Equities
Highlights We have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range; when the economy is at full employment, stocks are more likely to sell off after these sideways periods than if there is still some slack in the labor market. Feature The outlook for global risk assets will likely be more challenging in the coming months. With that in mind, we have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. BCA still expects that the U.S. stock-to-bond ratio will grind higher in the next 12 months, as U.S. stocks move sideways and Treasury yields climb (Chart 1A and 1B). We recommend that investors put the proceeds from the sale of equity positions into cash. Chart 1AScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.80% Chart 1BScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.29% Within a fixed-income only portfolio, we are selling credit and putting the proceeds into Treasuries. We maintain our underweight duration stance given our view of the Fed and the 10-year Treasury. At 2.91%, the 10-year is still below BCA's view of fair value (3.29%). Moreover, BCA's position is that the Fed's gradual path of rate hikes is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels.1 On the credit side, we note that late in the cycle the yield curve is moderately flat, between 0 and 50 bps. Work by our U.S. Bond Strategy team2 shows that periods when the curve is flat are consistent with much lower excess returns than when the slope is above 50 bps (Chart 2). Given the low potential reward, a neutral posture on credit makes the most sense. Investors will not give up too much by starting to downgrade early. Tomorrow's U.S. Bond Strategy report will provide more details on the corporates versus Treasuries allocation. Chart 2Corporate Bond Performance And The Yield Curve BCA has recommended overweight positions in U.S. risk assets since spring 2009 when equities became attractive from a risk/reward perspective. At that time, the U.S. economy was weak, the Fed was easing, equity valuations were depressed and forward earnings estimates were dismal (Chart 3). In contrast, the risk/reward for risk assets today is much less attractive. The economy is in the late stages of an expansion and is running beyond full employment. The central bank is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (Chart 3 again). This means that good news is already priced into the equity market. When the Shiller PE, a measure of the market's valuation, is between 30 and 40, 1-year returns are tepid at best (Chart 4). Chart 3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Chart 4Expected Returns Given Starting Point Shiller P/E We are not trimming exposure to risk assets because we are more concerned about the economic outlook. BCA's view is that odds of a U.S. recession in the next 12 months remain low. Furthermore, the traditional recession signals that we track do not suggest a recession is nigh (Chart 5). For example, the 2/10 yield curve is still positive at 34 basis points (panel 2). Upward movement in long-dated breakevens will offset some of the upward pressure at the front-end from further Fed rate hikes, limiting the amount of curve flattening during the next few months. Once long-dated breakevens get back to a range between 2.3% and 2.5% then flattening could proceed more rapidly.3 Panel 3 shows that the LEI crosses below zero when a recession is imminent. The May LEI rose by 6% year-over-year. Initial claims for unemployment insurance in the week ending June 16 were 24K below their mid-December 2017 reading. Panel 4 shows that a 6-month increase in unemployment claims of between 75,000 and 100,000 is associated with a recession. The bottom line is that we are not concerned about a recession. Nonetheless, BCA's Equity Scorecard has dropped to 2, below the critical value of three that has been consistent in the past with positive equity returns (not shown). Table 1 updates our Exit Checklist of items that are important for the equity allocation call. Three of the nine are now giving a 'sell' signal and they suggest that prudence is necessary, despite the constructive economic outlook. Chart 5No Recession Signal Here Table 1Exit Checklist For Risk Assets Furthermore, several technical indicators that we monitor signal caution. The National Association of Active Investment Managers (NAAIM) says that active managers have increased equity risk since the start of the year (Chart 6). At 89%, the average equity exposure of institutional investors is close to the cycle high reached in March 2017, which was the highest since 2007, just before the S&P 500 peak in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated. At slightly under 2, it is at a position where bear markets began in 2000 and 2007, and it is well above the level seen just before the 2015 bear market (Chart 7, panel 1). That said, not all technical indicators are flashing red. Chart 8 shows that BCA's Technical Indicator is not at an extreme (panel 1). Moreover, BCA's Equity Sentiment Composite Index is neutral (panel 2); panel 3 shows that the U.S. large cap equities remain in the middle of their 2009-2018 recovery channel, albeit in the top half of the channel. Note that the S&P 500 tested the top end of the channel (near 2850) in January 2018. Chart 6Active Managers Have Increased ##br##Equity Exposure This Year Chart 7Equity Speculation Is Elevated Chart 8Not All Technical Indicators Are Bearish The risk to our neutral stance on equities is that credit and equities will rally to fresh highs before the cycle is done. However, given our bias for capital preservation and views on the late stage of the business cycle, it is not advisable to reach for the last few drops of return. With equity valuations stretched, we would rather be early and judicious and miss out on the last few basis points of outperformance rather than be late and underperform as risk assets sell off. BCA's view is that the next recession will be sparked by the Fed overtightening in 2019 and 2020 when it finds itself behind the curve on inflation. Moreover, because inflation is at the Fed's 2% target and the economy is beyond full employment, the price at which the Fed's "policy put" gets exercised is much lower than earlier in the cycle. The implication is that the Fed will be reluctant to deviate from its tightening path even in the face of more turmoil in the EM space or in Europe. This supports our guarded view on equities and our decision to move into cash instead of Treasuries. Geopolitical risk is another reason to be cautious. Chart 9 shows that globalization, a tailwind for risk assets, is stalling. Moreover, there is an increased threat of a breakup in the Eurozone, led by political uncertainty in Italy (Chart 10). In addition, tensions with Iran are mounting. Nonetheless, our Geopolitical Strategy service notes that the U.S.'s relationship with China is the primary source of geopolitical peril (Chart 11).4 Although we are not adjusting our view on the dollar,5 a stronger greenback would bolster our case for caution on risk assets. A higher dollar would hurt the profits of U.S. multinationals and could lead to instability in the emerging markets, raising the odds of a policy misstep. Chart 9Globalization Has Reached Its Zenith Chart 10Risk Of Eurozone Breakup Is Rising Chart 11BCA's Geopolitical Power Index Illustrates A Multipolar World Equity volatility will accelerate through year end, as is often the case late in equity bull markets. Bottom Line: If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months, especially if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Treading Water BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range (See Appendix Charts 1 and 2).6 We excluded bear markets and recessions from our analysis because our view is that neither condition will occur in the next 12 months. Table 2 shows that these sideways episodes lasted an average of eight months. At the end of six of the ten intervals, U.S. large cap equities rallied (1986, 1988, 1992, 1997-1998, 2004, and 2015); after two phases, stocks recovered briefly and then sold off (1951-52 and 1972). At the conclusion of the 1991 episode, stocks rallied and then resumed moving sideways. Stocks sold off after the eight-month sideways phase in 1976. Table 2What Happens After Stocks Move Sideways? Four (1951-52, 1972, 1988, 1997-98) of the ten sideways periods occurred after the U.S. economy reached full employment. The 10 year Treasury yield increased as stocks moved sideways in 1972 and in 1988, but fell in the 1997-98 episode. The S&P 500 PE ratio increased in two sideways phases (1972 and 1997-98) and contracted in 1988. S&P 500 EPS growth accelerated in 1972, 1988 and 1997-98 phases. The S&P 500 rallied after the sideways episodes in 1988 and 1997-98, but sold off after the 1951-52 and 1972 sideways phases that occurred after the economy hit full employment (Chart 12). Chart 12S&P 500 Valuations, EPS Growth, Margins And The 10-Year Treasury Yield When Stocks Move Sideways As the S&P 500 moved sideways when the economy was not yet at full employment (1976, 1986, 1991, 1992, 2004 and 2015), 10-year Treasury yields fell four times (1976, 1986, 1991 and 1992) and rose in two (2004 and 2015). The forward PE ratio for the S&P 500 expanded in 1986 and 1992, but contracted in 1991, 2004 and 2015. EPS growth during sideways episodes for stocks when the economy was not yet at full employment is mixed. EPS growth accelerated in 1976, 1992 and 2004, but slowed in 1986, 1991 and 2015 as oil prices fell. U.S. large cap equities rallied after four of the sideways periods when the economy was not yet at full employment (1986, 1992, 2004 and 2015) but sold off after the 1976 sideways move (Chart 12 again). We intend to further examine the macro backdrop during sideways periods for U.S. equities in future Weekly Reports. Bottom Line: BCA expects bond yields to rise in the next 12 months and S&P 500 profit growth will peak. Stocks are more likely to move higher after a period of sideways price action if the economy is not at full employment. Rising PE ratios as stocks move sideways most often lead to equity rallies after the sideways phases end. With valuations already elevated, PEs are unlikely to expand much further in this cycle. Moreover, the U.S. economy reached full employment in early 2017, making it less likely that the Fed will hit the pause button on its rate hike regime. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA's U.S. Bond Strategy Weekly Report, "As Good as It Gets For Corporate Debt," published April 24, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," published June 19, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA's Geopolitical Strategy "Are You Sick of Winning Yet," published June 20, 2018. Available at gps.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," published June 20, 2018. Available at gis.bcaresearch.com. 6 There are well-established periods for bull and bear markets for U.S. equities, however not for "sideways" episodes for stocks. We have defined "sideways" as a period of range-bound equity price movements that have lasted for at least five months outside of recessions and bear markets. Readers may have other definitions of "sideways". APPENDIX CHARTS Chart 1Sideways Epsisodes For Stocks 1950-1980... Chart 2..And 1980-2018
Highlights Portfolio Strategy Selling in the S&P cable & satellite index is overdone. Recession type valuations fully reflect the acquirer discount heavyweight CMCSA is still commanding. Lift exposure to neutral. Content providers' assets are highly coveted, and these firms remain in play as media is undergoing a tectonic shift. The industry's demand backdrop is also on the rise, signaling that it no longer pays to underweight the S&P movies & entertainment index. Increasing construction expenditures, ballooning balance sheets, soft relative selling prices and a rising U.S. dollar all suggest that restaurant profits will underwhelm. Downgrade to underweight. Recent Changes Raise the S&P cable & satellite index to neutral today. Lift the S&P movies & entertainment index to a benchmark allocation today. Act on the downgrade alert and trim the S&P restaurants index to underweight today. Table 1 Feature Geopolitical risks held equities hostage last week as President Trump toughened his tariff rhetoric toward China. While the risk of a global trade spat remains acute, the market is becoming desensitized to daily trade-related headlines and remains resilient. Given the plethora of political risks and upcoming midterm elections, I look forward to hearing Greg Valliere's keynote speech in BCA's Toronto Investment Conference on September 24-25. Importantly, last week rising protectionism along with "Three Policy Puts Going Kaput" compelled BCA's Global Investment Strategy service to turn more cautious toward global risk assets over its 6 to 12 month cyclical horizon, prompting them to downgrade global equities from overweight to a neutral stance.1 We have sympathy for this view and acknowledge that the risks to our still sanguine U.S. equity market view, which we have been flagging in recent publications, have increased a notch. We are especially worried about the greenback's appreciation and increasing potential to infiltrate SPX EPS in calendar 2019 (please see Chart 2 and Chart 4 from the June 4th Weekly Report). Given that technology has the highest foreign sales exposure (58% of total sales) among GICS1 sectors, and a 26% market cap weight, we are closely monitoring leading indicators for tech profits. Indeed, for calendar 2019 the S&P tech sector's contribution to S&P 500 profit growth is the highest at 21%, with financials right on its tail at 20% (Chart 1). Energy sector EPS base effects are filtered out in 2019, but industrials, that have a 37% foreign sales exposure and are at the epicenter of President Trump's tariff rhetoric, also explain 13% of SPX EPS growth in calendar 2019 (Chart 1). Chart 1Contribution To S&P 500 2019 EPS Growth In fact, over a structural (2-3 year) time horizon we are aligned with BCA's more bearish equity outlook. We have been advocating this longer term thesis in our travels visiting BCA clients (please download our latest marketing slide deck here that highlights our bearish secular equity market view). Importantly, the three signposts we are monitoring to help us time the end of the business cycle, and thus equity bull market, are: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). There are currently no ticks in any of these three boxes, and we conclude that the S&P 500 has yet to peak for the cycle (Chart 2). Crucially, the Fed is inflating a massive bubble by staying too easy for too long. It is rather obvious to us that the U.S. economy is firing on all cylinders with real non-residential investment growing near 10% in Q1, but the real fed funds rate is still near the zero line (Chart 3). In addition, recent Fed minutes signaled that the Fed is willing to take some inflation risk, which will further push equity markets into steeper disequilibrium. It would be unprecedented for the cycle to end with the real fed funds rate glued to zero (Chart 3). Chart 2Recession Indicators Chart 3Real Fed Funds Rate Is Still Zero! Moreover, the U.S. economy just received a two year fiscal stimulus injection which is rare in both duration and magnitude during the late stages of the expansion and thus inherently inflationary. Worrisomely, the last time this happened was in the mid-to-late 1960s that led to the inflationary 1970s (please see Chart 1 and Table 2 from our October 9th "Can Easy Fiscal Offset Tighter Monetary Policy?" Weekly Report). Tack on the starting point of a World War-like debt-to-GDP ratio and the only regulatory mechanism for government profligacy is the bond market (Chart 4). Chart 4Interest Rates Have Nowhere To Go But Up Another way to make the debt arithmetic work is if one believes the White House's real GDP projections of 3%+ as far as the eye can see, which stand in marked contrast to the IMF's, the CBO's and the Fed's own projections (Chart 5). Therefore, the path of least resistance for interest rates is higher as a way to slow down the economy and also rein in debt excesses. Typically, this overheating late in the cycle is synonymous with a blow off phase in equities (Chart 6), before the bottom falls out. Chart 5Don't Believe The White House Chart 6Blow Off Phase In sum, while BCA downgraded global equities to neutral last week on a cyclical time horizon, we are deviating from the BCA House View and still believe that the S&P 500 will make new all-time highs in absolute terms before the next recession hits. This week we are making a few subsurface changes to the S&P consumer discretionary sector, but we maintain an underweight allocation to this interest rate-sensitive sector. New Media Landscape: (Pipelines Vs. Content Providers) Vs. Netflix At last count Netflix broke into the top 25 largest companies (market cap based) in the S&P 500, and if it keeps up its frenetic pace it is on track to surpass Boeing. While legacy media giants had a chance to scoop up Netflix in the past few years, its current stratospheric valuation makes it uneconomical and nonsensical. Instead, the specter of Netflix, as well as other tech giants circling the space, has accelerated an inter- and intra-industry consolidation (bottom panel, Chart 7). Why? Because Netflix not only went straight to the consumer on a new medium, the internet, and sped up cord cutting, but also blurred industry lines by becoming a content provider producing its own original content in addition to offering third party content. The media landscape is thus still trying to adjust to the Netflix induced "creative destruction" and media executives are scrambling to compete with/protect legacy franchises from Netflix. The recently cleared AT&T/Time Warner merger has intensified the bidding war of remaining crown jewel assets in the legacy content media world. We were well positioned for this shake up in the space as we went underweight the media complex in early March.2 But now, we deem that the easy money has been made and most of the negative narrative is reflected in bombed out relative valuations despite depressed relative profit and sales growth estimates (second & third panels, Chart 7). As a result we recommend lifting exposure back to benchmark in the broad S&P media index. Beyond these industry related intricacies, the macro backdrop is starting to turn in favor of media outfits, warning that it no longer pays to be bearish. Chart 8 shows that relative consumer outlays on media have spiked recently. The implication is that industry revenue growth has more upside. BCA's ad spending indicator also corroborates this firming top line growth message, as does the latest ISM services survey that remains squarely above the 50 boom/bust line on a broad array of measures. Unsurprisingly, this budding demand recovery has translated into a pick up in industry pricing power with our media selling price gauge even surpassing overall inflation. The implication is that media profits could surprise to the upside. Chart 7M&A Frenzy Continues Chart 8Overlooked Demand Recovery While our sense is that pipelines (S&P cable & satellite index) are the likely losers and content providers (S&P movies & entertainment) are the likely winners from the ongoing broad media deck reshuffling, the way we are executing the S&P media upgrade to neutral is by lifting both the S&P cable & satellite and S&P movies & entertainment sub-indexes to neutral. On the cable front, M&A activity is weighing heavily on relative share prices as index heavyweight Comcast is a possible acquirer of the Murdoch empire assets. However, this bellwether company is not a pure pipeline play and were it to win the FOX-related assets bidding war, it would further diversify its cash flow. Monetizing those assets involves execution risk, especially as the legacy cable business is wrestling with decelerating selling prices and still has to contend with cord cutting (top & middle panels, Chart 9). Encouragingly, the bottom panel of Chart 9 shows that likely all the negative news flow is already baked into compelling relative valuations. With regard to the content providers, not only are some of these assets currently caught up in a bidding war, but every remaining independent content provider is now in play, and deal hungry investment bankers are aggressively pitching M&A to media (and likely other industry) CEOs. Macro headwinds are also morphing into tailwinds for the S&P movies & entertainment group. Consumer confidence is pushing multi decade highs and given the fact that the economy is at full employment any increase in discretionary consumer incomes will likely further boost recreation outlays (Chart 10). Industry pricing power is also expanding at a healthy clip at a time when industry executives are showing labor restraint (Chart 11). If selling prices stay firm on the back of improving demand as we expect, then movies & entertainment profit margins will enter an expansion phase (middle panel, Chart 10). Chart 9Cable's Blues Are ##br##Well Discounted Chart 10Firming ##br##Recreation Outlays... Chart 11And Recovering Operating Metrics##br## Remain Underappreciated None of this rosy outlook is reflected in cyclically low S&P movies & entertainment relative valuations (bottom panel, Chart 10). Bottom Line: Book relative profits of 13.5% in the S&P cable & satellite index since inception and lift to neutral. Boost the S&P movies & entertainment index to a benchmark allocation for a relative loss of 8.3% since the early March inception. As a result the broad S&P media index also commands a neutral weighting. The ticker symbols for the stocks in the S&P cable & satellite and S&P movies & entertainment indexes are: BLBG: S5CBST - CMCSA, CHTR, DISH and BLBG: S5MOVI - DIS, FOXA, FOX, VIAB, respectively. Portion Control In Restaurants Restauranteurs are eternal optimists; at least that is the lesson we take from the National Restaurant Association's Restaurant Performance Index (RPI) which only rarely dips below the expansion line (Chart 12, second panel). However, changes in this overly optimistic sentiment survey are useful as they closely lead the S&P restaurants index's relative performance. This indicator has recently rolled over and we think the timing is right to turn negative on restaurants (Chart 12, bottom panel). The recent evaporation of industry pricing power echoes the RPI's early indications of a downturn (Chart 13, second panel). In view of how tightly it moves with relative industry sales, the growth outlook for restaurants has darkened considerably. The underlying driver of weakening pricing power is the industry's collapsing share of the consumer's wallet over the past two years, which has been at least as destructive to industry growth as the Great Recession (Chart 13, bottom panel). While both relative consumption and sales, which move in lockstep, have been staging a recovery in 2018, they both remain firmly in deflationary territory. Meanwhile, industry wages - the largest input cost - have been expanding above trend for the better part of the past four years (Chart 14, second panel). Though restaurant wage growth has recently slowed considerably it has not been enough to bring our margin proxy out of negative territory, implying sliding relative earnings growth is set to continue (Chart 14, bottom panel). Chart 12Optimism Reigns In Restaurants Chart 13Falling Pricing Should Weigh On Sales Chart 14Labor Costs Are A Profit Headwind A rising U.S. dollar is an additional profit headwind for this heavily internationally-geared consumer discretionary sub-index. Despite dollar strength offering an input cost tailwind via lower food commodity costs, declining translation of foreign profits will likely swamp those gains. McDonald's and Starbucks, which together represent 80% of the weight of the S&P restaurants index, had 62% and 49%, respectively, of their locations outside the U.S. at the end of last year. To compensate for a tough profit outlook, restaurants have embarked on a construction spending spree that shows no signs of abating (Chart 15, second panel). The predictable result has been a near-doubling of leverage ratios over the past three years (Chart 15, bottom panel). A weak profit backdrop signals that relief from these levels will be hard to find. Chart 15Restaurants Are Binging On Debt Chart 16Valuations Do Not Reflect Risks Valuations have been treading water at above-normal levels for several years (Chart 16, second and third panels). Perky valuations seem poised for a fall given the cloudy profit outlook and the higher risk premium that recently geared up balance sheets typically command. Bottom Line: Still-high valuations are not supported by falling returns in an increasingly capital intensive industry. Accordingly, we are pulling the trigger on last month's downgrade alert on the S&P restaurants index and moving to an underweight allocation. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG. What Does All This Mean For The S&P Consumer Discretionary Index? Chart 17Stay Underweight Consumer Discretionary Despite the S&P media's heavy weighting in the broad consumer discretionary sector, our S&P restaurants downgrade sustains the below benchmark allocation in the S&P consumer discretionary sector. Importantly, the three key factors weighing on this early-cyclical sector we identified in early March remain intact: rising fed funds rate, quantitative tightening and higher prices at the pump (Chart 17). Meanwhile, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (middle panel, Chart 17). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 17). Bottom Line: Earnings underperformance will eventually result in relative share price underperformance. Stay underweight the S&P consumer discretionary index. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 19, 2018, available at gis.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Short oil and gas versus financials. Stick with underweights in the classically cyclical sectors. Downgrade the FTSE100 to neutral. Overweight France, Ireland, Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Overall market direction will be range-bound through the summer. Feature Two market oddities stood out in the first half of the year. The first oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-2). For many years, bank equity performance and bond yields have been joined at the hip (Chart I-3). The faithful relationship exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart of the WeekWhen Technology Outperforms, European Equities Struggle Versus Emerging Market Equities Chart I-2Oddity 1: Banks Abruptly Decoupled##br## From Bond Yields Chart I-3Banks And Bond Yields Have Been ##br##Joined At The Hip For Years The second oddity was the abrupt decoupling of crude oil from industrial metal prices (Chart I-4). It is rare for crude oil to outperform copper by 30% in the space of just six months (Chart I-5). Chart I-4Oddity 2: The Crude Oil Price Abruptly ##br##Decoupled From Metal Prices Chart I-5It Is Rare For Crude Oil To Outperform ##br##Copper By 30% In Six Months Explaining The Oddities In The 1st Half The underperformance of banks is consistent with similar underperformances in the other classically growth-sensitive sectors - industrials, and basic materials (Chart I-6). Furthermore, the underperformances of these cyclicals is closely tracking the downswing in the global 6-month credit impulse (Chart I-7). Chart I-6The Odd Man Out: ##br##Oil And Gas Chart I-7The Underperformance Of Cyclicals Is Closely ##br##Tracking The Global 6-Month Credit Impulse Note also that these underperformances started well before any inkling of a trade spat. Hence, the recent escalation in the trade skirmishes is reinforcing a change of trend that was already in place. Taken together, this evidence would strongly suggest that global growth is not accelerating; it is decelerating. Oil is the odd man out because its supply dynamics, rather than demand dynamics, have been dominating its price action, lifting its year-on-year inflation rate to 60%. However, a large part of this surge in year-on-year inflation is also to do with the 'base effect', the dip in the oil price to $45 a year ago. The base effect is a statistical quirk, and shouldn't really bother markets. After all, most people do not consciously compare today's price with that exactly a year ago. Unfortunately, central banks' inflation targets are based on year-on-year comparisons, and this could explain why bond yields have decoupled from growth. If oil price inflation is running at 60% it will underpin headline CPI inflation, central bank reaction functions, and thereby bond yields. So here's the explanation for the oddities in the first half. Banks, industrials, and the other classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation and on central bank reaction functions. Spotting An Opportunity In The 2nd Half Chart I-8Crude Oil's 12-Month Inflation Rate Is 60% Ultimately, an oil price spike based on supply dynamics without support from stronger demand is unsustainable - because the higher price eventually leads to demand destruction (Chart I-8). On the other hand, if global demand growth does reaccelerate, it is the beaten-down bank equity prices that have the recovery potential. Either way, this leads us to a compelling intra-cyclical trade: short oil and gas versus financials. In aggregate though, we expect cyclical sectors to continue underperforming defensives through the summer. Based on previous credit impulse mini-cycles, we can confidently say that mini-deceleration phases last at least six to eight months and that the typical release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating growth and slow-to-budge bond yields risks protracting this mini-deceleration phase. Therefore, through the summer, it is appropriate to stick with underweights in the classically cyclical sectors. The strategy has worked well since we initiated it at the start of the year, and it is too early to take profits. Likewise, the portfolio of high-quality government 30-year bonds which we bought in early May is performing well, and we expect it to continue doing so for the time being. Don't Over-Complicate The Investment Process! To reiterate, stick with an underweight to the classical cyclicals versus defensives; and within the cyclicals, short oil and gas versus financials. These sector stances then have a very strong bearing on regional and country equity allocation. This is because up to a quarter of the market capitalisation of each major stock market is in one dominant sector, and this dominant sector gives each equity index its defining fingerprint (Table I-1): for the FTSE100, it is oil and gas; for the Eurostoxx50 it is financials; for the Nikkei225 it is industrials. So all three of these regional indexes are dominated by classical cyclicals. Table I-1Each Major Stock Market Has A Defining Sector Fingerprint For the S&P500 and MSCI Emerging Markets indexes, the dominant sector is technology. Although the technology sector is not strictly speaking defensive, it is much less sensitive to growth accelerations and decelerations than the classical cyclicals. There is another important factor to consider: the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in London in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining sector fingerprints for the major indexes turn out to be: FTSE100 = global oil and gas shares expressed in pounds. Eurostoxx50 = global banks expressed in euros. Nikkei225 = global industrials expressed in yen. S&P500 = global technology expressed in dollars. MSCI Emerging Markets = global technology expressed in emerging market currencies. Professional investors might argue that this trivializes an investment process on which they spend a lot of time, resource, research, and ultimately money. But we would flip this argument around. To justify the large amounts of time and resource spent on the investment process, professional investors are often guilty of over-complicating it! We fully admit that many factors influence the financial markets, but these factors follow the Pareto Principle, also known as the 80:20 rule. A small number of causes explain the majority of effects. And the 20% that explains 80% of a stock market's relative performance is its defining sector fingerprint. The Chart of the Week and Chart I-9-Chart I-12 should dispel any lingering doubts that readers might have. Chart I-9FTSE 100 Vs. S&P 500 = Global Oil And Gas##br## In Pounds Vs. Global Tech In Dollars Chart I-10FTSE 100 Vs. Nikkei 225 = Global Oil And Gas ##br##In Pounds Vs. Global Industrials In Yen Chart I-11FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas ##br##In Pounds Vs. Global Banks In Euros Chart I-12Euro Stoxx 50 Vs. S&P 500 = Global Banks ##br##In Euros Vs. Global Tech In Dollars So what does all of this mean for investors right now? A stance that is short oil and gas versus financials necessarily implies that the FTSE100 will struggle versus the Eurostoxx50, given the FTSE100's oil and gas fingerprint and the Eurostoxx50's banks fingerprint. Hence, today we are taking profits in our overweight to the FTSE100, and downgrading this position to neutral. This leaves us with overweight positions to France, Ireland, Switzerland and Denmark, and underweight positions to Italy, Spain, Sweden and Norway. Meanwhile, a stance that is underweight the classical cyclicals necessarily implies that European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Finally, in terms of overall market direction, we expect the range-bound pattern established in the first half of the year to hold through the summer. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. However, we reiterate that the outperformance of oil and gas versus financials is technically very stretched, which reinforces the fundamental arguments in the main body of this report to go short oil and gas versus financials. 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-13 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
Highlights Portfolio Strategy A rare buying opportunity has emerged in the S&P consumer staples index, especially for long-term oriented capital. The bearish story is already baked into current valuations, and industry green-shoots are flying under the radar. Similarly, the bearish packaged foods narrative is well ingrained in depressed relative valuations, whereas the budding recovery in industry final demand is severely underappreciated. This offers investors a compelling entry point to this unloved and under-owned consumer products subgroup. Recent Changes There are no changes to our portfolio this week Table 1 Feature The S&P 500 digested receding geopolitical risks last week, and continued to consolidate recent gains. Stocks are poking at the upper end of the 10% trading range in place since early-February, and internal equity dynamics suggest that a breakout in a bullish fashion is in store for later in the summer, as we first posited in late April.1 Chart 1 shows our Equity Market Internal Dynamics Indicator (EMIDI) that does an excellent job capturing the shifting internal forces that drive market returns. This coincident-to-leading market Indicator comprising economically sensitive sectors and portfolio biases is signaling that the path of least resistance is higher for the SPX. Similar to the EMIDI, the Value Line Arithmetic Index (an equal weighted broad-based stock market index) broke out to fresh all-time highs and the Value Line Geometric Index (a gauge of median stock prices) is following closely behind (third & fourth panels, Chart 2). Market darling AAPL is making a run at a $1tn valuation, spearheading the tech-laden NASDAQ Composite that remains on a pattern of hitting higher highs (top panel, Chart 2). Equity buying power is also evident in the breakout of Thomson/Reuters' "Most Shorted Stocks Index" (second panel, Chart 2). All of this suggests that before long the SPX will follow the uptrend and vault to all-time highs, a message corroborated by the record highs in the broad market's advance/decline (A/D) line (bottom panel, Chart 2). Chart 1Breakout... Chart 2...Looming An enticing macro backdrop continues to underpin equities. The latest ISM manufacturing report confirmed the IHS Markit U.S. manufacturing PMI release that we highlighted in our Report two weeks ago2: the U.S. is firing on all cylinders and has the potential to pull global growth out of its recent lull. In particular, the reacceleration in the ISM new orders-to-inventories ratio suggests that equities will gain steam in the coming months (second panel, Chart 3). Another source of upbeat news was the backlog subcomponent of the May ISM manufacturing survey. Unfilled orders hit a 14-year high, just shy of the all-time record. Historically, backlogs have been an excellent leading indicator of SPX revenue growth and the current message is that S&P 500 top line growth is on a solid footing (bottom panel, Chart 3). The Fed acknowledged this mini economic overheating last week, and the FOMC slightly bumped its median expectation to a total of four hikes in calendar 2018. Moreover, fiscal easing will continue to gain thrust as the year progresses and the cash repatriation will also provide an assist to the stock market. We are modeling between $650bn-to-$800bn in equity retirement for calendar 2018. Chart 4 depicts our estimates and if the historical correlation between share buybacks and equity prices holds, then there is more upside to stocks in the back half of the year. Nevertheless, retail investors are replenishing cash coffers according to the American Association of Individual Investors (AAII), rather than actively participating in the latest market run up. At the margin, this beefing up of retail investor dry powder represents a headwind to additional equity market gains. We heed the message from this traditionally leading Indicator and in order for our cyclical (9-12 month horizon) sanguine equity market view to pan out, individual investors will have to drawdown their cash balances (AAII cash shown inverted, Chart 5). Chart 3Macro Tailwinds Chart 4Corporate Underpinnings... Chart 5...But Retail Investor Has To Participate This week we are revisiting a broad defensive sector and one of its key subcomponents. What To Do With Staples Investors have deserted consumer staples stocks at a dizzying speed, and valuations have cratered to a multi-decade low, according to our composite Valuation Indicator (Chart 6). Technicals are also as washed out as can be, as staples equities have been sold off indiscriminately. Other sentiment and breadth measures confirm that this safe haven sector has lost its allure: the A/D line is probing multi-year lows, EPS breadth is waning and groups with a positive 52-week rate of change and trading above the 40-week moving average have all but disappeared (Chart 7). Chart 6Buy Into Weakness Chart 7Bombed Out Sentiment Our sense is that this consumer staples wholesale liquidation provides a great buying opportunity, especially for longer-term oriented capital with a time horizon of at least 2-3 years. Even on a shorter-term outlook, a bounce seems likely from extremely depressed levels, as relative share prices may find support close to the pre-Great Recession trough (top panel, Chart 7). From a cyclical perspective we continue to view this defensive sector as a hedge to our overall portfolio position that sustains a pro-cyclical bent. Importantly, the bearish consumer staples case is well discounted in bombed out valuations. The stock-to-bond ratio is weighing on this fixed income proxy sector that sports a dividend yield on a par with the 10-year Treasury (top & second panels, Chart 8). Moreover, subsiding volatility bodes ill for relative share prices; the opposite is also true (bottom panel, Chart 8). On the demand front, once again the uninspiring non-cyclical spending backdrop is well entrenched in sinking relative share prices. Relative staples retail sales - both compared to discretionary and to total sales - are deflating as is typical in the late stages of the business cycle (top & second panels, Chart 9). Chart 8Bearish Narrative Baked In Chart 9Lack Of Demand... Such waning demand has weighed on industry selling prices at a time when executives are making labor additions, blowing out our wage bill proxy. As a result, profits margins are suffering a squeeze (Chart 10). However, there are some pockets of strength hidden beneath the surface. While non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. True, this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (bottom panel, Chart 9). Other industry green-shoots are also surfacing. Consumer staples exports are on a slingshot recovery path, expanding by a low double digit growth rate, defying the year-to-date trade-weighted U.S. dollar appreciation (second panel, Chart 11). In fact, given the defensive stature of this index, any additional greenback gains will boost relative profits especially in the first half of 2019 (third panel, Chart 11). Chart 10...Weighing On Margins... Chart 11...But Green-Shoots Surfacing Finally, CEO confidence of non-durable industries is far outpacing the broad animal spirit recovery according to The Conference Board, and this relative Chief Executive euphoria has historically been positively correlated with share price momentum, underscoring that better times lie ahead for consumer staples stocks (bottom panel, Chart 11). Adding it up, a rare buying opportunity has emerged in the S&P consumer staples index, especially for long-term oriented capital. The bearish story is already baked into current valuations, and industry green-shoots are flying under the radar. Tack on impressive industry return on equity and this index appears extremely undervalued (bottom panel, Chart 6). Bottom Line: Were we not already overweight the S&P consumer staples index, we would not hesitate to lift exposure to above benchmark. Appetizing Packaged Foods Not only have investors shunned consumer staples stocks in general, but the S&P packaged foods sub-index has also suffered, even trailing the broad staples sector. As a reminder, within consumer products we are overweight packaged foods and household products but maintain a below-benchmark allocation to soft drinks. Packaged foods relative share prices have returned to the mid-2000s level offering a compelling entry point for fresh capital, especially longer-term oriented money (top panel, Chart 12). Part of the reason that these stocks are under-owned boils down to their defensive characteristics. These safe-haven equities pay handsome, steadily growing and secure dividends. Thus, when the bond market's selloff gains steam, investors flock to deep cyclical stocks and trim fixed income proxied equities, and vice versa. Moreover, the Warren Buffett induced M&A premia have now fully reversed from this group, with the base effect weighing on relative performance (bottom panel, Chart 12). Nevertheless, we are not willing to throw in the towel in this staples sub-index that offers hidden value. A number of leading industry demand indicators are firming and suggest that a top line growth period is in the cards. Food and beverage exports are rising at a healthy clip, despite the U.S. dollar's year-to-date appreciation, and so are domestic consumer outlays (second panel, Chart 12). The industry's shipments-to-inventories ratio is sending a similar message, jumping to a level last seen four years ago (third panel, Chart 12. Importantly, relative to overall spending, real (volume) food and beverage spending is expanding smartly. Add on tame raw food commodity costs, especially compared with broad commodity price inflation and relative EPS will overwhelm extremely depressed analysts' expectations (relative grain prices shown inverted, bottom panel, Chart 13). Chart 12Budding Demand Recovery... Chart 13...Should Aid Top Line Growth This encouraging demand backdrop is showing up in industry pricing power. Rising food manufacturing shipments are underpinning food producers' selling prices (second panel, Chart 14), and coupled with the contained crude food input costs suggest that packaged foods margins will continue to expand (middle panel, Chart 14). Even down the supply chain, food manufacturers' appear to be making significant headway, a harbinger at least of a profit margin relief phase. While channel captains food retailers have been dictating pricing terms to food suppliers for the better part of the past five years, industry producer prices are now on an even keel with CPI foods, a good proxy of what super markets are charging the consumer (fourth panel, Chart 14). Any additional pricing power gains will represent a boost to industry margins and, thus, profitability. Finally, firming demand is also showing up on industry operating metrics: factory activity is running red hot with resource utilization rates vaulting to multi-decade highs and industry hours worked picking up momentum (third panel, Chart 15). While CEOs have expanded the labor footprint and wage inflation is a cause for concern (bottom panel, Chart 15), a simple industry productivity proxy (industrial production divided by employment) shows that profits should enjoy a lift in the coming quarters. Chart 14Margins Can Expand Further Chart 15Brisk Factory Activity Netting it out, the bearish packaged foods narrative is well ingrained in depressed relative valuations (bottom panel, Chart 14), whereas the budding recovery in industry final demand is severely underappreciated, offering investors a compelling entry point to this unloved and under-owned consumer products subgroup. Bottom Line: Stay overweight the S&P packaged foods index. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, KHC, GIS, TSN, K, CAG, HSY, MKC, SJM, HRL, CPB. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Underweight This week's NFIB small business survey was a record-setter on a number of fronts; the small business optimism index is at its second highest level in the survey's 45 year history with a net 34% of respondents saying that now is a good time to expand, the highest level ever (top and second panel). However, the news is not all positive for small business owners; an all-time record 35% of firms reported higher worker compensation while only 15% reported higher sales, implying margins are tightening. We downgraded small caps last month, moving to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (third and bottom panels). The strength of this NFIB survey actually reinforces our negative thesis. Small businesses are as likely as they ever have been to expand their businesses and their balance sheets at the same time. Meanwhile, quality of labor problems, now the single largest issue facing small businesses according to the NFIB, and the resulting compensation increases present significant headwinds to EBITDA growth. Bottom Line: We reiterate our large cap preference over small caps.
Highlights Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. There have been a number of noteworthy divergences in the EM space of late. They are probably part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. The selloff in EM risk assets will broaden and intensify. A defensive positioning is warranted. India's relative equity performance has by and large been undermined by rising oil prices. A potential roll-over in crude prices will aid the Indian bourse's relative performance versus its EM peers. The South African rand remains on shaky foundation; stay short. Feature There have been a number of noteworthy divergences in financial markets of late, in particular between emerging markets (EM) and commodities, as well as between Chinese investable stocks trading outside the mainland and equity prices listed domestically. In our view, these divergences are part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. In dominos, tiles do not all fall simultaneously. They fall one by one, and there is a time lag between the first domino and the last-standing domino to drop. Also, unlike in natural sciences, time lags and speed in economics and finance vary with each experiment - because they are contingent on complex human psychology and behavior, not on well defined natural phenomena such as gravity or motions of objects. Hence, they are impossible to forecast with much precision. A Message From Our Risky Versus Safe-Haven Currency Ratio Although U.S. share prices have lately been firm, EM stocks have broken below their 200-day moving average (Chart I-1, top panel). So has our risky versus safe-haven currencies ratio 1 (Chart I-1, bottom panel). Indeed, while having held up at its 200-day moving average several times in the past two years, the ratio has recently decisively broken below this technical support line. This indicator correlates extremely well with EM share prices, and its message is presently unambiguous: The rally in EM is over, and a bear market has likely commenced. Crucially, this ratio measures commodities currencies versus the average of the Japanese yen and Swiss franc - two defensive currencies - not against the U.S. dollar. Hence, it is not impacted by the greenback's trend. Given that all six risky currencies used in the numerator of this ratio - AUD, CAD, NZD, BRL, ZAR and CLP - are commodity currencies, it is not surprising that the ratio also correlates with commodities prices. In this context, it currently suggests the outlook for both industrial metals and oil is troublesome (Chart I-2). Chart I-1Beware Of These Breakdowns Chart I-2A Red Flag For Commodities Prices The common denominator that links all these financial variables is global growth. The risky versus safe-haven currencies ratio typically leads world trade cycles by several months, and it currently points to a notable slowdown in global export volumes (Chart I-3). Chart I-3Global Export Growth Is Set To Slow Further, commodities prices have exhibited a rare decoupling from the U.S. dollar. It is very unlikely that this divergence can be sustained for much longer. Our bias is that global trade will slow as China/EM demand weakens despite robust U.S. growth. Growth dynamics shifting in favor of the U.S. entails that the greenback will continue to appreciate. Consistently, EM/China growth disappointments and U.S. dollar's persisting strength suggest that commodities will reverse their current trend sooner rather than later. A relapse in commodities prices will reinforce EM currency depreciation, triggering more outflows from EM equities and fixed-income markets. Decoupling Or A Time Lag? Chart I-4Domino Effect In 2007-08 Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. The EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then it spread to Korea, Malaysia and Indonesia and finally, to the rest of Asia. In August 1998, Russian financial markets collapsed triggering the LTCM debacle. The last leg of this crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Similarly, the U.S. financial/credit crisis commenced with the selloff in sub-prime securities in March 2007. Following that, corporate spreads began widening and bank share prices rolled over in June 2007. In the meantime, the S&P 500 and EM stocks peaked on October 9 and 29, 2007, respectively. Despite all of these developments, commodities prices and EM currencies continued rallying until summer of 2008 and then quickly collapsed in the second half of that year (Chart I-4). Finally the Lehman crash took place on September 29 of 2008. That marked the apogee of the crisis, causing a complete unravelling of financial markets and the global economy, and lasting until March of 2009. It seems some sort of domino effect is now taking hold of the EM universe. Initially, it started with Turkey and Argentina. Then, it spread to Indonesia, India and Brazil. The currency weakness across the wider EM universe has already led to EM credit spread widening. Yet, there are a few EM financial markets, particularly Chinese, Korean and Taiwanese, that are still holding up relatively well. Moreover, U.S. share prices and high-yield credit spreads have done quite well too. How should investors interpret these divergences? Our view has been, and remains, that EM risk assets will do poorly regardless of the direction of the S&P 500. In fact, an escalation in EM turmoil and a slowdown in developing economies are among the main risks to American share prices themselves. The primary link from EM financial markets to the S&P 500 is via the exchange rate - a strong dollar along with an EM/China growth slump will weigh on American multinationals' profits. The following three questions are presently vital for investors: 1. Can EM and U.S. risk assets de-couple from each other, and has a sustainable divergence happened in the past? Although short-term moves in U.S. and EM equity indexes often appear correlated, from a big-picture perspective there have been considerable divergences. The overall EM stock index is now at the same level it was in 2007 (Chart I-5). Meanwhile, the S&P 500 index is a hair below its all-time high. Chart I-5EM Share Prices And The S&P 500: A Long-Term Perspective The same is true for many EM currencies and the S&P 500. A substantial decoupling did occur in the not-so-distant past: EM currencies depreciated from 2011 to early 2016, while U.S. share prices rallied strongly from late 2011 until 2015 (Chart I-6). With respect to U.S. credit spreads, Chart I-7 illustrates that EM and U.S. credit spreads have had a much higher correlation than their respective equity indexes. During the 1997-'98 EM crises and the 2014 -'15 EM turmoil, U.S. high-yield corporate spreads widened. In brief, there has historically been little decoupling between U.S. and EM credit markets. Hence, the U.S. high-yield credit market's latest resilience in the face of widening in EM credit spreads is historically exceptional. Chart I-6EM Currencies And The S&P 500 Chart I-7EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective As EM currencies continue to depreciate versus the U.S. dollar, EM sovereign and corporate credit spreads will widen. Given their past high correlation with U.S. credit markets, odds point to widening corporate credit spreads in the U.S. On the whole, if EM risk assets continue to sell off, which is our baseline scenario, the S&P 500 and U.S. credit markets could defy gravity for a while, but not forever. At some point, risks stemming from EM turbulence will cause a selloff in American stocks and corporate bonds. It is impossible to know when and by how much U.S. stocks will suffer. Our bias is that a U.S. equity selloff will likely be on par with the 2015-'16 episode. 2. Can North Asian equity markets such as China, Korea and Taiwan remain relatively resilient if the turbulence in other EM countries continues? Based on history, they can, but only for a short period of time. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - at which point they began plummeting (Chart I-8, top panel). In 2007-'08, emerging Asian equities started tumbling along with the S&P 500 in late 2007, but Latin American bourses fared well until the middle of 2008 due to surging commodities prices (Chart I-8, middle panel). Finally, the bottom panel of Chart I-8 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Regarding Asia's business cycle conditions, the slowdown is already taking place and will likely intensify. Leading indicators of exports and manufacturing such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart I-9). Chart I-8Asian And Latin American Equities: ##br##Unsustainable Divergences Chart I-9Asia's Export Slowdown Is In Making 3. Is there any other notable financial market decoupling that investors should be aware of? Chart I-10China: A Decoupling In Various Equity Segments Since early this year, there has been substantial decoupling between Chinese investable stocks and the onshore A-share market. First, the overall A-share index has dropped since early this year, but the MSCI Investable Chinese stock index has so far been resilient (Chart I-10). Second, while it might be tempting to explain this decoupling by discrepancies in the sectors' weights in these indexes, this has not been the case this time around. The fact remains that there has been considerable divergence between share prices of the same sectors. For example, onshore and offshore equity prices have diverged for the following sectors: real estate stocks, materials, industrials, technology, utilities and consumer discretionary (Chart I-11A and Chart I-11B). Only defensive sectors such as consumer staples and health care have done well in both universes. Share prices of financials and telecoms have dropped in both the onshore and offshore markets. Chart I-11AChinese Equity Sectors: Puzzling Decoupling Chart I-11BChinese Equity Sectors: Puzzling Decoupling Finally, a similar performance gap has appeared between Chinese small cap stocks trading onshore and in Hong Kong (Chart I-12). Chart I-12China's Small-Cap Stocks: A Perplexing Gap How do we explain these divergences? Our bias is that local investors in China are much more concerned about the mainland growth outlook than foreign investors. This is the opposite of what occurred in 2015. Back then, international investors were somewhat cautious on China - commodities prices and other China-related global financial market plays were in a bear market. Meanwhile, local investors were caught up in a full-fledged equity mania that ended with a crash. Given our downbeat outlook on China's capital spending and related plays in financial markets, we reckon that domestic investors in China will be proven right in the months ahead, while the international investment community will be left flat-footed. Importantly, there has been an unexplainable mismatch between monetary/credit tightening in China and complacency among international investors about the outlook for the mainland economy. Specifically, the cost of borrowing has gone up, and credit standards have tightened. Chart I-13 illustrates that both onshore and offshore corporate bond yields have risen to new cycle highs, Chinese banks' lending rates are rising, while banks' loan approvals are dropping. Consistently, money and credit growth have plunged. Importantly, this is occurring in an economy with immense credit excesses. Nevertheless, commodities prices have so far defied such a pronounced deceleration in money and credit aggregates in China (Chart I-14). Chart I-13China: Ongoing Credit Tightening Chart I-14China's Money/Credit And Commodities Prices All in all, we interpret these divergences by varying lead and lags rather than as a fundamental breakdown in the relationship between money/credit and the real economy. We continue to expect tightening liquidity and credit to escalate the growth slowdown in China. As a result, there continues to be considerable downside risks for Chinese investable stocks and commodities prices. Bottom Line: The dominos have begun to fall. We continue to recommend a defensive strategy and an underweight position in EM equities, credit and currencies versus their U.S./DM peers. High-yield local currency bonds that are a de-facto bet on the underlying currencies are vulnerable too. For investors willing to go short, it is not too late to short EM stocks and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Average of cad, aud, nzd, brl, clp & zar total return (including carry) indices relative to average of jpy & chf total returns. India's Equity Underperformance: Blame It On Oil Indian stocks have been underperforming their EM counterparts. Rising oil prices have created a toxic macro mix for India, triggering the equity underperformance (Chart II-1): Rising crude prices have led to widening current account and trade deficits. Oil price swings are often instrumental to trends in India's current account balance (Chart II-2). The deterioration in the nation's external accounts has been behind the rupee's poor performance. Chart II-1Higher Crude Oil Prices Hurt Indian Stocks Chart II-2Crude Oil And Current Account Deficit Given that India is a major oil importer, falling commodities prices - especially crude oil - will benefit India's stock market. The recent surge in oil prices has also reinforced inflation dynamics in India (Chart II-3). Chart II-3Higher Crude Oil Boosts Inflation The basis for the high correlation between core consumer price inflation (excluding energy and food) and oil prices is due to the fact that core inflation includes components that are heavily influenced by fluctuations in oil prices. For instance, the transportation and communication component of inflation is very sensitive to changes in oil prices. This component accounts for 18% of core consumer price index. Further, the personal care and effects component also correlates with crude oil. Personal care goods use petroleum products as an important input in their production process. This component accounts for 8% of core consumer price index. Together these components account for a non-trivial 26% of core consumer price index, and will likely subside as oil prices fall. On the inflation front, we highlighted in our April 19 Weekly Report that risks to inflation are tilted to the upside due to strong consumer and government spending in an otherwise under-invested economy.1 Domestic demand has been accelerating, providing tailwinds for higher inflation (Chart II-4). Higher inflation and currency weakness has led to a considerable rise in both government and corporates local currency bond yields (Chart II-5). Chart II-4Domestic Economy Is Strong Chart II-5Rising Borrowing Rates Given the very high equity valuations, share prices in India are especially sensitive to rising local borrowing costs. All in all, India's relative equity performance has by and large been undermined by rising oil prices. BCA's Emerging Markets Strategy team believes the risk-reward for oil prices is skewed to the downside due to the expected deterioration in EM/China oil demand, investors' extremely high net long positions in crude and appreciating dollar.2 That is why we are still reluctant to downgrade Indian stocks within the EM equity universe. It is vital to emphasize, however, that our overweight call is relevant to dedicated EM equity portfolios. We have been, and remain, negative on Indian share prices in absolute U.S. dollar terms. Bottom Line: Odds are that commodities prices will drop meaningfully in the months ahead and that will support India's relative equity performance versus the EM benchmark. EM dedicated investors should keep an overweight stance on Indian equities for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Country Perspectives: India And Turkey," dated April 19, 2018, link available on page 21. 2 The Emerging Markets Strategy team's view on oil differs from BCA's house view which remains bullish. The South African Rand Remains On Shaky Foundations Although the rand has not been among the worse hit EM currencies, investors should remain cautious on it. The currency presently finds itself resting on very shaky foundations, raising odds of substantial depreciation for the remainder of the year: First, South Africa's external funding has solely been driven by portfolio inflows, leaving the exchange rate highly exposed to potential portfolio outflows. As illustrated in Chart III-1, net portfolio inflows reached all-time highs while net FDIs reached all-time lows at the end of 2017 (the latest available statistics). Meanwhile, foreign ownership of domestic bonds has reached new highs (Chart III-2). The total return in dollar terms on South Africa's local currency bond index1 has failed to break above its previous highs and has relapsed (Chart III-3). It seems this asset class has entered a new bear market. Further decline in the total return of bonds will spur more selling or hedging of currency risks by international bond investors. Chart III-1South Africa: Highly Exposed To Portfolio Flows Chart III-2Foreign Holdings Of South African Local Bonds Is Elevated Chart III-3South African Bonds Were Unable To Break Out Second, the country's trade balance is set to deteriorate. Despite continued episodes of currency weakness throughout last decade, there has been little to no import substitution in South Africa. Consequently, a reviving domestic demand will prompt higher imports. That, and a potential relapse in export (raw materials) prices, will lead to a widening trade balance. Chart III-4The Rand Is Not Cheap Finally, the rand is not cheap; its valuation is neutral (Chart III-4). When an exchange rate is close to its fair value, it can either appreciate or depreciate. In short, the rand's valuation is not extreme enough to be a major factor in driving the market right now. Bottom Line: Currency traders should stay short the ZAR versus both the USD and the MXN. Relative trade balance dynamics and valuations continue to play in favor of the Mexican peso relative to the South African rand. Predicated by our negative view on the rand, we recommend EM dedicated equity and fixed-income investors to maintain an underweight allocation to South Africa. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 JP Morgan GBI-EM Global Diversified Emerging Markets Government Bond Index for South Africa. Equity Recommendations Fixed-Income, Credit And Currency Recommendations