Financial Markets
Highlights Portfolio Strategy Upgrade capital markets stocks to overweight and put them on the high-conviction list. Capital formation is poised to accelerate in the second half of the year. Our Indicators suggest that demand for media services will continue to improve. Stay overweight both the movies and entertainment and cable and satellite indexes. Recent Changes S&P Investment Banking & Brokerage - Upgrade to overweight and add to the high-conviction overweight list. S&P Consumer Finance - Remove from the high-conviction overweight list. Table 1Sector Performance Returns (%) Feature The S&P 500 continues to churn near its highs. Following a robust earnings season, the onus is now on the economy to provide confidence that the corporate profit recovery will prove durable, thereby justifying thinning equity risk premia. While slumping commodity prices suggest that global end-demand has downshifted a notch, the former boost real purchasing power and provide a reflationary support for stocks, particularly since resource-dependent sectors do not have a market leadership role. In fact, financial conditions remain sufficiently accommodative to expect a growth reacceleration in the back half of the year. It is notable that the recent selloff in the Treasury market has been driven by the real component, while inflation expectations have moved sideways. As a result, there is little pressure on the Fed to normalize at a faster pace than currently discounted in the forward curve. Thus, we expect the window for additional equity price appreciation to remain open this summer, unless growth reaccelerates sufficiently to stir inflation fears. Nevertheless, selectivity will become even more critical. Cross asset correlations have collapsed. Diminishing global macro tail risks have reduced the dominance of the beta-oriented "risk on/risk off" trade as a source of return. Empirical evidence suggests that asset correlations and the broad equity market are inversely correlated. This message is corroborated by falling correlations between regional stock market returns. Receding equity index correlations have been associated with positive S&P 500 returns (middle panel, Chart 1). This inverse correlation is also mirrored in the CBOE's implied correlation index, which tracks the correlation of the S&P 500 stocks with one another: tumbling correlations imply solid overall equity returns (top panel, Chart 1). These relationships are intuitive. Diminished macro tail risks bring earnings fundamentals to the forefront as the key driver of returns, and reward differentiation and discrimination in sector/region/asset class selection. While an eerie calm has dominated markets of late, as our Asset Class Volatility Indicator has collapsed to a multi-decade low (bottom panel, Chart 1), a more bullish explanation is that all-time highs in equities are synonymous with all-time lows in the VIX. This can be viewed as a contrary warning sign, but history shows that the VIX can stay depressed for a prolonged period. Our Equity Market Internal Dynamics Indicator (EMIDI), first introduced in late-March, has tentatively troughed, suggesting that sub-surface dynamics are becoming more supportive of the broad market (Chart 2). The EMIDI, which comprises relative bank, relative transport, small/large and industrials/utilities share prices, has been coincident to the leading market indicator, especially since the GFC. Chart 1Tumbling Correlations = Rising Stock Returns Chart 2Sub-Surface Dynamics Have Turned The Corner In that light, this week we are further augmenting our cyclical portfolio exposure by lifting another interest rate-sensitive group to overweight and are also updating the early cyclical media index and its major components. Capital Markets Stocks Have Rally Potential Two weeks ago, we recommended using this year's financial sector underperformance to boost allocations to overweight. This week we are further augmenting our exposure by upgrading the S&P investment banks & brokerage index to above benchmark. While the equity bull market is in the later innings, our view is that the overshoot will be extended for a while longer as a consequence of the overall sales and profit recovery and low probability that monetary conditions will tighten meaningfully in the near run. If this plays out, there is an opportunity for capital markets stocks to recover from their recent consolidation. This sub-index thrives when investor risk appetites are healthy and the business sector is moving from retrenchment to expansion mode, and vice versa. The outlook for increased capital formation has improved considerably. The corporate sector financing gap is beginning to widen anew (Chart 3), reflecting the surge in business and consumer confidence since the pro-business U.S. Administration took power. The widening financing gap is particularly notable because it is occurring alongside improving profit growth. In other words, the wider financing gap reflects accelerating capex demand, not weak corporate cash flows. This is confirmed by BCA's Capital Spending Indicator, which signals an increase in business investment ahead. Consequently, corporate sector demand for external capital should accelerate. The latter is the lifeblood of capital markets profitability. The nascent recovery in total bank credit growth after a period of malaise reinforces that working capital requirements are on the upswing (Chart 3).1 As businesses shift from maintenance capital spending to a more expansionist mindset, and companies reach further for growth to justify high stock valuations, capital markets activity could accelerate in the second half of the year. After all, investor confidence is high. Corporate bond spreads have tightened and corporate bond issuance is soaring. The Equity Risk Premium is steadily narrowing (shown inverted, second panel, Chart 4), reducing the cost of equity capital. New stock issuance is following on the heels of corporate bond issuance. Stocks are outperforming bonds by a comfortable margin and total mutual fund assets have grown sharply (Chart 3). The upshot is that access to corporate sector capital should stay healthy. As flows into equities advance, it will fuel a reacceleration in M&A activity (Chart 5). Chart 3Capital Markets Activity Is... Chart 4...Firing On All Cylinders Chart 5ROE On The Upswing Capital markets return on equity (ROE) is highly levered to business and investor risk appetite. Fees earned on M&A activity heavily influence overall profitability. As such, it is normal for ROE to expand when M&A activity picks up, and shrink when financial conditions tighten and takeovers dry up. Currently, M&A transactions represent an historically elevated share of GDP, but that is not a barrier to an increased rate of takeover activity. Companies are no longer using their balance sheets to repurchase their own shares en masse. Instead, there is an incentive to pursue business combinations as the global economy reaccelerates, underscoring that capital allocation should shift in favor of capital markets firms. Indeed, Chart 5 shows that ROE also follows the trend in our global leading economic indicator, and the current message is bullish. Even capital markets companies themselves confirm that their pipelines are full. Hiring activity remains robust. Pro-cyclical firm headcount rises quickly alongside revenue opportunities, and is just as quick to shrink when the outlook darkens. Ergo, we interpret headcount growth as a net positive. While trading activity is always a wildcard, and could be a source of weakness if bond market, and generalized asset class, volatility stays muted, the upbeat outlook for fee generation from increased capital formation provides us with confidence to use share price weakness as an opportunity to build a bigger position. Bottom Line: Lift the S&P investment banking & brokerage index to overweight, adding to our recent decision to upgrade the overall financials sector to above-benchmark. The ticker symbols for the stocks in this index are BLBG: S5INBK - GS, MS, SCHW, RJF, ETFC. Media Stocks: Temporary Pressure Media stocks have come under pressure recently, giving back all of this year's relative gains. Investor worries have centered around two thorny issues: cord-cutting and ad spending. Cord-cutting is not new, but weak overall Q1 TV subscriber numbers have refocused investors' attention on the secular challenges ahead. In addition, a number of companies noted softening ad spending on Q1 conference calls. According to media executives, this slowdown is not isolated to the automotive segment. Is it time to pull the plug or is a worst case scenario already priced into the group? We side with the latter. In aggregate, demand for media services is brisk. Consumer outlays on media have soared to a two decade high, hitting a double digit annual growth rate. S&P media sales are tightly correlated with media spending (second panel, Chart 6). Despite coming off the boil recently after hitting unusually high growth rates, media pricing power also remains in expansionary territory. Importantly, buoyant demand is boosting industry productivity gains. The third panel of Chart 6 shows that our media productivity proxy has reaccelerated. Meanwhile, an improving economic backdrop also bodes well for media earnings prospects. The ISM services new orders sub component has been an excellent leading indicator of relative profit growth expectations and the current message is positive (middle panel, Chart 7). If the overall economy bounces smartly from the weak Q1 print, as we expect, then an earnings-led recovery should sustain the valuation re-rating phase (bottom panel, Chart 7). Chart 6Buoyant Media Demand Chart 7Valuation Re-Rating Looms Our Ad Spending Indictor (ASI) incorporates all of these key media profit drivers, including consumption and overall corporate profits. The ASI has recently hooked up, signaling that earnings estimates should continue to rise (bottom panel, Chart 8). Nevertheless, sub-media group returns have been bifurcated, with the S&P movies and entertainment index exerting downward pressure on the overall sector of late. Relative performance has mostly treaded water since our upgrade last summer, but hit a soft patch after recent quarterly results. Before rushing to make a bearish judgment, it is notable that the relative forward P/E remains close to an undervalued extreme, signaling that it will be increasingly difficult to disappoint. Historically cheap valuations exist despite depressed expectations, which should serve to artificially inflate valuations: both top and bottom line are expected to lag the broad market, representing a very low hurdle (Chart 9). Chart 8Rosier EPS Prospects Lie Ahead Chart 9Unloved And Undervalued Beyond the positive consumer spending backdrop (Chart 10), we are inclined to stick with overweight positions in this sub-component for four major reasons. First, merger and acquisition activity should reduce capacity, and by extension, support pricing power, especially if the AT&T/Time Warner deal clears the regulatory hurdle. There is scope for additional M&A that could further reduce shares outstanding (Chart 11). Chart 10Improving Demand... Chart 11...And M&A Activity Are An EPS Tonic Second, content providers are adapting to the competitive threat. New online-only offerings and slimmer/nimbler packages should stem the drag from the likes of Netflix and other streaming services. Consumer spending on electronics continues to surge, suggesting that content providers have ample opportunity to fill increasing demand. Third, there is no substitute for live TV. News and live sports are two sticky offerings that will continue to be cash cows for the industry and drive select subscriber growth. Fourth, media giants have stepped up focus on other segments with higher growth potential, such as studios and franchises highlighting increasingly diversified revenue streams. Moreover, CEOs have been aligning cost structures to the new realities of cord-cutting, exercising strict cost control. Companies have also been careful with capex allocation decisions. All of this suggests that any shakeout in this media subgroup is a good entry point for building new positions with a compelling valuation starting point. Unlike the S&P movies and entertainment index, the S&P cable and satellite group has been relentlessly grinding higher, underpinning the broad media index. The multiyear share price advance has been cash flow driven. As a consequence, cable stocks still trade at a 25% discount to the broad market on a price/cash flow basis and the relative multiple is hovering near the historical mean (third panel, Chart 12). Cable and satellite sales growth has surged to healthy low double-digit growth rates after a one year lull. Encouragingly, soaring pricing power signals that recent revenue momentum is sustainable (second panel, Chart 12). As mentioned above, consumer outlays on cable services have had a V-shaped recovery, underscoring that the latest upleg in selling prices is demand driven (bottom panel, Chart 12). It is remarkable that the industry has consistently raised selling prices at a faster pace than overall inflation for decades (Chart 13). This impressive track record reflects cable operators' ability to continually evolve offerings and provide attractive content, even in the face of cord-cutting. Chart 12Cash Flow Driven Outperformance Chart 13The Cable Signal Is As Strong As Ever Meanwhile, content inflation rates have remained within the range of the past few years, underscoring that threats to robust profit margins are limited (bottom panel, Chart 13). More recently, news that Comcast and Charter will come together and cooperate on a wireless offering adds another layer of defense in effectively combating cord-cutting. How? By increasing the bundle offering beyond cable and internet services, cable providers are positioned to attract new clients by offering a one stop shop triple-play solution. A move into wireless service offerings would also assist in retaining existing customers. In sum, most of our indicators suggest that the demand outlook for media services continues to improve. Our Ad Spending Indicator is climbing, underscoring that fears of a deep and widespread slump are overblown. Bottom Line: The media index remains an overweight and we continue to recommend an above benchmark exposure both in the S&P movies and entertainment and S&P cable and satellite sub-groups. The ticker symbols for the stocks in these two indexes are BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively. 1 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds," dated April 11, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlight Once-ebullient oil markets are overwrought. Fears that an economic slowdown in China will spill over into EM - the engine of global commodity demand growth - along with a very weak 1Q17 U.S. GDP performance, will keep oil markets focused on downside risks to prices. On the supply side, high-frequency inventory data from the U.S. suggests visible OECD stocks remain high, seemingly impervious to OPEC 2.0's best efforts to drain them. Steadily rising U.S. shale output also weighs on prices. Markets appear to be looking right through the choreographed comments on production cuts from leaders of OPEC 2.0, which suggest these cuts will definitely be extended to year-end 2017, and possibly into 2018. We doubt the demand picture is anywhere close to a fundamental downshift, expecting, instead, continued robust demand. We also expect the extension of OPEC 2.0's production cutbacks to year-end 2017 to significantly drain storage, even as shale output continues to grow. If anything, recent market action has presented an opportunity re-establish length, and to position for backwardation toward year-end. Energy: Overweight. The stop-loss on our Dec/17 Brent $45/bbl puts vs. $65/bbl calls was elected May 4/17, leaving us with a loss of $1.54/bbl (-327.7%). We are reinstating the position as of tonight's close, anticipating Brent will reach $60/bbl by year-end. We also stopped out of our Dec/17 Brent long vs. Dec/18 Brent short on May 4/17, with a $0.50/bbl loss (-263.2%). We will re-establish this position as well basis tonight's close. Base Metals: Neutral. LME and COMEX stock builds are keeping copper under pressure, offsetting possible renewed labor unrest. This is keeping us neutral. Precious Metals: Neutral. We were made long spot gold at $1230.25/oz basis last Thursday's close as a hedge against inflation risk, and a possible equities correction. Ags/Softs: Underweight. USDA data indicate a favorable start to the grain planting season. We remain bearish. Feature Softer Chinese PMIs spooked commodity markets, coming as they did on the heels of a very visible and much-reported weakening of base metals and iron ore prices emanating from Chinese markets (Chart of the Week).1 Financial markets fear weaker Chinese growth could presage weaker EM growth, which is the engine of commodity growth generally.2 With U.S. GDP coming in weak as well - registering a paltry growth of 0.7% in 1Q17 - markets started re-calibrating oil demand estimates for this year in light of still-high inventory levels. Adding to the market's agita, visible oil inventories in the OECD remain stubbornly high, thwarting OPEC 2.0's best efforts to drain them via their closely followed production cuts. By Wednesday of this week, this potent combination shaved some 9.6% off 1Q17 average prices, taking international benchmarks Brent and WTI below $50/bbl. Dubai prices have largely been spared similar carnage, as Gulf OPEC states continue to reduce supplies of heavier sour crude availabilities (Chart 2). Chart of the WeekChina PMIs Weaken As Monetary##BR##Conditions Tighten Slightly Chart 2Oil Prices##BR##In Retreat OPEC 2.0 Responds To Weaker Prices OPEC 2.0 - our moniker for the producer group comprised of OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia - was not oblivious to these concerns. Indeed, earlier this week KSA Oil Minister Khalid al-Falih said the group would "do whatever it takes" to drain stocks and normalize global inventories (Chart 3). The OPEC 2.0 leadership is well aware that failure to do so would again expose these petro-states to the risk of a price collapse, as, absent production discipline, oil inventories once again would fill. This would force prices through producers' cash costs until enough production was knocked off-line to drain the storage overhang.3 Comments by leaders of OPEC 2.0 regarding the extension of its 1.8mm b/d production cuts this year and into next year are consistent with a strategy we laid out earlier, part of which includes the use of forward guidance to convince markets the supply side will tighten in the future.4 The other critical part of the strategy is for OPEC 2.0 to keep the front of the Brent curve at or below $60/bbl, using their own production, spare capacity and storage, and guiding to higher supply in the future, which would keep markets backwardated in 2018 once visible storage returns to five-year average levels. A persistent and deep backwardation - on the order of 10% p.a. - would, based on our modelling, slow the return of rigs to U.S. shale fields. In addition, the combination of a front-end forward curve capped at $60/bbl and persistent backwardation would keep depletion rates elevated, as cash-strapped producers - e.g., non-Gulf OPEC producers with high fiscal breakeven oil prices - are forced to forego maintenance capex. Taken together, this would give OPEC 2.0 a stronger hand in guiding prices - provided the coalition can hold together and maintain production discipline. We continue to expect an extension of the 1.8mm b/d OPEC 2.0 cuts will backwardate markets once inventories normalize later this year, even with strong growth from U.S. shales.5 Indeed, we expect this combination of fundamentals will clear the storage overhang by end-2017, and produce draws of more than 1mm b/d on average from April - December (Chart 4). Chart 3OPEC 2.0 Leaders KSA,##BR##Russia: "Whatever It Takes" Chart 4Steady Demand,##BR##Extended Cuts Will Drain Inventories Wobbly Oil Demand Is Transitory The 1Q17 demand-side scares emanating from China and the U.S. are transitory. Chart 5Fiscal And Infrastructure Spending##BR##Picked Up This Year In China Following their return from the mainland, our colleagues on BCA's China Investment Strategy desk note that monetary conditions still are fairly stimulative, and are unlikely to cause the economy to roll over.6 Most of the deterioration in economic growth results from a slowing in the depreciation of China's trade-weighted RMB, following a years-long appreciation from 2012 to 2015, which did dampen growth. In addition, while fiscal stimulus was reduced at the end of 2016, the government "quickly reversed course" as direct spending and investment in infrastructure picked up substantially (Chart 5). Our China Investment Strategy colleagues note China's fiscal spending is pro-cyclical - it increases as the economy improves and tax revenues increase. The government shows no sign of wanting to wind this down: "China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant." The impact of Chinese demand on global oil demand is increasing, based on econometric work we've recently completed. From 2000 to end-April 2017, a 1% increase in Chinese oil demand has translated into a 0.64% ncrease in Brent prompt prices. During this period, the impact of non-OECD demand ex China was more than two times that of China's - a 1% increase there could be expected to lead to a 1.3% increase in Brent prices. China's impact on Brent prices in the post-GFC world more than doubled, while the impact of non-OECD demand ex-China increased marginally. Since the Global Financial Crisis, a 1% increase in China's oil consumption has produced a 1.4% increase in Brent prices, while a similar increase in EM ex-China has translated into a 1.8% increase in Brent prices.7 Turning to the U.S., we believe, along with the Fed, the weak patch in GDP in 1Q17 is transitory. Following the report on the quarter's weak 0.7% GDP growth, the U.S. Bureau of Labor Statistics surprised markets with a reading of 4.4% unemployment (U3 measure), and an equally impressive U6 measure of 8.6%, which takes it almost to pre-GFC levels. We expect robust U.S. labor-market conditions will keep demand for refined products in the U.S. robust, which will support oil prices there going forward. Globally, the U.S. EIA expects oil consumption will grow 1.6mm b/d this year - unchanged from last year. This is above our 1.4mm b/d estimate for the year. If the EIA's demand estimate is accurate, we can expect a sharper draw (+200k b/d) in global inventories than the average 860k b/d we currently are projecting, all else equal (Chart 4). This would lead to a sharper and earlier backwardation in prices that we currently expect. We will be re-estimating our balances model next week. Investment Implications We continue to expect the global storage overhang to clear by year-end, given the extension of OPEC 2.0's production cuts to at least year-end 2017. Wobbly demand is a transitory phenomenon, and we expect a recovery in the balance of the year. Given our expectation, we are re-establishing our long year-end Brent exposure, and are going short a $45/bbl Dec/17 Brent put vs. long a $65/bbl Dec/17 Brent call at tonight's close. We had a -$1.00/bbl stop-loss on this position, which was elected May 4/17 and resulted in a 1.54/bbl loss (-327.7%). We stopped out of our long Brent front-to-back position - long Dec/17 Brent vs. short Dec/18 Brent - in anticipation of backwardation. We also will be looking to re-establishing this position at tonight's closing levels, and for a good entry point to re-establish the same position in WTI. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Iron-ore (62% Fe) prices are down 33.5% after peaking this year at close to $91/MT in March. The LMEX base metals index is down 7.7% from its 2017 peak in February. Regular readers of Commodity & Energy Strategy will recall we've been bearish iron ore and steel for months, and have remained neutral base metals. Please see "China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals," and "Copper's Price Supports Are Fading," in the January 19, and March 23, 2017, issues of Commodity & Energy Strategy. They are available at ces.bcaresearch.com. 2 In the May 5, 2017, issue of BCA Research's Foreign Exchange Strategy, our colleague Mathieu Savary notes, "The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing." Please see "The Achilles Heel of Commodity Currencies" in the May 5 FES, available at fes.bcaresearch.com. 3 Please see "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," published by BCA Research's Commodity & Energy Strategy April 20, 2017, for a further discussion of the logic behind these cuts. 4 This aligns with a strategy we laid out last month, which uses forward guidance to convince markets to anticipate tighter supply further out the curve. By leading markets to anticipate lower crude oil availabilities in the future - while storage is drawing - OPEC 2.0 is setting the stage for forward curves to remain backwardated. Please see "The Game's Afoot In Oil, But Which One?" published April 6, 2017, in BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 5 "Backwardation" refers to a futures forward-price curve in which contracts for prompt delivery are higher than prices for deferred delivery. This indicates merchants and refiners are willing to pay more for a commodity delivered close in time versus in the future. It is the opposite of a "contango" curve, in which deferred prices exceed prompt prices. 6 Please see "Has China's Cyclical Recovery Peaked?" in BCA Research's China Investment Strategy Weekly Report published May 5, 2017. It is available at cis.bcaresearch.com. 7 These coefficients are all significant at less than 0.01. R2 coefficients of determination for these cointegrating regressions, which include the USD broad trade-weighted index (TWIB) all exceed 0.90, indicating that the USD TWIB and Brent prices share a common long-term trend, and that FX effects remain important in assessing oil prices. 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 Shorting the RMB against the dollar is no longer a one-way bet. Investors should look to reduce bearish positions on the RMB going forward. The RMB is no longer overvalued. Therefore, any further decline will push the RMB deeper into undershoot territory, which is ultimately subject to mean reversion. The recent focus on China's low and falling reserve-to-M2 ratio largely reflects lopsided expectations on continued capital outflows and further RMB declines. The PBoC should have no difficulties maintaining control over the exchange rate with the country's massive current account surplus, low foreign currency debt and pervasive capital account control measures. Feature With widespread consensus among investors and market-watchers for the RMB to continue depreciating against the U.S. dollar, a key question is whether the seemingly unloved RMB could once again become appreciated. Indeed, the widely shared consensus a mere three years ago - that the RMB had nowhere to go but up - has now become a highly controversial rhetorical question. The current prevailing view is that the RMB is under intense downward pressure against the dollar, and the People's Bank of China (PBoC) is fighting an uphill battle in maintaining exchange rate stability. Some have gone even further, relating the RMB's ongoing weakness to "money printing" and "credit largess." According to these pundits, the country's mighty official foreign reserves pale in comparison to domestic capital flight, and the end game will have to be a substantial currency depreciation before a new equilibrium is re-established. Chart 1The RMB's Rollercoaster Ride In June 2013, amid the comfortable consensus that the RMB would perpetually rise against the dollar and the RMB "carry trade" was running amok, we published a Special Report titled "Is The RMB Still Undervalued?"1 We argued at the time that "the large valuation buffer for the RMB has mostly been eliminated," and that "there is a strengthening case for the RMB to fall against the greenback." Fast forward four years, the CNY/USD peaked in January 2014 and has since depreciated by about 15% (Chart 1). As the consensus on the RMB has now completely swung to the other extreme, it is time for a new reality check and some provocative rethinking. What Has Changed? With the benefits of hindsight, it is easy to spot what went wrong for the RMB as well as for the Chinese economy. In our 2013 Special Report, we concluded that "the dollar appears to be bottoming out from its structural bear market" and that "the Chinese central bank should guide the RMB lower versus the greenback in order to maintain a relatively stable exchange rate against a currency basket." In reality, the sharp dollar rally of 2014-'15 pushed up the trade-weighted RMB by another 10% and led to draconian tightening in China's monetary conditions - a major policy mistake that caused relentless deflationary pressure and growth woes. By the same token, the depreciation of the RMB since early 2016 has turned out to be a key reflationary force that has helped stabilize the Chinese economy. As far as the RMB is concerned, there have been a few important changes in the macro environment. Chart 2The Dollar: A Long Term Perspective First, the dollar's multi-year bull market has pushed the greenback up by 25% since 2014. The U.S. economy is currently a bright spot in the world, and the Federal Reserve appears to be the most determined to tighten among the major monetary authorities - two factors that are likely to maintain dollar bullishness. However, it is important to note that the sharp rally has already pushed the dollar close to two sigma above its long-term trend (Chart 2). The dollar may remain well bid in the near term, but another major up leg similar to the one in 2014-'15 is highly unlikely. Second, the valuation froth in the RMB accumulated in previous years has been squeezed out (Chart 3). The trade-weighted RMB has fallen back to its long-term trend line after a two-sigma overshoot. Its spot rate against the dollar has now dropped below our PPP model fair value estimate. In real effective terms, the RMB has also quickly swung back from overvalued territory. The increase in Chinese producer prices since September 2016 also suggests the RMB may have become cheap again. Third, the massive RMB "carry trade" has been largely unwound. Before 2014, the RMB's one-way ascendance attracted speculative "hot money" inflows to China in anticipation of both higher yields and further currency upside. Chinese companies also sharply ramped up borrowing in foreign currencies, mostly U.S. dollars, for lower rates and potential exchange rate gains. Both trends abruptly reversed as the RMB began to fall, with hot money fleeing and domestic borrowers rushing to pay back foreign currency obligations. Chart 4 shows the abnormal surge of the RMB "carry trade" before 2014 has essentially vanished. Chart 3The RMB Is No Longer Overvalued Chart 4The Unwinding Of The RMB "Carry Trade" Finally, the reflationary benefit of a weaker exchange rate on the Chinese economy has been proven since 2016, which in of itself rules out the possibility of an endless RMB decline. As the largest manufacturer and exporter in the world, a weaker RMB is good news for the Chinese industrial sector's pricing power, profit margins and overall business activity - unless broad protectionist backlash blocks the positive feedback loop.2 The bearish argument on the RMB fixating on Chinese credit, even if true, ignores the reflationary impact on a major part of the Chinese economy, which in turn puts a floor under its exchange rate. What's Intact? Meanwhile, some factors that were widely viewed in previous years as supportive for an ever-rising RMB have remained largely intact. China still runs by far the largest trade surplus in the world, amounting to an annualized US$ 500 billion. Chinese foreign reserves, although having fallen by US$ 1 trillion since their all-time peak, still accounts for almost 30% of the global total (Chart 5). In comparison, China's official hoarding of foreign assets accounted for about 15% of the world in 2005, when the RMB was de-pegged from the greenback and began a decade-long ascent. In addition, Chinese exporters have continued to gain global market share, currently accounting for about 14% of world exports, more than double 2005 levels. Meanwhile, it is fairly likely that China's recent export numbers have been under-reported, as exporters have hidden part of their overseas proceeds offshore in anticipation of further RMB declines. Overall, there is no evidence that the value of the RMB has hindered Chinese exporters' competitiveness. From a long-term perspective, a country's productivity growth relative to the rest of the world fundamentally determines its relative competitiveness in global trade, which in turn is the ultimate driving force behind its exchange rate (Chart 6). On all these fronts, China still compares favorably to other major countries. Chart 5China's Foreign Official ##br##Reserves Remain Massive Chart 6Relative Productivity Determines ##br##Export Sector Competitiveness Are China's Foreign Reserves Enough? Chart 7 shows that the ebbs and flows of China's foreign exchange reserves are tightly linked with the USD/CNY "risk reversal" indicator, defined as the implied volatility for call options minus the implied volatility for put options on the cross rate. Chinese foreign reserves have increased for three consecutive months, a sign of slower capital outflows and easing concerns surrounding the RMB. It remains to be seen whether this is a permanent shift or a temporary pause. A more important question is whether China's foreign reserves are large enough for the PBoC to maintain control over its exchange rate. Chart 7The RMB Risk Aversion And Capital Flows Central banks' precautionary holdings of foreign reserves are mainly to reduce the likelihood of balance-of-payments pressures. From this perspective, for a country running chronic and massive trade surpluses with minimal foreign currency debt, China should not hold large foreign reserves at all. This is also why its massive foreign reserve holdings were long regarded as wasteful before 2014 by both market participants and Chinese policymakers - and since 2014 as the RMB has weakened the exact opposite: as not enough. Based on traditional yardsticks for reserve adequacy such as coverage ratios for imports or short-term foreign currency debt, China's reserves are far more than adequate. The more recent focus has been on additional metrics proposed by the IMF, particularly the ratio of reserves relative to a country's broad money supply (M2). This ratio captures potential residents' capital flight through the liquidation of their highly liquid domestic assets, which reflects potential drains on the balance of payments. Chart 8 shows a sharp decline in China's reserves-to-M2 ratio in recent years. However, this does not mean that Chinese foreign reserves are insufficient for the following reasons. Historically China's reserve-to-M2 ratio has had no direct correlation with the broad RMB trend. China's reserve-to-M2 ratio peaked at 28% in 2008, long before the RMB peaked. At 13% currently, the ratio is comparable to 2005 when the RMB began to rise against the dollar. Globally speaking, there is no empirical evidence that a higher reserve-to-M2 ratio helps alleviate downward pressure on a country's exchange rate. Other major emerging countries such as Brazil, Russia and India have much higher reserve-to-M2 ratios than China, but their currencies have suffered brutal declines in recent years (Chart 9). In contrast, Japan's reserve-to-M2 ratio is comparable to China, but the Bank of Japan has been trying desperately to weaken the yen. Germany's ratio is even lower. Finally, China's pervasive capital account control measures and its largely state-controlled financial institutions are powerful tools to hinder capital outflows, and can be adjusted to accommodate changes in the marketplace. This further diminishes the usefulness of this ratio. Chart 8China's Reserves-To-M2 Ratio Has Been Falling... Chart 9...But Does It Matter? Overall, the recent focus on China's low and falling reserve-to-M2 ratio largely reflects lopsided expectations on continued capital outflows and further RMB declines. This has all but ignored the prospect for capital inflows. True, Chinese households and companies will likely continue to diversify into foreign assets. However, there is an equally compelling case that foreign demand for RMB-denominated assets will also increase going forward. For example, Chinese local bond yields, both sovereign and credit, are substantially higher than other major economies. Meanwhile, foreign ownership in Chinese bonds is practically non-existent compared with other bourses (Chart 10). It is almost a sure bet that foreign demand for RMB bonds will increase significantly, especially if market expectations on the RMB stabilize. Given how dramatic market expectations on the RMB have shifted in the past several years, this could come much sooner than many expect. Chart 10The Case For Increasing Foreign Demand##br## For RMB Bonds Investment Conclusions We are not making the case for an immediate resumption of a rising RMB. In the near term, the USD/CNY cross rate will continue to be dominated by the broad dollar trend, the upside of which may not yet be exhausted. However, the prevailing bearish consensus means that shorting the RMB against the dollar has become a very crowded trade. Meanwhile, our valuation models suggest the RMB is currently no longer overvalued. Therefore, any further decline will push the RMB deeper into undershoot territory, which is ultimately subject to mean reversion. Overall, we caution against being overly negative at the moment, and investors should begin to reduce bearish bets on the RMB going forward. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Is The RMB Still Undervalued?," dated June 12, 2013, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Reflecting On The Trump-Xi Summit," dated April 13, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights ECB policy is set to become less dovish relative to other central banks. Stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female labour participation is surging. The state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Allowing for euro break-up risk, European equities are fairly valued - rather than cheap - versus U.S. equities. Prefer to gain exposure via a 50:50 combination of Germany (DAX) and Sweden (OMX). Feature "Domestic sources of risk to euro area growth have diminished while global, geo-global sources of risk have increased." - Mario Draghi The Cleanest Dirty Shirt Since the end of 2014, an unspectacular 1.9% growth rate1 has been enough to make the euro area the world's top-performing major economy - bettering the U.S., U.K. and Japan (Chart I-2). Chart of the WeekThe Percentage Of The French Population In Employment Is At An All-Time High Chart I-2The Euro Area Is The Top-Performing Economy The euro area economy has achieved this outperformance with exceptionally low volatility. For eight consecutive quarters, growth2 has remained within a very tight 1.2-2.2% band, less than half of the equivalent volatility in the U.S., U.K. and Japan. And growth is now "solid and broad", meaning that it includes all countries. The ECB's dispersion index of value-added growth in different countries stands at a historical minimum. We expect the euro area to remain the cleanest dirty shirt. As Draghi points out, the ECB is less worried about domestic risks and more worried about global risks. Specifically: "Markets are in the course of reassessment of U.S. fiscal policy" - Trumponomics will not be nearly as stimulative as first thought. "How the U.K. economy does post-Brexit has a channel of economic consequences for the euro area." "Possible negative surprises in some emerging market economies" - notably China. If any of the global risks do flare up, the ECB will sit pat, but other central banks will have to become more dovish relative to current expectations. If the risks do not flare up, the ECB will start to reduce its own extreme dovishness - at least with words, if not actions. Either way, ECB policy is set to become less dovish relative to other central banks. And the investment implications are: stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female Labour Participation Is Surging Chart I-3Rising Participation Boosts Employment As Emanuel Macron prepares to become the twenty fifth President of the French Republic, he can take heart from a statistic which may surprise you: The percentage of the French population in employment has never been this high. (Chart of the Week). How can this be when the French unemployment rate is still hovering around 10%? The answer is: as millions of formerly inactive French citizens have entered the labour market, it has lifted the percentage of the population with jobs to an all-time high (Chart I-3). But the flip side of rising participation is that it has kept the unemployment rate elevated - because some citizens who were formerly 'uncounted inactive' are now 'counted unemployed'. Remember that to count as unemployed, a person has to be in the labour market available for work. Some argue that French citizens have simply flooded into the labour market to claim generous and long-lasting unemployment benefits. This argument might hold during downturns, but it cannot explain the 25-year uptrend which also includes economic booms. Unpalatable as it might be to the pessimists, we are left with a more optimistic explanation. France has raised activity levels in the working age population with policies that encourage much greater female participation in the labour market. The important lesson is that when labour participation is rising or falling, we must interpret the headline unemployment rate with extreme care.3 If a country's unemployment rate is high because labour participation has increased - as in France - the labour market is not quite as bad as the high unemployment rate might suggest.4 Conversely, if a country's unemployment rate is low because labour participation has decreased - as in the U.S. (Chart I-4) - the labour market is not quite as good as the low unemployment rate might suggest. Counted unemployment has just been replaced with uncounted inactivity. We propose that the percentage of the working age population in employment is the truer measure of labour utilisation. With surging female participation boosting employment in France and most other European countries (Chart I-5), the state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Chart I-4Participation Down In The U.S.,##br## But Up In Europe... Chart I-5...Led By ##br##Women Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Political Risk Is Correctly Priced Many people saw the Brexit and Trump victories as the leading edge of a wave of economic nationalism. However, subsequent election results in the Netherlands, Austria, Finland, Bulgaria and now France have seen economic nationalists consistently underperforming their expectations. In hindsight, the Brexit and Trump victories were idiosyncratic. Both the Remain and Clinton campaigns were lacking in personality or a strong emotional message, and this proved to be their undoing. Nowadays, many voters care about personalities more than policies; emotional appeal matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Crucially, in a tight contest, both the Brexit and Trump campaigns resonated with the emotional System 1 with passionate pleas such as "Take Back Control" and "Make America Great Again". By contrast, the Remain and Clinton campaigns tried to appeal mainly to the rational System 2. But as Kahneman explains, when rational System 2 competes with emotional System 1, emotional System 1 almost always wins. Chart I-6Euro Break-Up Probability = 5% A Year In more recent elections, candidates and parties opposing the nationalists - including Emanuel Macron - have used a good balance of System 1 and System 2 arguments, thereby helping to prevent shock outcomes. This is also likely to be case in the two round French legislative elections on June 11 and 18 which we do not expect to impact financial markets significantly. Does this mean that political risk is over in Europe? No. Until the euro area turns into a permanent and irreversible political union, there has to be a probability of euro break-up. To value euro area assets, investors must ask: what is this break-up probability? The sovereign bond market says it is 5% a year (Chart I-6). This shows up in a discount on German bund yields, because after a euro break-up a new deutschmark would rise; and a symmetrical premium on Italian BTP yields, because a new lira would fall. For the aggregate euro area bond, the risk largely cancels out because intra-euro currency redenomination would be zero sum. But European equities must trade at a discount for this tail-event. At the peak of the euro debt crisis in 2011, the Eurostoxx600 underperformed the S&P500 by 25% in one year. In an outright break-up, the underperformance would almost certainly be worse, let's conservatively say 30-40%. So assuming the tail-event probability is 5% a year, European equities must compensate with a valuation discount which allows a 1.5-2.0%5 excess annual return over U.S. equities. Today, the valuation discount on European equities relative to U.S. equities implies an excess annual return of 1.8%.6 This makes European equities cheap versus U.S. equities only if the annual probability of euro break-up is less than 5%. Our assessment is that a 5% annual risk is about right. Therefore, European equities are fairly valued - rather than cheap - versus U.S. equities. But to avoid the undesirable sector skews in the Eurostoxx600, a much better way to gain long-term exposure to European equities is via a 50:50 combination of Germany (DAX) and Sweden (OMX) (Chart I-7). Chart I-7Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. 2 At an annualized rate. 3 Geek's note: the unemployment rate can be expressed as: 100*(participation rate - employment to population rate) / (participation rate). Hence, all else being equal, a rising participation rate will raise the unemployment rate and a falling participation rate will depress the unemployment rate. 4 This lesson applies equally to any studies of labour market slack such as this one: https://www.ecb.europa.eu/pub/pdf/other/ebbox201703_03.en.pdf that do not take into account the dynamics of participation rates. 5 5% multiplied by 30-40% equals 1.5-2.0% 6 Through the next ten years. Please see the European Investment Strategy Weekly Report titled "Markets Suspended In Disbelief" dated April 13, 2017 available at eis.bcaresearch.com Fractal Trading Model The rally in the CAC40 after the French election is technically extended. The recommended technical trade is to short the CAC40 versus the Eurostoxx600. 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-8 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
Please note that we are publishing a Special Report today titled "EM Local Bonds: Looking At Hedged Yields". Feature Commodities prices have plunged lately, even though the U.S. dollar, up until this past week, has been weak versus European currencies. Hence, the recent selloff in the commodities complex cannot be attributable to U.S. dollar strength. Something else has been at work. Furthermore, EM share prices and currencies have decoupled from both commodities prices and DM commodities currencies such as the AUD, NZD and the CAD (Chart I-1). Chart I-1Unsustainable Divergence Is this time different, and are we entering a new era in EM investing? We do not think so. This divergence is unsustainable and reflects irrational exuberance and fund flows into EM. The decoupling is already overstretched - although it could last another several weeks, it will not continue for much longer. We have the following observations: The commodities selloff has been very broad-based, and has been especially intense in commodities that are trading in China as well as those that are leveraged to Chinese growth (Chart I-2A & Chart I-2B). Such a simultaneous gap down in various commodities prices can be explained either by a decline in speculative long positions in commodities or weakness in real demand. It cannot be attributed to supply because the selloff has transpired at the same time across various commodities. Commodities' supply dynamics are idiosyncratic. China's central bank has been tightening liquidity, forcing deleveraging in the financial system. It is very plausible that this has led to an unwinding of long positions in commodities trading in China. Chart I-2AWidespread Carnage In Commodities Chart I-2BWidespread Carnage In Commodities China bulls would correctly argue that the selloff in commodities is indicative of a reduction in speculative trading activities - not in final demand. However, to be consistent, we should also accept that that the commodities rally in 2016 was not entirely due to demand improvement in China. Instead, it was at least partially due to speculative investment demand. It is impossible to quantify the magnitude of speculative activity in China's commodities markets, yet it has probably been a non-trivial force supercharging both last year's rally as well as the latest selloff. In regard to commodities demand from the real economy, China's growth has not yet turned decisively down. That said, the growth outlook is downbeat as credit growth downshifts in response to the ongoing policy tightening. Chart I-3 illustrates that the annual growth in the number and value of newly started projects has recently contracted. This heralds weaker demand for commodities, materials and capital goods in the months ahead. The surge in new projects launched last year marked the beginning of an upturn in industrial activity, and could well be indicative of a budding downtrend now. Besides, Chinese imports of industrial metals (excluding iron ore) has by and large been flat since 2010 (Chart I-4). The mainland's iron ore imports have been strong because inefficient/expensive domestic production has been shut down, leading to an increase in imports. Chart I-3China: Capital Spending To Slump Again Chart I-4China: No Growth In Industrial Metals' Imports Although China's oil imports have been strong (Chart I-5, top panel), underlying final demand has been weaker as there is evidence that the country has used imports of crude to increase inventories (Chart I-5, bottom panel). Provided that inventories are mean-reverting, such a large build-up in crude inventories poses a risk to China's oil demand and oil prices in the months ahead. Remarkably, the Brazilian real and South African rand have recently decoupled from the overall commodities price index and platinum prices, respectively (Chart I-6). These divergences represent a substantial departure from historical correlations. We cannot find any explanation other than the ongoing irrational exuberance in EM financial markets. Finally, signposts of potential growth deceleration are not only limited to the commodities complex. For example, Taiwanese narrow money (M1) impulse has decisively rolled over; it typically leads Taiwanese exports and correlates well with the equity market (Chart I-7). Chart I-5China's Oil Imports And An Inventories Proxy Chart I-6EM Commodity Currencies And Commodities Prices Chart I-7Taiwanese Export Growth And Equities Are At Risk Too Bottom Line: The recent decoupling between commodities prices and EM risk assets is unsustainable. This divergence reflects irrational exuberance that typically transpires around a major market top. While not chasing this rally has been painful, there is no point in doing so at current levels. We recommend investors maintain a negative stance on EM risk assets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Chart 3Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The Economic Surprise Index has declined and may continue to roll over until expectations wash out. But that shouldn't derail risk assets or the Fed. The GDP data is a mix of art and science. For investors focused on what the quarterly GDP release reveals about the state of the economy, it is important to remember that the advance release involves more of the former. The FOMC called the weakness in Q1 "transitory". The U.S. economy can grow fast enough over the final three quarters of the year to meet the Fed's 2.0% growth target. The recent readings on inflation and the labor market remain consistent with 2 more rate hikes this year, starting in June. We expect the stock-to-bond ratio to hit new highs by the end of the year even without a big move in equity prices. Feature U.S. equities have now returned to their early March highs despite the ongoing weakness in economic surprises. The latest high profile negative surprises were in the Q1 GDP report, and the March reading on core PCE inflation. Have equity prices disconnected from the underlying economic fundamentals or is something else at play? More importantly, how does the Fed view the recent weakness in economic data? The outlook for inflation, the Fed, and growth supports the relative performance of stocks vs bonds, even assuming modest returns to the former. What To Expect After A Weak Q1 The Q1 GDP report was weak. It was the latest in a string of U.S. economic reports stretching back to mid-March that have disappointed relative to (raised) expectations. In February,1 we highlighted the risk that the "current period of economic surprise could last for another month or two..." before inevitably giving way to elevated expectations and finally disappointment. On average since 2010, elevated levels of economic surprise have lasted roughly two months, with the latest period lasted about 11 weeks (Chart 1). So now what? Chart 1Economic Surprise Index Has Rolled Over Since Early to Mid March Each day that passes, economic expectations move lower, adjusting the bar down for the next batch of economic reports. The starting point was set relatively high just after last fall's election and early this year, as investors anticipated quick action from the Trump Administration and Congress on tax cuts, tax reform and infrastructure. More recently however, some of the key data have not only failed to match raised expectations, but have begun to roll over. Since 2010, periods of disappointing economic reports have persisted, on average, for 4 months (Chart 1). We are nearly 2 months in, implying that expectations will be washed out soon. With a solid backdrop for corporate earnings, and ebbing geopolitical risk, any equity pullback based on near-term weakness in the economic data should be short-lived. Q1 real GDP growth came in at just 0.7%, well below expectations of a 1.1% increase. At the start of 2017, consensus estimates were in the 2 to 2.5% range, but we were not surprised by the weak report and markets should not have been either. In our two most recent reports,2 we highlighted the well-known seasonality issues with Q1 GDP. Markets seemed to have - correctly in our view - taken the Q1 GDP report in stride and are looking ahead to Q2 and beyond. We expect a snapback in growth in Q2 and over the rest of 2017. The Atlanta Fed's Q2 estimate (+4.2%) supports our view but the NY Fed's latest nowcast for Q2 (+1.8) suggests a more modest rebound. In addition to the potential for higher growth later in the year, there is also the chance that Q1 growth was misstated. Investors can track revisions to Q1 GDP via the Atlanta and NY Fed's Nowcasts, and should bear in mind that the GDP data is a mix of art and science. For investors focused on what the quarterly GDP release reveals about the state of the economy, it is important to remember that the advance release involves more of the former. The Bureau of Economic Analysis' (BEA) GDP data are subject to near constant revision. For example, the Q1 2007 GDP data (released in April 2007) has already been revised 10 times (Table 1). Availability to the BEA of input data that is both timely and comprehensive is at the root of this constant revision. Investors need to take this into account as they try to assess the health of the U.S. economy in "real time". In the past 8 years, Q1 GDP has been revised lower half the time between the advance estimate (1/3 of the hard data) and the second estimate (50% of the data). But as currently reported, Q1 GDP in 5 of the last 8 years is now higher than it was when first reported and in some cases these revisions have been significant in magnitude (Table 1). Which reading should investors trust? A look at the composition of those estimates may help. Table 1GDP Is A Mix Of Art And Science When the BEA released Q1 GDP in late April it had collected just over a third of the "hard" data that feeds into GDP (Chart 2). The rest of the data used to calculate Q1 GDP was filled in by the BEA using assumptions, or "judgmental trend," or by using data from a similar data series. By the time the second estimate is released in late May, the BEA will have just 50% of the "hard" data. Thus, a healthy dose of skepticism is warranted when evaluating the U.S. economy on the initial reports of GDP. Chart 2Advance Estimate Of GDP##br## Is More Art Than Science For now, U.S. equities have not been affected by the weak Q1 GDP data or the recent collapse in positive economic surprises. Our work shows that the disappointing economic data may persist for another few months. Stocks are within a few points of their all-time high set in March; which suggests that markets are less focused on the noise in the economic data, but remain intently focused on the Trump Administration passing some profit friendly legislation at some point this year. If economic disappointments persist for longer than a few more months and Congress doesn't follow through, we can't rule out a meaningful correction in U.S. equities. Nonetheless, the lack of excesses in the economy, general agreement between the Fed and the market on the path of rates for this year and rising, but still modest, inflation are likely to make any pullback in U.S. stocks a buying opportunity for investors. Bottom Line: Investors should fade the recent disappearance in positive economic surprises by staying overweight stocks vs bonds over the coming 6-12 months. FOMC: Growth Weakness Is Transitory Chart 3GDP, Inflation And Labor Market All Tracking##br## To Fed's Forecast = Gradual Rate Hikes The pace of economic growth, and more importantly how that growth impacts the labor market and inflation, remain a crucial factor in how investors assess the number of additional Fed rate hikes that can be expected this year. We continue to expect two more 25 basis point hikes in 2017, whereas the market, as of May 4, was pricing in just 38 bps. At the start of the weakness in the economic data in early March, the market had penciled in 68 bps (almost 3 rate hikes). The soft performance of the economy in Q1 was certainly a focus at last week's FOMC meeting. The FOMC's assessment was that the slowdown in growth in the economy in Q1 was "transitory." The FOMC made no material changes to its assessment of inflation or the labor market in the statement. The minutes of last week's meeting due on May 24 will provide more color. While not officially part of the Fed's dual mandate (of inflation and unemployment), economic growth obviously matters to the Fed. Growth that runs above the Fed's view of potential GDP will push the unemployment rate lower and push inflation higher. Top panel of Chart 3 shows that real GDP growth rose 1.9% from a year ago in Q1, just a tenth of a percent below the Fed's central tendency range for 2017 of 2.0 to 2.2% (Chart 3, panel 2). Despite the poor start to 2017, real GDP growth would have to average only a modest 2.5% per quarter over the rest of the year to hit the Fed's 2.0% target. Is 2.5% growth over the final three quarters achievable absent positive revisions to Q1? We think it is. Since 2010, GDP growth in the final 3 quarters of the year has averaged 2.5%. The headwinds facing the economy today are weaker than they were in the early years of the recovery. The April readings on manufacturing (54.8) and non-manufacturing (57.5) ISM imply GDP growth in the 3 to 3.5% range in Q2. The FOMC is correct to look through the temporary weakness in Q1 and continue on its gradual path of rate hikes this year to match the "modest" pace of economic growth. Investors got a few other key inputs to the FOMC's decision making process last week: The March reading on PCE inflation and the April employment report. Both readings keep the Fed on track for gradual hikes in 2017. A soft reading on core PCE inflation - the Fed's preferred measure - was also a contributor to the weakness in the economic surprise index. For now, we see few signs that suggest core inflation is headed sustainably lower. Chart 4 shows that, since 2000, core PCE inflation has closely correlated with a one year lag of real consumer spending. Even with the recent deceleration in spending, the chart suggests that the recent decline in inflation is temporary. In addition, our sense is that the Fed is more likely to tolerate a rate of inflation that is modestly below its estimate as long as growth remains strong and there is evidence that the weakness in inflation is transitory. Chart 4Core PCE Inflation Likely To Move Higher To Meet Spending The April labor market data was released last week as well and confirmed the FOMC's assessment of a solid labor market, but it also had a one negative surprise for markets. The 211,000 increase in jobs in April exceeded expectations (+185,000) and accelerated from the 79,000 gain in March. Over the past three months, the average monthly gain in payrolls was 174,000,well above the 100,000 to 125,000 per month pace the Fed says is needed to tighten the labor market. The drop in the unemployment rate in April to 4.4% puts the unemployment rate at pre-recession lows and more importantly, below the lower end of the Fed's 4.5% to 4.6% central tendency for this year. (Chart 3, panel 3). The negative surprise in the April jobs report came from wages. Average hourly earnings decelerated to 2.5% year-over-year in April from +2.6% in March. The consensus was looking for a 2.7% increase. Despite the lack of traction on wages, the April jobs supports the view that the economy is growing fast enough to tighten the labor market, push up wages and ultimately inflation. June remains a close call for the next Fed rate hike, but an analysis of the economy and the Fed's reaction function suggests that two rate hikes remain the most likely event this year. Our view is that the market will adjust up expectations toward the Fed's view for 2018. Bottom Line: The recent disappointment in the data is not enough to knock the Fed off course. Investors should continue to expect two additional rate hikes in 2017, with the next move coming at the June meeting. A Pro-Cyclical Asset Stance: It's Not Just About Stocks Chart 5Investors' Preference For Bonds##br## Is Understandable... One of the most basic ways that BCA evaluates the trend in financial markets is to look at what we call the "stock-to-bond ratio". In this publication the ratio is shown as the S&P 500 total return index divided by that of U.S. 10-year government bond. Chart 5 shows the amazing evolution of the stock-to-bond ratio over the past decade, rebased to 100 at the end of 2007 (the official beginning of the 2008-2009 recession). Panel 2 of the chart shows the component total return indexes, also rebased to 100 at the end of 2007. The chart illustrates two incredible points. First, while it is true that stocks have massively outpaced bonds since the low in March 2009, it took equity investors who bought and held at the onset of recession until late-2013 to outpace bond investors who did the same. Second, until the U.S. election in November, the stock-to-bond ratio was only 10% higher than it was in December 2007, which is a powerful testament to the ability of bonds to preserve capital over the long haul. Given these observations and the still-fresh memory of the global financial crisis, it is easy to see how some investors continue to prefer the relative safety of bonds, especially since equity multiples have risen significantly over the past year. However, Chart 6 highlights how our long stock-to-bond call is motivated by an expectation of higher stock prices and negative returns from bonds. The chart shows the likely trajectory of the 10-year Treasury yield over the coming year, under the base case scenario envisioned by our U.S. Bond Strategy service: core PCE inflation rises to 2%, and the spread between the 10-year breakeven inflation rate and core rises to 50 bps. Chart 7 illustrates the implications of this forecast for bond total returns, alongside the resulting stock-to-bond ratio. For stocks, we assume a very conservative 3% annualized nominal total return, which is the sum of a 2% dividend yield and a 1% assumed nominal price return. Chart 6...But The Bond Bull Market Is Over Chart 7A New High By Year-End The key point from Chart 7 is that the stock-to-bond ratio is likely to rise to a new high by the end of the year, even without aggressive assumptions for equity returns. We agree that bond yields will fall in the event of another risk-off event, and that 10-year Treasurys remain an important component of a diversified portfolio. But it is also important for investors to recognize that, absent these types of events, the relative performance of stocks vs. bonds is set to move higher in part because 10-year Treasurys are likely to generate a negative absolute return over the coming 6-12 months. Bottom Line: Investors should retain a pro-cyclical asset allocation stance. The outlook for the inflation, the Fed, and growth supports the relative performance of stocks vs bonds, even assuming modest returns to the former. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "Goldilocks: For How Long?," dated February 20, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Special Reports "Spring Snapback" dated April 24, 2017 and "The Good And The Bad". May 1, 2017, available at usis.bcaresearch.com.
Highlights Portfolio Strategy Any advance in Treasury yields should be gradual and more reflective of an improving global economy than it would be restrictive for equities. Book profits in homebuilders and downgrade to neutral. Rising lumber prices will do more harm than good. In contrast, home improvement retailers are in a sweet spot. We reiterate our high-conviction overweight stance. Recent Changes S&P Homebuilding - Downgrade to neutral. Table 1 Feature Equities marked time at the top end of their range last week. A catalyst may be required to sustain a breakout to new highs, as robust corporate profitability and forward guidance, coupled with tame monetary conditions, are battling against a spate of economic disappointments and soft commodity prices. Financial conditions remain sufficiently easy that economic growth should rebound in the back half of the year. The Fed is in no hurry to aggressively tighten monetary policy, owing to the lack of a serious inflation threat. If hard data begin to firm, then investors will gain confidence in the durability of the profit recovery, powering a further share price advance. While there may be some concern that stronger growth will simply embolden the Fed and push up Treasury yields, we doubt that the latter will become a roadblock just yet. Last week we highlighted that it typically takes a rise to at least one standard deviation above the mean in BCA's Treasury Bond Valuation Indicator to warn that the economy and stocks are at risk of a major downturn. That level would equate to 3.3% on the 10-year Treasury yield (Chart 1). Such large moves in Treasury yields do occur occasionally, (Nov/2010-Feb 2011, summer of 2013 and winter of 2016) and have sometimes preceded/caused economic slowdowns and/or financial accidents. The speed of the adjustment clearly plays a role, as short-term spikes are much harder to digest than gradual yield advances. Nominal GDP growth is comfortably above the 10-year Treasury yield, signaling that financial conditions will stay sufficiently easy for some time, barring a major bond selloff (second panel, Chart 2). Chart 1Yields Have Room To Rise##br## Before Becoming Restrictive Chart 2Sales Will Support##br## The Overshoot In other words, any advance in yields should be gradual and more reflective of a better global economy than restrictive, especially given the ongoing gentle softening in the U.S. dollar. The upshot is that the string of economic disappointments should begin to fade. In recent research, we have stressed the importance of a meaningful revival in corporate sector revenue growth in order to sustain sky-high valuations (top panel, Chart 2). Encouragingly, inflation expectations are recovering globally. A whiff of inflation is a positive omen for top line growth prospects. Inflation and economic growth expectations have firmed around the world. Chart 2 shows that euro area sales per share are on track to exit deflation after a multiyear slump, based on the message from the bond market. The same is true for emerging markets. If companies outside the U.S. finally enjoy renewed top-line growth, that would bode well for a continued recovery in U.S. business sales, especially if the U.S. dollar weakens. Chart 3 shows that both EM currencies and regional confidence surveys are heralding ongoing gains in U.S. profits sourced from overseas. Nevertheless, it is critical to keep the backdrop in a longer-term context. BCA's Equity Speculation Index (ESI) signals that the advance is at a very high risk stage (Chart 4). The ESI can stay in elevated territory for a prolonged period, as occurred in 2014/2015, before a correction unfolds. But, investors should maintain some non-cyclical exposure even if the market continues its advance in the short run. Chart 3Foreign-Sourced Profit Support Chart 4The Rally Is Very High Risk This week we are updating our overall view of the consumer discretionary sector and tweaking our housing-related equity positioning. Consumer Discretionary: On The Way To All-Time Highs Consumer discretionary stocks have been portfolio stalwarts in 2017 (outside of autos and select media), advancing by over 10% and besting the S&P 500 by about 400bps. The heavyweight media sub-group (ex-cable and satellite) has come under scrutiny recently, as fears that ad spending will endure a deep slump have resurfaced. However, most of our indicators suggest that ad spending, at least outside of autos, will not suffer a major downturn, given our upbeat outlook for consumption and profits. Cord-cutting is not a new phenomenon, and is already reflected in very washed out profit expectations, both on a cyclical and structural horizon (we will be covering media in more detail in an upcoming Report). Consequently, there are good odds that this impressive consumer discretionary showing will remain intact especially as last Friday's payrolls bounced smartly. Two key drivers have added fuel to this fiery performance: border adjustment tax fears have subsided and soft economic data have given the Fed enough breathing room to continue erring on the dovish side. Importantly, leading indicators of discretionary spending are heralding a solid recovery in consumer outlays. Interest rates remain near generationally low levels and oil price inflation has peaked. The economy is near full employment, signaling that wage inflation will quicken. According to BCA's Income Indicator1, consumer income growth is expected to reaccelerate imminently (bottom panel, Chart 5). While consumers have demonstrated a preference for saving vs. spending, several factors suggest that purse strings should soon loosen. Consumer confidence has soared, buoyed by income gains (third panel, Chart 5). Moreover, new highs in household net worth as a percent of disposable income signal that the upward pressure on the personal savings rate should diminish (second panel, Chart 5). The implication is that recent disappointing consumer spending data should prove transitory. While these factors could ultimately put upward pressure on interest rates, there may be a window where limited inflation pressures and weak credit growth permit only a gradual upshift in the Treasury curve. Regardless, there are other indicators pointing to additional outperformance. For instance, there is still a wide gap between forward earnings breadth and washed-out technical conditions. Roughly 75% of consumer discretionary sub-groups have rising 12-month forward profit estimates. This is sustainable as long as consumers have an incentive to spend. In contrast, the proportion of consumer discretionary sub-indexes with a positive 52-week rate of change and/or are trading above their 40-week moving average remains well below 50%. This divergence between fundamentals and technicals is an exploitable gap, which should narrow via a sustained rise in relative share prices (Chart 6). Chart 5Upbeat Consumption Outlook Chart 6Exploitable Gap Finally, consumer discretionary stocks are no longer expensive. On a relative forward P/E basis they trade below the historical mean and at a discount to the S&P 500. Consumer discretionary EV/EBITDA is also trailing the broad market, as well as its long-term average. If a recovery in consumer outlays pans out in the back half of the year, as we expect, then a re-rating phase is likely. However, not all sub-groups are created equal. This week we are tweaking our housing-related consumer discretionary exposure. Homebuilders' Pain... Homebuilding stocks have been moving sideways for the better part of the past four years in a narrow trading range. They are currently sitting near the top of this range. Is it time to book profits? The short answer is yes. The recent confirmation of U.S. tariffs on Canadian lumber imports represents a source of cost inflation that may embed a risk premium in share prices until a new trade deal can be worked out. Lumber prices have nearly doubled during the past sixteen months and remain the best performing commodity in 2017 (bottom panel, Chart 7). Lumber comprises anywhere between 10%-20% of the cost of a new home, underscoring that a 20% lumber tariff will add to the cost of building a new home, squeezing margins unless homebuilders can pass this cost on via increased house prices. However, we are skeptical that there is a lot of room for new house price increases given that it would make it more difficult to compete with existing house sales. While new homes have taken market share from existing homes since the residential housing market trough earlier in the decade (Chart 8), market share gains have come at the expense of profit margins. Homebuilders have been aggressively discounting properties in order to lure new buyers. Given the buildup in new home inventories, further market share gains are at risk, unless additional selling price concessions materialize. Chart 7Elevated Lumber Prices... Chart 8...Spell Trouble For Homebuilding Margins The implication is that builders would likely have to absorb any input cost inflation, to the detriment of margins. Indeed, homebuilder sales are already decelerating as a consequence of pricing pressure (second panel, Chart 7). A simple homebuilder profit margin proxy (comprising new house price inflation minus the residential construction wage bill) warns that operating margins will compress, irrespective of the path of lumber prices (bottom panel, Chart 8). Nevertheless, there are some positive offsets that prevent us from turning outright bearish on the niche S&P homebuilding index. These counterbalances are related to the stage of the housing recovery. Homebuilders' sales expectations have surged, nearing the previous cycle's peak, according to the NAHB survey (Chart 9). Similarly, overall housing market conditions are probing multi-year highs and buyer traffic has vaulted to the highest level since mid-2005. Homebuilders remain optimistic about new housing demand. Household formation is still running higher than housing starts, representing a bullish backdrop for future new home construction. Rising incomes and a firming job market also bode well for the prospects of residential real estate. In aggregate, house prices are still expanding according to the Case-Shiller indexes and there are pockets of frothiness in select markets. The thirty year fixed mortgage rate recently broke back below 4% (Chart 10) and banks are willing extenders of mortgage credit, allaying fears that the price of credit will undermine housing affordability. According to our updated estimates (not shown), even if mortgage rates spiked 200bps from current levels, neither affordability nor mortgage payments as a percent of median incomes would return to their respective long-term average. Chart 9Housing Market Remains Firm... Chart 10...Warranting A Neutral Stance Still, these positives are already reflected in expectations, as the sell side has aggressively upgraded homebuilding profit estimates. The net earnings revisions ratio has catapulted to a 12-year high (Chart 10). Given our more balanced outlook for homebuilding earnings, we are leaning against this exuberance. Bottom Line: Book profits of 3.4% in the S&P homebuilding index and downgrade to neutral. The ticker symbols for the stocks in this index are: DHI, LEN, PHM. ...Is Home Improvement Retailers' Gain While our confidence in further homebuilding outperformance has ebbed, the opposite is true for the S&P home improvement retail (HIR) index. We put the S&P HIR index on our high-conviction overweight list at the beginning of the year, and so far, so good. HIR stocks have outperformed the broad market and the S&P consumer discretionary sector year-to-date. There are good odds that more gains lie ahead. Industry retail sales are running at a mid-single digit rate, surpassing lackluster overall retail sales (second panel, Chart 11). Importantly, household appliance and furniture selling prices have surged, reinforcing that demand is robust and signaling that HIR same-store sales growth will likely accelerate in the busy spring selling season, and beyond (middle panel, Chart 11). Unlike homebuilders, home improvement retailers benefit from rising lumber prices. HIR companies typically earn a set margin on lumber-related sales. Thus, any absolute increase in lumber prices boosts top line growth, and profit margins (bottom panel, Chart 11). The industry's disciplined approach to store additions in the aftermath of the GFC has set the stage for ongoing selling price gains. Chart 12 shows that while house prices have overtaken the 2006 highs, increasing the incentive for homeowners to remodel and invest in this key asset, building and supply store construction activity has remained depressed. Easier mortgage lending standards should ensure that total home sales activity remains elevated, to the benefit of home prices, and provide the necessary financing needed for large projects (Chart 12). Tight labor markets, rising wages and surging consumer confidence are signaling that consumers have an appetite to re-lever and space to take on more debt (Chart 12). With store capex budgets under tight control, same-store sales and cash flow growth are bound to sustain their solid advance as renovation activity accelerates. All of this is best encapsulated by our HIR model. The model has recently soared, driven by the drop in fixed mortgage rates and surge in lumber prices, signaling that the path of least resistance is higher for relative share prices (top panel, Chart 11). Indeed, relative profits have already soared to fresh highs, also signaling the same for relative share prices (top panel, Chart 13). Oddly, analysts are overly pessimistic about the industry's sales and earnings growth prospects. In fact, top line growth estimates are trailing those of the broad market, and the 12-month forward relative profit growth hurdle is set very low at 2% (middle panel, Chart 13). Chart 11All Signals Flashing Green Chart 12Capacity Restraint Is Paying Dividends Chart 13Earnings Led Advance Given the positive message from leading indicators of remodeling activity we are far more optimistic, and expect both relative top and bottom line growth numbers to overwhelm. Bottom Line: The re-rating phase in the S&P home improvement retail index has room to run. We reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: HD, LOW. 1 Please see Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights Chart 1Global Equities At Record Highs Our Stock Market Timing Model points to a heightened risk of a correction for global equities over the next few months. However, the 12-month cyclical outlook still looks reasonably good thanks to accelerating earnings growth. Monetary policy has also yet to reach restrictive levels in most economies. Beyond the next 12 months, lofty valuations (especially in the U.S.), as well as the prospect of a meaningful economic slowdown late next year, will weigh on returns. Tactically, go short the S&P 500 with a target of 7.5% and stop-loss of 2.5%. This trade will automatically expire in six weeks. Cyclically, go long the December 2017 Brent Oil futures contract. Feature Aging Bull? Global equities have been on a tear lately. The MSCI All-Country Index reached a fresh record high this week (Chart 1). The index is up 14.1% in local-currency terms and 13.3% in U.S. dollar terms since early November. Our philosophy at BCA Research is that the best market calls come from combining informed qualitative analysis with time-tested quantitative indicators. With that in mind, this week's report distills the results of our proprietary Stock Market Timing Model. Our main conclusions are only partly reassuring. While the cyclical 12-month outlook for stocks remains reasonably auspicious, our model suggests that there is an elevated risk of a near-term correction. The model is also forecasting subpar long-term returns for stocks, particularly in the U.S. where valuations have become stretched. What Predicts Stock Returns? As we have documented in past research,1 a number of empirical regularities help predict stock market returns: 1. Stocks Tend To Perform Better When Economic Growth Is Accelerating The state of the business cycle is the most important driver of stock returns over horizons of around 12 months. Our model incorporates a variety of forward-looking cyclical variables that span different parts of the economy. For example, Table 1 shows the S&P 500 has delivered an average annualized real total return of 9.8% since 1948 whenever the gap between the ISM manufacturing new orders and inventories components - based on the prior month's ISM reading - was positive. In contrast, the S&P 500 has fallen by an average of 1.2% whenever the gap was negative. In the same vein, the S&P 500 has produced an average annualized real total return of 9.2% since 2000 whenever initial unemployment claims have declined over the prior three months, while losing 3.6% whenever claims have increased. The gap between new orders and inventories fell to 6.5 in April, down from a March reading of 15.5. The downtrend in initial unemployment claims has also flattened out. The moves in the ISM manufacturing index and unemployment claims, along with other measures such as auto sales, suggest that the economy is going through a soft patch. This softening, in turn, has been reflected in a steep drop in Citi's economic surprise index (Chart 2). Table 1Stocks Tend To Perform Better When Growth Is Accelerating Chart 2Some Signs Of Softening U.S. Economic Data... Still, we would not overstate the extent of the deterioration in the growth picture. Goldman's Current Activity Indicator remains near cyclical highs (Chart 3). The Atlanta Fed's preliminary Q2 growth estimate stands at 4.2%, while the NY Fed's Nowcast stands at 2.3%. If these preliminary estimates prove to be correct, Q1 will end up being just a temporary speedbump along the road to recovery. Consistent with this, a variety of forward-looking indicators suggest that the U.S. economy will grow at an above-trend pace over the remainder of the year (Chart 4). Durable goods orders are rising, business capex intentions have surged, building permits are trending higher, and consumer confidence is strong. Chart 3...But Growth Backdrop Still Solid... Chart 4...And Forward-Looking Indicators Remain Upbeat Globally, the picture remains reasonably upbeat, as highlighted by our Global Leading Indicator (Chart 5). Growth in the euro area is particularly strong. Green shoots are also appearing in beleaguered emerging markets such as Brazil and Russia. The Chinese economy has slowed a notch, but is still in much better shape than it was at this time last year. Above-trend global growth is helping to propel corporate earnings. The Q1 earnings season is off to a strong start. According to Thomson Reuters, EPS for the S&P 500 in the first quarter is expected to increase by 14.8% from year-ago levels. 75% of companies have beat earnings estimates, compared to the long-term average of 64%. 63% of companies have beaten revenue estimates, compared to the historic average of 59%. BCA's global earnings model predicts further upside for profits over the coming months (Chart 6).2 Chart 5Global Economy Is Doing Well Chart 6More Upside For Global Earnings Bottom Line: Cyclical indicators are somewhat mixed, but generally point to further upside for global stocks. 2. Stocks Tend To Perform Better When Financial Conditions Are Easing Easy money and equity bull markets tend to go hand in hand. Since 1970, the S&P 500 has delivered a real total average annualized return of 12.9% whenever our monetary indicator - which looks at money growth, bank lending, as well as short-term and long-term rates - was above its long-term average in the prior month, but only 0.5% when the indicator was below its long-term average. Similarly, the S&P 500 has risen at a 9.6% annualized pace whenever BCA's Financial Conditions Index (FCI) - which includes such components as credit spreads, the trade-weighted dollar, oil prices, home prices, and the relative performance of bank shares - was above its 250-day moving average, while gaining only 1.4% when the FCI was below its 250-day moving average. Chart 7 shows that our U.S. FCI remains slightly above its moving average, thanks to the decline in credit spreads over the past 12 months, along with higher stock market and house prices. However, the monetary indicator has now dipped below its respective moving average due to rising rates and slower broad money growth. Chart 7Financial Conditions Still Bode Well For Equity Returns, But U.S. Rate Hikes Loom Large Looking out, monetary and financial conditions are likely to be buffeted by various crosswinds. On the one hand, business lending should recover thanks in part to a rebound in manufacturing output (Chart 8). On the other hand, consumer lending standards have been tightening for some time and delinquencies and charge-offs for auto and credit card loans have edged higher, albeit from very low levels (Chart 9). Higher interest rates are also likely to weigh on credit demand. On balance, we expect a modest tightening in U.S. financial conditions over the remainder of the year. Chart 8Business Lending Should Recover Chart 9Tightening Consumer Lending Standards Outside the U.S., financial conditions are likely to stay accommodative. Unlike the Fed, most other central banks will keep rates near rock-bottom levels. In fact, real short-term rates in the euro area and Japan could even decline as stronger GDP growth lifts inflation expectations. Bottom Line: Financial conditions are still somewhat supportive for global equities, but are likely to become less so in the U.S. as the Fed continues to hike rates. 3. Stocks Tend To Perform Better When Sentiment Is Poor But Improving Warren Buffet once famously said that the secret to being a successful investor is to be "fearful when others are greedy and greedy when others are fearful." There is no doubt that the level of sentiment can be a powerful contrarian indicator. However, our research indicates that the change in sentiment is also important in predicting equity returns. Trading rules that overweight stocks whenever sentiment over the prior weeks has improved from bearish levels, while underweighting stocks whenever sentiment has deteriorated from bullish levels, can significantly outperform a buy-and-hold strategy (Chart 10). This finding is similar to what one sees for individual stocks. As we discussed in our report on bottom-up stock picking,3 the best stocks tend to be the ones for which the consensus analyst opinion is bearish but improving. In contrast, the worst stocks are typically the ones for which the consensus analyst opinion is bullish but deteriorating. Today, market sentiment is on the bullish side (Chart 11). According to the Marketvane survey, the share of traders that expect stocks to rise over the coming weeks is only slightly below where it was during past stock market peaks. Bullish sentiment is less pronounced in the AAII's survey of individual investors. However, equity allocations among AAII members are about five points above their historic average, which limits the scope for "new money" to come into the market. Meanwhile, complacency is setting in (Chart 12). The VIX hit its lowest level in ten years this week. The Minneapolis Fed's market-based probability of a 20%+ correction in the S&P 500 has also dropped to below 10%, a level last seen during the peak of the previous bull market in 2007. Yale University's One-Year Confidence Index - which measures how likely market participants think that stocks will go up in the succeeding year - is near record levels for individual investors and at an absolute record high for institutional investors. U.S. margin debt, expressed as a share of GDP, has also risen above its 2000 and 2007 peaks. Chart 10Buy Stocks When Sentiment Is Poor But Improving Chart 11Equity Sentiment Is More Bullish Than Usual Chart 12Complacency Reigns Bottom Line: Current levels of bullish sentiment are a warning sign for equities. Should sentiment measures begin to deteriorate without a correspondingly large drop in stock prices, it will be time to head for the exit doors. 4. Stocks Tend To Perform Better In "Young" Bull Markets Following Pullbacks When is the trend your friend? The answer is over horizons of about two years. Returns tend to be positively serially correlated over this range. This means that if stocks have done well over the past two years, they are likely to continue doing well. Over shorter horizons of less than a year and longer horizons exceeding three years, the trend is not your friend - returns tend to be negatively correlated (Chart 13). Thus, if stocks have fallen over the past few weeks, they are likely to do better over the following few weeks than if they had risen. Likewise, if stocks have done well over, say, the past five years, then this is evidence that the bull market is getting long in the tooth. Obviously, these are not hard and fast rules, but they do give some guidance about what the future may have in store. The fact that the S&P 500 has done well over the past two years is a bullish sign, but the fact that the bull market is now in its eighth year and price gains have accelerated over the past few months (raising the risk of a blow-off top) are both bearish signs. The bull market is less mature outside the U.S., which works in favor of non-U.S. stocks. Relative momentum is also turning more favorable for non-U.S. markets, especially those in the euro area (Chart 14). Chart 13When Is The Trend Your Friend? Chart 14Relative Momentum Favors Non-U.S. Stocks Bottom Line: Recent price momentum is sending mixed signals for U.S. stocks, but somewhat more encouraging signals for non-U.S. stocks. 5. Stocks Tend To Perform Better When They Are Cheaply Priced Valuations are not especially useful as a short-term timing tool. However, they are by far the most useful tool for gauging long-term expected returns. This can be seen in the fact that there is a strong negative correlation between the Shiller PE ratio and subsequent real total returns (Chart 15). In the U.S., the Shiller PE ratio currently stands at 29. This is 45% above the post-1960 median and 82% above the median since 1880. If profit margins over the past 10 years had been what they were on average during the 1990s, the Shiller PE ratio would stand at 41 today - within reaching distance of its 2000 peak (Chart 16). U.S. valuations are even more stretched if one looks underneath the indices: The median NYSE stock currently trades at a higher price-to-earnings and price-to-cash flow ratio than at the 2000 peak (Chart 17). Chart 15Valuation Is The Single Best Predictor Of Long-Term Equity Returns Chart 16U.S. Valuations Are Stretched... Chart 17...Especially For The Median Stocks One could argue that a structurally lower neutral interest rate justifies a higher equilibrium PE ratio. There are plenty of reasons to challenge this argument - a lower neutral rate may foreshadow slow earnings growth, for instance - but even if one accepts its basic premise, it does not imply that stocks will do well in absolute terms. If you assume a lower discount rate in calculating the present value of future cash flows, you must also assume a lower long-term rate of return from owning stocks. You can't one have without the other. Valuations are generally more favorable outside the U.S., even if one adjusts for differences in sector weights across countries (Chart 18). Chart 18Valuations More Favorable Outside The U.S. Bottom Line: Valuations are stretched in the U.S. Long-term investors should favor non-U.S. stocks over their U.S. peers. 6. Stocks Tend To Perform Better During Certain Days And Months Of The Year Than Others No discussion of stock market-timing strategies would be complete without a few words on calendar effects (Table 2). Table 2When to Buy Stocks As with all stock market anomalies, there is a risk that any particular calendar pattern will disappear once it has been documented. For example, the "Blue Monday" effect, popularized by Yale Hirsch's 1987 book "Don't Sell Stocks On Monday," vanished soon after the book was published, only to make a comeback of sorts during the past 15 years. The so-called January Effect, which describes the tendency for stocks to do well at the start of the year, largely disappeared from the data at the turn of the century. In its place the "Santa Claus rally" was born, presumably reflecting the desire of traders to front run the January effect. Other calendar effects remain alive and well. The tendency for stocks to underperform during the summer and autumn months (the "Sell In May And Go Away" effect) is still around (Chart 19). The same goes for the so-called "turn-of-the-month effect" - the tendency for stocks to do best in the last few days and first few days of each month. Less well known is the tendency for stocks to do much better on FOMC days.4 Remarkably, the S&P 500 would be more than 50% lower today if one were to exclude all the days since 1990 when scheduled FOMC meetings took place from the return tally (Chart 20). Chart 19Sell In May And Go Away Chart 20The Fed Effect Bottom Line: High frequency, tactical investors may be able to profit from exploiting calendar effects in the data. Putting It All Together Our Stock Market Timing Model incorporates the factors discussed above. As Chart 21 illustrates, it has an admirable track record of predicting market returns. The current message from the model differs across time horizons. Tactically, over a three-month horizon, it suggests that stocks are overbought and vulnerable to a correction. This is mainly due to the sharp run-up in most global bourses over the past six months, as well as elevated levels of bullish sentiment. The fact that we are also entering the historically weak summer months is also a slight negative in our model. Cyclically, however, the picture still looks fairly reassuring: leading economic indicators and corporate earnings are in an uptrend. Financial conditions also remain accommodative. Thus, the model continues to predict modestly above-average returns for global equities over a 12-month horizon. Looking beyond the next 12 months, however, the picture begins to dim. The U.S. now accounts for over 50% of global equity market capitalization. Valuations for U.S. stocks have reached elevated levels. The U.S. economy is also approaching full employment, which means that growth will fall back to what so far has been a very anemic pace of potential GDP growth. Interest rates may also eventually reach punitive levels as the Fed continues to hike rates. All this suggests that the bullish window for global stocks, and U.S. stocks in particular, may close late next year. Two New Trades We are initiating two new trades reflecting our differing tactical and cyclical views: Tactically, go short the S&P 500 with a target of 7.5% and stop-loss of 2.5%. This trade will automatically expire in six weeks. Cyclically, go long the December 2017 Brent Oil futures contract (Chart 22). Our commodity strategists remain convinced that the supply backdrop for oil is tighter than the market is discounting. Add to that a firm demand picture, and we have a recipe for what is likely to be at least a temporary recovery in oil prices. Chart 21Message From Our Stock Market Timing Model Chart 22Go long December 2017 Brent Futures Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Market Timing: Holy Grail Or Fool's Gold?" dated May 27, 2016, available at gis.bcaresearch.com. 2 Please see Global Alpha Sector Strategy Bi-Weekly Report, "Quarterly Review And Outlook," dated April 7, 2017, available at gss.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Introducing ETS: A Top-Down Approach To Bottom-Up Stock Picking," dated December 3, 2015, available at gis.bcaresearch.com. 4 David O. Lucca., and Emanuel Moench, "The Pre-FOMC Announcement Drift," Federal Reserve Bank Of New York Staff Reports, August 2013. Appendix Tactical Global Asset Allocation Monthly Update We announced in late March that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations in the first week of every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 1Global Asset Allocation Recommendations (Percent, Relative To Benchmark) Our tactical recommendations are based on a three-month horizon. Thus, at times, they can differ significantly from both our cyclical (12-month) and structural (12-month plus) recommendations. Compared to last month, we are cutting our tactical allocation to global stocks from +7 percentage points to zero (relative to benchmark), reflecting the heightened risk of a near-term pullback. We continue to maintain an underweight position in U.S. stocks within the equity portion of the portfolio. However, given the low-beta nature of U.S. stocks, most of the downgrade in overall equity exposure has occurred among European, Japanese, and EM bourses. We are also increasing our exposure to bonds from -9 to -6 percentage points, and increasing our tactical allocation to cash from +2 to +6 percentage points. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades