Equities
Highlights China's ongoing industrial sector slowdown will not likely lead to a global growth shock, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Feature We have presented the following views about China's economy and its financial markets over the past several months: China's industrial sector is slowing, and is set to slow further based on our proprietary leading indicators for the Li Keqiang index. This will cause a further deceleration in Chinese nominal import growth and suggests that Chinese ex-tech earnings per share growth will soon peak. Residential investment has potential to provide a tailwind to domestic growth if home sales sustainably pick up, but there are no firm signs that this is occurring. Robust export growth will help China's economy from slowing sharply, but there are several risks to the external demand outlook that need to be monitored. Given the poor growth momentum in the industrial sector, fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. China's consumer-oriented tech sector ostensibly stands out as a shelter from an old economy slowdown, but it is extremely expensive, earnings momentum is very stretched, and it may be adversely impacted by the U.S.' section 301 investigation. We have recommended avoiding exposure since mid-February. China's ex-tech equity market is comparatively cheap, high-beta vs the global benchmark, and technically robust. While the risks to the economic outlook are clear, investors should continue to overweight Chinese ex-tech stocks vs their global peers. For global investors who are perennially concerned that a slowdown in China's economy will culminate in a significant shock to the global economy, Chart 1 provides a helpful visual representation of our view. The chart depicts two scenarios: first, the ongoing industrial sector slowdown in China results in an outright subtraction from global growth momentum via a contraction in imports, despite positive growth impulses from the U.S. and euro area. In our view, Chinese import growth is likely to remain positive, but will largely be driven by strong demand in the developed world (scenario 2). Chart 1Two Different Scenarios Concerning China's Contribution To The Global Economy Chart 1 highlights that our view is more positive for the global economy than one might otherwise think, but it is important for investors to understand the nature of China's relative stability in the event that export growth surprises to the downside over the coming months. In fact, Chart 2 highlights that the most salient data development over the past two weeks has been a fairly significant deceleration in smoothed nominal export growth, which is our preferred method of analyzing Chinese trade data. Despite the relative stability of China's PMIs over the past few months, a 3-month moving average of US$ exports decelerated from 17.5% to 7% in May, or from 10% to -1% in RMB-terms. Sequentially, Chinese export growth improved in May (vs April's reading) in both US$ and RMB-terms, and both beat market expectations. As a result, we are sticking with the second scenario depicted in Chart 1 as the more likely of the two for the coming 6-12 months. However, the reliance on strong external demand to prop up China's import growth is somewhat of a "shaky ladder" for global investors to climb, given the clear risks from U.S. protectionist action, the headwinds to Chinese export competitiveness from a strong currency (or, alternatively, the punishing impact of translation effects on exporter revenue), and the potential for robust export growth to embolden Chinese policymakers to push forward with even more aggressive reforms over the coming year. Still, Chart 3 highlights that many investors are perfectly willing to climb this ladder, shaky or otherwise. The chart shows that the relative performance of Chinese ex-tech stocks versus their global peers remains firmly within the ascending trend channel that has been in place since early-2017, despite the ongoing slowdown in the industrial sector. As we noted in our May 30 report,1 this message is consistent with the view that any recent negative relative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. Chart 2A Nontrivial Slowdown In Chinese Export Growth Chart 3Investors Are Fine Climbing A Shaky Ladder We remain nervous bulls concerning Chinese ex-tech stocks, and continue to recommend an overweight stance. But our reading of China's macro dynamics suggests that investors should not be dogmatic about their equity allocation to China, and should be prepared to cut exposure in response to a material shift in sentiment towards the Chinese economy. As a final point, while we have clearly presented our framework over the past several months for thinking about and analyzing China, investors attending BCA's Annual Investment Conference in September will get an opportunity to hear additional perspectives about the cyclical trajectory of its economy. Leland R. Miller, CEO of the China Beige Book, will be presenting his thoughts on the outlook for Chinese growth and risk assets. Based on his firm's unique insights into China's economic and financial market developments, Mr. Miller's panel will certainly be among those not to miss. Bottom Line: China's ongoing industrial sector slowdown will not likely lead to a shock to global demand, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. A-Shares: EM Inclusion, Factor Analysis, And A Contrarian Shadow Trade The beginning of June marked a milestone for Chinese equities, as MSCI added over 226 large-cap A-shares to their Emerging Markets index. Box 1 provides some brief details about the inclusion, and also notes how it affects several of the trades in our trade book. Chart A1A-Share Inclusion Added 10% Market Cap ##br##To The MSCI China Index Box 1 The Inclusion Of Chinese A-Shares In The MSCI Emerging Markets Index On May 31 2018, 226 China large-cap RMB-denominated A-shares were included in the MSCI Emerging Markets Index. The change represented a 1.4% increase in the market capitalization of the MSCI Emerging Markets index, and 10% increase in the MSCI China Index (Chart A1). We have often referred to the MSCI China Index as the "investable" index in previous reports and in our trade table, but this index now includes some domestic stocks as a result of the recent inclusion. We plan to continue to use the MSCI China Index (or its ex-tech equivalent) as the main outlet for our investment recommendations, which means that the benchmark for five of our trades will be re-labeled in our trade table (from China investable to MSCI China Index). One exception is our trade favoring the MSCI China ESG Leaders Index, as MSCI has yet to publish an ESG rating index for Chinese domestic stocks. We last wrote about the outlook for A-shares in our March 14 Weekly Report,2 and noted that the significant underperformance of A-shares relative to global stocks over the past few years was due to the legacy effects of an enormous, policy-driven speculative bubble in 2014-2015. We highlighted that while domestic stocks have worked off some of this bubble and multiples are no longer extreme, that a neutral allocation was still warranted due to an uninspiring earnings outlook and, at best, a very modest valuation discount relative to global stocks. Chart 4 illustrates this latter point; based on all four trailing valuation ratios that we track, ex-tech onshore stocks are either on par or considerably more expensive than global ex-tech stocks. By contrast, the MSCI China Index (excluding technology) is cheaper than their global peers by all measures, in some cases considerably so. Nevertheless, while we continue to recommend that investors maintain a neutral stance towards A-shares within a global equity portfolio, the inclusion of A-shares in the EM index may force some investors to increase their exposure to domestic stocks beyond the level that they otherwise would have maintained. In order to provide some perspective of what domestic stocks to favor, we have taken a quantitative approach to analyzing A-shares that is loosely inspired by the Fama-French three-factor model. More precisely, we have examined the historical relative performance of three separate factor strategies for A-shares and global stocks, both relative to their respective broad market. The three factors tested are as follows: Return On Equity (ROE): Replacing market beta in the F&F model, we have built a historical portfolio for both Chinese domestic and global stocks that favors level 1 GICS sectors with above-median ROE. Within high-ROE sectors, the portfolio allocates to the sectors on a value-weighted basis to maximize the investability of the strategy. Sector Weight: Our second approach favors GICS sectors with a below-median sector weight, which conceptually mimics the firm size factor in the F&F model. In reality, this strategy is selecting among sectors made up of large cap firms, meaning that investors should regard the performance of this strategy as reflecting the success or failure of investing in potentially underowned or unloved sectors. Value: Our third factor is exactly in line with the F&F model, with portfolios using this approach favoring sectors with above-median dividend yields. We have chosen a cash flow-based valuation measure instead of the book value yield to assuage potential investor concerns about accrual quality. Chart 5 presents the cumulative returns of these strategies, for both global and Chinese domestic stocks. Several important observations are noteworthy: Chart 4A-Shares Are Not Cheap Vs##br## Global Stocks In Ex-Tech Terms Chart 5ROE, Sector Weight, and Value Are ##br##All Successful Factors In China's Domestic Market Favoring high-ROE sectors has been a more profitable strategy when allocating among global sectors than those of the domestic Chinese market, but we have seen similar returns from the strategy in both markets since early-2011. This is consistent with an important conclusion that we made in our March report: the perception among some global investors that domestic Chinese stocks are a "casino" market disconnected from fundamentals does not appear to be supported by the data over the past several years. A strategy of favoring sectors with a low market cap weight has fared better for Chinese A-shares than for the global market, albeit with considerable volatility. We suspect that the underperformance of smaller-than-average sectors at the global level has been affected over the past four years by the underperformance of resources, but the outperformance of the strategy in China also makes sense: underowned or unloved sectors should have more abnormal return potential in smaller, less scrutinized markets. Favoring cheap stocks has been an abysmally poor strategy at the global level over the past decade, due to the chronic underperformance of the financial sector. But cheaper sectors have outperformed China's domestic equity market at a modest pace over the past several years, which is good news for value-oriented investors. Chart 6 highlights where each of China's domestic equity sectors currently sits in the ROE/size/value spectrum. There are three sectors exhibiting two of the factors employed in our analysis: health care, financials, and real estate. For now, we would caution investors against buying domestic health care stocks, as Chart 7 shows that the sector has become heavily overbought over the past several months. Domestic financials would appear to be a better bet: despite underperforming financials in the MSCI China Index, domestic financials have outperformed the domestic broad market over the past year and have not broken materially below their trend line despite a recent selloff. Chart 6Health Care, Financials, And Real Estate Are At The Intersection Of Successful Factors Chart 7Financials Are A Better Bet Than Health Care; Watch For A Housing Catalyst To Buy Real Estate Finally, real estate stocks have the potential to become a fantastic contrarian trade if Chinese home sales do sustainably pick up. The sector is cheap, profitable, and highly unloved given the view among many investors that the Chinese government's structural reforms will weigh on performance for some time to come. But as we have noted in previous reports, the persistent gap between home sales and housing construction over the past few years may very well be over, implying that the latter may rise in lockstep with the former if sales begin to trend higher. Chart 7 shows that investors are not even remotely pricing in such a scenario, as domestic real estate companies have underperformed the domestic benchmark since early-2016 and remain in a relative downtrend. We would not recommend fighting negative investor sentiment towards the sector for now, but domestic real estate companies should clearly be on an investor's watch list, alongside the trend in residential sales volume. Bottom Line: The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. An Update On China's Corporate Bond Market China's equity market may not be the only financial market segment to garner more addition from increased index inclusion over the coming year: Bloomberg recently announced that it will add Chinese RMB-denominated government and policy bank bonds to the Bloomberg Barclays Global Aggregate Index over a 20-month period beginning in April 2019, conditional on the implementation of certain "operational enhancements" to the market by the PBOC and Ministry of Finance.3 China's total bond market (government and corporate) is the third-largest in the world, with a record of 79 trillion yuan ($12.7 trillion) outstanding. Yet foreign investors have little exposure to Chinese bonds, due to frictions concerning investability, a lack of transparency on issuers/index components, and concerns about the quality of domestically-issued credit ratings (95% of China's corporate bonds are rated AA- or higher). Chart 8The Recent Uptick In Yields Has Had A Paltry Impact On Total Returns While the proportion of foreign ownership of Chinese bonds may rise slowly over time, our sense is that it will indeed rise. First, there is a clear yield advantage for Chinese relative to global bonds, in a world where high long-term absolute return prospects are scarce. Second, Chinese policymakers continue to (slowly) open China's financial markets to the rest of the world, and global investors can now gain access to China's onshore bond market through four channels without quota: the qualified foreign institutional investors program (QFII), the renminbi qualified foreign institutional investor program (RQFII), the China interbank bond market (CIBM), and the Bond Connect program.4 Third, China's regulators allowed foreign-owned ratings agencies to set up shop in China last year, in an attempt to address the ratings quality issue. BCA's China Investment Strategy service initiated our long China onshore corporate bonds trade on June 22 last year, which has since earned a 3.7% return in spite of widening yield spreads and a spike in default concerns over the past several weeks. Indeed, Chart 8 highlights that the recent rise in corporate yields has had a minimal impact on the index total return profile. There is one critical factor driving this apparent discrepancy that is not well understood by global investors: compared with corporate issues in the developed world, China's corporate bond market has considerably shorter duration. Table 1 highlights that most of the corporate bonds issued in China have a maturity of three years or less, and the duration for the ChinaBond Company Credit Index, the benchmark that we have used for our corporate bond trade, is approximately 2.3 years. By contrast, U.S. investment- and speculative-grade bonds currently have an effective duration of 7.5 and 4 years, respectively. Chart 9 illustrates the 12-month breakeven spread for the Company Credit Index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. The chart shows that Chinese corporate bond yields would have to rise approximately 250 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that is totally inconsistent the PBOC's monetary policy stance. Table 1Maturity Distribution Of China's Bond Market Chart 9A Compelling Cushion Against Potentially Higher Rates Another way to gauge the attractiveness of a corporate bond position is to look at the spread relative to comparable duration government bonds in order to calculate the default loss that would be required to erase the spread (which is also roughly 250 bps today). Using the relatively conservative assumption of a 35% recovery rate, a 2.5% default loss implies a default rate of close to 4%. We noted in our May 23 Special Report that recent corporate defaults in China amounted to only 0.1% of the outstanding corporate bond market,5 implying that the ultimate scope of corporate bond defaults in China would have to be 40 times larger than currently observed to wipe out the spread relative to Chinese government bonds of comparable duration. While we cannot rule such an event from occurring, there is no evidence to suggest that such a dramatic escalation in defaults is about to occur. Bottom Line: Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "11 Charts To Watch", dated May 30, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "A-Shares: Stay Neutral, For Now", dated March 14, 2018, available at cis.bcaresearch.com. 3 These enhancements include the implementation of delivery vs. payment settlement, the ability to allocate block trades across portfolios, and clarification on tax collection policies. 4 The first three programs have a clear statement that no quotas apply, whereas the bond connect program has no specific statement concerning quotas. 5 Pease see China Investment Strategy Special Report "Messages From BCA's China Industry Watch", dated May 23, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
As stocks have been stuck in a mini 'risk-off' phase, investors have begun to question whether the current global growth soft patch will prove transitory or morph into a severe global growth deceleration. We side with the former. The latest ISM manufacturing survey print is clearly signaling that SPX momentum will resume its ascent in the coming months (second panel). Further, the IHS Markit U.S. manufacturing PMI has been steeply diverging from the J.P. Morgan-calculated global manufacturing PMI (third panel) but, given America's heavy weighting in global output, recent strength in the U.S. should pull global growth higher. What could push our still constructive cyclical 9-12 month equity view offside is a surge in the U.S. dollar. The greenback's trough coincided with last year's peak in global growth (bottom panel), and further dollar appreciation would represent a meaningful headwind to earnings growth, particularly in the U.S. tech sector with its hefty foreign sales exposure. Netting it all out, there are high odds that the U.S. will lead global growth higher in the coming quarters and result in a recoupling higher of global growth, assuming the greenback stops appreciating. This would support low double digit calendar 2019 SPX profit growth. Under such a macro backdrop, it still pays to maintain a cyclicals over defensives portfolio bent; please see Monday's Weekly Report for more details.
The GAA DM Equity Country Allocation model is updated as of May 31, 2018. No significant changes in the model's allocation this month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 111 bps in May, largely driven by Level 2 model which underperformed by 300 bps. The model's largest overweight, Italy, turned out to be the worst performer in May as a result of Italian politics, an event that is difficult for a quantitative model to capture. Level 1 model outperformed by only 7 bps in May. Consequently, since going live, the outperformance of the Level 2 model, which allocates funds among 11 non-U.S. countries, has reduced to 52 bps, while the overall model has performed in line with the MSCI World benchmark. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of May 31, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The largest shift was a move from underweight to overweight in the materials sector, driven by improving momentum. On the other hand, the overweight in energy was reduced by 1.7 percentage points. The aggregate model now has a small overweight on cyclicals versus defensives, although this is entirely in commodity-related cyclicals. The only other overweight sector is utilities, which saw a small decrease in its weight in the model. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com.
Highlights Portfolio Strategy A virtuous software capex upcycle will continue to bolster industry sales/profits in the coming months. We reiterate our high-conviction overweight recommendation on the S&P software index. Depressed relative valuations signal that the weak airline profit margin backdrop is baked in the cake. Rising load factors and the possibility of an easing in jet fuel prices compel us to put this transportation sub-index on our upgrade watch list. Recent Changes Put the S&P Airlines Index on upgrade alert. Table 1 Feature Stocks took it on the chin early last week as geopolitical risks resurfaced in a big way, but managed to bounce smartly and end the week on a high note. Not only did Trump slap new tariffs reigniting trade war fears, but Italian political instability rocked global bond and stock markets. While this mini 'risk-off' phase has rattled investors, the key question hanging over markets is: will the current global growth soft patch prove transitory or morph into a severe global growth deceleration? We side with the former. While it is too early to call the end of the global growth lull, there are high odds that the U.S. will lift the world out of its year-to-date mini-slump in the back half of the year. The third panel of Chart 1 shows that the IHS Markit U.S. manufacturing PMI has been steeply diverging from the J.P. Morgan-calculated global manufacturing PMI. The latter has ticked up recently, and given recent U.S. economic greenshoots and America's heavy weighting in global output, it should pull global growth higher. Chart 1Too Soon To Bail Chart 2Monitor The Greenback's Impact On Profits Importantly, this leading U.S. economic growth indicator is also signaling that SPX momentum will resume its ascent in the coming months, a message corroborated by the latest ISM manufacturing survey print (second panel, Chart 1). What could push our still constructive cyclical 9-12 month equity view offside is a surge in the U.S. dollar. The greenback's trough coincided with last year's peak in global growth (bottom panel Chart 1), and further dollar appreciation - resulting from either stress in emerging markets or a further flare-up of Eurozone breakup risk - would necessitate downward revisions to calendar 2019 sell-side earnings forecasts (Chart 2). We are closely monitoring Eurozone geopolitical risks, and are also awaiting the ECB's response. If persistent turmoil causes the ECB to stay easier for longer than the market expects, then the euro will come under downward pressure against the dollar, especially if the Fed continues to hike as we expect. Last week alone BCA's months-to-hike gauge for the ECB jumped by five months, implying the first hike moved to mid-year 2020 (second panel, Chart 3). We recently showed the U.S. tech sector's hefty foreign sales exposure of roughly 60% of total revenues, greater than for any other GICS1 sector by a wide margin (please refer to Chart 8 from the April 9, 2018 Weekly Report titled "Buying Opportunity?"). As such the technology sector's profits serve as a great leading indicator of any U.S. dollar appreciation related blues. Up to now, tech net EPS revisions have not been sniffing out any currency related earnings trouble that could infiltrate overall SPX EPS (U.S. trade-weighted dollar shown inverted, third panel, Chart 4). Similarly, relative tech sector stock momentum and our tech sector EPS growth model are not waving any yellow flags (Chart 4). Chart 3Steadfast ##br##SPX Chart 4Tech Stocks Will Be The First To Sniff ##br##Out U.S. Dollar Profit Woes Netting it all out, there are high odds that the U.S. will lead global growth higher in the coming quarters and result in a recoupling higher of global growth, assuming the greenback stops appreciating. This would support low double digit calendar 2019 SPX profit growth. Under such a macro backdrop, it still pays to maintain a cyclicals over defensives portfolio bent. This week we are revisiting one tech sector high-conviction overweight and putting a transport sub-index on upgrade watch. Stick With Software Stocks The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 Although this may appear exuberant, from a longer-term perspective, relative share prices only recently reclaimed the upward sloping historical time trend mean (top panel, Chart 5). The implication is that more gains are in store prior to the end of the business cycle. BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. In the aftermath of the dotcom bust, tech investment in general and software in particular, went into hibernation for a whole decade. Currently, software investment is outpacing overall capital outlays (middle panel, Chart 5). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Animal spirits remain upbeat with both consumer and most importantly CEO confidence probing multi-year highs. Tack on the still buoyant message from our capex indicator and software spending has more room to grow (second & third panels, Chart 6). In addition, the government sector may also increase spending on IT/software services on the back of easing fiscal policy and beefing up on cybersecurity (Chart 7). Chart 5Buy The Breakout Chart 6Even Uncle Sam Is Buying Software Chart 7Margin Expansion Phase Has Legs While our S&P software EPS growth model corroborates this encouraging news (bottom panel, Chart 5), sell side analysts do not share our optimism. In fact, software profits are forecast to trail the broad market by 500bps, a rather low hurdle. On the operating front, sales are accelerating at a time when labor costs remain contained. Importantly, software prices are on the verge of exiting deflation, underscoring that software demand is robust. Moreover, the secular advance in cloud computing and SaaS represent a long-term positive demand backdrop. The upshot is that the mini margin expansion phase in place since early-2016 has more legs (Chart 7). Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt, a high interest coverage ratio and galloping higher free cash flow (Chart 8). Unsurprisingly, this cash rich tech subsector has also been in the middle of an M&A frenzy. This supply reduction is not only bullish for industry pricing power, and thus profit growth, but it has also led to hefty M&A premia and a significant valuation rerating (bottom panel, Chart 9). Chart 8Pristine Balance Sheet Chart 9Software Will Grow Into Pricey Valuations If our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. Could Jet Fuel Be The Tailwind Airlines Need? It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (top panel, Chart 10). This relationship has grown more acute as the industry, having been burned when fuel prices collapsed in 2014, has all but abandoned fuel hedging. The timing for rising jet fuel prices could scarcely be less opportune; historically, airlines have been able to pass through rising fuel costs. Now, in the midst of an industry price war, pricing power and fuel costs are diverging (second panel, Chart 10). The impact is apparent on industry margins, which have been in decline for nearly two years and more pain likely lies ahead (second panel, Chart 11). The head of airline industry group International Air Transport Association (IATA), recently noted that rising oil prices would significantly bite into airline profitability next year; IATA is widely expected to lower its industry benchmark profit forecast this week. Chart 10Mind The Gap Chart 11Acute Margin Trouble... The source of industry conflict has been an uptick in capacity growth. Airlines are adding capacity faster than the economy is growing (third and fourth panels, Chart 11) and the only relief valve to preserve market share is to cut prices. In this context, it is difficult to understand analysts' 20%+ EPS growth forecast for next year, significantly outpacing the S&P 500 (bottom panel, Chart 11). However, the news is not all bad. Despite the competitive headwinds, the industry has been successful at moving unit revenues higher and airlines have been doing so at an aggressive pace in 2018 (second panel, Chart 12). Further, industry load factors (in essence, the percentage of filled seats) are near their highest level ever, indicating capacity growth is being met with lower price-induced demand growth (bottom panel, Chart 12). Rising load factors are typically a precursor to price (and profit) increases. Investors appear to have capitulated. Airlines trade at roughly half the market multiple on an EV/EBITDA basis and a substantial discount on a price/book basis (second & third panels, Chart 13). From a valuation perspective, airlines look set to take off. Chart 12...But Demand is Firming... Chart 13...And Most Bad News Is Likely Priced In Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations. We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Recommended Allocation A Series Of Unfortunate Events Markets have taken a series of hits in recent months - sharp drops in emerging market currencies, a political crisis in Italy, and the ongoing trade war between the U.S. and China - not to mention a slowdown in cyclical growth. But risk assets have been remarkably resilient: the U.S. stock market is in the middle of its year-to-date range, and U.S. small cap stocks (more attuned to domestic conditions) are at record highs (Chart 1). The uncertainty is set to continue for a while. But, with global growth likely to settle at an above-trend pace, fiscal and monetary policy still accommodative, and earnings continuing to grow strongly, the recent resilience says to us that risk assets are likely to grind higher and to outperform bonds over the next 12 months. A major underlying cause of the recent volatility has been the growing disparity between growth in the U.S. and in the rest of the world (Chart 2). This is partly due to the strength of the euro and yen last year, which is now dampening activity in these regions, but the slowdown in Chinese industrial growth and a higher oil price may also be having a disproportionate effect on growth outside the U.S. This growth disparity has widened interest rate differentials, which have again become the major driver of currencies, pushing up the U.S. dollar (Chart 3). Chart 1Small Cap Stocks At A Record High Chart 2Disparity Between The U.S. And The Rest... Chart 3...Means Dollar Has Further To Rise In combination with rising U.S. interest rates (the 10-year Treasury yield rose above 3% last month, before correcting a little), dollar appreciation is a threat for emerging markets. EM assets have long shown a consistently strong inverse correlation with the dollar (Chart 4). We expect the EM sell-off to continue. Further Fed hikes and rising inflation expectations in the U.S. (relative to the euro area and Japan) will increase interest-rate differentials and push the dollar up further: we forecast 1.12 for euro/dollar. Investors are still far from capitulating on EM assets after several years of large purchases (Chart 5). Many EM central banks are being forced to raise rates to defend their currencies, which will dent growth. Some may even be forced into reintroducing capital controls. Several emerging economies besides Argentina and Turkey remain vulnerable, having worryingly high amounts of foreign currency debt (Chart 6). Chart 4Strong Dollar Is Bad For Em Assets Chart 5Em Is Still A Consensus Favorite Chart 6Worrying Levels Of FX Debt Chart 7Not Surprising That Italians Are Fed Up Geopolitics is likely to remain a drag on markets for a while, too. Italy remains the biggest threat. The discontent of the Italian population is unsurprising given the country's stagnation since it joined the euro (Chart 7). The probable coalition government of the Lega and Five Star Movement would introduce aggressive fiscal stimulus, putting it in confrontation with the EU's budgetary rules. But BCA's geopolitical strategists see little risk of Italy exiting the euro in the next two years (though 10 years might be a different story).1 Political gyrations may continue for some months, particularly if the new government persists with its plan to blow the fiscal deficit out to 7% of GDP, but the sell-off in short-term Italian bonds looks to be overdone. Developments in trade tariffs, Iran and North Korea could also weigh on markets in coming months. But ultimately economic fundamentals almost always outweigh geopolitical risk. Global growth is slowing, but to an above-trend pace. Fiscal policy is particularly stimulative this year, with 17 of the 33 OECD countries undertaking large fiscal easing, and a further 11 some easing. The overall cyclically-adjusted primary budget balance in OECD countries is forecast to ease by 0.5% of GDP this year and 0.4% next (Chart 8). Monetary policy remains accommodative almost everywhere. The FOMC, in its May statement, by adding the word "symmetric" to describe its 2% inflation objective, was clearly emphasizing that it sees no need to accelerate the pace of rate hikes, despite the recent pickup in core PCE inflation. We expect the Fed to continue to raise rates once a quarter, meaning that monetary policy will not become restrictive until around Q1 next year. With inflation expectations not yet fully normalized (Chart 9), the Fed could still exercise its "put option" by holding for a quarter or two if global risk were to rise significantly. Italy's problems also make it more likely that the ECB will stay easier for longer, and the probability is rising of its deciding to extend asset purchases into next year. Chart 8Fiscal Stimulus (Almost) Everywhere Chart 9Inflation Expectations Have Further To Rise With the consensus already forecasting global GDP to grow 3.4% this year, and U.S. earnings by 22%, there is no obvious catalyst for risk assets to rebound sharply (Chart 10). However, we find it inconceivable that equity markets will not be higher in 12 months' time - and will not have outperformed bonds over that time - if the macro environment plays out as we expect. We, therefore, continue to recommend an overweight on equities and underweight on fixed income, but might start to turn more defensive around the end of the year if the signs are in place that the recession we expect in 2020 is still on the cards. Equities: For the reasons described above, we remain cautious on EM equities. Within EM, our preference would be for markets such as China, Korea and India, which are likely to be less affected by investors' concerns about current account deficits and foreign-currency denominated debt. In DM, our preference remains for late-cyclical sectors, especially energy, financials and industrials. We mainly view regional and country selection as a derivative of the sector call: this supports our preference for euro zone and Japanese stocks over those in the U.S. and U.K. Fixed Income: A combination of quarterly Fed rate hikes, a further normalization of inflation expectations, and moderate rises in the real rate and term premium are likely to push the 10-year U.S. Treasury yield up to 3.5% by year-end (Chart 11). We, therefore, remain underweight duration and prefer TIPs to nominal bonds. We keep our overweights on spread product within the fixed-income bucket, since it should continue to outperform for another couple of quarters. U.S. high-yield spreads are likely to remain steady, giving an attractive carry even after accounting for defaults; investment grade spreads might start to recover, given that the sell-off of quality bonds by companies repatriating short-term investments held offshore ($35 Bn from the 20 largest U.S. companies in Q1) is now mostly over (Chart 12). Chart 10Can Growth Beat These Expectations? Chart 11Treasury Yield To Rise To 3.5% Chart 12Selective Spread Product Remains Attractive Currencies: Interest-rate differentials, as described above, are likely to push the dollar up further, especially against the euro. This should continue until the effect of a strong dollar/weak euro starts to rebalance growth surprises back to the euro area, perhaps around the end of the year. We see less chance of dollar appreciation against the yen (which is still undervalued against its PPP value of 98, and may benefit from its safe-haven status) and against the Canadian dollar (given the Bank of Canada's hawkish stance). Commodities: Industrial commodities are likely to continue to struggle against headwinds from the appreciating dollar, and the continuing moderate slowdown in China (Chart 13). The oil price has become a tougher call recently, with talk that OPEC may agree later this month to bring back as much as 1 million barrels/day in production, but Venezuelan and Iranian supply likely to exit the market. BCA's energy strategists now forecast WTI and Brent to average $70 and $78 in 2H18, and $67/$72 in 2019, but expect higher volatility in the price over coming months (Chart 14).2 Chart 13Continuing Signs Of China Slowdown Chart 14Forecasting Oil Is Getting Harder Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Client Note, "Italy, Spain, Trade Wars... Oh My!," dated 30 May 2018, available at gps.bcaresearch.com 2 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output: Volatility Set To Rise ... Again," dated 31 May 2018, available at ces.bcaresearch.com GAA Asset Allocation
Dear Client, I will be visiting clients next week. Instead of our Weekly Report, we will be sending you a Special Report written by my colleagues Matt Gertken and Ray Park. The report addresses the North Korean situation and argues that a positive, if not perfect, diplomatic solution will result from U.S.-North Korean negotiations. Best regards, Peter Berezin, Chief Global Strategist Highlights The U.S. can withstand further rate hikes. Neither economic nor financial imbalances are especially elevated, while fiscal stimulus will offset much of the sting from tighter monetary policy. Unfortunately, America's resilience to higher rates does not extend to the rest of the world. A stronger dollar is undermining emerging markets, which are already under pressure from slower Chinese growth and the looming prospect of trade wars. The crisis in Italy will further restrain the ECB from withdrawing monetary support. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors could consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield has reached 4%. EUR/USD came within a whisker of our 1.15 target this week. We will book profits on our long DXY trade recommendation if the dollar index reaches 96. A defensive posture is appropriate for now, but risk assets should recover later this year as the global economy finds its footing. This could set the scene for a blow-off rally in stocks. Feature Gauging The Pain Threshold From Higher Rates Chart 1Market Expectations Slightly Below Fed Dots After the recent turbulence, the market is pricing in 100 basis points of Fed rate hikes between now and the end of 2020 (Chart 1). Such a pace of rate hikes would be quite slow by historic standards. In past tightening cycles, the Fed would typically raise rates by about 50 basis points per quarter. Investors expect the real fed funds rate to peak at around 1%, well below the historic average of 3%-to-5%. Underlying these expectations is the presumption that the neutral rate of interest - the rate consistent with full employment and stable inflation - is quite low, and that the Fed will not have to raise rates much above neutral to cool the economy. According to the April FOMC minutes, "a few" participants thought that the fed funds rate was already close to its equilibrium level. There are many reasons to think that R-star has fallen over time, but in practice, the margin of error around estimates of the neutral rate is huge. Thus, rather than getting bogged down over technical issues, investors would be well served by taking a more practical approach and asking what they should be on the lookout for to determine whether interest rates have moved into restrictive territory. The State Of The U.S. Housing Market Housing has historically been the most important interest rate-sensitive sector, so much so that Ed Leamer entitled his 2007 Jackson Hole symposium paper "Housing Is The Business Cycle."1 Given the recent runup in mortgage yields, it is not too surprising that the latest data on U.S. housing has been on the weak side (Chart 2). Mortgage applications for purchase have come off their highs. Housing starts, building permits, and new and existing home sales all declined in April. Homebuilder sentiment improved a tad, but this was due to an increase in the current sales component; future sales expectations were flat on the month. The share of respondents who indicated that now was a good time to buy a home in the latest University of Michigan Consumer Sentiment survey declined to 69% in May, continuing its slide from a peak of 83% in December 2014. Still, we would not fret too much about the state of the U.S. housing market (Chart 3). Construction activity has been slow to increase this cycle, which has pushed vacancies to ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2006 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Chart 2U.S. Housing: Higher Mortgage##br## Rates Are A Headwind... Chart 3...But Don't##br## Fret Yet Household Debt Is Not Yet At Worrying Levels Lenders also remain circumspect (Chart 4). Mortgage debt has barely grown as a share of disposable income throughout the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. A dwindling share of loan originations since the financial crisis has involved adjustable rate mortgages (Chart 5). This has made the housing market more resilient to Fed rate hikes. Other parts of the household credit arena look more menacing, but not so much that they threaten to short-circuit the economy. Banks have been tightening lending standards on auto loans since Q2 of 2016 and credit card loans since the second quarter of last year. This should help moderate the increase in default rates that has been observed in those categories (Chart 6). Chart 4Mortgage Debt Is Not ##br##A Cause For Concern Chart 5Housing Market: More Resilient To ##br##Rate Hikes Than It Used To Be Chart 6Lenders Are More ##br##Circumspect These Days Student debt has continued to trend higher, but the vast majority of these loans is backstopped by the government. While the Treasury's own finances are on an unsustainable trajectory, this is more of a long-term concern than a short-term problem. If anything, fiscal stimulus over the next two years will allow the Fed to raise rates more than it could otherwise without endangering the economy. Corporate Borrowing: High But Not Extreme Like a river, market liquidity tends to flow along the path of least resistance, rather than towards those who happen to be the most thirsty. While the household sector was piling on debt during the 2001-2007 boom, the U.S. corporate sector was still recovering from the hangover produced by the capex boom in the late 1990s. A decade later, corporate balance sheets were in good shape. Spurred on by ultra-low interest rates, corporate debt levels began to rise. Today, the ratio of corporate debt-to-GDP is near a record high. Valuations for corporate assets have reached lofty levels. In inflation-adjusted terms, commercial real estate prices are 4% above their pre-recession peak (Chart 7). U.S. equities also trade at a historically elevated multiple to earnings, sales, and book value (Chart 8). There are bright spots, however (Chart 9). Thanks to lofty corporate profits, the ratio of corporate debt-to-EBITDA is in the middle of its post-1990 range based on national accounts data. Interest payments-to-EBIT are near historic lows. Corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. Although the picture is not as benign if one performs a bottom-up analysis of publicly-listed companies, the overall message is that the U.S. corporate sector can handle higher rates. Corporate stresses will eventually rise, but it will likely take a recession for this to happen, which we don't expect until 2020. Chart 7Commercial Real Estate Prices: ##br##Above Pre-Recession Levels Chart 8U.S. Equities##br## Are Overvalued Chart 9Corporate Debt Is High,##br## But So Are Profits Cyclical Spending Still Subdued The discussion above suggests that U.S. interest rate-sensitive sectors can withstand further rate hikes. This conclusion is buttressed by the observation that the cyclical sectors of the economy - the ones that tend to weaken the most during recessions - have yet to reach levels that make them vulnerable to a sharp retrenchment. Chart 10 shows that the sum of business capital spending, residential and commercial construction, and consumer discretionary goods purchases is still well below levels that have preceded past recessions. Along the same lines, the private sector financial balance - the difference between what the private sector earns and what it spends - is currently in surplus to the tune of 2.2% of GDP. This compares to deficits of 5.4% of GDP in 2000 and 3.8% of GDP in 2006 (Chart 11). Further monetary tightening, to the extent that it prevents any brewing imbalances in the real economy and financial markets from worsening, may be just what the doctor ordered. Chart 10Cyclical Spending Still Below Levels##br## Preceding Past Recessions Chart 11U.S. Private Sector Financial##br## Balance Is Healthy The Sneeze Felt Around The World The U.S. is not an island unto itself. Even if a bit outdated, the old adage which says that when the U.S. sneezes the rest of the world catches a cold, still rings true. As such, focusing on the neutral rate only as it pertains to the U.S. is a bit too parochial. There may be a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain in the U.S. itself. Emerging markets are particularly sensitive to changes in U.S. financial conditions. About 80% of EM foreign-currency debt is denominated in dollars. A stronger dollar and higher U.S. interest rates make it more difficult for EM borrowers to service their debts. While EM foreign-currency debt has declined as a share of total debt outstanding, this is only because the past decade has seen a boom in local debt issuance (Chart 12). As a share of GDP, exports, and international reserves, U.S. dollar debt is at levels not seen in over 15 years (Chart 13). Most emerging markets entered 2018 with strong growth momentum. Recent tracking estimates point to some deceleration in GDP growth, but nothing too alarming (Chart 14). That could begin to change. EM financial conditions have started to tighten, which is likely to weigh on activity. BCA's Emerging Market and Geopolitical Strategy teams have flagged the prospect of policy-inducing tightening in China. Trade tensions also seem to be escalating again following President Trump's decision this week to curb Chinese investment in the U.S., impose a 25% tariff on $50 billion of Chinese imports, and slap tariffs on foreign steel. All this could put an additional dent in global growth. While this publication does not expect a full-blown EM crisis, a period of EM underperformance over the next few months is likely. Chart 12EM Borrowers Like Local Credit, ##br##But Don't Dislike Foreign-Currency Debt Chart 13EM Dollar##br## Debt Is High Chart 14EM Growth Decelerating,##br## But Not Dramatically... Yet Italy: If You Are Gonna Do The Time, You Might As Well Do The Crime Even if emerging markets avoid another major crisis, one can always count on Europe to try to fill the void. The Italian 10-year bond yield is up over 100 basis points since the middle of April. Assuming a fiscal multiplier of one, a standard Taylor Rule equation says that Italy would need 2% of GDP in fiscal stimulus per year to offset the tightening in financial conditions brought upon by the recent increase in borrowing costs.2 That is 20% of GDP in stimulus over the next decade to pay for a fiscal package that has yet to be implemented by a government that does not yet (and may never) exist. At this point, investors are basically punishing Italy for a crime – defaulting and possibly jettisoning the euro – it has yet to commit. If you are going to get reprimanded for something you have not done, you have more incentive to do it. The market realizes this, which is why it is locked in a vicious circle where rising yields make default more likely, leading to even higher yields (Chart 15). The fact that GDP per capita in Italy is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 16). Chart 15When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Chart 16Italy: Neither Divine Nor A Comedy As we go to press, rumours are swirling that the Five Star Movement and Lega may be able to form a government after agreeing to appoint a less euroskeptic finance minister than the one the Italian President previously rejected. Regardless of whether this happens, investors are likely to remain on edge. Support for Lega has risen by seven percent since voters went to the polls in March. Populism is here to stay. All this suggests that the brewing crisis in Italy will not blow over easily. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors should consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield reaches 4%. At that point, the risk-reward trade-off from owning Italian debt would be too good to ignore. Until the Italian bond market reaches a capitulation point, the euro will remain under pressure. The Italian sovereign debt market is the biggest in Europe and the fourth largest in the world after the U.S., Japan, and China. If foreign investors continue to shun Italian debt, that will reduce capital inflows into the euro area. This means less demand for the common currency. Investment Conclusions The softening of global growth this year, along with tensions in emerging markets and Italy, have lit a fire under the dollar. Our long DXY trade is up 10.7% inclusive of carry. We continue to think that the path of least resistance for the dollar is up, but we will be looking to book gains on our trade recommendation once the dollar index reaches 96. That's roughly 2% above current levels. Slower global growth is bad news for cyclical equities. European and Japanese equities have a greater tilt towards cyclical sectors, so it is likely that their stock markets will underperform the U.S. over the next few months. This is particularly the case for Europe, where banks have come under pressure due to slower domestic growth, rising bond yields in Italy and Spain, and heightened exposure to emerging markets. For now, our MacroQuant model, which is designed to capture short-term movements in the stock market, is recommending a somewhat below-benchmark allocation to equities. Looking further out, our 12-month cyclical view on stocks remains modestly constructive, reflecting our expectation that the next major recession in developed markets is still two years away. Keep in mind that even the EM crisis in the 1990s did not plunge the U.S. into recession. On the contrary, the crisis restrained the Fed from raising rates too quickly. The resulting dose of liquidity led to a massive blow-off rally in equities, which took the S&P 500 up 68% between October 1998 and March 2000. European stocks did even better during that period, outperforming their U.S. peers by 40% in local-currency terms. We may be heading for a similar sequence of events. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 The original Taylor Rule introduced by John Taylor in 1992 assigns a coefficient of 0.5 on the output gap. Thus, a one hundred basis-point rise in interest rates would be necessary to offset a 2% of GDP increase in output. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The global trade slowdown will intensify, even if U.S. domestic demand remains robust. The large emerging Asian bourses will recouple to the downside with their EM peers. Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. In Chile, receive 3-year swap rates. Continue to overweight stocks relative to the EM benchmark. Short the Colombian peso versus the Russia ruble. Stay neutral on Colombian equities and local bonds but overweight sovereign credit within their respective EM universes. Feature Performance of large equity markets in north Asia - Korean, Taiwanese and Chinese investable stocks -- has been relatively resilient compared with other EM bourses. Specifically, the EM ex-China, Korea and Taiwan equity index has already dropped 16% in U.S. dollar terms, while the market cap-weighted index of investable Chinese, Korean and Taiwanese stocks is down only 8% from its peak in late January.1 These three markets account for 60% of the MSCI EM stock index. A pertinent question is whether these North Asian markets will de-couple from or re-couple with the rest of EM. Our bias is that they will re-couple to the downside. Global equity portfolios should continue to underweight Asian stocks versus the DM bourses in general, and the S&P 500 in particular. That said, dedicated EM equity portfolios should overweight Korea and Taiwan and maintain a neutral stance on China and Hong Kong relative to the EM and Asian equity benchmarks. The Global Trade Slowdown Will Intensify Emerging Asian stock markets are very sensitive to global trade cycles. Slowing global trade is typically negative for them. There is growing evidence that the global trade deceleration will intensify: The German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart I-1). Chart I-1Global Trade Slowdown Will Persist Export volume growth has already slowed across manufacturing Asia (Chart I-2). The most recent data points for these series are as of April. Asia's booming tech/semiconductor industry is also slowing. Both Taiwan's export orders growth and Singapore's technology PMI new orders-to-inventory ratio have relapsed (Chart I-3). Chart I-2Asian Exports Growth: Heading Southward Chart I-3Asian Tech: Feeling The Pinch One of the causes of weakness in the global semiconductor cycle could be stagnating global auto sales (Chart I-4). The latter are being weighed down by weakness in auto sales in China and the U.S. Cars require a significant amount of semiconductors, and lack of improvement in global auto sales will suppress semiconductor demand. So far, China has not been at the epicenter of investors' concerns, but this will soon change as its growth slowdown intensifies. Credit conditions continue to tighten in China, which entails downside risks to mainland capital spending and consequently imports. China's imports are set to slump considerably, reinforcing the global trade downturn.2 First, China's bank loan approvals have dropped considerably in the past 18 months, suggesting a meaningful slowdown in bank financing and in turn the country's investment expenditures (Chart I-5). Chart I-4Global Auto And Semiconductor Sales Chart I-5China: Bank Loan Approval And Capex Second, not only are bank loan standards tightening but costs of financing are also rising. The share of loans extended above the prime lending rate has risen to a 15-year high (Chart I-6, top panel). This represents marginal tightening. Finally, onshore corporate bond yields as well as offshore U.S. dollar-denominated corporate bond yields have broken to new highs in this cycle (Chart I-6, bottom panels). Mounting borrowing costs and tighter credit standards in China point to further deceleration in credit-sensitive spending such as investment expenditures and property purchases. On the whole, rising interest rates and material currency depreciation in EM ex-China and credit tightening in China will prompt a considerable slump in imports, depressing world trade. EM including Chinese imports account for 30% of global imports, while the U.S. and EU together make up 24% of global imports values. Hence, global trade will disappoint if and as EM and Chinese imports stumble. A final word on the history of de-coupling among EM regions is in order. 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 - when they plummeted (Chart I-7, top panel). Chart I-6China: Rising Borrowing Costs Chart I-7De-coupling Between Asia And Latin America In 2007-'08, emerging Asian equities tumbled along with the S&P 500, but Latin American bourses fared well until the middle of 2008 due to surging commodities/oil prices (Chart I-7, middle panel). Finally, the bottom panel of Chart I-7 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. Bottom Line: Global trade is set to head southward, even if U.S. demand remains robust. China's growth slump will be instrumental to this global trade slowdown. Consequently, Chinese, Korean and Taiwanese equities will be vulnerable. Heeding To Market Signals Financial markets often move ahead of economic data, and simply tracking data is not always helpful in gauging turning points in business cycles. By the time economic data change course, financial markets would typically have already partially adjusted. Besides, past economic and financial market performance is not a guarantee of future performance. This is why we rely on thematic fundamental analysis and monitor intermediate- and long-term trends in financial markets to navigate through markets. There are presently several important market signals that investors should be heeding to: EM corporate bond yields are surging, which typically foreshadows falling EM share prices (Chart I-8). Meanwhile, there is no robust correlation between EM equities and U.S. bond yields. Chart I-8EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening, offsetting the drop in U.S. bond yields. Hence, a drop in U.S. bond yields is not in and of itself sufficient to halt a decline in EM share prices. So long as EM corporate and sovereign credit spreads are widening by more than the decline in U.S. Treasury yields, EM corporate and sovereign bond yields will rise, heralding lower EM share prices. The ratio of total return (including carry) of six commodities currencies relative to safe-haven currencies3 is breaking below its 200-day moving average after having bounced from this technical support line several times in the past 12 months (Chart I-9). This could be confirming that the bull market in EM risk assets is over, and a bear market is underway. Chinese property stocks listed onshore have broken down, and those trading in Hong Kong seem to be forming a head-and-shoulder pattern (Chart I-10). In the latter case, such a technical formation will likely be followed by a considerable down-leg. Chart I-9An Important Breakdown Chart I-10Chinese Property Stocks Look Very Vulnerable Further, China's onshore A-share index has already dropped by 15% from its cyclical peak in late January. Finally, both emerging Asia's relative equity performance against developed markets, as well as the emerging Asian currency index versus the U.S. dollar (ADXY) seem to be rolling over at their long-term moving averages (Chart I-11). The same technical pattern is presenting itself for global energy and mining stocks in absolute terms, and also in the overall Brazilian equity index (Chart I-12). Chart I-11Asian Equities And Currencies Are ##br##At Critical Juncture Chart I-12Commodity Equities And Brazil ##br##Are Facing Technical Resistance The failure of these markets to break above their long-term technical resistance levels may be signalling that their advance since early 2016 has been a cyclical - not structural - bull market, and is likely over. These technical chart profiles so far confirm our fundamental analysis that the EM and commodities rallies since early 2016 did not represent a multi-year secular bull market. If correct, the downside risks to EM including Asian markets are substantial, and selling/shorting them now is not too late. Bottom Line: EM including Asian stocks, currencies and credit markets are at risk of gapping down. Absolute-return investors should trade these markets on the short side. Asset allocators should underweight EM markets relative to DM in general and the U.S. in particular. A complete list of our currency, fixed-income and equity recommendations is available on pages 20-21. An EM Equity Sector Trade: Long Consumer Staples / Short Banks EM consumer staples have massively underperformed banks as well as the overall EM index since January 2016 (Chart I-13). The odds are that their relative performance is about to reverse. Equity investors should consider implementing the following equity pair trade: long consumer staples / short banks: Consumer staples are a low-beta sector because their revenues are less cyclical. As EM growth downshifts, share prices of companies with more stable revenue streams will likely outperform. Bank stocks are vulnerable as local interest rates in many EMs rise in response to the selloff in their respective currencies (Chart I-14). Consumer staples usually outperform banks when local borrowing costs are rising. Chart I-13Go Long EM Consumer Staples / ##br##Short EM Banks Chart I-14EM Banks Stocks Are Inversely Correlated With##br## EM Local Bond Yields We expect more currency depreciation in EM, which will exert further upward pressure on local rates, including interbank rates. Further, growth weakness in EM economies typically leads to rising non-performing loan (NPL) provisions. Chart I-15A and Chart I-15B demonstrates that weakening nominal GDP growth (shown inverted on the charts) leads to higher provisioning. Hence, a renewed EM growth slowdown will hurt bank profits. Chart I-15AWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Chart I-15BWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Our assessment is that banks in many EM countries have provisioned less than what is probably necessary following years of a credit boom. Indeed, in the last 12-18 months or so, many banks have even been reducing their NPL provisions to boost profits. Hence, a reversal of these dynamics will undermine banks' earnings. Bottom Line: Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. This is in addition to our long-term strategy of shorting EM banks versus U.S. banks as well as shorting banks in absolute terms in individual markets such as Brazil, Turkey, Malaysia and small-cap banks in China. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These calculations are done using MSCI investible stock indexes in U.S. dollars terms. 2 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports", dated May 24, 2018, available at ems.bcaresearch.com. 3 Average of cad, aud, nzd, brl, clp & zar total returns (including carry) relative to average of jpy & chf total returns (including carry). Chile: Stay Overweight Equities, Receive Rates 31 May 2018 Chart II-1Chilean Equities Relative Performance And Copper Prices It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. Chart II-2Chile: Economic Conditions Chart II-3Interest Rates In Chile Can Fall When Peso Depreciates First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Chart II-4Chile: Output Gap And Inflation Chart II-5Chile: Inflation Is Very Low And Falling Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Chart II-6Chile: Wage Growth Is Very Weak Chart II-7Chile: Rising Labor Force Chart II-8Chile: Excessive Labor Supply... Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). Chart II-9...Despite Robust Employment Growth Chart II-10Chile: Receive 3-Year Swap Rates The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Colombia: The Currency Will Be A Release Valve The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). Chart III-1Colombia's Achilles' Hill: Trade Balance Excluding Oil Chart III-2The Colombian Peso Is Fairly Valued The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Chart III-3Colombia: Little Sign Of Recovery Chart III-4Colombia: Little Sign Of Recovery Chart III-5Colombian Banks: NPL And NPL Provision Continue Rising Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The 10-year Italian BTP yield at 4% yield marks a 'line in the sand' at which the current drama could escalate into something considerably worse. The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stay underweight in the classically cyclical sectors: banks, basic materials and industrials. Prefer France's CAC over Italy's MIB and Spain's IBEX. The equity market's range-bound pattern can continue, as long as the line in the sand isn't breached. It is a good time to own a small portfolio of high-quality 30-year government bonds. It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. Feature Italian politics have blindsided almost everybody, us included. Few anticipated that the unlikely bedfellows 5S and Lega would try and form a 'government of change'. In March we wrote: "The Italian election result is not an investment game changer. The one exception would be if 5S and Lega joined forces to govern, as it could throw EU integration into reverse. But the likelihood of this unholy alliance seems very low." Even fewer anticipated that Italy's President, Sergio Mattarella, would then scupper this government of change by vetoing the proposed Finance Minister. This has cast a new pall of uncertainty over Italian politics and Italian public support for EU rules and institutions. The 10-Year BTP Yield At 4% Marks A 'Line In The Sand' The market's response has been to fear the worst: shoot first, ask questions later. The danger is that this sets off a negative feedback loop. Higher bond yields weaken Italy's still-fragile banks; which threatens Italy's economic recovery; ahead of a possible new election, this increases the support for parties and policies that push back against EU rules; which further lifts bond yields; and then in a vicious circle until the fear of the worst becomes a self-fulfilling prophecy... Chart of the WeekItalian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% The Italian BTP versus German bund yield spread is effectively a fear gauge for Italy's future in the euro (Chart I-2). As these fears increase, and Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Chart I-2The BTP-Bund Yield Spread Is A Fear ##br## Gauge For Italy's Future In The Euro As a rule of thumb, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart I-3). Chart I-3Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4%.1 Hence, the 10-year BTP yield at 4% marks a 'line in the sand' at which the current drama could escalate into something considerably worse (Chart of the Week). To short-circuit the negative feedback loop, the financial markets would need to sense a discernible shift in Italian support for its populist parties; or an explicit de-escalation in the populist pushback against the EU. The question is: could this happen quickly enough? Global Growth Is In A Mini-Downswing The market's concerns about Italy come at a time when global growth has in any case been losing momentum. This is one development that did not blindside us, and has unfolded exactly as predicted. In January we wrote: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting." The theory underlying these mini-cycles is an economic model called the Cobweb Theorem.2 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a delay. The delay occurs because credit demand leads credit supply by several months (Chart I-4). Chart I-4Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months, and the regularity creates predictability. Moreover, as most investors are unaware of these cycles, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. The global 6-month credit impulse is now indisputably in a mini-downswing phase, and exactly as predicted in January, the majority of economically sensitive sectors have underperformed. The glaring anomaly is oil, whose supply-side dynamics have dominated price action (Chart I-5). Given oil's major impact on headline inflation, inflation expectations, and on central bank reaction functions, the global bond yield has also disconnected from the mini-cycle - until now. Chart I-5Oil Is The Glaring Anomaly Mini-downswings last six to eight months and the usual release valve is a decline in bond yields. So one concern is that the apparent disconnect between decelerating global activity and slow-to-react bond yields could extend the current mini-downswing phase beyond the summer. How To Invest Right Now From an equity market perspective, the relative performance of the classically cyclical sectors - banks, basic materials and industrials - very closely tracks the phases of the global credit impulse mini-cycle (Chart I-6 and Chart I-7). For example, in all five of the last five mini-downswings, banks have underperformed healthcare, and we are seeing exactly the same in the current mini-cycle. Chart I-6In A Mini-Downswing##br## Banks Underperform Chart I-7In A Mini-Downswing ##br##Basic Materials Underperform For the next few months at least, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. This strategy has worked extremely well since we initiated it at the start of the year, and it should continue to do so. Sector strategy necessarily impacts stock market allocation. Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. The defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks (Chart I-8 and Chart I-9). Irrespective of the political uncertainties, our sector allocation establishes our near-term caution on these two markets. Prefer France's CAC over Italy's MIB and Spain's IBEX. Chart I-8Italy's MIB = Long Banks Chart I-9Spain's IBEX = Long Banks For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the global economy provide a natural cap and a tradeable reversal in yields. Hence, it is a good time to own a portfolio of high-quality 30-year government bonds. Regarding currencies, the recent developments in Italy have hurt our 50:50 combined long position in EUR/USD and SEK/USD; but this has been countered by gains in our short position in EUR/JPY. We have no tactical conviction on any of these crosses, but we will maintain this medium term currency portfolio unless the Italian 10-year BTP yield breaches the 4% line in the sand. Finally, the hardest call to make is on the direction of equity market. This is because a mini-downswing in global growth creates a headwind to earnings expectations; conversely, if bond yields are capped, this will provide some support to equity market valuations. On balance, this suggests that the year-to-date pattern of a range-bound equity market is set to continue. The caveat is that if Italy's line in the sand is breached, it would warrant a substantial de-risking. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model* It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. This week, we note that the 65-day fractal dimension of the Polish zloty / U.S. dollar (or inverse) is approaching its lower limit. Go long PLN/USD with a profit target of 3.5% and 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 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 - 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