Developed Countries

Today's dangerous distortion does not result from credit excesses. It results from an irrational mispricing of risk caused by a protracted period of ultra-loose monetary policy. In turn, the ultra-loose monetary policy results from the dangerous dogma of the 2% inflation target. How should investors position short-term and long-term?

On Monday, we downgraded the S&P agricultural chemicals index owing to excess global food supplies, which threaten to dampen prices for a while longer. This also has negative ramifications for heavy equipment and agricultural equipment companies. To make matters worse, other end markets are in even worse shape. Resources companies have neither the financial wherewithal nor incentive to undertake expansion. Free cash flow has plunged in the mining and oil & gas industries, and balance sheets are saddled with debt. Meanwhile, global construction markets are coming off the boil, even prior to any increase in borrowing costs. Both residential and commercial real estate construction growth is decelerating rapidly, suggesting that oversupply has seeped into markets. The bottom line is that the earnings recession in heavy and ag equipment companies will stay intact. Please see Monday's Weekly Report for more details on our downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.

After a prolonged consolidation phase, small caps are now on the cheap side of fair value compared with large caps. We anticipate a return to premium valuations. The main driver will be a narrowing in the yawning profit margin gap. The chart shows that small companies have already experienced a massive margin compression. But the latest NFIB survey of the small business sector showed that labor compensation plans have continued to ease, while price hikes ticked higher. In contrast, the overall employment cost index is grinding higher. We doubt revenue contribution to large companies from the rest of the world will be able to offset this convergence in labor costs, given that the global credit impulse continues to signal that growth reacceleration is not imminent. The bottom line is that the budding advance in the small/large cap ratio should stay intact. We reiterate our bullish view on small caps.

Special Report

The median voter moving to the left has spurred paradigm shifts. These new regimes are giving way to transformational leaders who seek change by breaking convention. As they test their constraints and pursue their preferences, a cautious stance towards risk assets is warranted. In this Monthly Report, BCA's Geopolitical Strategy discusses Trump's recent comeback, rising EM political risk, and Italy's upcoming constitutional referendum.

The median voter moving to the left has spurred paradigm shifts. These new regimes are giving way to transformational leaders who seek change by breaking convention. As they test their constraints and pursue their preferences, a cautious stance towards risk assets is warranted. In this Monthly Report, BCA's Geopolitical Strategy discusses Trump's recent comeback, rising EM political risk, and Italy's upcoming constitutional referendum.

The Fed is sending signals that another rate hike is coming, despite sluggish U.S. growth and modest inflation, while both the ECB and BoJ are facing questions about the ability to maintain the pace of bond purchase programs. Amidst all this uncertainty, bond risk premiums can rise further in the near term.

Equities have finally run into some selling pressure. Any time the market pulls back, especially from current lofty valuation levels, many wonder whether a major trend change is occurring. However, history shows that equities typically do not run into serious trouble until the threat of recession feels imminent. The yield curve can provide a helpful timing tool for when recession risks have become too acute for equity investors to ignore. A very flat or inverted yield curve has previously signaled that monetary policy was too tight, warning of previous major cyclical equity peaks. Currently, the 10/2 year Treasury yield curve is still positively sloped, although at the current pace of narrowing it won't take much for it to flatten completely. As the curve flattens, we expect capital to gravitate to non-cyclical sectors, as has historically occurred. The chart shows that the cyclical/defensive share price ratio has generally been positively correlated with the steepness of the yield curve. The major exception was a decade ago, when the Fed was tightening but lagged behind the housing/financial credit boom, which supported optimism toward cyclicals until the onset of the Great Recession. Unless the yield curve begins to widen decisively on the back of a growth-driven pickup in inflation expectations, the risk is that cyclical sector profits will disappoint. As such, we prefer to maintain a core defensive strategy, despite some valuation concerns, because momentum driven markets can reverse at a moment's notice.

We went overweight the S&P agricultural chemicals index in early May, a contrarian bet to take advantage of extreme bearishness, undervaluation and the potential for a rise in underlying commodity prices. Since then, a rise in industry M&A activity has borne out our thesis of cheap valuations, generating solid relative returns. Nevertheless, operating conditions may be slower to improve than originally anticipated. Burgeoning wheat and corn harvests this year threaten to keep the supply/demand balance for grains out of whack for another year. The USDA forecasts a hefty surplus in both key commodities. When grain prices advance, farm incomes receive a shot in the arm, providing farmers with both the means and the confidence to increase planting acreage, thereby boosting fertilizer demand. If food prices stay soft, then that positive dynamic is not going to take hold on a cyclical horizon. Instead, farmland prices will stay near cyclical lows, and agricultural-related credit availability will continue to tighten. The latter is already at a 10-year low, reflecting reduced farm incomes. Consequently, we recommend taking profits and downgrading to neutral. Please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5FERT - MON, MOS, CF.

The Treasury curve will bear-flatten between now and a likely December rate hike. Beyond December, our strategy will depend on how the dollar responds to increased rate hike expectations. For now, maintain below benchmark duration and favor convexity risk over credit risk.

Disappointing ISM surveys could signal a growth consolidation.
That, in turn, would spur a correction in risk assets.