positioning has been lifted by synchronized global growth and a soft U.S. dollar (Chart 1C), while the key risk to our portfolio of a hard landing in China looks to be mitigated (Chart 1D). A return of volatility, spurred on by Fed tightening (Chart 1E), caused an SPX pullback in February, and while the market pushed through that rough patch, it has since been replaced with fears of a trade war, exacerbated by musical chairs in the Trump administration (Chart 1F). Our buy-the-dip strategy remains appropriate on a cyclical time horizon (Chart 1G), given a dearth of evidence of a recession in the next year. SPX forward EPS estimates still show near-20% increases this calendar year (corroborated by our EPS growth model, Chart 1H) which should underpin outsized equity returns in the absence of a major valuation rerating. Still, the return of volatility warrants a review of our macro, valuation and technical indicators. The best combination in our review is S&P financials (Overweight) with an elevated and accelerating cyclical macro indicator (CMI), fed by both of our key capex growth and rising interest rate themes, combined with a modest undervaluation. The worst combination is S&P telecom services (Underweight, high-conviction), whose CMI recently touched a 30-year low as sector deflation hit acute levels. Valuations make the sector look cheap, but every indication is that telecoms are a value trap. Chart 1AGlobal Trade Is Rising... Chart 1B...But So Too Is Inflation Chart 1CA Weaker Dollar Is A Boon To Growth Chart 1DSoft Landing In China Seems Likely Chart 1EThe Return Of Vol May Spoil The Party... Chart 1F...And Policy Uncertainty Doesnt Help Chart 1GBuy The Dip Has Worked Out Nicely Chart 1HHeed The Message From A Booming EPS Model Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI, Chart 2) has climbed to new cyclical highs with significant upward momentum, driven by broad improvement in virtually all of its underlying components. More than any other variable, rising yields and the accompanying higher price of credit are a boon to financials. Higher interest rates is one of BCA's key themes for 2018 and an ongoing selloff in the bond market bodes well for profits in the heavyweight banks sub-index and should deliver the next up leg in bank stocks performance (top panel, Chart 3). Another of BCA's key themes for 2018 is a global capex upcycle; higher demand for capital goods should drive outsized capital formation in the year to come. Our U.S. commercial banks loans and leases model echoes this positive outlook, pointing to the best loan growth of the past 30 years (middle panel, Chart 3). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 3). Despite the much-improved cyclical outlook and a revival of overall animal spirits, our valuation indicator (VI) suggests that financials are modestly undervalued. At this point in the cycle, we would expect a modest overvaluation; the implication is that financials should be a core portfolio overweight. Our technical indicator (TI) has approached overbought levels several times over the course of this bull market, though history suggests it can stay at elevated levels for a considerable time. Chart 2S&P Financials (Overweight) Chart 3RS1 Rising Yields Are A Boon To Financials Earnings S&P Industrials (Overweight) Our industrials CMI (Chart 4) has gone vertical and is very near its all-time high. A combination of a supportive currency, a recovery in commodity prices and synchronized global growth are responsible for the rise. A falling U.S. dollar and capital goods producers' top line growth acceleration have historically moved hand-in-hand as this group is one of the most international of the S&P 500. The trade-weighted U.S. dollar has fallen by more than 10% from its most recent peak at the end of 2016 which suggests U.S. industrials should have a leg up in sales for the year to come (top panel, Chart 5). The slide in the U.S. dollar is coming at an opportune time; global growth is remarkably synchronized (and remains a key BCA theme for 2018) and has proven an excellent harbinger of industrials margins (bottom panel, Chart 5). Overall, an expanding top line and widening margins imply solid relative EPS gains. Our valuation gauge is near the neutral zone, where it has been for much of the past 3 years as the market has failed to capture the sector's outlook strength. Our TI echoes the neutral message, having unwound a significant overbought position at the beginning of last year. Chart 4S&P Industrials (Overweight) Chart 5Global Euphoria Should Lift Industrials S&P Energy (Overweight) Our energy CMI (Chart 6) has maintained its upward trajectory after bouncing off all-time lows last year. Importantly, the relative share performance does not yet reflect the drastically improved cyclical conditions, underpinning our overweight recommendation. Falling oil inventories and rising prices (top and second panel, Chart 7) combined with solid gains in domestic production underlie the CMI recovery. Our key themes for 2018 of a global capex expansion and synchronized global growth should be the most important drivers for energy stocks this year. With respect to the former, the capex intentions from the Dallas Fed survey hit their highest level in a decade, which usually presages domestic oil patch expansion and energy stock outperformance (third panel, Chart 7) With respect to global growth, emerging markets/Chinese demand is the swing determinant of overall oil demand, and non-OECD demand has been moving higher for most of the past year (bottom panel, Chart 7). Our VI has retreated far into undervalued territory, a result of the aforementioned failure of stocks to react to the enticing macro outlook. The TI too is in deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are so appealing. Chart 6S&P Energy (Overweight) Chart 7Energy Share Prices Have Trailed Oils Recovery S&P Consumer Staples (Overweight) Our consumer staples CMI (Chart 8) has turned up recently, following a two year decline. Strong employment gains and positive retail sales are the key pillars underlying the modest recovery. The euphoric consumer continues to push our consumer staples EPS model higher, now pointing to the best earnings growth of the past 5 years (middle panel, Chart 9). Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (bottom panel, Chart 9). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put our positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. Further, our VI is waving a green flag as consumer staples are now nearly two standard deviations below their 30-year mean valuation. Technical conditions too are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 8S&P Consumer Staples (Overweight) Chart 9Robust Consumer Confidence Bodes Well S&P Utilities (Neutral) Our utilities CMI (Chart 10) has spent the last decade in a long-term downtrend, albeit one with periodic countertrend moves. The key underlying factors are natural gas prices and relative spending on utilities, both of which have been retreating since 2008 (middle panel, Chart 11). Encouragingly, the sector's wage bill has slowed from punitively high levels, though pricing power has followed it down, implying muted margin changes (bottom panel, Chart 11). Like other defensive sectors, utilities have underperformed cyclical sectors in the last year; utilities equities trade as fixed income proxies, and a rising interest rate environment is punitive. As a result of the underperformance and relatively constant earnings, valuations have collapsed to the neutral zone. We reacted by booking solid gains and upgrading to a benchmark allocation earlier this year; synchronized global growth and higher interest rates are headwinds for this niche defensive sector and prevent us from lifting positions further. Our TI has fallen steeply over the past year and is now closing in on two standard deviations below the 30-year average. Chart 10S&P Utilities (Neutral) Chart 11Pricing Is Falling But Margins Look Neutral S&P Real Estate (Neutral) Our real estate CMI (Chart 12) has been in decline since its most recent peak at the end of 2016. This is confirmed by a darkened outlook for REITs; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (top panel, Chart 13). Further, bankers appear less willing to extend commercial real estate credit, despite recent stability in underlying prices; declines in credit availability will directly impact REIT valuations (bottom panel, Chart 13). Our VI is consistent with BCA's Treasury bond indicator (not shown), indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 12S&P Real Estate (Neutral) Chart 13Peaking Rents and Tight Credit Are Headwinds S&P Materials (Neutral) Our materials CMI (Chart 14) has maintained its downward trajectory, largely due to the ongoing Fed tightening cycle. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as rates are moving higher (top panel, Chart 15). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018, representing a substantial headwind to sector performance. Still, the news is not all negative. Exceptionally strong global demand growth has revitalized chemicals prices (bottom panel, Chart 15). Combined with the industry's relatively newfound restraint, capacity has not overextended and the resulting productivity gains bode well for earnings growth. Despite the improving outlook, valuations have been retreating for much of the past year and our VI has fallen back to the neutral zone. Our TI has been hovering near the neutral line for the past year, though a recent hook downward indicates a loss of momentum and downside relative performance risks. Chart 14S&P Materials (Neutral) Chart 15Rising Rates Are Offset By Improving Demand S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI (Chart 16) has fallen back after reaching highs earlier in 2017, though remains elevated relative to the long term trend. Rising interest rates (top panel, Chart 17) are more than offsetting higher home prices and real wage growth, both have which have recently stalled. This rising short-term interest rate backdrop is not conducive to owning the extremely interest rate-sensitive equities that fall into the S&P consumer discretionary index. Both the household financial obligation ratio and household debt service payments have bottomed and are actually increasing. A higher interest rate backdrop will sustain the upward pressure on both and likely weigh on consumer discretionary relative share prices (third and bottom panels, Chart 17). This underpins our recent downgrade to a below benchmark allocation. Elevated valuations support our negative thesis as our valuation indicator has been rising recently out of the neutral zone. Our TI has fully recovered from oversold levels, and is now well into overbought territory, though historically this indicator has been excessively volatile. Chart 16S&P Consumer Discretionary (Underweight) Chart 17Higher Borrowing Costs Bode Ill For Consumer Discretionary S&P Health Care (Underweight) Our health care CMI (Chart 18) rolled over last year and has been treading water at these lower levels, driven by weak fundamentals in the key pharmaceuticals sector. Poor pricing power, a soft spending backdrop and a depreciating U.S. dollar have been pressuring the sector and keeping a tight lid on the CMI (top and second panels, Chart 19). Other non-pharma indicators are mixed as lower healthcare consumer spending is offset by a tick up in overall pricing power. Relative valuations have fallen deep into undervalued territory and are approaching one standard deviation below the 25 year average. Our TI too has reversed course and is well into oversold territory. However, the message from our health care earnings model is that sector earnings will continue to decelerate; this environment in not conducive for a sector re-rating (bottom panel, Chart 19). Chart 18S&P Health Care (Underweight) Chart 19Pharma Pricing Power Continues To Collapse S&P Telecommunication Services (Underweight) Our telecom services CMI (Chart 20), after moving sideways for much of the past decade, has recently fallen to a new 30-year low. Extreme deflation continues to reign in the beleaguered sector as relative consumer outlays on telecom services have nosedived (top panel, Chart 21) which is broadly matched by melting selling prices (middle panel, Chart 21) as demand contracts. This is reflected in our S&P telecom services revenue growth model, which remains deep in contractionary territory (bottom panel, Chart 21). The sector remains chronically cheap, exacerbated by the recent sell-off, and is currently as cheap as it has ever been. Still, given the brutal operating environment, we think such valuations have created a value trap. Our Technical Indicator has sunk but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. We recently downgraded the sector to underweight and added it to our high-conviction underweight list based on the factors noted above.1 Chart 20S&P Telecommunication Services (Underweight) Chart 21Telecom Services Remain A Value Trap S&P Technology (Underweight, Upgrade Alert) The technology CMI (Chart 22) has been falling for the past three years, driven by ongoing relative pricing power declines and new order weakness. However, the sector has proven resilient, at least until recently, as a handful of stocks (the FANGs, excluding the consumer discretionary components) and the red-hot semiconductor group have provided support. Still, market euphoria aside, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods; inflation is gradually rising after a prolonged disinflationary period (bottom panel, Chart 23). Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is extremely overbought, though it has been at this high level for several years. Chart 22S&P Technology (Underweight, Upgrade ALert) Chart 23Inflation Is No Friend To Tech Size Indicator (Neutral Small Vs. Large Caps) Our size CMI (Chart 24) has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher (top panel, Chart 25). A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. Earlier this year, we downgraded our recommendation on small caps vs. large caps to a neutral allocation, based on a deterioration in small cap margins and too-high leverage.2 Recent NFIB surveys would suggest this move was prescient; firms reporting planned labor compensation increases have steadied near a two decade high, while price increases are trailing far behind (middle panel, Chart 25). With "quality of labor" having overtaken "taxes" as the single most important problem facing businesses, labor compensation growth seems likely to continue moving up at an elevated pace and small cap margins should likely continue to trail large cap peers (bottom panel, Chart 25). Valuations have improved and small caps are relatively undervalued, though our TI echoes a neutral message. Chart 24Size Indicator (Neutral Small Vs. Large Caps) Chart 25Small Businesses Remain Exceptionally Confident Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.
Highlights Chart 1Inflation Pressures Mount Spread product underperformed equivalent-duration Treasuries for the second consecutive month in March. But last month's underperformance was different than February's in one important way. In February it was the fear of inflation and tighter Fed policy that prompted the sell-off in spread product. Investment grade corporate bonds underperformed Treasuries by 62 basis points, while the Treasury index provided a total return of -75 bps and TIPS outperformed nominals. In March, the sell-off in spread product coincided with Treasury returns of +94 bps and TIPS underperformed nominals. The negative correlation between yields and spreads re-asserted itself signaling that the sell-off was not driven by inflation, but by concerns about a potential slow-down in global growth. A severe slow-down in global growth is not imminent. But higher inflation and tighter Fed policy remain our chief concerns. With that in mind, core inflation printed higher again last month (Chart 1), and we think it is only a matter of time before our TIPS breakeven target range of 2.3% to 2.5% is met. That will trigger a reduction in our recommended allocation to corporate bonds. Stay tuned. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 91 basis points in March, dragging year-to-date excess returns down to -81 bps. The sell-off of the past two months has returned some value to the investment grade corporate space, but spreads are still quite tight relative to history. The 12-month breakeven spread for a Baa-rated corporate bond has only been tighter 19% of the time since 1989.1 Our opinion of investment grade corporate bonds is unchanged. We continue to view value as relatively unattractive, and will reduce our overweight allocation once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are above 2.3%. Corporate profit data for the fourth quarter of 2017 were released last week, and our measure of EBITD for the non-financial corporate sector grew at an annualized rate of 2.4%, slightly below the 3% annualized increase in corporate debt. Gross leverage for the non-financial corporate sector ticked higher as a result (Chart 2). In a recent report we showed that sustained periods of corporate spread widening almost always coincide with rising gross leverage.2 We also showed that while most leading profit indicators are still in good shape, a profit margin proxy based on the difference between corporate selling prices and unit labor costs is sending a warning sign. We expect profit growth to fall sustainably below debt growth later this year, driven by rising unit labor costs. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Chart 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 114 basis points in March, dragging year-to-date excess returns down to -19 bps. The average index option-adjusted spread widened 18 bps on the month and currently sits at 354 bps. The 12-month trailing speculative grade default rate ticked up to 3.56% in February, its highest reading since last July, but Moody's still expects it to decline to 1.96% during the next year. Based on the Moody's default rate projection and our own estimate of the recovery rate, we forecast High-Yield default losses of 0.97% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an un-changed junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -149 bps during this time horizon, and 100 bps of spread tightening would lead to an excess returns of +664 bps. However, such a large amount of spread tightening is probably over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cycle lows (top panel). We continue to await a firmer signal from our inflation indicators before reducing our allocation to high-yield. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in March, dragging year-to-date excess returns down to -39 bps. The conventional 30-year zero-volatility MBS spread widened 7 bps on the month, split between a 4 bps widening in the option-adjusted spread (OAS) and a 3 bps widening in the compensation for prepayment risk (option cost). The widening in MBS OAS has not been as severe as the widening in investment grade corporate OAS. As a result, mortgages no longer appear cheap relative to investment grade corporates (Chart 4). But while the value proposition in mortgages is less alluring, we still see limited potential for spreads to widen during the next 6-12 months. Refinancing risk will remain muted as interest rates rise (bottom panel), and in past reports we showed that extension risk will likely be immaterial.3 In the structured product space, Agency MBS offer 11 bps less spread than Aaa-rated consumer ABS, but are supported by falling residential mortgage delinquencies and easing bank lending standards. In contrast, consumer credit (auto loan and credit card) delinquency rates have bottomed and banks have begun to tighten lending standards (see page 12 for further details). Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 20 basis points in March, dragging year-to-date excess returns down to +2 bps. Sovereign debt underperformed the Treasury benchmark by 58 bps on the month, while Foreign Agencies underperformed by 38 bps and Local Authorities underperformed by 33 bps. Domestic Agencies outperformed duration-equivalent Treasuries by 6 bps, and Supranationals underperformed by a single basis point. USD-denominated sovereign bonds have performed worse than Baa-rated U.S. corporate bonds during the past six months, despite persistent weakness in the U.S. dollar (Chart 5). However, we do not think recent dollar weakness will provide much support for sovereign bond returns going forward. Rather, it is more likely that the U.S. dollar will appreciate during the next 6-12 months as the distribution of global growth shifts toward the United States. This month's issue of the Bank Credit Analyst discusses the cyclical and structural outlook for the U.S. dollar in detail.4 Elsewhere, Foreign Agencies and Local Authorities continue to offer attractive spreads after adjusting for duration and credit rating. We remain overweight those segments of the Government-Related universe despite an overall underweight allocation. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 56 basis points in March, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio widened 4% on the month, with short maturities performing somewhat worse than long maturities. The tax-adjusted yield for a 10-year municipal bond remains about 17 bps below the yield offered by an equivalent-duration corporate bond (Chart 6). As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.5 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.6 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve flattened in March, as long maturity yields fell quite sharply despite a small increase in yields out to the 2-year maturity point. The 2/10 slope flattened 15 basis points on the month and currently sits at 47 bps. The 5/30 slope flattened 7 bps on the month and currently sits at 41 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the path for the yield curve during the next six months. Last month the Fed lifted rates for the sixth time this cycle, and signaled its desire to hike another 2-3 times before the end of the year. But just as further rate hikes will apply flattening pressure to the curve, the recent rebound in inflation will exert some offsetting steepening pressure. The 10-year TIPS breakeven inflation rate is still 25-45 bps below a range that is consistent with inflation being anchored around the Fed's target. We recommend a curve steepening trade for now, specifically a position long the 5-year bullet and short a duration-matched 2/10 barbell, because upward pressure on inflation will make it difficult for the curve to flatten much further during the next few months. We will shift aggressively into flatteners once TIPS breakevens reach our target range. Further, the 2/5/10 butterfly spread is priced for 19 bps of 2/10 flattening during the next six months (Chart 7). In other words, the 2/10 slope needs to flatten by more than 19 bps for a long 5-year bullet position to underperform. We view this as unlikely. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in March, dragging year-to-date excess returns down to +67 bps. The 10-year TIPS breakeven inflation rate fell 7 bps on the month and currently sits at 2.05%. The 5-year/5-year forward TIPS breakeven inflation rate fell 2 bps on the month and currently sits at 2.18%. 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.7 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. If the recent trend in realized inflation continues, then this re-anchoring could occur relatively soon. February data show that the annualized 6-month rate of change in trimmed mean PCE rose to 2.03% (Chart 8), and while the 12-month rate of change held steady at 1.7%, it will start to move higher in March when the strong inflation prints from January and February 2017 are removed from the sample. Pipeline measures of inflation pressure also suggest that inflation will head higher, as evidenced by our Pipeline Inflation Indicator, and in particular, the Prices Paid component of the ISM Manufacturing index which just hit its highest level since 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in March, dragging year-to-date excess returns down to -19 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and currently sits at 44 bps, 11 bps above its pre-crisis low. While in prior research we highlighted that consumer ABS offer attractive spreads relative to many other sectors, we also pointed out that collateral credit quality is starting to weaken.8 With respect to value, Aaa-rated Consumer ABS offer a 12-month breakeven spread of 21 bps, while Agency MBS offer a spread of 6 bps and Agency CMBS offer a spread of 9 bps.9 However, household debt service ratios and delinquency rates appear to have bottomed for the cycle (Chart 9). While the pace of consumer credit accumulation remains robust, it has also moderated in recent months alongside rising delinquencies and tightening lending standards. We maintain a neutral allocation to ABS for the time being due to attractive valuation, but expect to downgrade in the future as household credit quality deteriorates. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 36 basis points in March, dragging year-to-date excess returns down to +11 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month and currently sits at 72 bps, close to one standard deviation below its pre-crisis mean. While a spread of 72 bps is still attractive compared to similarly-rated alternatives, we remain concerned about the gap that has emerged between CMBS spreads and the rate of appreciation in commercial real estate (CRE) prices (Chart 10). While bank lending standards on CRE loans are still tightening, they are tightening less aggressively than in recent years (bottom panel). This could eventually remove a headwind from CRE prices, but for now we view a position in non-agency CMBS as overly risky. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 22 basis points in March, dragging year-to-date excess returns down to -14 bps. The index option-adjusted spread widened 6 bps on the month and currently sits at 47 bps. The Agency CMBS sector continues to offer an attractive spread pick-up relative to similar investment alternatives, and has historically exhibited low excess return volatility.10 Remain overweight. 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 2.96% (Chart 11). While the fair value reading from our 2-factor model remains elevated for now, we expect it to fall once March Global PMI data are released this week. Based on a combination of final PMI data and Flash estimates for countries that have yet to report final March figures, we estimate that the Global PMI will decline to 53.8 in March from 54.2 in February. When combined with the most recent reading for dollar bullish sentiment, this gives a fair value of 2.85% for the 10-year Treasury yield. We will provide an official update to the model in next week's report, after the data are finalized. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 1, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.74%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 The 12-month breakeven spread is the spread widening required during the next 12 months for the bond to break even with a position in an equivalent-duration Treasury security. 2 Please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 4 Please see Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?", dated March 29, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 9 The 12-month breakeven spread is the spread widening required during the next 12 months for the bond to break even with a position in an equivalent-duration Treasury security. 10 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 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)