Financial Markets
Highlights Portfolio Strategy A more balanced cable & satellite and movies & entertainment industry profit backdrop is signaling that only a neutral stance is warranted in both these media sub-indexes. Trim to neutral. These moves also push our S&P consumer discretionary sector weight to a benchmark allocation. Recent Changes S&P Consumer Discretionary - Downgrade to neutral. S&P Cable & Satellite - Trim to equal weight. S&P Movies & Entertainment - Downgrade to a benchmark allocation. Table 1 Feature Equities sustained recent gains last week, largely ignoring the mildly hawkish Fed. The S&P 500 is undeterred by the prospect of another interest rate hike later this year with investors focused squarely on synchronized reaccelerating global growth. Highly-sensitive growth indicators are surging: South Korean exports are on fire, the Baltic Dry Index, lumber prices and a long forgotten global growth barometer, Brent oil prices, are breaking out (Chart 1). This suggests that S&P 500 profits are well positioned to continue expanding at a healthy clip, underpinning prices. Firming economic growth will eventually show up in inflation. In the U.S., empirical evidence signals that expanding real output growth usually does lead to a pickup in core CPI, albeit with an 18 month lag (top panel, Chart 2). A tightening labor market also corroborates this data. As the year-over-year change in the unemployment rate recedes, inflation typically rises, again with a 6 quarter lag (unemployment rate shown inverted, second panel, Chart 2). Finally, the bottom two panels of Chart 2 show the Cleveland Fed's Inflation Nowcasting1 series as a 3-month annualized rate of change in core CPI and core PCE. Both point to a continued rise in inflation. This inflation backdrop is significant as it will likely sustain the corporate sector's pricing power gains. Chart 3 updates our corporate sector pricing power proxy and the related diffusion index. We also update the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. Selling prices are recovering at a time when wages remain stable. Taken together, out margin proxy indicator suggests that the ongoing profit margin expansion phase has more legs (bottom panel, Chart 3). Chart 1Vibrant Global Growth Chart 2Inflation Comeback? Chart 3Margins Should Expand Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power This analysis shows that 75% of the industries we cover are able to raise selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-June update. The outright deflating sectors dropped by one to 15 since our last update, but are still up from the 14 figure registered in April. Encouragingly, only 12 industries are experiencing a downtrend in selling price inflation, a decrease of 7 since our late-June and April reports. Chart 4Cyclicals Have The Pricing Power Advantage Moreover, 9 out of the top 12 industries with the highest selling price inflation are deep cyclicals/commodity-related (Chart 4), highlighting that the fall in the U.S. dollar is aiding the commodity complex to increase prices. The bottom of the table is equally split between 5 deflating tech industries and 5 consumer discretionary sectors. In sum, corporate sector pricing power is recovering painting a positive sales growth backdrop for the coming months. This will also prop up operating leverage, as we have been suggesting,2 as will still modest wage inflation. All in all, we envision a sound profit margin and EPS growth outlook for the back half of the year. This week we are executing a further early cyclical downshift to our portfolio. Consumer Discretionary Juggernaut Is Over Since the fed funds rate hit the zero line in December 2008, the S&P consumer discretionary index is not only the best performing GICS1 sector, but it is also the best performing asset class globally. In fact, it has risen by over 384% since December 1, 2008, nearly double the S&P 500's return. Even if one recalculates the GICS1 sector returns since the March 2009 broad market trough, U.S. consumer discretionary stocks still come out on top. Interestingly, relative performance bottomed in July 2008 (Chart 5), roughly two months before Lehman's collapse and in advance of that autumn's trough in deep cyclicals/China & EM levered equity plays. Simply put, U.S. discretionary equities sniffed out a massive reflationary impulse. This sector is extremely sensitive to interest rate changes and the quick slashing of the fed funds rate to zero and undertaking of unconventional monetary policies worked in their favor. Fast forward to today and our sense is that there are high odds that the consumer discretionary juggernaut is over and thus we are downgrading exposure to neutral. The Fed last week announced the commencement of the renormalization of its balance sheet. If consumer discretionary stocks are the ultimate beneficiaries of zero interest rate policy and the quantitative easing experiment, the unwinding of these emergency policies should also work in reverse (Chart 5). In other words, a winding down of the Fed's balance sheet and a rising fed funds rate should eat into consumer discretionary relative returns (top panel, Chart 6). Chart 5Mind The Fed's Balance Sheet Chart 6Rates, Money Growth... Money growth has also taken a backseat. M1 money supply is decelerating and so is M2 growth. Historically, money creation and relative performance have been joined at the hip and the current message is to lighten up on discretionary stocks (bottom panel, Chart 6). Beyond tighter, at the margin, monetary policy capping this early cyclical sectors future returns, energy inflation is also working against the S&P consumer discretionary index. The recent knee-jerk jump in retail gasoline prices will dent consumer disposable incomes as higher prices at the pump act as a tax on consumers. Our consumer drag indicator, capturing both rising interest rates and gasoline prices, is weighing on relative performance momentum (bottom panel, Chart 7). Nevertheless, there are some sizable positive offsets preventing us from downgrading exposure all the way to underweight. Recovering household net worth has historically been a boon for discretionary consumer outlays (second panel, Chart 8). Consumers feeling more flush, coupled with the jump in confidence, typically underpin real PCE growth. Tack on the fresh all-time highs in real median incomes, with the latest two year period registering the highest income gains since the history of the data, and the ingredients are in place for sustained gains in consumer spending (third & bottom panels, Chart 8). Finally, relative valuations and technicals have unwound previously expensive and overbought conditions, respectively. The S&P consumer discretionary forward P/E currently trades at a mild discount to the broad market and below the historical mean, and our Technical Indicator still hovers near washed out levels (Chart 9). Chart 7...And Energy Prices Weigh##br## On Consumer Discretionary Chart 8Positive ##br##Offsets... Chart 9...With Washed##br## Out Technicals Bottom Line: Adding it up, the Fed's historic exit from unconventional monetary policies, coupled with higher interest rates and gasoline prices, which are all income sapping, signal that only a benchmark allocation is warranted in the S&P consumer discretionary sector. We are executing this downgrade to neutral by trimming the media heavyweight sub-index (comprising cable & satellite and movies & entertainment) to a benchmark exposure. Intermittent Cable Signal Similar to the broad consumer discretionary index, cable & satellite stocks have been on a tear since troughing at the onset of the Great Recession. The more defensive in nature cable-related spending served as a catalyst to push up relative performance to all-time highs (Chart 10). This defensive industry backdrop is also evident in the positive correlation between the U.S. dollar and relative share prices. Empirical evidence shows that over the past three decades cable stocks outperform during dollar bull markets and suffer during periods of U.S. dollar weakness (Chart 10). Synchronized global growth is allowing other G10 central banks to play catch up to the Fed, which raised rates for the first time this cycle in December 2015. As a result, this looming coordinated G10 tightening monetary policy backdrop has forced investors out of the greenback. Given that the cable & satellite index sources nearly 100% of its revenues domestically, in a relative sense, the year-to-date U.S. softness is negative for sales/profits (Chart 10). On the industry operating front, there are some demand cracks forming. Cable outlays are trailing overall PCE and are anchoring relative share price momentum (middle panel, Chart 11). This message is corroborated by the softness in the ISM services survey that has been negatively diverging from ISM manufacturing. Waning services demand has historically been a bad omen for relative profit growth. At a minimum, a leveling off in the V-shaped recovery in sell-side analysts relative EPS expectations is in order (bottom panel, Chart 11). Chart 10Dollar Blues Chart 11Demand Softening Worrisomely, recent comments from Comcast that subscriber losses in the current quarter will likely erase all of last year's gains are disconcerting. This anecdote also confirms that demand for cable services is failing. The second panel of Chart 12 shows that real cable spending peaked in early 2014 and since then has been continually losing traction. If it were not for the successful offset from price hikes, cable companies would be in dire straits. The cable operators' ability to lift selling prices is undeniable and unmatched with a multi-decade track record, and remains solid despite the plethora of industry woes of late (Chart 13).Recent chatter that Charter Communications is about to be gobbled up is another factor underpinning cable pricing power. Additional industry M&A activity will take supply out of the market; recall that Charter bought out Time Warner Cable last year with positive industry pricing power results. The implication is that industry sales will remain resilient. Chart 12Margin Squeeze Alert Chart 13But Pricing Power And Valuations Are Tailwinds Tack on compelling relative valuations with the relative price-to-cash flow ratio probing 5-year lows and the industry's threats are likely well reflected following the recent derating phase (bottom panel, Chart 13). Netting it all out, a more balanced cable industry profit backdrop is signaling that only a neutral stance is warranted in this media sub-index. Bottom Line: Downgrade the S&P cable & satellite index to neutral and lock in gains of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CBST - CMCSA, CHTR, DISH. Movies & Entertainment: Intermission Similar to the S&P cable & satellite downgrade to neutral, the S&P movies & entertainment media sub-index no longer deserves an overweight and we recommend trimming exposure to neutral. Cord cutting is not a new phenomenon and content providers have been regrouping in order to fend off cutthroat competition from Netflix and similar outfits. This is a secular industry force that traditional media outlets must embrace and adapt to rather than be ground down by inertia. M&A activity has been a key defense mechanism for this sector and share count retirement explains a sizable part of the torrid relative performance since the Great Recession (Chart 14). This source of industry support is in late stages on the eve of the mega deal involving Time Warner. Demand for movies and entertainment has also come under pressure lately as depicted by the deceleration in recreation PCE. The softness in the ISM services survey is a yellow flag (Chart 15). The hurricane catastrophe is disquieting in the near-term, especially given the unintended consequence of the spike in gasoline prices. Historically, rising prices at the pump eat into demand for recreation activities (third panel, Chart 15). Chart 14End Of Share Retirement? Chart 15Decreasing Demand... In a broader context, when overall media-related consumer outlays suffer a setback, as is currently the case, relative forward profit estimates tend to follow suit and vice versa. The implication is that the earnings-led decline in relative share prices likely has more room to fall (bottom panel, Chart 15). All of this is transpiring in softening industry pricing power. While selling prices are still expanding, the growth rate has been cut in half since peaking early last year. Input cost inflation is not offering any positive offsets. Chart 3 showed that our broad based wage inflation diffusion index is plunging, but movies & entertainment executives have been fighting for talent, boosting industry wage growth. Taken together, they are sending a negative signal for sky high margins that appear vulnerable to a squeeze (Chart 16). Nevertheless, there is some light at the end of the tunnel for this media sub-group. Disney recently announced that it would pull content out of Netflix and start its own streaming service, disintermediating its core movie and sports (ESPN) content. Content providers in general are also working on introducing/beefing up their own streaming services options in order to better compete with online-only rivals. Live television (news and sports in particular) are still a near-monopoly that traditional media content providers are working hard to preserve. Moreover, diversified business models also assist in cushioning the cord cutting secular decline in the content business segments. Importantly, consumer confidence is pushing decade highs and will likely make all-time highs prior to the end of the business cycle. Historically, relative performance and consumer sentiment have been positively correlated for the better part of the past 22 years. Currently, a wide gap has opened and there are good odds of a catch up phase in the former (top panel, Chart 17). Chart 16...Showing Up In Loss Of Pricing Power Chart 17Cheap With Low EPS Growth Hurdle Finally, we refrain from turning very negative on this index as we deem that most of the bearish news is already reflected in historically inexpensive valuations on below par relative sales and EPS 12-month forward expectations (middle & bottom panels, Chart 17). Bottom Line: Downgrade the S&P movies & entertainment index to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.clevelandfed.org/our-research/indicators-and-data/inflation-nowcasting.aspx 2 Please see BCA U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?" dated April 17, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights The Fed still wants to hike in December and thrice next year, but euro area inflation could roll-over versus the U.S. This could cause some weakness in EUR/USD. Long USD/JPY remains a cleaner way to capitalize on the Fed and on higher U.S. bond yields. U.K. trend growth is falling, this will limit how high the BoE will push interest rates up. While the pound can rebound further until year-end, it is not as cheap as it may currently look. AUD/NZD could move back toward parity, but be patient before shorting this cross. Feature The Fed Is On, The Dollar Will Strengthen The dollar bear market is likely over for now, but in our view, U.S. inflation still needs to bottom meaningfully for the DXY to be able to move above 95, and for EUR/USD to trade below 1.15. We expect inflation to bottom late in the fourth quarter, and noticeably re-accelerate in 2018. For now, markets will have to fully price a December rate hike from the Federal Reserve and handle the fallout of a potential slowdown in euro area inflation in the coming months. Moreover, the European Central Bank's tapering announcement next month has been well telegraphed, and is likely to be fully priced in a euro already trading well above levels implied by interest rate differentials. Fed Chair Janet Yellen and the Fed's economic projections have been unequivocal: Governor Lael Brainard has not convinced the rest of the FOMC that U.S. inflation expectations are becoming unmoored to the downside. As a result, the Fed still plans to hike in December and still expects to lift U.S. interest rates thrice next year. The committee also continues to foresee inflation returning to 2% in 2019. The market got the message: on Wednesday, the dollar experienced its strongest rally in eight months, and bond yields moved higher. New evidence is also accumulating that U.S. core CPI will soon trough. This week, U.S. non-oil import prices, a key input to non-oil goods prices continued to increase and the Philly Fed survey's prices-paid and price-received components both showed improvement - corroborating the message from the ISM price paid, which has shot up to 62. This should give Wednesday's message from the Fed more credence among investors. Meanwhile, euro area growth remains very strong, but there are early signs that core inflation may be peaking. BCA's euro area core CPI diffusion index has rolled over and fallen below 50%, normally a precursor sign to a top in core CPI (Chart I-1). Moreover, the strength in EUR/USD is redistributing previous U.S. deflationary pressures into the euro area. As Chart I-2 illustrates, the tightening in euro area financial conditions relative to the U.S. points to a rollover in relative inflation trends. Chart I-1Euro Area CPI Peaking? Chart I-2Euro Area Core CPI Peaking Against The U.S. The market is still pricing far too little in the way of rate hikes in the U.S. over the next two years, while it is pricing the ECB appropriately, anticipating a 2019 lift-off of euro area policy rates (Chart I-3). This leaves the EUR/USD quite vulnerable if the market reassesses the Fed's capacity to lift rates, as this pair continues to trade at a level of premium to interest rate parity models last recorded in 2009 (Chart I-4) - premia that have historically been followed by declines over the following six months, averaging 6%. Chart I-3The Potential For A Repricing Of The ##br##Fed Relative To The ECB... Chart I-4..Will Hurt ##br##EUR/USD The yen too remains at risk. The yen might be cheaper than the euro, trading in line with its interest rate-implied fair value, but it is also burdened by a central bank inclined to leave policy as easy as possible for as long as possible. In fact, new Bank of Japan board member Goshi Kataoka dissented this week because, in his view, Japan needs more easing, both fiscal and monetary. Thus, in an environment where the Fed is trying to lift interest rates and where U.S. Treasury yields trade well below fair value (Chart I-5), the yen could suffer greatly as interest rate differentials move in favor of the USD, since the BoJ will still cap JGB yields for an extended period. Moreover, on the political front, an October election is becoming increasingly possible. Japanese Prime Minister Shinzo Abe's popularity has rebounded, and the opposition is in disarray, pointing to a very likely win for the LDP. Abe is seeking a new mandate as he wants to set a referendum to amend the Japanese constitution, removing its pacifist bias in order to increase military spending, which has greatly lagged that of rival China (Chart I-6). The North Korean crisis is obviously beneficial to this goal, and Abe wants to capitalize on it. Chart I-5Biggest Problem For The Yen Chart I-6Abe Wants To Rectify This Gap In order to increase the likelihood of a successful referendum, we anticipate Abe to push for more stimulus to goose the economy. Additionally, when Japanese wages are adjusted for the change in the breakdown between full-time and part-time positions, wage growth has already picked up significantly - well above 3% compared to a paltry 0.4% annual rate for the headline measure. This combination of potential fiscal stimulus, improving underlying wage growth and a staunchly dovish central bank could ultimately put upward pressure on inflation expectations, and thus downward pressure on Japanese real yields. This could further augment the negative impact of rising U.S. bond yields on the yen. Bottom Line: The dollar is set to appreciate against the euro and the yen in the coming weeks. The Fed has not deviated from its message and it still intends to follow the path set in the "dot plot." Meanwhile, euro area inflation could roll over, limiting how close to today markets can bring forward the first hike from the ECB. The euro is too expensive to withstand this eventuality. The BoJ in unwilling to abandon its current extremely dovish policy, setting the stage for additional yen weakness in the face of higher U.S. bond yields. GBP: As Cheap As It Seems? GBP/USD is currently trading at a large 20% discount to its purchasing parity equilibrium rate, and the trade-weighted pound is 10% below our long-term fair value estimate (Chart I-7). Since valuations have been strong predictors of currency returns on a two- to five-year horizon, this begs the following question: Is the pound a buy? Tactically, yes, the GBP still offers upside for the next three months or so, especially vis-à-vis the euro. The Brexit negations are likely to lead to long transition periods for FTAs after the U.K. leaves the EU. Moreover, interest rate markets currently assign a 65% probability of a hike by the Bank of England in November. However, recent communications from BoE Governor Mark Carney and his colleagues suggest the British central bank will hike that month. House prices have regained some composure and wage growth has rebounded to 2.2% after hitting a low of 1.7% six months ago, explaining some of the recent strength in retail sales. Inflation remains sticky at 2.9% per annum, and even the non-tradeable sector, where the pound's movements should bear little influence, continues to experience elevated inflation readings. This would support Carney's recent assertion that the U.K.'s output gap is closing faster than the BoE originally anticipated. It also raises question marks as to whether long-term inflation expectations in the private sector are beginning to become unanchored - something that would justify removing monetary accommodation from the system. Beyond this time horizon, the picture becomes more complex. The problem for the pound arises from the fact that the earlier-than-expected closure of the output gap is first and foremost a reflection of falling trend growth, a phenomenon that will continue well into the future. It is one of the inevitable consequences of last year's Brexit vote. Brexit principally impacts trend growth by depressing the U.K.'s labor force growth. As Chart I-8 illustrates, pre-Brexit, the U.K. experienced much more robust labor force growth than its EU peers thanks to a steady inflow of immigrants. However, at its core, the Brexit vote was a referendum on immigration. The U.K. government's hard stance on rejecting free movement of people going forward demonstrates that the Conservatives understand this, and it will remain a key pillar of their strategy going forward. Chart I-7Is The Pound Really That Cheap? Chart I-8U.K. Trend Growth Will Fall Problematically, leaving the EU will not improve the British trade balance, despite the fall in the pound. It may even hurt it. The fall in the pound can marginally help the U.K.'s goods balance with the EU, which currently stands at a deficit of 5% of GDP. However, this deficit is structural and reflects the U.K.'s lack of competitive advantage in manufacturing vis-à-vis the rest of the EU. Thus, a fall in the pound will do little to fully redress this gap. Meanwhile, the U.K. runs a surplus of 1.3% of GDP in the services balance (Chart I-9). However, by leaving the EU, the U.K.'s service sector is likely to lose much access to the continent as trade in services is heavily regulated, and creating new trade deals on services between the U.K. and the EU will prove a difficult process. Moreover, this services balance seems insensitive to the gyrations in EUR/GBP. Thus, while leaving the EU might marginally help the goods balance thanks to a lower pound, this exchange rate benefit will be nullified by a loss of access to EU markets by U.K. service sector firms. Why does a lower trend growth matter for the pound in the long run? The U.K. has been running a large current account deficit for 20 years. Even at 3.9% of GDP, this deficit does not have to be a problem if it can be financed. Thankfully, the U.K. has benefited from a higher level of neutral interest rates, itself a function of Britain's higher trend GDP growth. This higher neutral rate means the U.K. has been able to enjoy higher interest rates in general than the EU or the U.S. (Chart I-10). These higher returns have attracted the necessary capital to finance the current account. Chart I-9A Lower Pound Will Not Undo##br## The Pain Of Leaving The EU Chart I-10Lower Trend Growth Equals##br## Lower Terminal Rate Going forward, lower trend growth will lower the neutral interest rate, which will limit both the terminal rate hit by the BoE this cycle as well as the average level of rates in the U.K. In this context, the U.K. will need a permanently cheaper pound to finance its current account deficit. As a result, the apparent cheapness of the pound on long-term valuation metrics may prove to be nothing more than an illusion. Chart I-11Will Higher GBP Volatility Hurt London? The other problem that could negatively affect the pound is that the U.K. remains a global financial center. Historically, having low exchange rate volatility has helped financial centers achieve the pre-requisite level of stability needed to attract foreign capital (Chart I-11). However, the pound's volatility has increased in the aftermath of Brexit. If realized volatility was computed from 2000 to 2015, the standard deviation of the pound's returns rank below that of the Swiss franc and the Norwegian krone; if the sample is expanded to today, its volatility ranks above that of the CHF and the NOK. Not only does this point to a large increase in the relative volatility of the pound in the interim two years, but this trend could continue in the future, especially if as our Geopolitical Strategy sister service argues, the leftward-shift in the U.K.'s median voter could lead to a Corbyn Premiership down the road.1 Bottom Line: The pound still has upside in the short-term as markets re-assess the path of the BoE toward a rate hike this year, removing the emergency easing implemented in the wake of the last year's referendum. However, the long-term outlook for the pound is trickier. The GBP's apparent cheapness is warranted. The U.K.'s potential growth rate is falling, which will drag down the country's neutral interest rates. As a result, the BoE will not be able to increase interest rates much over the course of the cycle. This means that financing the U.K.'s current account deficit will require the pound to remain cheap for an extended period of time. AUD/NZD: The RBNZ Can Tighten More Than The RBA The AUD/NZD is likely to experience a move toward parity over the next six months. Currently, AUD/NZD trades approximately 10% above its long-term fair value (Chart I-12, left panels), a level that has historically resulted in sharp reversals. This cross is also trading at a significant premium to our Intermediate-Term timing model (Chart I-12, right panels), further highlighting the medium-term downside risk for the aussie/kiwi. Chart I-12AAUD/NZD Is Expensive Chart I-12BAUD/NZD Is Expensive Valuations are not the only consideration raising a red flag for AUD/NZD. Relative monetary policy dynamics could also weigh on this cross going forward. As the Reserve Bank of New Zealand has been trying to talk down the kiwi, interest rate markets are pricing in 34 basis points of hikes over the next 12 months, while they expect the Reserve Bank of Australia's Cash Rate to increase by 41 basis points over the same timeframe. We think the RBNZ has more room to tighten policy than the RBA, especially as our central bank monitor is much more hawkish on New Zealand than Australia (Chart I-13). Corroborating the message of this indicator, the New Zealand output gap is now at 0.9% of potential GDP while it stands at -1.6% in Australia, suggesting more pronounced underlying inflationary pressures in the smaller economy. Moreover, New Zealand's growth is outpacing Australia's by nearly 1%, and relative LEIs suggest no end in sight for this trend. Thus, the relative output gap between the two countries will continue to move in favor of a tighter RBNZ than RBA. Additionally, Australia house prices have been in a cyclical downtrend versus New Zealand, depreciating nearly 15% in relative terms since 2011. This is resulting in a large underperformance of Australia's credit growth against New Zealand, which points to downside risk in AUD/NZD (Chart I-14). Mirroring these two factors, Aussie retail sales are lagging their neighbors by a near-record 3% annual pace. Beyond domestic conditions, terms-of-trade dynamics are also a negative for AUD/NZD. This cross tends to mimic movements in the prices of metals relative to dairy prices, reflecting the composition of the two nations' exports. Since May this year, metals have been outperforming milk, but AUD/NZD has massively overshot this driver (Chart I-15), exposing the cross to a reversal in relative commodities prices. Going forward, with Chinese monetary conditions tightening, with Chinese fiscal stimulus waning, and with EM money growth sharply decelerating, metals prices, which are much more sensitive to global industrial activity, are likely to underperform the less growth-sensitive dairy prices. Chart I-13The RBNZ Needs To be More##br## Hawkish Than The RBA Chart I-14Disconnect Between AUD/NZD##br## And Relative Credit Growth Chart I-15AUD/NZD Out Of Line ##br##With Terms Of Trade Technically, it is too early to enter this bet with any degree of certainty. Short-term momentum metrics are deeply oversold, and AUD/NZD, currently trading at 1.085, could rebound once it moves to 1.08 - the next key support level and slightly above the 50% retracement of the rally begun in June. This rebound could lift AUD/NZD close to the 1.11 neighborhood. Thus, we will wait for a better entry point to begin shorting this cross, especially as this weekend's election remains too close to call despite a recent rebound in the National Party. A Labour/NZ First coalition could cause a temporary sell-off in the NZD. Bottom Line: AUD/NZD is very expensive, and the market is underestimating the risk that the RBNZ will tighten policy more than the RBA over the next 12 months. The New Zealand economy has much less slack and is growing more strongly than Australia's, pointing to greater inflation risk. Additionally, metals prices are likely to underperform dairy prices, which will hurt Australian terms of trade relative to New Zealand. Technically, a better opportunity to short AUD/NZD is likely to emerge in the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The highlight of this week was the Fed's Monetary Policy meeting, where the FOMC announced the unwinding of the Fed's US$4.5 trillion balance sheet in October. It also intend to boost in interest rates in December, with the probability of a hike that month now at 63%. This is likely to move to 100%. While data continued to be mixed this week - existing home sales slowed but the Philly Fed survey was very strong, the Fed decided to ignore this as well as the potential impact of hurricanes, instead concentrating on the strong fundamentals underpinning the U.S. economy. Interest rates will therefore increase alongside inflation, providing a fillip for the greenback. On the fiscal side, tax cuts seem increasingly likely to be implemented. As investors begin to price out fiscal policy disappointments, the dollar will rally. Nevertheless, inflation is likely to pick up some time in 2018, and the dollar will fully bloom then. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data continues to outperform expectations: Core CPI, unchanged at 1.3%, beat expectations of 1.2%; Headline CPI also remained unchanged at 1.5%; German ZEW Economic Sentiment outperformed greatly coming out at 17.0, while the Current Situation also outperformed at 87.9; German producer prices grew at 2.6% annually, outperforming expectations of 2.5%. While the euro traded positively on the news, it lost most of this week's gains due to the Fed policy decision. We believe that sustained growth in the euro area will sustain the euro between 1.15 and 1.20. However, a pickup in U.S. inflation in 2018 could push EUR/USD toward 1.10. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth underperformed to the downside, contracting by 7.5%. The contraction also accentuated from July to August. Domestic corporate goods price yearly growth also underperformed, coming in at 2.9%. However both export and import growth outperformed expectations, coming in at 18.1% and 15.2% respectively. Additionally the merchandise trade balance in August also outperformed, coming in at 113.6 Billion yen. The Bank of Japan decided to leave their policy rate unchanged at -0.1% on Wednesday on an 8 to 1 vote, with dissenter Goshi Kataoka presenting an even more dovish slant. The BoJ highlighted that the economy continues to expand moderately, and that inflation should continue to slowly grind higher. Overall we are more bearish on the ability of the BoJ to spur inflation without a meaningful depreciation in the yen. Continue to long USD/JPY. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Fade North Korea, And Sell The Yen - August 11, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has surprised to the upside: Retail sales growth and retail sales ex-fuel growth outperformed expectations coming in at 2.4% and 2.8% respectively. Manufacturing production yearly growth came in at 2.9%, also outperforming expectations. Furthermore the ILO unemployment rate came in at 4.3%, outperforming expectations. The BoE left rates unchanged in their latest interest rate decision by a majority of 7 to 2. The BoE was more hawkish than expected, commenting that monetary policy could need to be "tightened by a somewhat greater extent over the forecast period than current market expectations". Overall we continue to be positive on the pound relatively to the euro. However on a longer term basis, the outlook for the pound remains tricky, as Brexit could result in a lower neutral rate in the U.K., and thus a lower pound. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD fell sharply following RBA Governor Philip Lowe's speech. Lowe stated that "a rise in global interest rates has no automatic implications for us here in Australia", prompting a repricing of Aussie rates. The high level of household debt was also brought to light, with Governor Lowe highlighting that "household spending could be quite sensitive to increases in interest rates, something the Reserve Bank will be paying close attention to." He also surmised that "there are risks on the horizon, with the Chinese economy going through some difficult adjustments". This speech largely confirms are bearish view on the Australian dollar. While the AUD did rally this summer, this was mostly due to disappointing U.S. inflation. When inflation re-emerges, which we believe will be in early 2018, the AUD could give up most of its gains. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Electronic card retail sales yearly growth increased to 4.4% from 2% the month before. Gross Domestic product yearly growth came at 2.5%, in line with expectations. Meanwhile the current account outperformed to the upside, coming in at a deficit of 2.8% of GDP, compared to expectations of 3%. Finally the Business NZ PMI came in at 57.9, increasing significantly from last month's reading of 55.4. The kiwi has appreciated in the past 2 weeks, as a weak dollar coupled with positive data in New Zealand and falling political risk in that country have helped the currency. At the present, we are bearish on AUD/NZD, as the inflationary backdrop continues to be more positive in New Zealand than in Australia. Meanwhile iron ore prices seem to have peaked. These factors should weigh on this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian consumer sector remains strong, with wholesale sales increasing at a 1.5% monthly pace in July, beating the expected 0.9% contraction. Higher rates are also increasing portfolio inflows, as foreign portfolio investment in Canadian securities jumped to CAD 23.95 bn in July, from the previous outflow of CAD 0.86 bn, also larger than the expected CAD 4.46 bn. While the CAD depreciated against the USD following the Fed's monetary policy meeting, it remained largely flat against other G10 currencies. The CAD will continue to fight headwinds against the USD but to rally on its crosses. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Producer price inflation came in at 0.6%, beating expectations. The trade balance came in at 2.713 billion CHF for the month of August, underperforming expectations. A week ago the SNB left rates unchanged as expected. Most importantly, there was a slight upward revision in the inflation forecast, with the SNB anticipating an inflation rate of 0.4% in 2018 and 1.1% in 2019 compared to the previous forecast of 0.3% and 1%. These forecast assume a 3-month LIBOR of -0.75% through the forecast period. Moreover, the central bank also expects the modest recovery in Switzerland to continue. However, it seems that the floor under EUR/CHF will stay for the time being, as the SNB said that the Swiss Franc continues to be "highly valued" and that that continued intervention in the FX market will continue to be necessary. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Despite a rebound in Norway's economic surprise index, Norway continues to experience a marked lack of inflation: Headline inflation came in at 1.3%, decreasing from last month's reading of 1.5% and underperforming expectations. Core inflation also underperformed expectations, falling from 1.2% last month to 0.9% in the latest data point. Yesterday the Norges Bank decided to keep rates unchanged at 0.5%. The bank released a statement highlighting that capacity utilization is "on the rise, and higher than previously assumed", however they also highlighted that "wage growth will remain moderate". More importantly they signaled that they would likely increase rates somewhat earlier than previously expected. Overall we continue to be bullish on USD/NOK, as interest rate expectations should help the dollar against the krone. That being said, higher oil prices should help the krone outperform its commodity peers and the euro. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has remained flat for a month, as markets are assessing the situation between the two hawkish central banks. Data in Sweden has disappointed recently: Manufacturing PMI went down to 54.7 from 60.4; The current account decreased by SEK 39.5 bn; Industrial production also grew by 5.3% annually, lower than the previous 8.9% figure; New orders are also growing by less than before at 2.1%; Inflation also underperformed the expected 2.2%, coming in at 2.1%; However, the unemployment rate dropped significantly from 6.6% to 6%. While inflation disappointed, it still remains in the target range and the upward trend is still intact. The Swedish economy is performing very well, and the Riksbank is likely to join the Fed and the BoC in hiking rates next year. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
Highlights Dear Client, We will not be publishing next week, as BCA Research's Investment Conference is being held in New York City. We will be back the following week with a Special Report on global agricultural markets, and a recap on the performance of our 3Q17 recommendations. Kind regards, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Our new supply-demand balances indicate OPEC 2.0 will have to extend its production cuts to June 2018 to meaningfully reduce global oil inventories, even with demand growth exceeding 1.60mm b/d this year and 1.70mm b/d next year. This will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. We continue to expect Brent to trade to $60/bbl by year-end 2017, and for WTI to trade ~ $3.00/bbl under that. Higher prices will incentivize higher production from U.S. shale operators. This is a risk OPEC 2.0 will have to manage, as it develops a modus operandi that allows it to co-exist with shale and still maintain adequate revenues for its member states. Energy: Overweight. We are taking profit on our Brent options positions at today's close, since December options will have only three weeks to trade when we return. These positions, recommended in May and June, were up 116.3% on average by Tuesday's close. We will initiate positions in May and December 2018 Brent call spreads, going long the $55/bbl strike vs. short the $60/bbl strike at tonight's close. Base Metals: Neutral. Our tactical COMEX copper short is up 5.5% since inception on September 7. Precious Metals: Neutral. Our long COMEX Gold hedge is up 6.2% since it was initiated May 4, 2017. We are retaining the position as a strategic portfolio hedge. Ags/Softs: Underweight. Corn is having a tough time holding a bid following last week's USDA's Crop Report, which called for higher production and ending stocks, and lower prices. We will be updating our global ags assessment in a Special Report October 5. Feature OPEC 2.0 will have to extend its 1.8mm b/d production cuts to end-June 2018, in order to bring global inventories closer to levels it considered necessary to clear the market when it embarked on its 1.8mm b/d production-cutting Agreement at the end of last year, based on our most recent supply-demand balances modeling (Chart of the Week). Chart of the WeekOPEC 2.0 Needs To Extend Cuts,##BR##To Reduce Global Inventories As a result, our base case for balances reflects the OPEC 2.0 Agreement being extended to end-June (Chart 2). As we noted in our assessment last week, compliance with the OPEC 2.0 production-cutting Agreement remains high.1 All told, we see global production growing 0.83mm b/d this year, and 2.13mm b/d next year, based on our expectation of the OPEC 2.0 Agreement being extended to end-June. On the demand side, our most recent assessment of global demand leads us to expect growth of 1.62mm b/d this year and 1.72mm b/d in 2018 (Table 1). Chart 2Base Case For BCA Oil Supply-Demand Balances Reflects June 2018 Expiry Of OPEC 2.0 Cuts Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Fundamentals Point To Higher Oil Prices Based on our latest assessment of the global oil market, we believe OPEC 2.0 will fall short of reducing visible inventories back to their 5-year average levels if the coalition's production-cutting agreement expires at end-March 2018 (Chart of the Week, top panel). In fact, we believe that the Agreement will have to be extended to at least June 2018 - assuming no change in OPEC 2.0 country-specific production quotas - in order to draw OECD inventories down to their 5-year average levels (Chart of the Week, middle panel). An extension of the cuts to December 2018 would push OECD commercial inventories closer to levels originally targeted by OPEC 2.0 when its Agreement was reached at the end of last year. There is a higher risk prices will exceed the upper end of the range we assume WTI will trade in - $45/bbl to $65/bbl - with greater frequency next year, given we expect WTI prices will average slightly less than $57.50/bbl and Brent prices will average just under $59.00/bbl. Given the draws we expect in global inventories, the likelihood the WTI forward curve trades in backwardation next year also is elevated. We expect Brent to continue to trade in backwardation next year, which we believe will benefit OPEC 2.0 member states, since it allows them to realize higher spot prices - against which term contracts mostly are written - and will limit the volume of hedging U.S. shale producers can effect. Given our updated balances, we re-estimated our oil fundamentals models, accounting for the higher demand we expect (Chart 3), and continued production restraint by OPEC 2.0 on the supply side (Chart 4). These are markedly different to the EIA's estimates. Chart 3BCA Expecting Stronger Oil Demand Than EIA Chart 4Oil Supply Evolution Under Different Scenarios Using these fundamental inputs, we derived forecasts for the WTI and Brent prices.2 The four scenarios we analyzed are: Expiry of OPEC 2.0 Agreement in March 2018; Expiry of OPEC 2.0 Agreement in June 2018; Expiry of OPEC 2.0 Agreement in December 2018; The U.S. EIA Short-term Energy Outlook (STEO) supply-demand assumptions. The estimated results are presented in Table 2 and Chart 5. Table 2Fundamentally Derived##BR##Price Expectations Chart 5Oil Prices Will Lift As OPEC 2.0##BR##Agreement Restricts Supply Interestingly, the 4Q17 WTI futures curve appears to be priced much closer to Scenario No. 4, the EIA's assumptions. This is something we have observed in the past - i.e., the market has a tendency to price to the EIA's supply-demand balances, in the short term. As far as we can tell, the EIA's estimates assume less steep cuts than we do, and appear to be projecting visible inventories will begin to rise starting next month - (Chart 6). Chart 6EIA Assumes OECD Inventories Will Rise Under the EIA scenario, the average WTI futures price for 4Q17 is $50.40/bbl. Under BCA Base Case Scenario, which assumes the OPEC 2.0 Agreement will be extended to end-June, we estimated WTI prices would average $54.00/bbl over the same period. For 2018, the divergence between the EIA and BCA base cases is even more dramatic: Under the EIA's assumptions, our fundamental model estimates WTI prices will average $45.55/bbl in 2018, while under our new base case scenario, which projects the OPEC 2.0 deal will be extended through June, we estimate WTI prices will average $57.44/bbl next year. In its September Short-Term Energy Outlook (STEO), the EIA substantially lowered its U.S. shale production growth estimates for this year. Our colleagues at BCA's Energy Sector Strategy highlight this revision in this week's report, noting that 3Q17 U.S. onshore production levels will be 540k b/d higher yoy, versus an earlier expectation of a 730k b/d increase. This represents a ~ 25% reduction in the yoy growth rate. In addition, EIA's forecasted 3Q17 quarter-on-quarter oil production growth was cut by 40%, with sequential production growth now estimated at 197k b/d.3 The EIA's estimate now is more in line with BCA's assessment. These revisions will be supportive of prices, once market participants realize the EIA's scaling back on its growth expectations. BCA Lifts Estimate Of Demand Growth In our revised supply-demand balances, we expect 2017 global oil consumption will increase 1.62mm b/d, while 2018 demand will be up 1.72mm b/d. This reflects the strong growth reported by the OECD, which we noted last week, and the IMF.4 Strong growth momentum also can be seen in the continued performance of world trade volumes (Chart 7). The trade expansion is led by EM economies, with EM Asia, Latin America and Central Europe all posting yoy growth of ~ 10% at mid-year. EM also drives most of global oil-demand growth (Chart 8).5 Chart 7Global Growth Reflected##BR##In Increased Trade Volumes Chart 8EM Import Volumes##BR##Remain Strong Our expectation is EM oil demand will grow 1.20mm b/d this year and 1.30mm next year, accounting for the bulk of the 1.62mm and 1.72mm of overall demand growth we expect in 2017 and 2018, respectively. We will continue to follow demand trends in EM closely, particularly China and India, given its importance to overall global oil demand growth. Backwardation Will Persist In Brent, Arrive Sooner In WTI The direct implication of our results is backwardation will become more pronounced going forward. In the Brent market, the forward curve is backwardated to the end of 1Q18 then pretty much flattens out, based on mid-week settlements. In the WTI curve forwards, WTI futures carry to June 2018 then backwardate slightly to the beginning of 4Q19. We expect both to backwardate next year as storage draws and markets tighten. We have maintained OPEC 2.0 member states would benefit from a strategy under which they manage production and storage in such a way as to backwardate Brent and WTI curves. This would allow member states to realize higher revenues from spot prices, which are referenced in long-term supply contracts and are received on outright spot sales, and limit the amount of hedging U.S. shale producers can do: Lower deferred prices are not as profitable for producers, since they result in less revenue per barrel hedge in the future. Upward-sloping forward curves - i.e., contango market structures - allow producers to hedged at higher prices in the future, providing higher revenues, assuming the starting point is the same as in a backwardated market. We expect that as 2017 winds down and we approach the end of 1Q18, it will become apparent to OPEC 2.0's leadership their production-cutting agreement needs to be extended in order to drain global storage and get prices to lift. This is particularly true for the Kingdom of Saudi Arabia (KSA), which most likely will IPO Saudi Aramco, the state-owned oil company toward the end of next year. If OPEC 2.0's production-management agreement is not extended and inventories do not draw sufficiently to lift prices and backwardate the Brent forward curve, KSA most likely will have to push its IPO into 2019. Given the country's keen desire to raise funds to support its diversification away from its oil dependency, we believe its leaders would prefer to get the funds raised by the IPO in the door and begin allocating them. Bottom Line: OPEC 2.0 will extend the expiry of its production-cutting agreement from end-March to end-June 2018. This will force global inventories to fall to levels closer to those expected when the coalition agreed to jointly manage production at the end of last year. Demand growth will exceed 1.60mm b/d this year and 1.70mm b/d next year. This, along with the extension of the OPEC 2.0 cuts to end-June, will lift average Brent prices to ~ $59/bbl and WTI to just under $57.50/bbl next year. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. 2 We estimate WTI and Brent prices for the balance of 2017 and 2018 with respect to their fundamentals. The adjusted R2 for the WTI and the Brent regressions are 0.89 and 0.92, respectively. 3 Please see BCA Research's Energy Sector Strategy Weekly Report "A Funny Thing Happened On The Way To The "Shalepocalypse," published September 20, 2017. It is available at nrg.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Hurricane Recovery obscures OPEC 2.0's Forward Guidance," published September 14, 2017. It is available at ces.bcaresearch.com. See also "A Firming Recovery," in the IMF's World Economic Outlook Update published July 24, 2017. We use IMF global GDP growth estimates as an input to our oil-demand modelling. 5 We have found EM imports to be a good explanatory variable for oil and base metals demand, as well as inflation in the U.S. and EU. Please see, e.g., BCA Research's Commodity & Energy Strategy Weekly Report "Trade And Commodity Data Point To Higher Inflation," published July 27, 2017. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights EM EPS growth is set to decelerate significantly and will likely turn negative in 2018 based on the China/EM money/credit indicators. All measures of Chinese broad money growth have fallen to a record low signifying a major growth slump. The two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields- are set to reverse. EM equities and credit markets relative performance versus their DM peers is about to relapse. A new fixed-income trade: receive 2-year swap rates in Mexico / pay 2-year swap rates in the U.S. Feature Last week we were on the road, meeting with some of our U.S. East Coast clients. This week we address some of the common questions we received. Q: Why do you think EM profits will relapse in the next six-to-nine months, given both global and EM growth continue to show strength? A: Our reluctance to change our view on EM risk assets in general and equities in particular has to do with EM/China business cycle/corporate profit indicators. Several indicators for EM profits - which have exhibited very good track records - presently forecast a material slowdown and possibly a contraction in EM EPS starting late this year and well into next year. In particular, China's broad and narrow money impulses lead EM EPS by about nine months, and are currently signaling that EPS growth is set to peak and begin to decline in the next nine months (Chart I-1). What's more, a few business cycle indicators from Korea and Taiwan, such as nominal manufacturing production and manufacturing shipments-to-inventory ratios, corroborate a peak in EM EPS growth (Chart I-2). Chart I-1EM EPS Is Set to Decelerate ##br##And Probably Contract Chart I-2More Signs Of Relapse##br## In EM EPS Growth Importantly, the EM corporate earnings slowdown will not occur in a vacuum. It will transpire amid a slowdown in Asian trade and lower commodities prices. In particular: China's broad money M3 impulse leads domestic industrial orders, nominal manufacturing production and imports (Chart I-3). Even though Asian export data were strong in August, China's container freight index signals a slowdown in Asian trade lies ahead (Chart I-4). Chart I-3China: M3 Impulse And Domestic Demand Chart I-4Asian Export Growth To Slow The Chinese broad money impulse also points to a rollover in Korean, Taiwanese, other EM as well as DM countries' shipments to the mainland (Chart I-5). This is how the slowdown in China's money/credit will hurt corporate profits in EM as well as in DM sectors with substantial exposure to Chinese growth. Besides, China's broad money impulse leads industrial metals prices in general and iron ore prices in particular (Chart I-6). This signifies downside risks to commodities producers. Finally, China's yield curve suggests that mainland manufacturing PMI will roll over after its recent ascent (Chart I-7). Chart I-5Shipments To China Are At Risk Chart I-6Industrial Metals Prices Have Peaked Chart I-7China: The Yield Curve And Manufacturing PMI In short, China has been gradually tightening monetary policy, which has already manifested in record-low broad money growth. The next phase is evidence of a material deterioration in sales and profits among China-exposed plays. The EM stock markets are unlikely to ignore it. Q: It seems you are putting a lot of emphasis on China's broad money M3 measure. Why do you look at your version of Chinese broad money M3 and not at official M2 and total social financing (TSF)? A: Over the past several months we have done a lot of research and analysis on China's money and credit, and believe that our broad money M3 measure and private and public credit aggregate calculated by BIS are presently better measures of money and credit than official broad money M2 and TSF: First, the TSF data have become distorted because of the local government financing vehicles (LGFV) debt swap program. Specifically, according to the LGFV debt swap mechanics, starting in 2015 provincial governments began issuing bonds that have been purchased by banks. The amount of bonds issued was RMB 3.2 trillion in 2015, RMB 4.9 trillion in 2016 and expected to be RMB 4.8 trillion in 2017. This amounts to total issuance of RMB 12.9 trillion since the commencement of the program. As the next step, local governments were supposed to transfer the proceeds from these bond issuances to their LGFVs, with the latter using the money to pay down their debt. The ultimate goal of the program is to shift the debt from LGFVs to provincial governments, as the latter's creditworthiness is much better than the former. This has also reduced interest rates on the debt as provincial governments borrow at lower interest rates than LGFVs. All that said, it is unclear how much of their debt LGFVs have repaid. The main problem with using TSF data is knowing the amount of proceeds from the issued debt swap bonds that were used to pay down LGFV debt. If the entire amount of these bonds issued by provincial governments was used to pay down LGFV debt, there would not be an impact on economic activity, and only a very short-term impact on money supply. When banks buy bonds from non-banks (including governments), they create new money. When debtors (including governments and their entities) pay down debt to banks, money is destroyed. Nevertheless, both official M1 growth and our measure of broad money (M3) were too strong in 2015 and 2016 – i.e., they remained strong much longer than would have been justified by the LGFV debt swap. Furthermore, private and public credit, M2 and M3 money measures have decoupled from TSF since the middle of 2015 (Chart I-8A). TSF adjusted for the LGFV debt swap – the latter is added to TSF – has also diverged from official M2, our broad money M3 and BIS’s private and public credit measures (Chart I-8B). This corroborates that TSF data can no longer serve as a reliable measure of credit/money origination. Chart I-8AChina: TSF Has Diverged From ##br##Other Money/Credit Measures Chart I-8BChina: TSF Adjusted For LGFV Debt Swap Has Also Decoupled From Money/Credit Measures Markedly, paying down debt by LGFVs should have reduced corporate debt outstanding by RMB 12.9 trillion, which would represent a 12% drop from the RMB 112 trillion outstanding at the end of 2015. However, corporate debt has continued to expand rapidly, even as government debt has surged. Given all of the above, we doubt all of the proceeds from bonds issued within the LGFV debt swap program were immediately used to repay LGFV debt. Instead, we suspect the proceeds from the bond issuance might have been at least partially invested into the economy in 2016, in defiance of the rules of LGFV debt swap operation. We played down the rise in M1 in late 2015 and early 2016 because we regarded it as temporary, reflecting the LGFV debt swap program. In retrospect, it was a mistake - this was one of the main reasons we did not heed the message from recovering money growth in early 2016 to turn cyclically positive on China's growth, and consequently on commodities and broader EM. Provided we do not know what portion of LGFV debt was repaid and when, corporate credit and total social financing data have become difficult to interpret. Chart I-8A and Chart I-8B demonstrate that TSF with and without the LGFV debt swap has diverged from private and public debt since the middle of 2015 when the LGFV debt swap program commenced. Apparently, one no longer can rely on TSF or adjust it by the amount of LGFV debt swap to gauge money and credit creation in China. In this context, the aggregate of private and public credit is a much more appropriate measure of credit provision and debt creation than TSF. The basis is because it includes both private and public debt. Indeed, the reshuffling of debt between local governments and LGFVs (the latter are treated as enterprises in China's banking statistics), does not affect either aggregate borrowing or amount of debt held in the economy. Second, when credit numbers are distorted, one needs to resort to money supply measures to judge credit dynamics. The reason is because financial engineering and, in the case of China, the LGFV debt swap program, can obscure the amount of outstanding credit, but they cannot conceal the amount of money banks create when they lend or purchase bonds or any other asset. Money is created when a bank originates claims on non-banks, and money is destroyed when a debt is paid back to the bank. Accordingly, money traces debt creation by banks. Banks can disguise their assets, and corporations and governments can conceal their liabilities, but none of them can camouflage the amount of money in circulation. In short, we trace money to gauge the amount of private and public sector borrowing from banks. This is why we have calculated various measures of money in China to overcome the shortcomings of the TSF. Specifically, we have calculated broad money M3 (see details of our calculation below) and credit-money. The latter is the sum of commercial banks' assets such as claims on non-financial institutions, claims on other financial institutions, claims on government and claim on other resident sectors and commerical banks' as well as the central bank's foreign currency assets. Chart I-9 demonstrates various measures of broad money and outstanding credit: official M2, our measure of broad money M3, our credit-money measure, and private and public debt (source BIS). Importantly, all measures of money and private and public credit suggest that credit origination/money creation was very strong in 2015 and 2016, and that it has slowed substantially in 2017. In brief, the message from various measures of money/credit is consistent. Chart I-9China: Money/Credit Growth Has Decelerated To New Lows Interestingly, broad money M3 rose by RMB 21 trillion in 2015, RMB 20 trillion in 2016 and by only RMB 16.5 trillion in the past 12 months through end of August. This is why the M3 impulse - a change in money flows - has turned negative since early this year. Third, we prefer our broad money measure M3 to official M2 because it is more consistent with the BIS's measure of private and public credit. It has also served as a better tool in forecasting the 2016-2017 recovery in Chinese growth. As can be seen in Chart 1, 3, 4, 5 and 6 on previous pages, the M3 impulse - its second derivative - has a great track record in forecasting China's business cycle dynamics. The acceleration in M2 growth in 2015-16 was milder than one would expect in order to achieve meaningful acceleration in nominal economic activity. M2 growth was more subdued than a rise in both private and public debt (Chart I-9). We suspect that M2 is no longer an encompassing measure of broad money in China, and therefore we have calculated other measures of broad money to gauge true money/credit creation. Chart I-10China: Consumer Price Inflation Is Rising Broad money consists of various liabilities of commercial banks. While the official M2 includes many of their liabilities such as corporate demand deposits, corporate time deposits and personal deposits. It does not include some others. We have added the following commercial banks' liabilities - transferable deposits and other deposits which are not included in M2, liabilities to other financial corporations and other liabilities - to M2 to produce a more all-inclusive measure of broad money M3. Q: Why can't the Chinese authorities stimulate and revive growth again, like they have done many times in the past? A: Of course, they can. However, if the authorities begin easing monetary/credit and fiscal policies now, it will affect growth six to nine months down the road. Based on money and credit indicators shown in the charts above, growth is set to slow over the next nine months because of the time lag that money/credit has on the economy. In the next six to nine months, economic activity and corporate profits are likely to decelerate considerably, based on the monetary/credit tightening that has already occurred in China. Provided China-related financial markets in general and EM risk assets in particular have so far not discounted the slowdown suggested by China's money/credit indicators, they are very vulnerable. Finally, the magnitude of the impending growth slump is likely to be large, as evidenced by the substantial decline in these money and credit indicators that has already occurred. In brief, policymakers have been tightening credit/money creation, and it has not yet impacted financial markets. Furthermore, inflation is rising in China (Chart I-10) and policymakers are unlikely to start easing before they witness a major growth slump. Until the latter becomes visible in economic data and on the ground, financial markets leveraged to mainland growth will sell off notably. Q: There is no indication that the Federal Reserve will turn hawkish. This will be especially true if global growth slows - as you argue it will because of China. Why do you expect the EM currency rally to peter out amid a dovish Fed? Historical empirical evidence suggests that EM currencies are often driven by commodities prices, not the interest rate differential over U.S. rates. Let's take the BRL and the ZAR as examples. Charts I-11A and Chart I-11B illustrate that the BRL and ZAR exchange rates versus the U.S. dollar have historically been closely correlated with commodities prices, not the level of or change in their interest rate differential over the U.S. Chart I-11ABrazil: What Drives The Currency? Chart I-11BSouth Africa: What Drives The Currency? This has also been true over the past 18 months. The rally in EM currencies since early 2016 can be largely attributed to the rise in commodities prices. As and when commodities prices roll over - as we expect to occur - the trade balances of commodities-producing nations will deteriorate, as will their currencies. Remarkably, there are tentative signs that the drop in U.S. bond yields and the greenback's depreciation are late and overdone. Two-year U.S. bond yields have bounced from their 200-day moving average (please refer to the middle panel of Chart II-1 in the Mexican section). Typically, such a technical profile leads to new highs. Our sense is that U.S. bond yields will rebound in the coming months, which will also weigh on EM currencies. Importantly, one of the drivers behind the U.S. dollar selloff since early this year has been the rise in banks' excess reserves at the Fed (Chart I-12). The latter was due to the debt ceiling, as the U.S. Treasury was running down its account at the Fed by issuing less paper. In short, since the beginning of this year the U.S. Treasury did not issue bonds/bills and deposit them at its Treasury General Account (TGA) at the Fed - meaning it was not destroying banking system reserves as it typically does. This boosted the supply of U.S. dollars - banks' excess reserves at the Fed rose by US$ 300 billion. More dollar supply depressed both the exchange rate and U.S. interest rates. Chart I-12 demonstrates that in the post-QE era, banks' excess reserves at the Fed have correlated with the U.S. dollar's exchange rate. The debt ceiling has been resolved for now, and the Treasury will now begin accumulating dollars in its TGA account again. It has already announced that its TGA will rise from $73 billion now to $400 billion at the end of this year. The Treasury will issue more paper, and deposit U.S. dollars in the TGA. This will shrink banks' excesses reserves. This, in tandem with the reduction in the Fed's balance sheet, will diminish banks' excess reserves. The latter will reduce U.S. dollar supply in off-shore markets and will likely trigger a U.S. dollar rebound. On the whole, the two pillars of the EM currency rally - strong growth in China that manifests in higher commodities prices and lower U.S. bond yields - are set to reverse. In turn, a potential EM currency selloff along with deteriorating EM corporate profits will likely weigh on EM equities and EM sovereign and corporate debt. Q: Does this mean EM stocks will relapse in absolute terms, or simply underperform the DM equity markets? Our strongest conviction at the moment is on EM relative equity performance versus DM equity markets. Odds are that a relapse in relative performance is imminent as and if U.S. bond yields rise (Chart I-13). Chart I-12U.S. Banks' Excess Reserves ##br##And The U.S. Dollar Chart I-13U.S. Stocks Outperform EM Ones When ##br##U.S. Bond Yields Are Rising In addition, U.S. stocks' underperformance versus the global equity index in common currency terms is at a technical support (Chart I-14, top panel), and will likely reverse as the dollar firms up. Historically, when U.S. stocks outperform the global benchmark in common currency terms - denoted by shaded periods in Chart I-14, EM stocks typically underperform the global equity index. The dynamics of EM equity absolute performance depends on investor's risk appetite. It will be hard for EM share prices to drop meaningfully as the DM rally persists. Global stocks are still trading well, and it is very difficult to pinpoint any trigger that will lead to a reversal. As our readers well know, we do not forecast triggers for the simple reason that the chances of getting it right are much lower than a coin toss. That said, in the medium term, the reason for a correction in DM stocks could well be EM/China growth, as it was in 2015. In such a scenario, EM risk assets will sell off first. As to timing, it is hard to find indicators that lead share prices, but aggregate EM narrow (M1) money growth has historically been coincident or leading with EM share prices - and it presently points to a considerable drop in EM equity prices (Chart I-15). This EM M1 aggregate is equity market-cap weighted making it relevant to investors. Chart I-14EM And U.S. Equites Typically Do Not Outperform Global Stocks Simultaneously Chart I-15EM M1 Growth And EM Share Prices Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com A New Trade: Receive Mexican / Pay U.S. 2-Year Swap Rates Mexico's 2-year bond yield has recently fallen through a technical support line while the U.S. 2-year bond yield has recently bounced off a major support level (Chart II-1). Our bias is that the 2-year yield in Mexico will fall relative to 2-year U.S. yield (Chart II-1, bottom panel). We recommend a new trade: receive 2-year swap rates in Mexico and pay U.S. 2-year swap rates. Historically, the domestic demand cycle in Mexico was synchronized with the business cycle in the U.S., mainly due to the fact these two economies are heavily integrated. However, the two economies have recently become desynchronized. This is evident by the fact that the Mexican export sector - which is leveraged to U.S. - is booming while the domestic demand in Mexico is slowing down (Chart II-2). Chart II-12-Year Bond Yields: Mexico And U.S. Chart II-2Divergence Within Mexican Economy The culprit behind this desynchronization is the previous collapse in the peso. Falling oil prices and excessive money/credit expansion in Mexico led to a major peso depreciation in 2014 and 2015. The election of Trump pushed it off the cliff in 2016. Inflation in Mexico spiked due to the massive currency depreciation. Consequently, the Mexican central bank has hiked interest rates by 400 basis points since the end of 2015. This, along with fiscal tightening, has choked domestic demand growth in Mexico. At this point, our bias is that the short-term interest rate differential between Mexico and the U.S. is unjustifiably wide and is about to narrow. Going forward, we expect inflation to fall in Mexico and interest rate expectations will at minimum not rise. Inflation in Mexico will roll over soon and moderate because of the following: A large part of the rise in inflation was caused by the depreciation in the peso. The peso's material appreciation this year will reduce the inflation rate (Chart II-3). Consumer spending and capital expenditure are set to continue slumping as the impact of higher interest rates continues filtering through the economy (Chart II-4, top and bottom panel). Chart II-3Mexico: Exchange Rate And Core Inflation Chart II-4Mexico: Domestic Demand To Disappoint Further Domestic vehicle sales are shrinking signifying no revival in interest rate-dependent sectors. Fiscal policy has been tightening and this will continue to be a headwind on economic growth (Chart II-5). Hence, despite flourishing exports to the U.S., very weak domestic demand will dampen inflation in Mexico. Finally, there were several one-off effects to inflation such as the gasoline subsidy removal that took place at the end of last year, and the minimum wage hike that was implemented at the beginning of the year. As the base effect of these fade, the inflation rate will moderate. In the U.S., our bias is that interest rate expectations are too low given the tight labor market, reasonably strong growth, and the U.S. dollar depreciation this year. Odds are that the U.S. interest rate expectations will rise as core inflation moves up (Chart II-6). Chart II-5Mexico: A Major Improvement In Fiscal Position Chart II-6U.S. Core Inflation To Rise Investment Recommendations We recommend fixed-income traders to receive Mexican / pay U.S. 2-year swap rates. The main risk to this trade lies in the event of an abrupt sell-off in the peso against the U.S dollar that could push up the 2-year swap rate differential. While we expect EM currencies, including the peso, to depreciate, this trade is still favorable in terms of risk-reward because of the starting point in interest rate differential and peso valuations: Despite the rally this year, the peso is still cheap (Chart II-7). Furthermore, its current account and fiscal balances have improved dramatically. So, the peso should depreciate less than many other EM currencies. Chart II-7The MXN Is Still Cheap In fact, the interest rate spread between Mexico and the U.S. is already historically high, and the peso depreciation might not push it much higher. We would not be recommending this trade if the peso was fairly or overvalued, or if interest rates in Mexico were not this high. Entering this position under these current circumstances reduces the downside risk and, therefore, makes the risk-reward attractive. As to Mexican financial markets in general, we remain constructive on the peso versus other EM currencies. More specifically, we continue to recommend long positions in MXN versus ZAR and BRL. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Finally, the outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Within an EM equity portfolio we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Portfolio Strategy The S&P hotels, resorts and cruise lines index will suffer from a profit margin squeeze, which should weigh on valuations. Cut exposure to underweight. A cyclical capex recovery is a boon for software outlays and coupled with reviving animal spirits, signal that it no longer pays to underweight the S&P software index. Augment positions to a benchmark allocation. Recent Changes Downgrade the defensive/cyclical portfolio bias to neutral. Downgrade the S&P hotels, resorts and cruise lines index to underweight today. Lift the S&P software index to neutral. Table 1 Feature Chart 1Weak Dollar Positive Contributor##br## To EPS Growth Equities broke out in a bullish fashion last week, as geopolitical fears subsided and the backlash from hurricane Irma was less severe than initially feared. Beneath the surface, non-inflationary synchronized global growth remains the dominant macro theme. While the latest U.S. CPI print was better than anticipated the Fed would have to see a couple more perky inflation reports before an uptrend is established, cementing the December hike. Until then, the path of least resistance is higher for equities. In our last Weekly Report, we noted that our four-factor S&P 500 operating EPS model has recently accelerated.1 This week, Chart 1 isolates the U.S. dollar as the sole regression variable on SPX earnings and the fitted value suggests that profits will likely surprise to the upside in the back half of the year despite difficult comparisons. Importantly, as we posited earlier this summer, irrespective of where the trade-weighted U.S. dollar ends the year, delayed FX translation effects will act as a tonic for S&P 500 profits. Since late-December's peak, the broad trade-weighted dollar has deflated by 9%. Regression analysis shows that a 1% fall in the U.S. dollar boosts operating EPS by 0.98%, with our dataset going back to the early 1970s. If, however, we narrow the interval of estimation starting in 1994 when NAFTA come into effect then the greenback's sensitivity on SPX EPS increases to 1.6%. While every cycle is different, a fresh all-time high in quarterly EPS - driven by a weak dollar - would not surprise us in Q3 and Q4. At some point, the deflating currency should show up in selling price inflation, again as a lagged effect (middle panel, Chart 2). This is encouraging for our firming operating leverage thesis, as a modest inflationary backdrop would reinforce top line growth (bottom panel, Chart 2). The implication of a sustainable revenue growth outlook is a profit margin-led flow through to EPS, especially for high fixed cost businesses. Already, sell side analysts' overall S&P 500 net earnings revisions are benefitting from the U.S. dollar's decline, and so is sector EPS breadth (trade-weighted dollar shown inverted, Chart 3). Chart 2Will The Dollar's Fall Show Up In Inflation? Chart 3EPS Breadth Improvement Moreover, U.S. dollar-based liquidity (defined as the sum of the Fed's balance sheet and foreign central bank U.S. Treasury holdings) has finally arrested its fall and has recently ticked higher above the zero line. This even mild increase in U.S. dollar-based liquidity represents a de facto easing in global monetary conditions, and historically has been synonymous with S&P 500 EPS acceleration (Chart 4). The upshot is that profits are on a solid upward trajectory. Chart 4Dollar Based Liquidity Also On The Rise The equity market's sensitivity to the greenback has been increasing as the percentage of foreign sourced earnings has been rising over the decades. Globally-exposed goods-producers are in the driver's seat. This raises the question: what to do with our long held preference for defensives versus cyclicals? We are taking our cue from the U.S. dollar-induced shifting macro backdrop, and locking in gains of 11% since the mid-2014 inception in our defensive over cyclical sector tilt, and moving to the sidelines. As a reminder, since the beginning of the spring we have been tweaking our portfolio adding cyclical exposure and, at the margin, removing defensive protection.2 Thus, a defensive over cyclical sector preference is no longer in place. Synchronized global growth, reviving emerging markets, a stable China, and a deflating U.S. dollar are all giving us confidence that it no longer pays to play defense (Chart 5). Finally, following a sling shot recovery, relative valuations are on a more even keel, as is our relative Technical Indicator which is hovering in the neutral zone (Chart 6). Chart 5Book Gains And Move##br## To Neutral Chart 6Valuations And Technicals##br## In The Neutral Zone This week we are making an early cyclical downshift and deep cyclical upshift to our portfolio. Hotels Update: Check Out Time This year has been a good one to be overweight the S&P hotels, resorts and cruise lines index which has outperformed the S&P 500 by a wide margin. However, earnings expectations have moved broadly in line with the market in 2017, meaning that the index's outperformance has been entirely valuation multiple driven. Normalizing earnings to smooth out profit volatility reveals a more severe picture with valuation multiples at decade highs, above the historical mean and at a 40% premium to the broad market (Chart 7). The index's strength has been most pronounced since the beginning of the summer and, unsurprisingly given the cyclical rotation into highly discretionary stocks, has been exclusive to the cruise line operator segment of the index. The two relevant stocks (RCL and CCL) now represent nearly half of the S&P hotels, resorts and cruise lines index's market capitalization. Cruise line operators' margins have climbed to 10-year highs (top panel, Chart 8), justifying soaring stock prices. Profit gains have come on the back of healthy unit revenue as unit costs have remained mostly unchanged (third panel, Chart 8). Chart 7Very Expensive Beneath The Surface Chart 8Cruise Lines Leading The Pack Cruise line occupancy rates corroborate this firm demand backdrop. They have risen in line with margin gains (second panel, Chart 8), a result of improving passenger growth and constrained capacity (bottom panel, Chart 8). This has been the industry's largest margin lever, i.e.: incremental passengers per room come with much higher incremental margin. As cruise lines cannot increase their occupancy ad infinitum (occupancy rates above 100% already imply more than two occupants of a double-occupancy berth), further margin gains of this magnitude seem doubtful. In fact, if cruise operators are to continue growing profits, a capacity growth cycle will eventually have to begin anew, meaning margin contraction rather than expansion. Thus, extrapolating profit growth far into the future is fraught with danger, warning that sky-high valuation multiples are vulnerable to even a modest de-rating. The outlook is even less bright for hotels, an industry that has been losing its share of the consumer's wallet for some time (Chart 9, second panel). Specifically, the low/non-corporate end of the market seems increasingly exposed to competition from Airbnb and other room share competitors; cutthroat competition is pricing power negative with industry selling prices sinking into outright deflation (Chart 9, third panel). Hoteliers are trying to compensate for low prices with huge capacity additions, adding a sense of permanence to recent pricing power declines. However, just as pricing has fallen, the accommodation related employment cost index has gone vertical (bottom panel, Chart 9). The implication of soft pricing power and a rising wage bill is a profit letdown. Our newly introduced S&P hotels, resorts and cruise lines EPS model (comprising the U.S. dollar, employment, PCE and confidence measures) does an excellent job encompassing all these moving parts and confirms our bearish industry profit stance. In fact, it is pointing to significant relative declines vis-à-vis the S&P 500 (Chart 10). Chart 9Mind The Deflationary Impulse Chart 10EPS Model Says Rush For The Exits Putting it together, shrinking margins and increased capital deployment mean lower return on capital and hence lower valuation multiples. This implies that the index's relative gains are in the past. Bottom Line: Take some chips off the table and reduce exposure to underweight in the S&P hotels, resorts and cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN. Software: A Capex Upcycle Winner? Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above-the-mean peak reached during the tech bubble (top panel, Chart 11). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Traditional hardware tech sectors, like communications equipment, are also suffering from the "virtualization" threat as software is making inroads into hardware and blurring the lines between the two. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced (see Chart 3 from last Monday's Weekly Report 3), and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (third & fourth panels, Chart 11). Reviving animal spirits also suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments (second panel, Chart 12). It has also rekindled software M&A activity, with the number of industry deals jumping in recent months (bottom panel, Chart 13). Chart 11Back To Trend Chart 12Capex Upcycle... Chart 13... And Reviving Animal Spirits Are Key Drivers Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (middle panel, Chart 14). But before getting too carried away, there is some cause for concern. The S&P software index is priced to perfection fully reflecting most, if not all, of the positive drivers (bottom panel, Chart 14), warning that any sales/profit mishaps will likely knock relative performance over. Moreover, productivity dynamics are waving a yellow flag. Business sector productivity growth troughed in early 2017. Historically, this output per hour worked metric has been inversely correlated with software outlays (productivity shown inverted, third panel Chart 15). Importantly, even shown as a deviation from the long-term trend, productivity gains have troughed, suggesting that relative profit growth will likely remain muted (productivity shown inverted, bottom panel Chart 15). Keep in mind that, historically, software spending has been countercyclical (second panel, Chart 15) and given that we are not at the end of the line yet, relative outlays on software may not rebound to the same extent as our other aforementioned indicators suggest. Chart 14Impressive Pricing Power, ##br##But Fully Priced Chart 15Productivity Dynamics##br## Are A Sizable Offset Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see Chart 5 of the U.S. Equity Strategy Report titled "Still Goldilocks", on September 11, 2017, available at uses.bcaresearch.com. 2 Please see the August 14, 2017 U.S. Equity Strategy Report titled "Three Risks" for a quick recap of most of our portfolio moves, available at uses.bcaresearch.com. 3 Please see the September 11, 2017 U.S. Equity Strategy Report titled "Still Goldilocks", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.