Financial Markets
Highlights Portfolio Strategy The reward/risk profile of air freight & logistics is extremely attractive. Synchronized global growth, the capex upcycle, a falling dollar and secular advance in e-commerce compel us to add this unloved transportation sub-index to our high-conviction overweight list. Prepare to lock in gains in managed health care. The positive demand and pricing backdrops are already reflected in perky valuations. While homebuilders still have to contend with rising lumber prices and interest rates and the partial elimination of mortgage interest deductibility, the near 20% peak-to-trough drawdown suggests that all of the bad news is baked in relative share prices, warranting an upgrade alert. Recent Changes Add the S&P air freight & logistics index to the high-conviction overweight list. Put the S&P managed care index on downgrade alert. Set an upgrade alert on the S&P homebuilding index. Table 1 Feature Equities lost ground last week and flirted with the bottom part of the trading range established during the past two months, but held the 200-day moving average. Our view remains that the SPX is digesting the early-February swoon, and the buy-the-dip strategy is still appropriate for capital with a cyclical (9-12 month) time horizon as the probability of a recession this year is close to nil. Nevertheless, the recent doubling in the TED spread and simultaneous spike in financials investment grade bond spreads is slightly unnerving (second panel, Chart 1). Junk spreads also widened as investors sought the safety of the risk-free asset. What is behind this fear flare up propagating in risk sensitive assets? First, the Fed continued its tightening cycle last week, raising the fed funds rate another 25bps. As we have been writing in recent research Weekly Reports, rising interest rates go hand-in-hand with increasing volatility (please see Chart 1 from the March 5th Special Report on banks). Thus, as the Fed tightens monetary policy and continues to unwind its balance sheet, the return of volatility will become a key market theme (bottom panel, Chart 1). The implication is that a bumpier ride looms for equities, and the smooth and nearly uninterrupted rise that market participants have been conditioned to expect is now a thing of the past. With regard to the composition of equity returns in the coming year, rising interest rates and volatility signal that the forward P/E multiple has likely crested for the cycle, leaving profits to do all the heavy lifting (Chart 2). Second, rising policy uncertainty (trade and Administration personnel related, please see Chart 1 from last week's publication) is muddying the short-term equity market outlook at the current juncture, and fueling the risk-off phase. However, synchronized global growth, a muted U.S. dollar and easy fiscal policy are a boon to EPS and signal that profit growth will reclaim the driver's seat in coming weeks. Stocks and EPS are joined at the hip and there are good odds that equities will vault to fresh all-time highs on the back of earnings validation as the year unfolds (Chart 3). Chart 1Closely Monitor These Spreads Chart 2EPS Doing The Heavy Lifting Chart 3Profits And Cash Flow Underpin Stocks Importantly, comparing net profit growth to cash flow growth rates is instructive, as SPX EBITDA is not affected by the new tax law. While EPS are slated to grow close to 20% in calendar 2018, the respective forward SPX EBITDA growth rate (based on IBES data) sports a more muted 10% per annum rate (second panel, Chart 4). Similarly, sell side analysts pencil in a visible jump in forward net profit margins, whereas the forward EBITDA margin estimate is stable (middle panel, Chart 4). The recent tax-related benefit is a one-time dividend to profits that will not repeat in 2019. Thus, the market will likely look through this one time effect and start to focus on the calendar 2019 EPS growth number that is a more reasonable 10%, and also similar to next year's EBITDA growth rate. Our sense is that this transition will also be prone to turbulence. Our EPS growth model corroborates this profit euphoria and is topping out near the 20% growth rate (Chart 5). While it will most likely decelerate in the back half of the year, as long as there is no relapse near the contraction zone à la late-2015/early 2016, the equity bull market will remain intact. Chart 4Investors Will See Through The Tax Cut Chart 5EPS Model Flashing Green As we showcased in the early February Weekly Report, four key macro variables are behaving as they have in four prior 20% EPS growth phases since the 1980s excluding the post-recession recoveries (please see the Appendix of the February 5th "Acrophobia" Weekly Report). Therefore, if history at least rhymes, the equity overshoot phase will resume. This week we add a neglected transportation group to the high-conviction overweight list, put a defensive index on the downgrade watch list and set an upgrade alert on a niche early cyclical group. Air Freight & Logistics: Prepare For Takeoff Last week we reiterated our overweight stance in the broad transportation space and today we are compelled to add the undervalued and unloved S&P air freight & logistics index to the high-conviction overweight list. Air freight services are levered to global growth. Currently, synchronized global growth remains the dominant macro theme. Firming export expectations suggest that global trade volumes will get a bump in the coming months (second panel, Chart 6). Importantly, U.S. manufacturers are also excited about exports; the latest ISM manufacturing export subcomponent hit a three decade high. While the specter of a global trade spat is disconcerting, our sense is that a generalized trade war will most likely be averted or, if the current executive Administration is to be believed, short-lived. The upshot is that air freight & logistics sales momentum will gain steam in the coming months (second panel, Chart 7). Chart 6Heed The Signals From Global Growth,##br## Capex And The Greenback Chart 7Domestic Demand##br## Is Also Firm Beyond euphoric survey data readings, hard economic data also corroborate the soft data message. G3 (U.S., the Eurozone and Japan) capital goods orders are firing on all cylinders and probing multi-year highs, underscoring that rising animal spirits are translating into real economic activity (third panel, Chart 6). Chart 8Mistakenly Unloved And Undervalued Tack on the near uninterrupted depreciation of the trade-weighted U.S. dollar and factors are falling into place for a relative EPS overshoot, given the large foreign sales component of this key transportation sub-group (bottom panel, Chart 6). Not only are air freight stocks' fortunes tied to the state of global trade, but this industry is also sensitive to capital outlays. A synchronized global capex cycle is one of the key themes we are exploring in 2018. The third panel of Chart 7 shows that our capex indicator points to a reacceleration in the corporate sales-to-inventories ratio. This virtuous capital spending upcycle, that would get a further lift were an infrastructure bill to be signed into law, is a boon to air cargo services. In addition, as the secular advance in e-commerce continues to make inroads in the bricks-and-mortar share of total retail dollars spent, demand for delivery services will continue to grow smartly, underpinning industry selling prices (bottom panel, Chart 7). As a result, we would look through recent softness in industry pricing power that has weighed on relative performance. Indeed, transportation & warehousing hours worked have recently spiked, corroborating the message from global revenue ton miles (not shown), rekindling industry net earnings revisions (second panel, Chart 8). Importantly, relative valuations are discounting a significantly negative profit backdrop, with the relative price/sales ratio at its lowest level since 2002 (third panel, Chart 8). Similarly, the index is trading at a 10% discount to the broad market's forward P/E multiple or the lowest level since the turn of the century (not shown). Finally, technical conditions are washed out offering a compelling entry point for fresh capital (bottom panel, Chart 8). The implication is that the group is well positioned to positively surprise. Bottom Line: The S&P air freight & logistics index has a very attractive reward/risk profile and if we were not already overweight, we would take advantage of recent underperformance to go overweight now. Therefore, we are adding it to our high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Downgrade Alert: Managed Health Care Managed health care stocks have been stellar outperformers not only versus the overall market, but also compared with the broad S&P health care sector. Since the April 2016 inception of our overweight recommendation, they have added considerable alpha to our portfolio to the tune of 21 percentage points above and beyond the SPX's rise (Chart 9). While most of the factors underpinning our sanguine view for health insurers remain intact, from a risk management perspective we are compelled to put them on downgrade alert. Most of the good news is likely baked into relative prices and valuations (bottom panel, Chart 9). In the coming weeks, we will be on the lookout for an opportunity to pull the trigger and crystalize gains and downgrade to a benchmark allocation, especially if defensive equities catch a bid on the back of the current mini risk off phase. Namely, recent inter-industry M&A euphoria is a key catalyst to lighten up on this health care services sub-sector (Chart 10). While regulators have disallowed intra-industry consolidation over the past few years, the M&A premia remained and now the proposed CVS/AET and CI/EXPR deals could be a harbinger of petering out relative valuations and share prices. Chart 9Prepare To Book Gains Chart 10M&A Frenzy True, melting health care inflation is likely a secular theme that is in the processes of reversing three decades worth of health care industry, in general and pharma in particular, pricing power gains. While this is a dire backdrop for drug manufacturers - which remains a high-conviction underweight - it is a clear benefit to HMOs (Chart 11). Health insurance labor costs are also well contained: the employment cost index for this industry is probing multi-year lows (bottom panel, Chart 12). The upshot is that profit margins are on a solid footing. Chart 11Operating Metrics Suggest... Chart 12...To Stay Overweight A While Longer Meanwhile, the overall U.S. labor market is on fire. Last month NFPs registered a month-over-month increase of 300K for the first time in four years and unemployment insurance claims are perched near five decade lows. This represents an enticing demand backdrop for managed health care companies, especially when the economy is at full employment and the government is easing fiscal policy (bottom panel, Chart 11). Despite the still appealing demand and pricing backdrop, the flurry of M&A deals will likely serve as a catalyst to lock in gains and move to a benchmark allocation in the coming weeks as this health care sub-index is priced for perfection. Bottom Line: Stay overweight the S&P managed health care index, but it is now on downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Upgrade Alert: Homebuilders Showing Resiliency In late-November 2017 when we launched our 2018 high-conviction call list, we downgraded the niche S&P homebuilding index to underweight (Chart 13). Our thesis was that the trifecta of rising lumber prices, mortgage interest deductibility blues and rising interest rate backdrop, a key 2018 BCA theme, would weigh on profit margins and, thus, profits would underwhelm. Since then we have monetized gains of 10% versus the SPX and removed this early-cyclical index from the high-conviction underweight list.1 Today we are putting it on upgrade alert. As a reminder, this was not a call based on a souring residential housing view. In fact, we remain housing bulls and expect more gains for the still recovering residential housing market that moves in steady prolonged multi-year cycles (Chart 14). Keep in mind that housing starts are still running below household formation and the job market is heating up. The implication is that the U.S. housing market rests on solid foundations. Chart 13Bounced Off Support Line Chart 14Housing Fundamentals Are Upbeat While interest rates and rising house prices are denting affordability (second and fourth panels, Chart 15), homebuilders share prices have been resilient recently and have smartly bounced off their upward sloping support trend line (Chart 13). Indeed, interest rates may continue to rise from current levels, but as we have highlighted in recent research, there is a self-limiting aspect to the year-over-year rise in the 10-year yield near the 100bps mark. Put differently, any rise above 3.05% on the 10-year Treasury yield in a short time frame would likely prove restrictive for the U.S. economy.2 Encouragingly, the mortgage application purchase index has well absorbed the selloff in the bond market, unlike its sibling mortgage application refinance index, signaling that there is pent up housing demand (second panel, Chart 16). New home sales are expanding anew as price concessions have likely been sufficient to compete with existing homes for sale (top panel, Chart 16). Chart 15Get Ready To Upgrade... Chart 16...Given Receding Profit Margin Risks On the lumber front, prices have gone parabolic year-to-date courtesy of trade war talk and a softening U.S. dollar. However, lumber inflation cannot continue at a 50%/annum pace indefinitely (third panel, Chart 16). While higher lumber prices are a de facto negative for homebuilding profit margins, we deem they are now well reflected in compelling relative valuations (bottom panel, Chart 15). In addition, if we are correct in assessing that housing demand remains upbeat, this will give some breathing room to homebuilders to partly pass on some of this input cost inflation to the consumer. Bottom Line: The S&P homebuilding index remains an underweight, but it is now on our upgrade watch list. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "Housekeeping In Turbulent Times," dated February 9, 2018, available at uses.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. Stay neutral small over large caps (downgrade alert).
Highlights Two big distortions in the euro area economy arose because Germany depressed its wages for a decade, and then Italy failed to fix its broken banks for a decade... ...but both distortions are now correcting. Long-term property investors in Europe should seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. Steer clear of Scandinavia, France and central London. Stay overweight a basket of German real estate stocks. Maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Feature In Germany and Italy, real house prices are at the same level today as they were in 1995 (Chart of the Week). Germany and Italy share another similarity. Through the past two decades, they have delivered their workers the same subpar real wage growth (Chart I-2). Chart of the WeekThe Mirror Image Journeys Of German ##br##And Italian House Prices Chart I-2The Mirror Image Journeys Of ##br##German And Italian Wages However, while the point-to-point growth rates for both house prices and wages look identical, the journeys that Germany and Italy have travelled have been mirror images of one another. Germany's journey has been a decline followed by rapid ascent; Italy's journey has been a rapid ascent followed by decline. These mirror image journeys encapsulate the two big distortions within the euro area economy. The Euro Area's Two Big Distortions The euro area's first distortion arose from Germany's labour market reforms at the start of the millennium. Germany's labour reforms were putatively to boost productivity. In fact, the reforms' main impact was to depress German wages for a decade. The consequent boost in competitiveness caused symmetrical distortions: a bubble in German exports, and an anti-bubble in German household incomes. Before Germany joined the euro, such a distortion would have been impossible. An appreciating deutschemark would have arbitraged away any rise in export competitiveness. But an exchange rate appreciation could no longer happen once Germany was sharing its currency with other economies that were not replicating Germany's wage depression strategy. Hence, German household incomes - and house prices - have been one of Europe's biggest losers in the single currency era. Conversely, Germany's export-oriented companies - and their shareholders - have been amongst the biggest winners (Chart I-3). Just consider, the Siemens dividend is up almost one thousand percent! The euro area's second distortion arose because Italy failed to fix its broken banks for a decade. After a financial crisis such as in 2008, the golden rule is to nurse the financial system back to health as quickly as possible. Which is precisely what all the major economies did. All the major economies, that is, apart from Italy (Chart I-4). Chart I-3Distortion 1: Germany Depressed##br## Its Wages For A Decade Chart I-4Distortion 2: Italy Failed To Fix Its ##br##Broken Banks For A Decade Italy procrastinated because its government is more indebted than other sovereigns and because its dysfunctional banks did not cause an acute domestic crisis. Nevertheless, Italy's reluctance to fix its banks is the central reason for its decade-long economic stagnation, and declining real house prices. The good news is that the euro area's two big distortions are now correcting. Germany is allowing its wages to adjust rapidly upwards. Meanwhile, in the space of just a year, Italy has raised almost €50 billion in equity capital for its banks. Italian bank solvency and loan quality have improved sharply. This raises an interesting question: do the German and Italian housing markets now offer compelling long-term investment opportunities? European Housing Markets: The Good, The Bad, And The Ugly Property investments offer income via rents. Over time, these rents should increase in real terms. Items such as a litre of milk or a London commuter train journey do not increase in quality. If anything, the London commuter train journey has decreased in quality! By contrast, accommodation does increase in quality. For example, kitchens and bathrooms, home security, and heating and cooling systems should all get better over time. In essence, the quality of accommodation benefits from productivity improvements, so real rents rise. Of course, such improvements require investment expenditure. But a property investor requires a return on this investment. Therefore, property income - even after expenses - should and does increase in real terms. What about capital values? In the long term, we would expect capital values to have some connection to rising real rents. So if real house prices have not increased over several decades, then it signals a very likely undervaluation. Conversely, if real house prices have increased an implausibly large amount over several decades, then it raises a red flag for a likely overvaluation (Chart I-5, Chart I-6, and Chart I-7). Chart I-5German Real House Prices Are No Higher Than In 1995 Chart I-6Scandinavian Real House Prices Have Trebled Since 1995 Chart I-7Italy, Portugal And Greece Offer Good Opportunities For Property Investors On this evidence, we expect the long-term returns from the housing markets in France, Netherlands, Belgium and Finland to be bad. More worrying, we expect the long-term returns from the housing markets in Sweden and Norway to be ugly. Real house prices have more than trebled since 1995. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated credit-fuelled bubbles... albeit in Sweden and Norway. Chart I-8London House Prices Have Rolled Over We are also reluctant to own London property. London house prices have rolled over, and headwinds persist (Chart I-8). Theresa May wants to drag the U.K. out of the EU single market and customs union, which cannot be a good thing for London. On the other hand, if parliament forces May to soften her Brexit stance, it could fracture a precarious truce between hard and soft Brexiters in her cabinet and topple the government. Thereby, it could pave the way for a Jeremy Corbyn led Labour government and the spectre of a high-end 'land value' tax. So where are long-term returns likely to be good? We repeat that where house prices have shown no real increase from 25 years ago, it bodes very well for the long-term investment opportunity. This describes the situation for the housing markets in Germany, Italy, Portugal and Greece. To summarise, if you are looking for a long-term investment property in Europe, steer clear of Scandinavia, France and central London. And seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. What Is The Related Opportunity In Equity Markets? Real estate holding and development companies and REITS are the equity market plays on real estate. The trouble is that the stocks are too few and too small for a meaningful investment in Greece, Italy and Portugal. However, in Germany, stay overweight the basket of real estate stocks which we first introduced a few years ago. The basket has outperformed by 50%, but the outperformance isn't over. In Germany, the catch-up of house prices is closely connected to the catch-up of household incomes. As Germany continues to reduce its export-dependence and rebalance its economy towards domestic demand, the catch-up has further to run. Chart I-9German Consumer Services Will ##br##Outperform Consumer Goods It is possible to play this structural theme in the equity market via an overweight in consumer services versus consumer goods. Consumer services tend to have more domestic exposure compared to the consumer goods sector which is dominated by autos. Understandably, during the era of German export-dominance, the German consumer services sector strongly underperformed consumer goods. But in recent years, as the German economy has rebalanced, the tables have turned. German consumer services have been outperforming German consumer goods (Chart I-9). We expect this trend to persist. Our preferred expression is to maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week's recommendation is a commodity pair-trade: short nickel / long lead. The pair trade's 65-day fractal dimension is at the lower bound which has signalled several reversals in recent years. Set a profit target of 8% with a symmetrical stop-loss. We are also pleased to report that all of the four other open trades are comfortably in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 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 Our supply-demand balances indicate oil fundamentals are softening slightly. All else equal, this might prompt us to lower our average-price forecasts for Brent and WTI from $74 and $70/bbl this year by $2 to $3/bbl. However, this is oil: All else equal seldom applies. An unusual confluence of risk factors has raised the likelihood of sharp price moves - down and up - this year. These range from the threat of trade wars (bearish for demand), to renewed U.S.-led sanctions against Iran and deeper sanctions against Venezuela (bullish, as they could remove as much as 1.4mm b/d of supply). The possible extended delay of the Aramco IPO compounds the uncertainty. Brent and WTI implied volatilities - the principal gauge of price risk in trading markets - had a brief spike earlier this month, but subsequently retreated (Chart of the Week). We believe the lower volatility offers an opportunity to get long a put spread in Dec/18 Brent options, to complement an existing long call spread in these options. Energy: Overweight. We are taking profit on our long Jul/18 vs. short Dec/18 WTI calendar spread to re-position for the higher volatility. As of Tuesday's close, this spread was up 90.4% since inception November 2, 2017. Base Metals: Neutral. Metal Bulletin reported the flow of zinc into China from Spain has turned into a flood, which is depressing physical premiums and causing unintended inventory accumulation. Almost 161k MT of Spanish zinc was shipped to China last year, a 15-fold increase in annual volumes. The bulk of the increase occurring during the August-to-December period. Spain accounted for a quarter of the ~ 67k MT of zinc imported by China in January. Precious Metals: Neutral. Going into Jerome Powell's first meeting as Fed Chair, gold held recent support ~ $1,310/oz. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. U.S. Ag Secretary Sonny Perdue warned farmers a tit-for-tat trade war could hit their markets particularly hard earlier this week, according to Reuters. Cotton could be especially hard hit (please see p. 9 for details).1 Feature Fundamentally, our global supply-demand balances indicate the global oil market will remain in a physical deficit this year, even though they do suggest a slight softening. As such, we are leaving our Brent and WTI forecasts for this year at $74 and $70/bbl (Chart 2). For next year, we also are leaving our average-price Brent and WTI expectations at $67 and $64/bbl, respectively, with the caveat that these are highly conditional on OPEC 2.0's expected forward guidance later this year.2 Chart of the WeekCrude Oil Volatility Lower,##BR##Even As Price Risks Mount Chart 2BCA's Oil Price Forecast##BR##Remains Unchanged Nonetheless, it is difficult to remain sanguine regarding the oil-price outlook. A remarkable confluence of geopolitical events has introduced higher risk to the downside and the upside for oil prices this year and next. On the downside, trade-war rhetoric continues to ramp up, as the Trump administration threatens sanctions against China for alleged theft of U.S. intellectual property, and slow-walks NAFTA negotiations with Mexico and Canada. Either or both of these could be the spark that lights a global trade war. Re the latter, U.S. Agriculture Secretary Sonny Perdue is warning U.S. farmers their markets could get caught up in a tit-for-tat trade war.3 Upside oil-price risk arises from increasingly bellicose signaling by the Trump administration re the Iran nuclear sanctions deal, and hints the U.S. could impose sanctions directly on Venezuela's oil industry, which would augment sanctions against individuals already in place. Rex Tillerson's expected replacement at the U.S. State Department, Mike Pompeo, shares President Trump's hostility to the 2015 deal that lifted trade sanctions on Iran, which allowed it to increase its production and boost exports. If the May 12 deadline for issuing waivers on the Iran sanctions passes, trade penalties again will be in force against Iran, which likely will, once again, reduce its production and exports, if U.S. allies fall in line with Washington. The odds of this are now higher with Rex Tillerson no longer at the helm at the U.S. State Department. Lastly, Saudi Crown Prince Mohammad bin Salman Al Saud, who, as Minister of Defense, is leading KSA's proxy wars against Iran throughout the Middle East, is in Washington cementing relations with President Trump. Trump has indicated his administration is abandoning his predecessor's pivot away from the Middle East and re-engaging at a deeper level with KSA. The Crown Prince also indicated he will be discussing the Iran sanctions with President Trump in meetings this week.4 Fundamentals Remain Supportive ... For Now Chart 3Supply-Demand Fundamentals##BR##Remain Supportive The slight softening detected in our supply-demand balances model is largely coming from the supply side (Chart 3). Most of this is due to surging U.S. crude and liquids production. The EIA's higher-than-expected U.S. crude oil production estimates for 4Q17 provides a higher base on which continued production gains can build this year. Our colleague Matt Conlan notes in this week's Energy Sector Strategy that, over the past three months, the EIA increased its U.S. onshore oil production estimates for 4Q17 by 310k b/d.5 Although we faded this estimate earlier this year, Matt's analysis of E&P balance sheet data for the quarter confirms this surge in production. U.S. production growth dominates global growth this year - up almost 1.3mm b/d on average y/y, led by a 1.2mm b/d y/y gain in shale-oil output. For next year, we have U.S. output up just over 1mm b/d, almost all of which is accounted for by increased shale production. Total U.S. crude production goes to 10.6mm b/d this year, and 11.9mm b/d next year. In 1Q18, the U.S. will displace KSA as the second-largest crude producer in the world. U.S. crude oil production will exceed Russia's expected crude and liquids production of 11.35mm b/d next year by 2Q19 (Table 1). Total U.S. crude and liquids production (including NGLs, biofuels, and refinery gain) goes to 17.4mm b/d this year, and 19.1mm b/d next year. Strong demand continues to absorb rising production this year and next. By our reckoning, global oil demand grows 1.7mm b/d this year, and 1.64mm b/d next year, up slightly from our earlier estimate of 1.57mm b/d. Global demand averages 100.3mm b/d this year, and just shy of 102mm b/d next year. These fundamentals continue to support our judgement that OPEC 2.0's primary goal - draining OECD inventories below their current five-year average - will be met this year (Chart 4). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Chart 4Expect OECD Inventories To Draw A Bit Slower Expect OPEC 2.0 To Endure Next year is a different story. Not because markets fundamentally change. But because we fully expect to be substantially revising our production estimates as OPEC 2.0 evolves into a more durable, longer-lasting structure. Chart 5Backwardation Weakens Under##BR##Provisional 2019 Estimates We expect OPEC 2.0 to provide forward guidance regarding its production-management goals for 2019 and beyond, once all of the particulars in formalizing its structure are agreed later this year. As a result, we fully expect to be revising our price forecasts and OECD inventory expectations in line with more definitive OPEC 2.0 production guidance throughout this year. As things stand now, we assume volumes voluntarily removed from production - some 1.1 to 1.2mm b/d by our reckoning - will slowly be returned to the market over 1H19. By 2H19, those states within OPEC 2.0 that actually cut production - mostly KSA and Russia - are assumed to be back at pre-2017 production levels. More than likely, the coalition will maintain its production cuts at a lower level so that OECD inventories do not grow excessively and place the OPEC and non-OPEC member states of the coalition in the same dire straits that led to the formation of OPEC 2.0. This will arrest the descent in prices generated by our fundamental models toward the end of 2019 (Chart 2). In addition, the renewed OECD inventory build our model generates (Chart 4) also will be arrested. This will keep markets backwardated in 2019, as opposed to moving toward contango as production growth exceeds consumption growth, restraining the erosion in the backwardation in the forward Brent and WTI curves (Chart 5). Tail Risks Rising In Oil Markets An unusual confluence of risk factors has raised the likelihood of sharp price moves to the downside and to the upside this year. These range from the threat of growth-killing trade wars, to renewed U.S.-led sanctions against Iran and deeper sanctions directed at Venezuela's oil sector. A full-blown global trade war would be bearish for prices, as it would depress growth globally, particularly in EM economies, which are the primary drivers of oil demand. At the other end of the price distribution, reimposing sanctions on Iran and targeting Venezuela's oil industry with sanctions could remove up to 1.4mm b/d of supply from markets later this year, by some estimates.6 A former Obama administration official familiar with the Iran sanctions estimates as much as 500k b/d of exports could be lost if sanctions are reimposed. Venezuela's crude oil output has been collapsing and currently is less than 1.6mm b/d. Oil-directed sanctions from the U.S. could force the Venezuelan oil industry to collapse. Added to this volatile mix, Saudi Crown Prince Mohammad bin Salman Al Saud, also known as MBS, called on President Trump this week in Washington. MBS is leading KSA's proxy wars against Iran, and remains at the forefront of efforts to deny them political and military advantage in the Gulf and the Middle East. MBS and President Trump are on the same page in their opposition to the Iran sanctions deal, as is the presumptive U.S. Secretary of State, Mike Pompeo, who, as Reuters notes, "fiercely opposed the Iranian nuclear deal as a member of Congress."7 Lastly, reports of a possible extended delay of the Aramco IPO creates additional uncertainty re our analysis. It is entirely possible KSA thus far has failed to get indicative bids for the 5% of the firm they intend to float anywhere near its $100 billion target. A target bid would value Saudi Aramco at ~ $2 trillion. Given that we view the IPO as the principal driver of KSA's oil policy over the next two years, this raises questions as to whether the Kingdom will remain committed to higher prices over the short term - $60 to $70/bbl is the range we assume - or whether it will lower its sights to a range we believe Russia favors ($50 to $60/bbl). We continue to expect KSA to favor higher prices over the short term, as it works to reduce its fiscal breakeven oil price from ~ $70/bbl to $60/bbl. A higher price range also will help the Kingdom raise debt under more favorable terms, should it decide to wait on the IPO and finance the early stages of its diversification away from oil-export revenues. Either way, we would expect the Kingdom to favor higher prices. It also is possible a lack of bids approaching KSA's Aramco target level will make a private placement more attractive. A consortium led by China's sovereign wealth fund is believed to have shown a bid for the entire 5% placement. The quid pro quo is believed to have been KSA accepting payment for its oil in yuan. This could have profound implications for the market, as we noted in a Special Report exploring the Kingdom's anti-corruption campaign. This alternative also would tend to favor higher prices, in as much as KSA would not want its new shareholder to realize a loss shortly after its purchase of 5% of Aramco.8 Investment Implications Of Higher Tail Risk As our Chart of the Week indicates, trading markets do not appear to have priced the growing tail risks into option premiums. The market's chief gauge of oil-price risk - the implied volatilities of traded put and call options - staged a brief rally, but have since retreated.9 Volatility is the critical driver of option value. We believe the low volatility levels in the market at present offer an opportunity to add to our long Brent call spreads in Dec/18 options. Specifically, we recommend getting long a $50/bbl Dec/18 Brent put and selling a $45/bbl Dec/18 Brent put option against it. This will give investors low-cost, low-risk exposure to a sudden down move, in addition to the upside exposure our existing Dec/18 $65 vs. $70/bbl Brent call spread provides to a sudden up move resulting from the risk factors we discussed above. Of course, more adventuresome investors can choose to get long put spreads and ignore taking exposure to the upside if they believe downside risks from trade tensions will dominate the evolution of oil prices this year. On the other side of the divide, those who believe the increasing geopolitical tensions discussed above will dominate price formation going forward, can choose to get long calls or call spreads and ignore taking exposure to the downside. Separately, we will be taking profits on our long Jul/18 WTI vs. short Dec/18 WTI spread trade, to re-position for our higher-volatility expectation. This position was up 90.4% as of Tuesday's close, when we mark our recommendations to market. Bottom Line: We are keeping our forecast for 2018 and 2019 unchanged, despite the unexpectedly strong U.S. oil supply growth being reported by the EIA and in E&P quarterly earnings reports. An unlikely confluence of geopolitical risks has raised price risk to the downside and the upside. To position for this, we are recommending investors get long put and call spreads in Dec/18 Brent futures. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We discussed the implications of a trade war vis-a-vis U.S. ag markets in last week's Commodity & Energy Strategy Weekly Report. Please see "Ags Could Get Caught In U.S. Tariff Imbroglio," published by BCA Research March 15, 2018. It is available at ces.bcaresearch.com. 2 In last month's publication, we noted the Kingdom of Saudi Arabia (KSA) and Russia - the putative leaders of the producer coalition we've dubbed OPEC 2.0 - favor formalizing their agreement with a long-term alliance. Among other things, OPEC 2.0 members would be expected to build buffer stocks to address any sudden supply outages, in order to maintain orderly markets. Please see "OPEC 2.0 Getting Comfortable With Higher Prices," published by BCA Research's Commodity & Energy Strategy February 22, 2018. It is available at ces.bcaresearch.com. 3 Please see footnote 1 references, and "U.S. agriculture secretary says exports at risk in tariff disputes," published by reuters.com March 19, 2018. 4 Please see "Trump Says of Iran Deal, 'You're Going to See What I Do,' published by bloomberg.com March 20, 2018. 5 Please see "Public Companies Confirm Large Q4 2017 Production Surge," in the March 21, 2018, issue of BCA Research's Energy Sector Strategy. It is available at nrg.bcaresearch.com. 6 Please see "U.S. foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts on its online site March 15, 2018. 7 Please see "Oil nears six-week high as concern grows over Middle East," published by uk.reuters.com March 21, 2018. 8 Please see our Special Report published by BCA Research's Commodity & Energy Strategy November 16, 2017. It is available at ces.bcaresearch.com. 9 Implied volatilities, or "implieds" in trading markets, are market-cleared pricing parameters for options. They are calculated once a put (the right to sell the underlying asset upon which an option is written) or call (the right to buy the asset) price (i.e., the option premium) clears the market. Implieds are the annualized standard deviation of expected returns for whatever asset is being priced in a trading market. As such, they are often used to measure the risk that is being priced in options markets by willing buyers and sellers. When implieds are high, risk expectations are high, and the range in which prices are expected to trade widens. "The opposite holds when volatility is low." Ags/Softs Can China Retaliate With Agriculture? China's outsized population means that it is a major consumer of many agricultural products. In last week's Weekly Report, we highlighted that this has made U.S. farmers increasingly wary of the impact of a prospective trade war on the agriculture sector. We concluded that while restrictions on China's imports of U.S. soybeans would have a large impact on U.S. farmers, retaliation by China may not be feasible, given that alternative sources of supply are not readily available. Instead, cotton appears to be the more vulnerable crop, in the event of retaliation. Table 2 below formalizes this analysis. The first column shows the importance of each ag to the U.S., as measured by the percent of U.S. exports that go to China. We use this measure to derive the qualitative value displayed in the third column. The results imply that restrictions on China's imports of U.S. sorghum, soybeans, and to a lesser extent cotton, would severely harm U.S. farmers of these crops. On the other hand, wheat, corn, and rice exports to China do not make up a large proportion of U.S. exports, and thus are not especially significant to American farmers of those commodities. The second column measures China's ability to substitute away from the U.S. as a supplier. We calculate a ratio using world inventories ex-U.S. versus the volume of China's imports from the U.S. for particular crops. The larger the value in column two, the greater China's ability to substitute away from the U.S. Based on these metrics, the last column reveals that China is extremely dependent on the U.S. in terms of sorghum and soybeans, while it has greater ability to find alternative suppliers of the other commodities. Cotton accounts for 16% of U.S. exports. World inventories ex-U.S. for cotton stands at 157 times more than the volume of China's 2017 imports from the U.S. This simple analysis indicates U.S. cotton exports likely will fall victim to retaliation by China, in the event of a trade war. Table 2Cotton Could Fall Victim In Trade Dispute Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Portfolio Strategy Synchronized global growth, a soft U.S. dollar, our resurgent Boom/Bust Indicator and avoidance of a Chinese economic hard landing, are all signaling that it still pays to overweight cyclicals at the expense of defensives. Economically hyper-sensitive transports also benefit from synchronous global growth and capex. We expect a rerating phase in the coming months. Within transports, we reiterate our overweight stance in the key railroads sub-index as enticing macro tailwinds along with firming operating metrics underscore that profits will exit deflation in calendar 2018. Recent Changes There are no portfolio changes this week. Table 1 Feature The S&P 500 continued to consolidate last week, still digesting the early February tremor. Policy uncertainty is slowly returning and sustained Administration reshufflings are becoming slightly unnerving (bottom panel, Chart 1). Nevertheless, the dual themes of synchronized global growth and budding evidence of coordinated tightening in global monetary policy, i.e. rising interest rate backdrop, continue to dominate and remain intact. Importantly in the U.S., the latest non-farm payrolls (NFP) report was a goldilocks one. Month-over-month NFPs surpassed the 300K hurdle for the first time since late-2014, on an as-reported-basis, while wage inflation settled back down. The middle panel of Chart 2 shows that both in the 1980s and 1990s expansions, NFPs were growing briskly, easily clearing the 300K mark. The 2000s was the "jobless recovery" expansion and likely the exception to the rule. In all three business cycle expansions wage growth touched the 4%/annum rate before the recession hit. The yield curve slope also supports this empirical evidence, forecasting that wage inflation will likely attain 4%/annum before this cycle ends (wages shown inverted, Chart 3). Chart 1Watch Policy Uncertainty Chart 2Goldilocks NFP Report... Chart 3...But Wage Growth Pickup Looms One key element in the current cycle is that the government is easing fiscal policy to the point where both NFPs and wages will likely surge in the coming months as the fiscal thrust gains steam, likely extending the business cycle. This is an inherently inflationary environment, especially when the economy is at full employment and the Fed in slow and steady tightening mode. Last autumn, we showed that the SPX performs well in times of easy fiscal and tight money iterations, rising on average 16.7% with these episodes, lasting on average 16 months (Table 2).1 The latest flagship BCA monthly publication forecasts that the current fiscal impulse will last at least until year-end 2019, contributing positively to real GDP growth. Thus, if history at least rhymes, SPX returns will be positive and likely significant for the next couple of years (Chart 4). With regard to the composition of the equity market's return, we reiterate our view - backed by empirical evidence - that EPS will do the heavy lifting whereas the forward P/E multiple will continue to drift sideways to lower.2 Not only will rising fiscal deficits cause the Fed to remain vigilant and continue to raise interest rates and weigh on the equity market multiple (Chart 5), but also heightened volatility will likely suppress the forward P/E multiple. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Chart 4Stimulative Fiscal Policy##br## Extends The Business Cycle... Chart 5...But Weighs On ##br##The Multiple This week we revisit our cyclical versus defensive portfolio bent and update the key transportation overweight view. Cyclicals Thrive When Global Growth Is Alive And Well... While retaliatory tariff wars are dominating the media headlines, global growth is still resilient. Our view remains that the odds of a generalized trade war engulfing the globe are low, and in that light we reiterate our cyclical over defensive portfolio positioning, in place since early October.3 Global growth is firing on all cylinders. Our Global Trade Indicator is probing levels last hit in 2008, underscoring that cyclicals will continue to have the upper hand versus defensives (Chart 6). Synonymous with global growth is the softness in the U.S. dollar. In fact, the two are in a self-feeding loop where synchronized global growth pushes the greenback lower, which in turn fuels further global output growth. Tack on the rising likelihood that the trade-weighted dollar has crested from a structural perspective, according to the 16-year peak-to-peak cycle4 (Chart 7) and the news is great for cyclicals versus defensives (Chart 8). Chart 6Global Trade Is Alright Chart 7Dollar The Great Reflator... Chart 8...Is A Boon For Cyclicals Vs. Defensives Related to the greenback's likely secular peak is the booming commodity complex, as the two are nearly perfectly inversely correlated. Commodity exposure is running very high in the deep cyclical sectors and thus any sustained commodity price inflation gains will continue to underpin the cyclicals/defensives share price ratio. BCA's Boom/Bust Indicator (BBI) corroborates this upbeat message for cyclicals versus defensives. The BBI is on the verge of hitting an all-time high and, while this could serve as a contrary signal, there are high odds of a breakout in the coming months if synchronized global growth stays intact as BCA expects, rekindling cyclicals/defensives share prices (Chart 9). Finally, if China avoids a hard landing, and barring an EM accident, the cyclicals/defensives ratio will remain upbeat. Chart 10 shows that China's LEI is recovering smartly from the late-2015/early-2016 manufacturing recession trough, and the roaring Chinese stock market - the ultimate leading indicator - confirms that the path of least resistance for the U.S. cyclicals/defensive share price ratio is higher still. Chart 9Boom/Bust indicator Is Flashing Green Chart 10China Is Also Stealthily Firming Bottom Line: Stick with a cyclical over defensive portfolio bent. ...As Do Transports, Thus... Transportation stocks have taken a breather recently on the back of escalating global trade war fears. But, we are looking through this soft-patch and reiterate our barbell portfolio approach: overweight the global growth-levered railroads and air freight & logistics stocks at the expense of airlines that are bogged down by rising capacity and deflating airfare prices (Chart 11). Leading indicators of transportation activity are all flashing green. Transportation relative share prices and manufacturing export expectations are joined at the hip, and the current message is to expect a reacceleration in the former (top panel, Chart 12). Similarly, capital expenditures, one of the key themes we are exploring this year, are as good as they can be according to the regional Fed surveys, and signal that transportation profits will rev up in the coming months (middle panel, Chart 12). The possibility of an infrastructure bill becoming law later this year or in 2019 would also represent a tailwind for transportation EPS. Not only is U.S. trade activity humming, but also global trade remains on a solid footing. The global manufacturing PMI is resilient and sustaining recent gains, suggesting that global export volumes will resume their ascent. This global manufacturing euphoria is welcome news for extremely economically sensitive transportation profits (Chart 13). All of this heralds an enticing transportation services end-demand outlook. In fact, industry pricing power is gaining steam of late and confirms that relative EPS will continue to expand (Chart 12). Under such a backdrop, a rerating phase looms in still depressed relative valuations (bottom panel, Chart 13). Chart 11Stick With Transports Exposure Chart 12Domestic... Chart 13...And Global Growth/Capex Beneficiary ...Stay On Board The Rails Railroad stocks have worked off the overbought conditions prevalent all of last year, and momentum is now back at zero. In addition, forward EPS have spiked, eliminating the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (Chart 14). The track is now clear and more gains are in store for relative share prices in the coming quarters. Despite trade war jitters, we are looking through the recent turbulence. If the synchronized global growth phase endures, as we expect, then rail profits will remain on track. In fact, BCA's measure of global industrial production (hard economic data) is confirming the euphoric message from the global manufacturing PMI (soft economic data) and suggests that rails profits will overwhelm (Chart 15). Our S&P rails profit model also corroborates this positive global trade message and forecasts that rail profit deflation will end in 2018 (bottom panel, Chart 15). Beyond these macro tailwinds, operating industry metrics also point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (second panel, Chart 15). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (second panel, Chart 16). Chart 14Unwound Both Overbought Conditions And Overvaluation Chart 15EPS On Track To Outperform Chart 16Intermodal Resilience The significant intermodal segment that comprises roughly half of all shipments is on the cusp of a breakout. The retail sales-to-inventories ratio is probing multi-year highs on the back of the increase in the consumer confidence impulse and both are harbingers of a reacceleration in intermodal shipments (Chart 16). Coal is another significant category that takes up just under a fifth of rail carload volumes and bears close attention. While natural gas prices have fallen near the lower part of the trading range in place since mid-2016 and momentum is back at neutral, any spike in nat gas prices will boost the allure of coal as a competing fuel for energy generation (middle panel, Chart 17). Keep in mind that coal usage is highly correlated with electricity demand and the industrial business cycle, and the current ISM manufacturing survey message is upbeat for coal demand. Tack on the whittling down in coal inventories at utilities and there is scope for a tick up in coal demand (third panel, Chart 18). Finally, the export relief valve has reopened for coal with the aid of the depreciating U.S. dollar, and momentum in net exports has soared to all-time highs, even surpassing the mid-1982 peak (bottom panel, Chart 18). Chart 17Key Coal Shipments Underpin Selling Prices Chart 18Upbeat Leading Indicators Of Coal Demand All of this suggests that coal shipments will make a comeback later in 2018, and continue to underpin industry pricing power, which in turn boost rail profit prospects (bottom panel, Chart 17). Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).
Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 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* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. 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 11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Chinese domestic stocks have materially lagged their investable peers over the past three years, due to the legacy effects of an enormous, policy-driven bubble in 2014-2015. While A-shares have worked off some of this speculative bubble and multiples are no longer extreme, the outlook for earnings is uninspiring and the valuation discount offered by domestic stocks is modest, at best. Investors should maintain a neutral stance towards Chinese A-shares over the coming 6-12 months, but should remain alert to any improvements in China's housing market and especially any easing monetary policy, as they may signal a potential upgrade catalyst. Finally, we note that the negative perception of Chinese domestic stocks by many global investors does not appear to be justified by the data. A-shares have a place within a regional equity portfolio, and should not be ignored when the right cyclical conditions present themselves. Feature Since last October we have written extensively about the character and magnitude of the economic slowdown in China, and what it means for both Chinese import growth as well as earnings growth for the MSCI China Index (our investable benchmark). Chart 1Disappointing Relative Performance ##br##From A-Shares We have focused our investment strategy discussions on investable stocks because domestic A-shares have underperformed our investable benchmark by a significant margin over the past three years (Chart 1). In this week's report we take a closer look at the reasons for this underperformance, and review the outlook for A-shares over the coming 6-12 months. We conclude that the case for A-shares is currently uninspiring over the cyclical investment horizon, warranting a neutral stance for now. However, we also note that the negative perception of China's domestic stocks among some global investors, that it is a "casino" market untethered from fundamentals, is not supported by the data. This underscores that A-shares deserve a place within a regional equity portfolio, and should be favored when cyclical conditions warrant it. 2014-2015: A Policy-Driven Bubble In Domestic Stocks The drivers of A-share underperformance over the past few years can be traced back to events that occurred in 2014/2015, when A-shares rose 160% over the course of 12 months (Chart 2). Following several years of poor performance in the domestic stock market, Chinese policymakers began a push in 2014 to encourage retail investors to buy A-shares. This policy was part of a plan to help reduce what the government saw as a massive flow of savings towards investments that were excessively speculative in nature (such as wealth management products and China's property market), as well as to support a market that authorities hoped would become a more prominent target of international investors. This push involved lowering transaction and account opening fees, lowering margin debt restrictions, and using state media to wage a campaign to encourage equity ownership.1 Chart 3 highlights that the authorities' efforts initially worked at boosting stock prices, by showing the strong relationship between the MSCI China A Onshore index and margin debt linked to the Shanghai and Shenzhen stock exchanges. But this experiment ultimately ended badly, and domestic stock prices and margin debt began to crash in the summer of 2015. In total, the MSCI China A Onshore index fell roughly 50% from June 2015 to January 2016, nearly rivaling the total decline experienced by the S&P 500 during the 2007-2009 global financial crisis. Chart 22014/2015 Was A Policy-Driven Bubble ##br##In Domestic Stocks Chart 3Easing Margin Debt Restrictions ##br##Had An Enormous Impact While domestic stocks have risen by an impressive 30% (12.5% annualized) since they troughed in early-2016, they have underperformed their investable peers (both overall and excluding technology) over the same period. This disappointing relative performance has caused many global investors to question whether they should bother investing in A-shares, and under what conditions, if any, should they favor domestic stocks over investable equities. A-Share Value No Longer Extreme... The narrative of a policy-driven bubble in 2014-2015 suggests that extreme overvaluation is the root cause of the recent underperformance of domestic Chinese equities. Chart 4 shows that this is indeed the case, by presenting the 12-month forward P/E ratio for MSCI China (our investable benchmark), MSCI China A Onshore, and All Country World. Chinese equities, both investable and domestic, were deeply discounted relative to global stocks in late-2014, reflecting the multi-year Chinese economic slowdown that began in mid-2010. But the government's campaign to encourage domestic stock ownership caused the A-share multiple to more than double in 12 months, and to exceed that of global stocks. Chart 4The Underperformance Of A-Shares, As Told By Multiples The multiple of investable equities also rose due to the campaign, but by a much smaller magnitude. It began to fall in mid-2015 alongside the domestic stock multiple but bottomed before the end of the year in response to signs that China's economy was about to enter the upswing of a mini economic cycle. The following 2 years saw investable equities re-rate significantly as China's economy recovered, whereas the still-elevated domestic market multiple simply trended sideways. But the bottom line for investors is that A-shares have worked off a good portion amount of the overvaluation that was caused by the policy-driven bubble of 2014-2015, meaning that their risk-reward profile has materially improved. ...But The Outlook For Domestic Stocks Is Uninspiring Given that domestic equities have largely closed their valuation gap relative to investable stocks, shouldn't investors be overweight the former? In our view, there are several factors currently arguing against an overweight stance towards A-shares: While we acknowledge the improvement in relative valuation, multiples at a level similar to the overall investable market are not cheap enough to make domestic stocks look highly attractive, given that the latter are no longer cheap themselves versus the global benchmark. We noted in our February 15 Weekly Report that investable technology stocks have been responsible for pushing our relative composite valuation indicator for China into overvalued territory over the past year,2 and we recommended in that report that investors continue to maintain their Chinese equity exposure on an ex-tech basis (which are considerably cheaper in relative terms). Given the fact that China's economy is slowing, and given that the corporate sector has substantially increased its leverage over the past decade, we believe that Chinese equities should be priced at some discount relative to global stocks. Chart 5 suggests that this discount is modest, at best. Chart 5 shows that domestic stocks are modestly cheap versus the global benchmark according to earnings and book value, but are expensive according to cash flow and dividends. While gaps of these kinds have existed in the past, the fact that cash-based measures have been lagging more accrual-based measures since 2013 raises the odds of a problem with earnings quality in the domestic market. This is a topic that we hope to revisit in the coming months, but for now it reinforces the view that the valuation discount applied to A-shares (versus global) is likely insufficient. Chart 6 presents a forecast for A-share earnings per share growth in U.S. dollars, based on its relationship with the Li Keqiang index. The chart shows that while a significant earnings contraction is not in the cards, the growth rate may fall to zero over the coming 6-12 months. This, in conjunction with only a minor valuation discount relative to global stocks, paints an uninspiring cyclical outlook for A-shares over the coming year. Chart 5The Current Valuation Discount Applied To A-Shares Is Modest, At Best Dispelling The Myth Of The "Casino" Market While we find the cyclical outlook for A-shares to be lackluster, the fact that valuation has improved significantly since mid-2015 is an important development from the perspective of regional equity allocation. From our perspective, A-shares should be on the radar screen of global investors as a potential market to favor if the opportunity presents itself, even if the cyclical conditions do not currently warrant an overweight stance. Besides the issue of regulated investability, one reason why global investors tend to overlook domestic Chinese stocks is the perception that A-shares are largely a "casino" market. Admittedly, the decision by policymakers in 2014 to effectively engineer a bubble in domestic stocks did not help to dispel this perspective. However, a closer examination of this question highlights that domestic Chinese equities are, while relatively volatile, hardly untethered from fundamentals at the broad index level. First, Chart 6 below highlighted that there is a close correlation between the Li Keqiang index and the growth rate of A-share trailing earnings. Earnings quality issues aside (the risk of which can be managed by assigning a valuation discount), this certainly does not suggest that A-share returns are more likely to be random than other stock markets. Second, as we noted in a September Special Report,3 the gap in the volatility of A-shares relative to other markets is slowly declining (Chart 7). More recently, the decline in A-share volatility appears to be due to the involvement of China's "national team", i.e. purchases by state-owned financial institutions that are designed to reduce the oscillation of daily price changes, and that began in the wake of the 2015 selloff with the goal of stabilizing the stock market. In the developed world, this type of government interference in financial markets is viewed with deep suspicion and is often referred to in the financial media as being necessary for the government to "prop up" its stock market to avoid an inevitable decline. Chart 6An Uninspiring Domestic Equity Earnings Outlook Chart 7A-Shares Are Relatively Volatile, But The Gap Is Narrowing But Chart 6 highlights how this is misleading: the recovery in A-share earnings that has occurred since 2015 is clearly legitimate given the mini-cycle upswing, meaning that China's "national team" has, at worst, prevented a sharp decline in an elevated multiple over the past two years. It is difficult to see this as anything but a genuine attempt at managing the workout process of a market that underwent a major shock, quite similar in concept to what the Federal Reserve did in the U.S. during the first few years of the subpar economic recovery. From our perspective, as long as this buying remains counter-cyclical and does not somehow interfere with the link between the economy and underlying earnings growth, this should argue in favor a global investor allocation to A-shares (via a lower equity risk premium), not against it. Third, a "casino" market that truly ignores fundamentals and is based heavily on herd-following behavior should rank as highly inefficient from the perspective of the Efficient Markets Hypothesis (EMH). We test whether the A-share market falls into this category by looking for two telltale signs of an inefficient market: whether past returns carry significant information about future returns, and whether simple technical trading rules can lead to outsized profits. Tables 1 and 2 present our findings: in Table 1, we show the F-statistic and R-squared of a second-order autoregression for several regional markets (higher numbers = less efficient), and in Table 2 we show the "win rate" of a trend following rule that buys stocks in the following month if the closing index price at the end of the prior month is above its 9-month moving average (higher win rate = less efficient). Table 1China's Domestic Market Is Less Inefficient Than It Used To Be Table 2Simple Technical Rules Don't Earn Outsized Profits In The A-Share Market The tables show that while there is some evidence to suggest that the A-share market has been relatively inefficient on average compared with other stock markets since the beginning of the last decade, this gap has been significantly reduced over the past few years. To us, this is a compelling sign that A-shares deserve a place within a global equity portfolio and should be favored when cyclical conditions warrant it. Investment Conclusions The ongoing economic slowdown in China means that the earnings outlook for domestic Chinese equities is uninspiring. When coupled with a modest (at best) valuation discount relative to global stocks, this suggests that global investors should have a neutral allocation to A-shares over the coming 6-12 months. However, the observable link between China's economy and domestic equity earnings growth means that investors should be looking to increase their allocation to A-shares on any signs of a pickup in Chinese economic activity. In particular, Chart 8 highlights that domestic stocks appear more likely to lead corporate bond spreads and housing market indicators than investable stocks are, suggesting that any significant easing in monetary policy or a continued improvement in the housing market could act as a potential catalyst to upgrade A-shares even within the context of a benign growth slowdown in China's industrial sector. Chart 8A-Shares Better Lead The Housing Market##br## And Domestic Corporate Bond Spreads As a final point, even if A-shares were to become a more attractive investment at some point in the future, investability remains somewhat of a challenge for some investors. Over the years, BCA's China Investment Strategy service has published and periodically updated our Research Note, "China Shop," as a practical guide for investors looking for exposure to Chinese assets. Our most recent edition, published last August, has a simple list of ETFs that investors can use to gain exposure to the domestic market when the right conditions present themselves.4 But for investors who wish to rank these ETFs based on a proprietary BCA methodology, or who want to easily compare key metrics such as liquidity, legal structure, constituents, sector exposure, performance, etc, BCA's Global ETF Strategy service has a new tool that will greatly assist the process. Effective mid-February, our Global ETF Strategy team launched a new completely redesigned interactive website, along with a Special Report that reviewed how investors can make the most of the matching engine at the heart of the platform (as well as how to best profit from the entire Global ETF Strategy service).5 Given the issues surrounding investability in China's domestic equity market, we highly recommend that any clients who are potentially interested in allocating to A-shares read the report, and take note of this unique, time-saving service. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China's State Media Join Brokerages Saying Buy Equities", Bloomberg News, September 4, 2014. 2 Please see China Investment Strategy Weekly Report, "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "A Stock Market With Chinese Characteristics", dated September 21, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Research Note, "China Shop: Calling Foreign Investors", dated August 10, 2017, available at cis.bcaresearch.com. 5 Please see Global ETF Special Report, "A User's Guide To Global ETF Strategy", dated February 14, 2018, available at etf.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Bond Strategy: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Japan Corporates: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Feature "I love it when a plan comes together." - Hannibal Smith, Leader of The A-Team Many investors likely came down with serious case of a sore neck last week, given the head-turning headlines that came out: Chart 1A Pause In The 'Inflation Scare' U.S. President Donald Trump announcing a blanket tariff on metals imports, then exempting some important countries (Canada, Mexico, Australia) only days later. Trump agreeing to an unprecedented meeting with North Korean leader Kim Jong Un on the nuclear issue, only to have the White House press secretary later announce that no meeting would take place without North Korean "concessions". The European Central Bank (ECB) hawkishly altering its forward guidance to markets at the March monetary policy meeting, but then having that immediately followed by dovish comments from ECB President Mario Draghi. The strong headline number on the February U.S. employment report blowing away expectations, but the soft readings on wages suggesting that the Fed will not have to move more aggressively on rate hikes. For bond markets in particular, the ECB announcement and the U.S. Payrolls report were most important. Investors had been growing worried about a more hawkish monetary policy shift in Europe or the U.S. This was especially true in the U.S. after the previous set of employment data was released in early February showing a pickup in wage inflation that could force the Fed to shift to a more hawkish stance. That created a spike in Treasury yields and the VIX and a full-blown equity market correction. Since then, inflation expectations have eased a bit and market pricing of future Fed and ECB moves has stabilized, helping to bring down volatility and supporting some recovery in global equity markets (Chart 1). With all of these "tape bombs" hitting the news wires, investors can be forgiven for re-thinking their medium-term investment strategy in light of the changing events. We think it is more productive to check if the initial expectations on which that strategy was based still make sense. On that note, the developments seen so far this year fit right in with the key themes we outlined in our 2018 Outlook, which we will review in this Weekly Report. The Critical Points From Our Outlook Still Hold Up In a pair of reports published last December, we translated BCA's overall 2018 Outlook into broad investment themes (and strategic implications) for global fixed income markets. We repeat those themes below, with our updated assessment on where we currently stand. Theme #1: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. ASSESSMENT: UNFOLDING AS PLANNED, BUT WATCH INFLATION EXPECTATIONS. Economic growth is still broadly expanding at a solid pace, as evidenced by the elevated levels of the OECD leading economic indicator and our global manufacturing PMI (Chart 2). The U.S. is clearly exhibiting the strongest growth momentum looking at the individual country PMIs (bottom panel), while there is a more mixed picture in the most recent readings in other countries and regions. Importantly, all of the manufacturing PMIs remain well above the 50 line indicating expanding economic activity. Last week's U.S. Payrolls report for February showed that great American job creation machine can still produce outsized employment gains with only moderate wage inflation pressures, even in an economy that appears to be at "full employment". The +313k increase in jobs, which included upward revisions to both of the previous two months of a combined +54k, generated no change in the U.S. unemployment rate which stayed unchanged at 4.1% with the labor force participation rate increasing modestly (Chart 3). Chart 2U.S. Growth Leading The Way Chart 3The Fed Can Still Hike Rates Only 'Gradually' The wage data was perhaps the most important part of the report, given that the spike in global market volatility seen last month came on the heels of an upside surprise in U.S. average hourly earnings (AHE) for January. There was no follow through of that acceleration in February, with the year-over-year growth rate of AHE slowing back to 2.6% from 2.9%, reversing the previous month's increase (middle panel). The immediate implication is that the Fed does not have to start raising rates faster or by more than planned. That pullback in U.S. wage growth, combined with the continued sluggishness of inflation in the other developed economies and the sideways price action seen in global oil markets, does suggest that inflation expectations may struggle to be the main driver of higher global bond yields in the near term. Overall nominal bond yields are unlikely to decline, however, as real yields are slowly rising in response to faster global growth and markets pricing in tighter monetary policy in response (Chart 4). Chart 4Real Yields Rising Now,##BR##Inflation Expectations Will Rise Again Later We have not seen enough evidence to cause us to change our view on inflation expectations moving higher over the course of 2018, particularly with BCA's commodity strategists now expecting oil prices to trade between $70-$80/bbl in the latter half of 2018.1 One final point: it is far too soon to determine if the protectionist trade leanings of President Trump will alter the current trajectory of global growth and interest rates. The implication is that investors should not change their overall planned investment strategy for this year at this juncture. Theme #2: Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. ASSESSMENT: UNFOLDING AS PLANNED. As shown in Chart 2, the big coordinated upward move in global growth seen in 2017 is already starting to become less synchronized in 2018. Recent readings on euro area growth have softened a bit while, more worryingly, a growing list of Japanese data is slowing. U.K. data remains mixed, while the Canadian economy is showing few signs of cooling off. China's growth remains critical for so many countries, including Australia, but so far the Chinese data is showing only some moderation off of last year's pace. Net-net, the data seen so far this year is playing out according to our 2018 Themes - better in the U.S. and Canada, softer in the U.K. and Australia. We are sticking to our view that the rate hikes currently discounted by markets in the U.S. and Canada will be delivered, but that there will be little-to-no monetary tightening in the U.K. and Australia (Chart 5). Theme #3: The most dovish central banks will be forced to turn less dovish: The ECB and Bank of Japan (BoJ) will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. ASSESSMENT: UNFOLDING AS PLANNED, ALTHOUGH WE NOW EXPECT NO BoJ MOVE TO TAKE PLACE THIS YEAR. Both central banks have already dialed back to pace of the asset purchases in recent months. This is in addition to the Fed beginning its own process of reducing its balance sheet by not rolling over maturing bonds in its portfolio. Growth of the combined balance sheet of the "G-4" central banks (the Fed, ECB, BoJ and Bank of England) has been slowing steadily as a result (Chart 6). The ECB continues to contribute the greatest share of that aggregate "G-4" liquidity expansion, although that is projected to slow over the balance of 2018 as the ECB moves towards a full tapering of its bond buying program by the end of the year (top panel). Chart 5Not Every Central Bank##BR##Will Deliver What's Priced Chart 6Risk Assets Are##BR##Exposed To ECB Tapering Barring a sudden sharp downturn in the euro area economy, the ECB is still on track for that taper. We have been expecting a signaling of the taper sometime in the summer, likely after the ECB gains even greater confidence that its inflation target can be reached within its typical two-year forecasting horizon. That story will not be repeated in Japan, however, where core inflation is still struggling to stay much above 0% and economic data is softening. We see very little chance that the BoJ will make any alterations of its current policy settings - with negative deposit rates and a target of 0% on the 10-year JGB yield - this year, as we discussed in a recent Special Report.2 We continue to expect a diminishing liquidity tailwind for global risk assets over the rest of 2018 (bottom two panels). Theme #4: The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. ASSESSMENT: UNFOLDING AS PLANNED. We saw a sneak preview of how this theme would play out during that volatility spike at the beginning of February, triggered by only a brief blip up higher in U.S. wage inflation. With a more sustained increase in realized global inflation likely to develop within the next 3-6 months, a return to that world of high volatility is still set to unfold in the latter half of 2018, in our view. After reviewing our four investment themes for 2018 in light of the latest news, we conclude that the themes are largely playing out. Therefore, we will continue to stick with the investment strategy conclusions for this year that were derived from those themes (Table 1):3 Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year 2018 Model Bond Portfolio Positioning: Target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Chart 7Tracking Our Recommendations 2018 Country Allocations: Maintain underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and add small overweights in the U.K. and Australia (where rate hikes are unlikely). The year-to-date performance of the main elements of our model bond portfolio are shown in Chart 7. All returns are shown on a currency-hedged basis in U.S. dollars. Our country underweights are shown in the top panel, our country overweights in the 2nd panel, our credit overweights in the 3rd panel and our credit underweights in the bottom panel. The broad conclusion is that our best performing underweight is the U.S. and best performing overweight is Japan. All other country allocations are essentially flat on the year (in currency-hedged terms). Our call to overweight corporate debt vs. government debt, focused on the U.S., has performed well, but mostly through our overweight stance on U.S. high-yield. Bottom Line: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Introducing The Japan Corporate Health Monitor Japan's relatively small corporate bond market has not provided much excitement for non-Japanese investors over the years. Japanese companies have always been highly cautious when managing leverage on their balance sheets, and have traditionally relied heavily on bank loans, rather than bond issuance, for debt financing. The result is a corporate bond market with far fewer defaults and downgrades compared to other developed economies, with much lower yields and spreads as well. Due to its small size, poor liquidity and low yields/spreads, we have not paid much attention to Japanese corporate debt in the past. Thus, we don't have the same kinds of indicators available to us for Japanese corporate bond analysis as we have in the U.S., euro area or U.K. One such indicator is the Corporate Health Monitor (CHM) to assess the financial health of corporate issuers.4 We are changing that this week by adding a Japan CHM to our global CHM suite of indicators. In other countries, we have both top-down and bottom-up versions of the CHM. The former uses GDP-level data on income statements and balance sheets to determine the individual ratios that go into the CHM (a description of the ratios is shown in Table 2), while the latter uses actual reported financial data at the individual firm level which is aggregated into the CHM. Table 2Definitions Of Ratios##BR##That Go Into The CHM Consistent and timely data availability is an issue for building a top-down CHM, as there is no one source of top-down data on the corporate sector. Some data is available from the BoJ or the Ministry of Finance, or even from international research groups like the OECD, but not all are presented using a consistent methodology. Some data is only available on an annual basis, which significantly diminishes the usefulness of a top-down CHM as a timely indicator for bond investment. Thus, we focused our efforts on only building a bottom-up version of a Japan CHM, using publically available financial information released with higher frequency (quarterly). We focused on non-financial companies (as we do in the CHMs for other countries) and exclude non-Japanese issuers of yen-denominated corporate bonds. In the end, we used data on 43 companies for our bottom-up CHM. By way of comparison, there are only 36 individual issuers in the Bloomberg Barclays Japan Corporate Bond Index that fit the same description of non-financial, non-foreign issuers, highlighting the relatively tiny size of the Japanese corporate bond market. Our new Japan bottom-up CHM is presented in Chart 8. The overall conclusions are the following: Japanese corporate health is in overall excellent shape, with the CHM being in the "improving health" zone for the full decade since the 2008 Financial Crisis. Corporate leverage has steadily declined since 2012, mirroring the rise in company profits and cash balances over the same period. Return on capital is currently back to the pre-2008 highs just below 6%, although operating margins remain two full percentage points below the pre-2008 highs. Interest coverage and the liquidity ratio are both at the highest levels since the mid-2000s, while debt coverage is steadily improving. The overall reading from the CHM is one of solid Japanese creditworthiness and low downgrade and default risks. It is no surprise, then, that corporate bond spreads have traded in a far narrower range than seen in other countries. In Chart 9, we present the yield, spread, return and duration data for the Bloomberg Barclays Japanese Corporate Bond Index. We also show similar data for the Japanese Government Bond Index for comparison. Japanese corporates have a much lower index duration than that of governments, which reflects the greater concentration of corporate issuance at shorter maturities. Chart 8The Japan Corporate Health Monitor Chart 9The Details Of Japan Corporate Bond Index Japanese corporates currently trade at a relatively modest spread of 36bps over Japanese government debt, although that spread only reached a high of just over 100bps during the 2008 Global Financial Crisis - a much lower spread compared to U.S. and European debt of similar credit quality. That is likely a combination of many factors, including the small size of the Japanese corporate market and the relatively smaller level of interest rate volatility in Japan versus other countries. Given the dearth of available bond alternatives with a positive yield in Japan, the "stretch for yield" dynamic has created a demand/supply balance that is very favorable for valuations - especially given the strong health of Japanese issuers. Chart 10Japan Corporates Do Not Like A Rising Yen It remains to be seen how the market will respond to a future economic slowdown in Japan, which may be starting to unfold given the recent string of sluggish data. On that note, the performance of the Japanese yen bears watching, as the currency has a positive correlation to Japanese corporate spreads (Chart 10). The linkage there could be a typical one of risk-aversion, where the yen goes up as risky assets selloff. Or it could be linked to growth expectations, where markets begin to price in the impact on Japanese growth and corporate profits from a stronger currency. Given our view that the BoJ is highly unlikely to make any changes to its monetary policy settings this year, the latest bout of yen strength may not last for much longer. For now, given the link between the yen and Japanese credit spreads, we would advise looking for signs that the yen is rolling over before considering any allocations to Japanese corporate debt. Bottom Line: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22nd 2018, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcareseach.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Portfolio In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 4 For a summary of all of our individual country CHMs, including a description of the methodology, please see the BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: No Improvement Despite A Strong Economy", dated November 21st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Portfolio Strategy Quantitative tightening, a rising fed funds rate and higher prices at the pump are all bearish consumer discretionary stocks. Downgrade exposure to underweight. We are executing this interest rate-sensitive sector downgrade by reducing the S&P movies & entertainment and S&P cable & satellite sub-indexes to underweight. A downbeat industry spending backdrop and fading pricing power paint a gloomy EPS picture. Recent Changes S&P Consumer Discretionary - Downgrade to underweight today. S&P Movies & Entertainment - Trim to underweight today. S&P Cable & Satellite - Downgrade to underweight today. Table 1 Feature Equities are still in the recovery ward and the consolidation/absorption phase in place since the February 5th crack has yet to fully run its course. According to our "buy the dip" cycle-on-cycle analysis, a retest of the recent lows typically occurs in the first month following the initial shock, suggesting that the market is already out of the woods (Chart 1A). However, the return of vol may keep a lid on the SPX for a while longer (Chart 1B). Our strategy in place since February 8th is to buy this dip as we do not foresee an end to the business cycle in 2018.1 Chart 1ABuy This Dip Worked Out Nicely... Chart 1BBut The Return Of Vol May Spoil The Party Recent tariff news has dominated the media, however, our sense is that a full blown retaliatory trade war is a low probability outcome. Keep in mind, that the average U.S. tariff rates have drifted lower during the past three decades and, according to the World Bank, are now 1.6%, one of the lowest in the world2 (third panel, Chart 2). And as for concerns that the rhetoric surrounding trade will lead to a surge in the U.S. dollar, we note that the last two times there was a trade spat of sorts the U.S. dollar actually depreciated, both in the early-2000s and in the early-to-mid 1990s (Chart 2). Tack on the recent euphoria surrounding manufacturing exports - which just hit a 30-year high - and it is likely that deep cyclical EPS would overshoot were a trade war to ensue (bottom panel, Chart 2). Such a weak U.S. dollar policy is also a boon for overall SPX profits, if history at least rhymes (Chart 3). Chart 2Tariffs Don't Matter Chart 3SPX EPS Would Get a Boost From A Tariff War Importantly, synchronized global growth and the selloff in the bond markets remain the dominant macro themes. Last week we showed that since the GFC, empirical evidence suggests that the U.S. economy can withstand a tightening of roughly 125bps in a short time span (please see Chart 3B from the March 5th Special Report). This week we add two components to our interest rate analysis and increase the dataset range back to the 1960s. We compare cyclical momentum in the SPX with the annual change in the 10-year Treasury yield, and also document the shifting correlation between these two asset classes. We then filter for a minimum year-over-year (yoy) 100bps tightening in the 10-year Treasury yield and a clear indication of a negative correlation between the two variables, i.e. a deceleration or straight up contraction in the SPX annual percent change. In other words, we are searching for tightness in monetary conditions that cause equity market consternation, excluding recessions. Table 2 summarizes our results. While cyclical stock momentum and changes in the 10-year Treasury yield have been a near carbon copy since the late-1990s (Chart 4), according to our analysis there have been five iterations when rising bond yields proved restrictive for equities: once in each of the 1960s, 1970s and 1990s and twice in the 1980s. Table 2SPX Returns In Times Of ##br##Restrictive 10-Year UST Selloffs Chart 4The Great ##br##Moderation Years In the mid-1960s, the U.S. deployed troops in Vietnam and the Fed also tightened monetary policy by enough to invert the yield curve (Chart 5). During the mid-1970s episode, fresh off the first oil shock-induced recession, the Fed started tightening monetary policy in 1977 in order to contain inflation and never looked back. Eventually, the Fed inverted the yield curve in late-1978 before the second oil shock hit that morphed into the early-1980s recession (Chart 6). Chart 5100bps Tightening... Chart 6...Can Hurt Equities... In the 1980s, following the double dip recession, Fed Chairman Paul Volcker started lifting interest rates as the economy was recovering, and similarly in 1987 the Fed was aggressively tightening monetary policy up until the "Black Monday" crash (Chart 7). Finally, in 1994 the Fed doubled interest rates in a span of nine months and in December of that year Mexico had to devalue the peso and the "Tequila effect" gripped Asia and Latin America. Such abrupt tightening caused a mild indigestion in the stock market (Chart 8). Chart 7...When The Stock-To-Bond Yield Correlation... Chart 8...Turns Negative On average, the SPX drawdown from peak-to-trough during these five iterations was 19% and lasted 6.5 months. Currently, in order for interest rates to turn from reflective of growth to restrictive and cause a sizable pullback in the SPX, we calculate that the 10-year Treasury yield would have to rise above 3.05% by September 2018. Simultaneously, the correlation between stocks and bond yields would have to sink into negative territory. Nevertheless, given the steepness of the recent selloff in bonds, in order for the yoy 100bps rule of thumb to remain in place, post September the 10-year Treasury yield should continue to gallop higher and end the year near 3.5%, and further rise to 3.94% in early 2019. While this is possible, we assign low odds to such an outcome. As a reminder, BCA's higher interest rate view calls for a selloff in the 10-year Treasury bond near 3.25% by year-end 2018, a level that both the economy and the SPX will likely be able to shake off (Chart 4). This week we act on our mid-January alert and downgrade an interest rate-sensitive sector to underweight. Trim Consumer Discretionary To Underweight In mid-January we put the S&P consumer discretionary sector on downgrade alert heeding the anemic signal from our EPS growth model and also owing to BCA's high interest rate theme for 2018. We are now acting on the alert and cutting exposure and moving the S&P consumer discretionary sector to a below benchmark allocation. At this stage of the cycle, when the Fed is on track to continue to steadily lift interest rates in the coming two years as the economy heats up, investors should lighten up on consumer discretionary stocks (Chart 9). In addition, this cycle the Fed is orchestrating dual tightening as it is simultaneously unwinding the size of its balance sheet. Quantitative tightening is also bearish discretionary stocks (Chart 10). Chart 9Mind The Fed Funds Rate Chart 10Quantitative Tightening Also Bites This rising short-term interest rate backdrop is not conducive to owning extremely interest rate-sensitive equities. Both the household financial obligation ratio and household debt service payments have bottomed and are actually increasing. A higher interest rate backdrop will sustain the upward pressure on both and likely weigh on consumer discretionary relative share prices (both series shown inverted, Chart 11). The U.S. consumer has been firing on all cylinders with PCE growing 4% in real terms last quarter and contributing positively to overall real output growth (Chart 12). Chart 11Household Financing ##br##Costs Have Troughed Chart 124% Real PCE Growth Is##br## Unsustainable Absent Wage Inflation However, such a breakneck pace is unsustainable without wage inflation follow through. Worrisomely, the personal savings rate has been depleted to the point where the consumer appears tapped out. Historically, consumer confidence and the savings rate have been perfectly inversely correlated (Chart 13). Sky high sentiment and almost zero savings suggest that the consumer has to resort to credit card debt in order to finance outlays in the absence of wage inflation. Revolving credit is soaring, but worryingly credit card delinquency and chargeoff rates at small commercial banks are at recession type levels, warning that this credit outlet may be drying up (Chart 14). Chart 13Depleted Savings Are Problematic Chart 14Early Signs Of Trouble? All of this is taking place at a time when bankers are still not willing extenders of consumer installment credit, according to the Fed's latest Senior Loan Officer Survey. The implication is that even a modest tick down in consumer confidence and simultaneous rebuilding of savings will likely, at the margin, dent consumer spending. Another macro headwind the consumer has to contend with is higher prices at the pump. BCA's constructive crude oil view suggests that increasing gasoline prices will continue to eat into consumer discretionary spending power. Taken together, these macro headwinds will dampen consumer discretionary outlays. Our Consumer Drag Indicator captures these forces and is signaling that relative share price momentum will dwindle in the coming months (Chart 15). Under such a backdrop, while consumer discretionary EPS can expand modestly, they will trail the broad market that is slated to grow profits close to 20% in calendar 2018. Relative performance will likely converge lower to falling relative profitability (top panel, Chart 16). We currently side with the sell-side community and expect a contraction in relative profit growth. Therefore, not only are we unwilling to pay an 18% premium valuation to own this interest rate-sensitive sector, but we would also sell into strength given our view of a derating phase taking root in the coming months (bottom panel, Chart 16). Our Cyclical Macro Indicator confirms this downbeat relative EPS growth outlook, and underscores that the path of least resistance is lower for consumer discretionary stocks (Chart 15). Chart 15Models Say Sell Chart 16Unsustainable Divergence Finally, a few words on AMZN.3 Cracks have already formed in relative share prices ex-AMZN (top panel, Chart 11). The AMZN juggernaut has masked the true consumer discretionary picture given its hefty market cap weight in the index (20%) that will only increase in late-summer following the already announced S&P index composition changes. Accordingly at that time, we will also make changes to our portfolio. While we maintain a neutral exposure to the S&P internet retail index, that AMZN dominates4 and that we recently initiated coverage on, the way we are executing the S&P consumer discretionary downgrade to underweight is by trimming the media index to a below benchmark allocation. Media: Exit Stage Right Since the late 1970s the media complex's fortunes have been joined at the hip with the U.S. dollar. When the greenback is roaring, investors pile into media shares and vice versa. While media outlets do have international sales exposure, it is small and significantly trails the overall market's foreign revenue exposure. Thus, the mostly domestic nature of media stocks explains the positive correlation with the U.S. dollar (Chart 17). This multi-decade relationship remains in place, and given the sizable losses in the trade-weighted U.S. dollar since the December 2016 peak, the relative share price ratio will remain under intense pressure. On the operating front, shifting consumer spending trends are weighing on relative performance. The top panel of Chart 18 shows that relative media outlays have been in a free fall. Millennials, currently the largest U.S. age cohort, have been "cord cutting" and preferring competitive "on demand" services, largely explaining the near collapse in media spending. Chart 17Joined At The Hip Chart 18Bearish Operating Metrics As a result, industry pricing power is under attack with relative sales and profit expectations steadily sinking (middle & bottom panels, Chart 18). Nevertheless, media barons have awakened to the threats engulfing this industry and are scrambling to fight back. The knee-jerk reaction in the movies & entertainment subindustry has been to seek intra-industry buyout candidates (Chart 19). Inter-industry M&A is also ongoing with the AT&T/Time Warner and Justice Department trial still pending, the tie-up between Disney and Fox and the competitive bids for Sky plc from Fox and Comcast. However, media consolidation is not a sustainable way forward for profit growth. Organic EPS growth remains anemic and the visible breakdown in the correlation between consumer confidence and relative share prices since early 2016 represents a yellow flag (top panel, Chart 20). Chart 19M&A Nearly Exhausted Chart 20Unnerving Breakdown In Correlations Similar to consumer confidence, the ISM non-manufacturing composite is also probing cycle highs, however, industry spending is now outright contracting and steeply diverging from the upbeat ISM services survey. Tack on rising gasoline prices and the news is grim for S&P movies & entertainment profitability (Chart 20). These bleak spending patterns are not isolated in the S&P movies and entertainment index, they have also infiltrated the S&P cable & satellite media sub-index. Chart 21 shows that relative consumer outlays on cable services have taken a plunge, warning that relative share prices will likely suffer the same fate in the coming quarters. Even extremely resilient cable TV pricing power is losing its luster on the back of shrinking industry demand, as cable price hikes can no longer keep up with overall inflation (bottom panel, Chart 21). The implication is that sales are at risk of further steep deceleration. Given that cable providers have to continually upgrade their networks in order to keep up with ever increasing bandwidth demand, tightening margins will eventually translate into cash flow compression (Chart 22). Chart 21Demand And Prices Are Deflating Chart 22Margin Trouble Bottom Line: Downgrade the S&P movies & entertainment and S&P cable and satellite indexes to underweight. This also pushes our exposure to the broad S&P consumer discretionary sector to the underweight column. The ticker symbols for the stocks in the S&P movies & entertainment and S&P cable and satellite indexes, are BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight, "Buy The Dip," dated February 8, 2018, available at uses.bcaresearch.com. 2 https://data.worldbank.org/indicator/TM.TAX.MRCH.WM.AR.ZS?locations=US 3 Please see BCA U.S. Equity Strategy Special Report, "Internet Retail: Dialed Up," dated February 26, 2018, available at uses.bcaresearch.com. 4 Ibid. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).