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Dear Clients, Please note that next week's report will be a joint effort with our geopolitical team, focused on North Korea. The report will be sent to you two days later than usual, on Friday June 8. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights Most episodes of negative relative Chinese equity performance this year have been driven by global stock market selloffs or related to the trade dispute with the U.S. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, we recommend against downgrading China for now, barring hard evidence of a pernicious global slowdown or that severe protectionist action from the U.S. will indeed occur. Our list of charts to watch over the coming months highlights, among several other important points, that monetary conditions are not overly restrictive and that financial conditions are not tightening sharply. This is in spite of a recent clustering in corporate bond defaults that has concerned some investors. Besides broad-based stimulus in response to an impactful trade shock, a sustained pickup in housing construction remains the most plausible catalyst for an acceleration in domestic demand. For now tepid sales volume casts doubt on this scenario, but investors should continue to watch Chinese housing market dynamics closely. Feature There have been several developments affecting Chinese and global stock markets over the past two weeks. On the trade front, Secretary Mnuchin's statement on May 20 that the U.S. would be "putting the trade war" with China on hold was greeted by a material pushback from Congressional Republicans, particularly the administration's plan to ease previously announced sanctions on ZTE Group. The administration's trade rhetoric has since become more hawkish, as evidenced by yesterday's statement from the White House that referenced specific dates for the imposition of tariffs and the announcement of new restrictions on Chinese investment. This uptick in tough language sets the scene for Secretary Ross' Beijing visit this weekend to continue negotiations. More recently, a political crisis in Italy has caused euro area periphery bond yields to rise sharply, roiling global financial markets. The Italian President's rejection of Paolo Savona as proposed finance minister by the anti-establishment Five Star Movement (M5S) and Euroskeptic Lega has led to the installation of a caretaker government until the fall, when new elections are set to take place. The sharp tightening in financial conditions for Italy and Spain over the past week has exacerbated concerns about a potential growth slowdown in Europe, and has fed a relative selloff in emerging market equities that began in late-March. Despite the recent turmoil, our recommendation to investors is to avoid making any major changes to their allocation to Chinese ex-tech stocks within a global portfolio. Unless presented with hard evidence that the slowdown in the global economy is more than a simple deceleration from an above-trend pace, or that protectionist action from the U.S. will occur in a severe fashion, Table 1 suggests that investors should stay overweight Chinese ex-tech stocks (with a short leash). The table highlights that most episodes of negative relative Chinese ex-stock performance since the beginning of the year been driven by global stock market selloffs or related to the trade dispute with the U.S., despite the ongoing slowdown in China's industrial sector that we have repeatedly flagged. Since Chinese ex-tech stocks have continued to outperform their global peers during this period, our interpretation is that investors are well aware of the deceleration in China's economy, but do not yet regard it as a material threat to ex-tech equity prices. Table 1YTD Weakness In Chinese Stock Prices Has Been Driven By Global Events Clearly, however, this assessment on the part of global investors can change, underscoring that the situation in China merits continual re-assessment. With the goal of providing investors with a toolkit to continually monitor the state of the Chinese economy and the resulting implications for related financial asset prices, this week's report presents a list of 11 charts "to watch" across five categories of analysis. In our view these charts span key potential inflection points for the economic and profit outlook, and will serve as an important basis for us to update our view on China over the months ahead. Monetary & Fiscal Policy Chart 1: The Policy Rate Versus Borrowing Rates Chart 1Borrowing/Policy Rate Divergence Should Not Last,##br## But Is Worth Monitoring An interesting divergence has occurred lately between the 3-month interbank repo rate (currently the de-facto policy rate) and both corporate bond yields and the average lending rate. While the repo rate fell non-trivially after it became apparent in late-March that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, corporate bond yields have recently risen sharply and China's weighted-average lending rate ticked higher in Q1. As we highlighted in last week's Special Report, the recent clustering of corporate bond defaults does not (for now) appear to be a source of systemic risk. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. But the possibility remains that the ongoing crackdown on China's shadow banking sector will cause some degree of persistence in the recent divergence between the interbank market and actual borrowing rates, implying that investors should continue to watch Chart 1 over the months for signs of materially tighter financial conditions. Chart 2: The Correlation Between Sovereign Risk And The Repo Rate We noted in a February Special Report that investors could use the rolling 1-year correlation between the 3-month interbank repo rate and the relative sovereign CDS spread between China and Germany as a gauge of whether Chinese monetary policy has become too restrictive for its economy.1 Despite the fact that actual sovereign credit risk in China is extremely low, Chart 2 shows that the relative CDS spread has acted as a good bellwether for growth conditions in the Chinese economy. It shows that the correlation between this spread and the 3-month interbank repo rate was initially positive in late-2016 (representing concern on the part of investors that monetary policy is restrictive), but has since come back down into negative territory. Interestingly, the correlation was consistently positive from mid-2011 to mid-2014, when average lending rates averaged 7% or higher and the benchmark lending rate exceeded the IMF's Taylor Rule estimate by about 1%.2 For now the correlation remains negative (as it was when we published our February report), meaning that it currently supports our earlier conclusion that monetary conditions are not overly restrictive and that financial conditions more generally are not tightening sharply (despite the recent rise in corporate bond yields). Chart 2No Sign Yet That Monetary Policy Is Overly Restrictive Chart 3Watch For Signs Of Fiscal Stimulus Chart 3: The Fiscal Spending Impulse Chart 3 presents the Chinese government's budgetary expenditure as an "impulse", calculated as expenditure over the past year as a percent of nominal GDP. Panel 2 shows the year-over-year change in the impulse. When compared with a similar measure for private sector credit, cyclical fluctuations in China's government spending impulse are relatively small. For this reason, BCA's China Investment Strategy service has not strongly emphasized fiscal spending as a major driver of China's business cycle. However, we also noted in a recent report that fiscal stimulus stands out as one of the "least bad" options available to policymakers to combat a negative export shock from U.S. protectionism, were one to occur.3 The potential for broader stimulus from Chinese authorities in response to an impactful trade shock raises the interesting possibility of another economic mini cycle in China, since the economy accelerated meaningfully in response to the last episode of material fiscal & monetary easing. As such, investors should closely watch over the coming months for signs that fiscal spending is accelerating, particularly if combined with potential signs of easing monetary policy. External Demand Chart 4: Global Demand And Chinese Export Growth Chart 4For Now, Resilient Exports ##br##Are Supporting China's Economy We have noted in several recent reports that a resilient export sector remains the most favorable pillar of Chinese growth. Besides the clear risk to Chinese trade from U.S. protectionism, two other factors have the potential to negatively impact the trend in export growth. The first (and most important) of these risks is a reduction in global demand, which some investors have recently been concerned about given the decline in global manufacturing PMIs. However, Chart 4 highlights that our global PMI diffusion indicator has done an excellent job of leading the global PMI over the past few years, and has barely registered a decline over the past few months. From our perspective, the odds are good that the recent deceleration in the PMI has been caused by sudden caution (even in developed countries) over the Trump administration's protectionist actions, and does not reflect a material or long-lasting slowdown in the global economy. But we will be closely watching the PMI releases over the coming months to rule out a more painful slowdown in global demand. Importantly, we have also highlighted that stronger exports may actually presage a further slowdown in China's industrial sector if it emboldens policymakers to intensify their reform efforts over the coming year. We argued in our May 2 Weekly Report that China's reform pain threshold is positively correlated with global growth momentum,4 meaning that the external sector of China's economy may have less potential to counter weakness in the industrial sector than many investors believe. In this regard, extreme export readings (to the up and downside) should be regarded by investors as a potentially problematic development. Chart 5: The Competitiveness Impact Of A Rising RMB Chart 5 highlights the second non-protectionist risk to Chinese export growth, namely the significant appreciation in the RMB that has occurred since mid-2017. The chart shows the percentile rank of three different trade-weighted RMB indexes since 2014, and highlights that all three are between their 70th & 80th percentiles (with our BCA Export-Weighted RMB index having risen the most). Importantly, the 2015-high shown in Chart 5 represents the strongest point for the currency in over two decades, suggesting that further currency strength may exacerbate the significant deceleration in export prices that has already occurred. Chart 5A Surging RMB Could Undercut Competitiveness Housing Chart 6: Housing Sales Versus Starts We have presented a variation of Chart 6 several times over the past few months, but it is important enough that it deserves to be continually monitored by investors over the coming year. Chart 6 tells the story of China's housing market from the perspective of an investor who is primarily interested in the sector because of its implications for growth. The chart highlights that residential floor space started, our best proxy for the real contribution to growth from residential investment, has fallen significantly relative to sales since 2012-2014. This appears to have occurred because of a significant build up in housing inventories, which has since reversed materially (even though the level remains elevated). To us, this suggests that the gap between housing sales and construction that has persisted for the past several years may finally be over, suggesting that the latter may pick up durably if sales trend higher. For now sales volume remains tepid, but this will be a key chart for investors to watch over the coming year given our view that housing is a core pillar of China's business cycle. The Industrial Sector Chart 7: The BCA Li Keqiang Leading Indicator And Its Components Chart 7 presents our leading indicator for the Li Keqiang index (LKI), which we developed in a November Special Report.5 There are six components of the indicator, all of which are related to changing monetary/financial conditions, and the growth in money and credit. Chart 6Housing Construction Could Accelerate##br## If Sales Pick Up Chart 7A Downtrend In Our LKI Leading Indicator, ##br##Within A Wide Component Range The indicator is at the core of our view, and we have been presenting monthly updates of the series in our regular reports since late last year. However, Chart 7 looks at the indicator from a different perspective, by showing it within a range that identifies the weakest and strongest components at any given point in time. Two points are noteworthy from the chart: While the overall LKI indicator has been trending down since early-2017, there is currently a wide range between the components. This gap is in stark contrast to the very narrow range that prevailed from 2014-2015, when the economy slowed considerably. This could mean that some of the components of the indicator are unduly weak, which in turn could imply that the severity of the slowdown in China's industrial sector will be less intense than the overall indicator would otherwise suggest. At least one component provided a lead on the subsequent direction of the overall indicator from late-2011 to late-2012, the last time that a significant gap existed between the components. This is in contrast to the situation today, in that all of the components are currently in a downtrend (albeit with differing paces as well as magnitudes). The key point for investors from Chart 7 is that all of the components of our indicator are moving in the same direction, which suggests with high conviction that China's economy is slowing. However, the wide range among the components suggests that indicator's message about the intensity of the slowdown is less uniform than it has been in the past, meaning that investors should be sensitive to a sustained pickup in the top end of the range. Equity Market Signals Chart 8: The Beta Of Our BCA China Sector Alpha Portfolio Chart 8 revisits a unique insight that we presented in our May 16 Weekly Report.6 The chart shows the rolling 1-year beta of our BCA China Investable Sector Alpha Portfolio versus the investable benchmark alongside China's performance versus global stocks, and suggests that the former may reliably lead the latter. While we noted in the report that drawing market-wide inferences from the beta characteristics of risk-adjusted performers is a not a conventional approach, finance theory is supportive of the idea. If investors are seeking to maximize their risk-adjusted returns and are engaging in tactical allocation across sectors, then it is entirely possible that beta-adjusted sector returns reflect the risk-on/risk-off expectations of market participants. For the purposes of China-related investment strategy over the coming year, our emphasis on Chart 8 will increase markedly if we see a sharp decline in the beta of our Sector Alpha Portfolio. As we noted in our May 16 report, the model is for now sending a curiously bullish signal, which we see as partial validation of our view that investors should have a high threshold to cut exposure to China within a global equity portfolio. Chart 8Watch For A Decline In The Beta Of ##br##Our Sector Alpha Portfolio Chart 9Decelerating Earnings Growth Could##br## Undermine Investor Sentiment Chart 9: Ex-Tech Earnings Versus The Li Keqiang Index We noted above that predicting the Li Keqiang index (LKI) is at the core of our view, and Chart 9 highlights why. The chart shows that a model based on the LKI closely fits the year-over-year growth rate of Chinese investable ex-tech earnings and, crucially, provides a lead. While the chart does not suggest that an outright contraction in ex-tech earnings is in the cards over the coming year, it does show that earnings growth is about to peak. This is potentially problematic, and warrants close attention, for two reasons: First, our leading indicator for the LKI suggests that it will decelerate further over the coming year, which could push our earnings growth estimate towards or below zero. Second, the peak in earnings growth could dampen investor sentiment towards Chinese ex-tech stocks, especially since bottom up analyst estimates for 12-months forward earnings growth have recently moved higher and are currently above what is predicted by our model. Chart 10: The Alpha Of Chinese Banks By now, the narrative surrounding Chinese banks is well known among global investors. The enormous leveraging of China's non-financial corporate sector is viewed by many as a clear sign of capital misallocation, meaning that a (potentially material) portion of the loan book of Chinese banks will have to be written off as bad debt. The ultimate scope of the bad debt problem in China is far from clear, but these longstanding concerns about loan quality suggest that Chinese bank stocks are likely to materially underperform their global peers if China's shadow banking crackdown begins to pose a significant threat to growth via restrictions on the provision of credit to the real economy. As such, we recommend that investors monitor Chart 10 over the coming year, which shows the rolling 1-year alpha significance for Chinese banks vs their global peers. While the rolling 1-year alpha of small banks has become less positive over the past few weeks, it remains in positive territory, similar to that of investable bank stocks. So, for now, this indicator supports our earlier conclusion that recent divergence between the interbank market and actual borrowing rates highlighted in Chart 1 is not heralding a material tightening in Chinese financial conditions. Chart 10Investors Should Monitor Chinese Bank Alpha ##br##For Significant Declines Chart 11No Technical Breakdown (Yet) In Ex-Tech Relative Performance Chart 11: The Technical Performance Of Ex-Tech Stocks BCA's approach to forecasting financial markets rests far more on top-down macroeconomic assessments than it does on technical analysis. However, technical indicators do contain important information, particularly when our top-down macro approach signals that a change in trend may be imminent. In this regard, technical indicators can provide valuable opportunities to enter or exit a position. To the extent that the technical profile of Chinese ex-tech stocks is informative in the current environment, Chart 11 shows that it is telling investors to stay invested despite the myriad risks to the economic outlook. This message is consistent with that of Table 1, namely that the negative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. From our perspective, a technical breakdown in relative Chinese ex-tech stock performance in response to China-specific news would serve as a strong basis for a downgrade within a global equity portfolio, and we will be monitoring closely for such a development over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Monetary Tightening In China: How Much Is Too Much?" dated January 18, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Question That Won't Go Away", dated April 18, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 6 Please see China Investment Strategy Weekly Report, "The Three Pillars Of China's Economy", dated May 16, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights An examination of the three pillars of China's economy provides an unambiguous signal that a slowdown is underway. This would normally warrant, at most, a neutral allocation to Chinese stocks, but several factors argue against cutting exposure for now. Stay overweight, but with a short leash. Recent changes in the BCA China Investable Sector Alpha Portfolio's recommended allocation have validated two of our recent investment recommendations. In addition, the model is providing a curiously bullish signal about the relative performance of Chinese vs global stocks that heightens our reluctance to reduce Chinese equity exposure. Our China Reform Monitor signals that investors do not view the current pace of structural reforms as being overly burdensome for the economy. In addition, while Chinese policymakers have made some significant gains in improving China's air quality over the past 18 months, these changes have mostly occurred from a near-hazardous starting point (suggesting that more progress will be needed). As such, we recommend that investors stick with our long ESG leaders / short investable benchmark trade over the coming year. Feature Global investor sentiment improved modestly on Monday, in response to statements from President Trump indicating a possible détente between the U.S. and China on the issue of trade. In particular, Mr. Trump signaled a willingness to assist ZTE, a Chinese telecommunications equipment maker, whose operations would have been enormously impacted by the U.S. Commerce Department's decision last month to ban American companies from selling to the firm. In the view of our Geopolitical Strategy Service, announcements like these should be viewed as marginally positive developments within the context of a serious downtrend in U.S./China relations. Investors appear to be eager to respond to positive news about waning U.S. protectionism, but the reality is that several important decisions related to the U.S.' section 301 probe have yet to be announced.1 As we noted in last week's Special Report,2 this underscores that the near-term risks to China from the external sector are clearly to the downside. Abstracting from the day-to-day assessment of the trade picture, we have emphasized that other core elements of the China outlook have deteriorated. As we present below, an aggregate view of the three pillars of China's economy continues to argue for a (contained) slowdown, with protectionism acting as a downside risk to an already sober economic outlook. Extremely cheap valuation and the high-beta nature of Chinese ex-tech stocks continue to justify an overweight stance versus global equities, but we recommend that investors keep Chinese stocks on downgrade watch for the remainder of Q2 as the risks to the Chinese economy warrant an ongoing assessment of what is currently a finely balanced equity allocation decision. Assessing The Three Pillars Chart 1 presents our stylized framework for analyzing China's economy. It highlights that China's business cycle is largely driven by three "pillars": industrial activity, the housing market, and trade. While the services sector, the Chinese consumer, and/or the technology sector are of interesting secular relevance, generally-speaking China's business cycle continues to be subject to its "old" growth model centered on investment and exports. Chart 1The Three Pillars Of China's Business Cycle Industrial Activity: We took an empirical approach to predicting China's industrial sector activity in our November 30 Special Report,3 and tested the ability of 40 different macro data series to lead the Li Keqiang index (LKI). While the LKI is closely followed and somewhat cliché, we have focused on it because of its strong correlation with ex-tech earnings and import growth. The results of our November report pointed to the success of monetary condition indexes, money supply, and credit measures to reliably predict the LKI since China's real GDP growth peaked in 2010. We constructed our BCA Li Keqiang Leading Indicator based on these measures, and we have frequently highlighted over the past few months that the indicator is pointing to a continued deceleration in China's industrial activity (Chart 2). Housing: We noted in our November report that housing market data also correlates with the LKI, albeit less well than the components of our Leading Indicator. One important observation about China's housing market that we highlighted in our February 8 Weekly Report is that residential floor space sold appears to have reliably led floor space started (a proxy for real residential investment) since 2010 (Chart 3). Over the past 6-8 months, however, floor space started appears to have diverged from the trend in floor space sold, which may have been caused by a non-trivial reduction in housing inventories over the past few years.4 Nonetheless, we also noted that the level of inventories remains quite elevated, suggesting that the uptrend in floor space started is unlikely to continue without a renewed uptrend in sales volume. In our view, this conclusion implies that the housing outlook over the coming 6-12 months is neutral, at best. Chart 2China's Industrial Sector ##br##Will Continue To Slow Chart 3Resi Sales Volume Does Not Point To ##br##A Sustained Pickup In Construction Trade: The third pillar of China's economy is the external sector, which remains important even though net exports have fallen quite significantly in terms of contribution to China's growth. We noted in our April 18 Weekly Report that there is a strongly positive relationship between the annual change in contribution to growth from China's net exports and subsequent gross capital formation, highlighting that external demand provides an important multiplier effect for Chinese activity. For now, nominal export growth (in CNY terms) remains at the high end of its 5-year range, reflecting the strength of the global economy. But three significant risks remain to the export outlook: 1) the clear and present danger of U.S. import tariffs, 2) the possibility that Chinese policymakers may accelerate their reform efforts to take advantage of the "window of opportunity" provided by robust global demand,4 and 3) the very substantial rise in the export-weighted RMB (Chart 4), which is fast approaching its 2015 high. As a final point on trade, Chart 5 highlights that the recent divergence between the LKI and nominal import growth is resolved when examining the latter in CNY terms. The chart suggests that while export growth has been buoyed by a strong global economy, China's contribution to the global growth impulse is diminishing. The very tight link demonstrated in Chart 5 also suggests that industrial activity is the most important pillar to watch among the three noted above, which means that Chart 2 argues for a negative export outlook for China's major trading partners. Chart 4A Non-Trivial Deterioration ##br##In Competitiveness Chart 5The Rise In CNYUSD Is Flattering ##br##Imports Measured In Dollars Our assessment of the three pillars of China's economy points to a conclusion that we have highlighted frequently in our recent reports: China's industrial sector is slowing, and there are downside risks to the export outlook. The character of the slowdown does not suggest that a major shock to the global economy is likely to emanate from China over the coming 6-12 months, but the outlook is more consistent with a reduction than an expansion in China's contribution to global growth. Under normal circumstances, at best this would warrant a neutral asset allocation outlook to China-related financial assets. Chart 6The Uptrend In Relative Chinese ##br##Ex-Tech Performance Is Intact However, we have also argued that the relatively attractive valuation and the technical profile of Chinese equities suggests that investors should have a high threshold for reducing their exposure to China within a global equity portfolio. Chart 6 highlights that Chinese ex-tech share prices continue to demonstrate resilient performance versus their global peers, despite the ongoing slowdown in China's economy. In addition, as we will note below, our BCA China Investable Sector Alpha Portfolio is providing a curiously bullish signal about the relative performance of Chinese stocks, which heightens our reluctance to cut exposure. Bottom Line: An examination of the three pillars of China's economy provides an unambiguous signal that a slowdown is underway. This would normally warrant, at most, a neutral allocation to Chinese stocks, but several factors argue against cutting exposure for now. Stay overweight, but with a short leash. Reading The Tea Leaves From Our Sector Alpha Portfolio We introduced our BCA China Investable Sector Alpha Portfolio in a January Special Report, in part to demonstrate that the concept of alpha persistence (i.e. alpha that is persistently positive or negative) has material implications for portfolio returns. In particular, we noted that the portfolio's strategy of allocating to China's investable equity sectors based on the significance of alpha has resulted in over 200bps of long-term outperformance versus the investable benchmark, without taking on any additional risk (Table 1). Table 1An Alpha-Based Sector Model Has Historically Outperformed China's Investable Stock Market Table 2 presents the portfolio's current allocation, relative to the current benchmark weights for each sector as well as the portfolio's sectoral allocation when we published our January report. Two observations are noteworthy: The model recommends an overweight allocation to resources; consumer staples; health care; utilities; and real estate, at the expense of industrials; consumer discretionary; financials; technology; and telecom services. These positions are largely in-line with the model's recommendations in January, except for a non-trivial increase in exposure to energy and financials, and a significant reduction in technology and consumer discretionary. The portfolio's reduced exposure to technology and consumer discretionary stocks validate two recent investment recommendations from BCA's China Investment Strategy team: we recommended a long consumer staples / short consumer discretionary trade on November 16,5 and we recommend that investors retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector on February 15.6 Table 2Our Sector Alpha Portfolio Has Validated Two Of Our Recent Recommendations Chart 7 highlights another interesting insight from the model, by presenting the beta of the portfolio relative to the investable benchmark alongside the benchmark's performance versus global stocks. First, the chart underscores the limited systemic risk of the portfolio, as the portfolio's beta rarely deviates materially from 1. But more importantly, it appears that the portfolio's beta versus the investable benchmark is somewhat correlated with (and leads) China's performance versus global stocks: Chart 7A Curiously Bullish Signal From ##br##Our Sector Alpha Portfolio Prior to the global financial crisis, the portfolio's beta was above 1 and rising, until early-2007 (preceding the peak in relative performance by about a year). Following the crisis, the portfolio beta steadily declined until late-2014/early-2015, interrupted only by a brief rise back above 1 from 2009-2010. Chinese stock prices steadily underperformed global equities during this period. The portfolio beta rose back to 1 in mid-2015, and stayed flat until early last year. Chinese stocks technically underperformed global stocks during this period, but by a much more modest amount than what occurred on average from 2009 to 2014. In this case, the rise in the portfolio beta in 2015 appeared to correctly signal that a sharply underweight stance towards Chinese stocks was no longer warranted. Finally, the portfolio beta surged rapidly higher last year, in line with a material rise in the relative performance of Chinese stocks. It has fallen modestly since January, but remains at one of the highest levels seen over the past 15 years. Drawing pro-cyclical inferences from the beta characteristics of risk-adjusted performers is a novel approach for BCA's China Investment Strategy service, and for now we regard the results of Chart 7 as a curious signal that warrants further examination. Still, this bullish sign is consistent with the general resilience of Chinese stocks that we have observed over the past several months, which continues to argue in favor of a high threshold to cut exposure to China within a global equity portfolio. Bottom Line: Recent changes in the BCA China Investable Sector Alpha Portfolio's recommended allocation have validated two of our recent investment recommendations. In addition, the model is providing a curiously bullish signal about the relative performance of Chinese vs global stocks that heightens our reluctance to reduce Chinese equity exposure. An Update On The "Reform Trade" We noted in the aftermath of last November's Communist Party Congress that China was likely to step up its reform efforts in 2018, and make meaningful efforts to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth7 Halt leveraging in the corporate/financial sector Eliminate corruption and graft As a result of this outlook, we highlighted that the pace of renewed structural reforms would be a key theme to watch this year, in order to ensure that the pursuit of these policies would not unintentionally cause a repeat of the significant slowdown in the economy that occurred in 2014/2015. We presented our framework for monitoring this risk in our November 16 Weekly Report, which was to track an index that we called the BCA China Reform Monitor. The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. We argued that significant underperformance of "loser" sectors could be a sign that reform intensity has become too burdensome for the economy (and thus a material headwind ex-tech equity performance), and highlighted that we would be watching for signs that our monitor was rising largely due to outright declines in the denominator. Using this framework, Chart 8 suggests that structural reform efforts are ongoing but that investors do not view the current pace of these reforms as overly burdensome for the economy. In particular, panel 2 highlights that recent movements in our Reform Monitor have been driven by fairly steady outperformance of the "winner" sectors, with "loser" sectors simply trending sideways. While it is possible that Chinese policymakers will intensify their efforts to reform the economy over the coming 6-12 months,4 for now our China Reform Monitor continues to support an overweight stance towards Chinese ex-tech stocks vs their global peers. However, given the message of our Reform Monitor, it is somewhat surprising that another of our reform-themed trades has fared so poorly over the past three months. Chart 9 presents the performance of our long investable environmental, social and governance (ESG) leaders / short investable benchmark trade, which was up approximately 4% since inception in late-January but is now down 1.4%. The basis of this trade was to overweight stocks that are best positioned to deliver "sustainable" growth, which we argued would fare well in a reform environment. Does the underperformance of this trade suggest that the reform theme is unlikely to be investment-relevant over the coming year? Chart 8Structural Reforms Not Viewed As ##br##Economically Restrictive By Investors Chart 9ESG Leaders Should Fare Quite ##br##Well In A Reform Environment In our view, the answer is no. First, while the MSCI ESG leaders index maintains roughly similar sector weights as the investable benchmark (which limits the beta risk of the trade), Table 3 highlights that differences do exist. These modest differences in sector allocation do appear to be impacting performance (Chart 10), in particular the underweight allocation to energy stocks (which are outperforming) and the overweight allocation to technology (which has sold off since mid-March). Table 3Sector Allocation Has Impacted The Recent Performance Of China's ESG Leaders Chart 10Sector Allocation Impacting Recent ##br##Performance Of ESG Leaders Second, while China made significant gains last year in improving air quality in several major population centers (such as Beijing and Shanghai), these improvements have mostly occurred from a near-hazardous starting point and have simply rendered China's air to be less unhealthy. Even in Beijing, Chart 11 highlights that PM2.5 readings have started to increase again, from a level that only briefly reached "good" quality. In addition, Chart 12 highlights that some of the improvement in air quality last year occurred, at least in part, because China shifted polluting activity from one province to another. This implies that Chinese policymakers will continue to wrestle with improving the country's air quality for some time to come, which in our view continues to favor ESG leaders over the coming year and beyond. Chart 11Some Significant Recent Gains In Air ##br##Quality, But Part Of An Ongoing Battle Chart 12Air Quality Gains In Some Provinces, At The Expense Of Others Bottom Line: Our China Reform Monitor signals that investors do not view the current pace of structural reforms as being overly burdensome for the economy. In addition, while Chinese policymakers have made some significant gains in improving China's air quality over the past 18 months, these changes have mostly occurred from a near-hazardous starting point (suggesting that more progress will be needed). As such, we recommend that investors stick with our long ESG leaders / short investable benchmark trade over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Inside The Beltway," dated May 2, 2018, available on gps.bcaresearch.com 2 Please see Geopolitical Strategy and China Investment Strategy Special Report "China's "Red Line" In The Trade Talks," dated May 9, 2018, available on cis.bcaresearch.com 3 Please see China Investment Strategy Special Report "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available on cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight," dated May 2, 2018, available on cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report "Messages From The Market, Post-Party Congress," dated November 16, 2017, available on cis.bcaresearch.com 6 Please see China Investment Strategy Weekly Report "After The Selloff: A View From China," dated February 15, 2018, available on cis.bcaresearch.com 7 Investors should note that BCA's China Investment Strategy service has long been skeptical of calls to shift China's economy to a consumption-driven growth model, because it significantly raises the odds that the country will not be able to escape the middle income trap. For example, please see Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. Residential investment will add to GDP growth this year and support housing-related investments. Q1 results for S&P 500 earnings and revenues are exceeding raised expectations amid increase in tariff talk. Feature Last Friday's employment report shows a strong U.S. labor market with moderate wage pressures. The Fed can continue with a leisurely pace of rate hikes, which do not disrupt risk assets. The U.S. economy added 164,000 of net new jobs in April. Taking into account the 30,000 upward revision to the prior months, the increase in payrolls was in line with the consensus forecast of 195,000. With the 3-month moving average at 208,000 the pace of jobs growth is running comfortably above the trend growth in the labor force. This is reflected in the unemployment rate dropping from 4.1% to a new cyclical low of 3.9%. The jobless rate is nearing the 3.8% low seen during the height of the tech bubble in 2000. Even though the pace of jobs growth is strong and the unemployment rate is probing new lows, wage gains remain moderate. Average hourly earnings increased by just 0.1% m/m in April. Moreover, last month's gain was revised down to 0.2% m/m from an initially reported 0.3% m/m. As a consequence, the annual rate of wage inflation has slowed slightly to 2.6% from a recent high of 2.8% in January. The underlying trend in wage inflation is higher, but it is fairly shallow (Chart 1). The April employment report is "Goldilocks" for U.S. equities. The labor market is strong and the economy is growing about 3%. With modest wage and inflation pressures, there is no need for the Fed to turn more aggressive to cool a rapidly overheating economy. The modest trajectory of Fed rate hikes alongside modest income gains and stout consumer balance sheets will insulate the largest segment of the economy from higher interest payments and rising gasoline costs. Residential construction will also benefit from a gradual central bank, and housing-related assets are poised to outperform. Corporate profits can also continue to grow while the Fed maintains a gradual pace of rate hikes. The Q1 earnings and revenue reports for S&P 500 firms are outstanding. BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. As we stated in our report on April 2,1 conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 2 shows that at 41.8%, household purchases of essentials as a percentage of disposable income are near all-time lows and have dropped by more than 1% since early 2013. In contrast, spending on necessities rose by a record 3% in the five years ending 2008. This matches levels reached at the end of the 1980s when interest rates, inflation and oil prices all soared. Wrenching consumer-driven economic downturns ensued after both episodes. Chart 1Another Goldilocks##BR##Jobs Report For U.S. Risk Assets Chart 2Consumer Is Not Stressed##BR##Despite Higher Energy Costs While investors remain concerned that rising rates and higher energy costs could derail the consumer and slow the economy, we take a different view. Energy represents 3.8% of consumers' spending on essentials while interest costs account for 15.9%. BCA expects that the Fed will continue to raise rates gradually in the next 12 months, in lockstep with the market's stance. However, we anticipate that the Fed will be more aggressive from mid-2019 through mid-2020 as inflation moves beyond the Fed's 2% target. BCA's U.S. Bond Strategy service notes that if we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will occur between 3.35% and 3.52%,2 roughly 35 to 50 bps higher than current levels. In previous research, we stated that a modest rise in rates would not be a burden on consumers.3 BCA's Commodity & Energy Strategy team forecasts that West Texas Intermediate oil prices will average $70/bbl. in 2018 and $64/bbl. in 2019. However, it also notes that tight balances in global oil make it likely those numbers will make excursions to $80/bbl.4 If production in Venezuela deteriorates more than expected or the supply in Iran or Libya is compromised, then oil could move beyond $80/bbl and, depending on the supply disruptions, to $90/bbl. Chart 3 shows that the consumer can easily withstand a rise in oil prices to $90/bbl. BCA's assumption is that natural gas and electricity prices will remain at current readings. Chart 3U.S. Consumer Is Well Insulated From Rising Energy Costs Bottom Line: Tighter labor markets and rising incomes will overcome rising interest rates and higher oil prices, and allow consumers to contribute to above-trend GDP growth. We see gradual upturns ahead for both oil prices and interest rates, but nothing so significant to trigger the collapse of consumer spending. Housing and housing-related assets will also flourish in the next year. Housing-Related Assets: An Update Residential investment will add to GDP growth this year and support housing-related investments. Chart 4 shows that housing in this cycle lagged previous slow-burn recoveries5 by a wide margin. Inventories of new and existing homes are near all-time lows, and the homeownership rate has turned higher alongside incomes and household formation (Chart 5). BCA's view is that escalating mortgage rates are not an impediment to housing construction. Nonetheless, housing did not contribute to economic growth in Q1 2018, but it did add 0.46% to real GDP in Q4 2017 as construction activity surged following last summer's hurricanes in Florida and Texas. Chart 4Residential Investment's Share##BR##Of GDP Has Lagged Prior Long Cycles Chart 5Solid Housing##BR##Fundamentals In Place Chart 6 estimates the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the gap implies an extra 1.35 million housing units. The equilibrium number of housing starts that cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' fully occurs in the next two years, which would add another 675,000 units per year, then total demand could be close to 2 million in each of the next two years. This compares with March's housing starts of 1.3 million. Clearly, this is an aggressive forecast, and we doubt starts will advance at this pace in the next few years, but it does suggest that housing construction is likely to perk up. Chart 6A Catch-Up Housing Construction##BR##Will Occur If This Gap Closes The above analysis suggests that residential investment will contribute to GDP growth this year and next. There are favorable implications for housing-related financial assets. We originally examined the implications of a rebound in residential construction activity in 2012.6 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables. We concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario in the following year (and beyond). Our original analysis is updated in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Secondly, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of houses for sale following the crisis period on housing-related asset returns. Table 1 presents the list of housing-related assets that we examined,7 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables contain useful information, with the exception of the two noted above, sales of new homes and inventories of unsold homes. The right-most column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset that varies from a low of 14% to a high of 22%. Table 1Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2017) Charts 7 and 8 present a set of relatively conservative assumptions for the key housing market variables shown in Table 1, based on a rise in housing starts only modestly above the scrappage rate referred to in the previous section. We assume that house price appreciation and housing affordability are moderate due to further rate hikes from the Fed and mounting inflation. We also suppose that the homebuilders' confidence index stays flat, refi applications remain low linked to the uptrend in mortgage rates, and purchase applications rise in conjunction with housing starts. Chart 7A Set Of Conservative Assumptions... Chart 8...For Key Housing Market Variables Finally, Table 2 illustrates the predicted excess returns of housing-related assets in the coming 12 months, along with the annualized excess returns in 2017 and, for reference, in the entire sample period. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 2Excess Returns Of Housing-Related Assets* (%) Investors can draw several important conclusions from our analysis: All but one of the housing-related assets are expected to outperform their respective benchmarks in the next year, even given our conservative assumptions about the pace of gains in the housing market. Our model predicts outperformance for the three corporate bond assets (shown in Tables 1 and 2) relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. Moreover, the model projects modest outperformance for agency MBS. With the exception of S&P 500 banks, the model's predicted excess returns are lower in the coming year than they have been on an annualized basis since the onset of the recovery. This highlights that housing-related assets have moved ahead at least some of the expected normalization in the housing market over the next few years. However, a full rise to our equilibrium estimate of 2 million starts during the next two years could potentially lead to an even larger outperformance than the model forecasts. Moreover, Charts 9A and 9B suggest that valuation will not be an impediment to the outperformance of housing-related assets. Chart 9AValuation Won't Be An Impediment... Chart 9B...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance in 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform, even given conservative assumptions about the housing factors. Stunning Results More than 80% of S&P 500 companies have reported Q1 results, and EPS and sales growth are well ahead of consensus expectations at the start of April. Moreover, the counter-trend rally in margins remains in place. We previewed the Q1 2018 S&P 500 earnings season earlier this year.8 82% of companies have released results so far, with 79% beating consensus EPS projections, which is well above the long-term average of 69%. Moreover, 76% have posted Q1 revenues that topped expectations, exceeding the long-term average of 56%. The surprise factor for year-over-year numbers in Q1 stands at a robust 7% for EPS and 1.5% for sales. The earnings surprise reading is well above the long-term average of 5%, while the sales surprise figure is right at the long-term average. Both the earnings and sales surprise figures are even more impressive given that analysts' views of Q1 results increased between the start of Q1 2018 and the actual Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, in effect lowering the bar for results. Table 3S&P 500: Q1 2018 Results* We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Even so, the results to date suggest that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is a stunning 26% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain high on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 3). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly stout in energy (84%), technology (35%), financials (30%), materials (30%) and industrials (25%). The technology, materials, real estate and industrial sectors likewise all experienced substantial sales gains (16%, 13%, 14% and 11% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 24%. BCA's U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors in January.9 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 10). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. The assessment grew to 20% at the start of the earnings reporting season in early April. As of May 4, 2018, the figure climbed slightly to 22%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 10High Bar For 2018... But Focus Will Quickly Turn To 2019 While the ebullience is linked to the tax bill, other factors such as solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. However, U.S. trade policy is a concern in several industries. Chart 11 shows that through April 27, 45 companies cited tariffs in their Q1 earnings calls, a jump from 5 in the Q4 2017 reporting season. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition.10 Analysts expect EPS growth to slow significantly in 2019 (9%) from the anticipated 2018 clip, which matches BCA's stance (Chart 12). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Chart 11Plenty Of Tariff Talk##BR##In Q1 Earnings Calls Chart 12Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data) and subsequently decelerate because of a modest margin squeeze as U.S. wage growth picks up (Chart 11). A slowdown in global growth will also crimp profit growth later this year. Incorporating the fiscal stimulus lifted the EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "A Signal From Gold?", published May 1, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst Monthly Report from February 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely", published April 19, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's The Bank Credit Analyst Monthly Report from March 2017. Available at bca.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report," U-3 Or U-6?," published February 13, 2012. Available at usis.bcaresearch.com. 7 Note that we have excluded fixed- and floating-rate home equity loan ABS from our list of housing-related assets because of a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," published January 16, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com.
Underweight Real estate stocks are behaving like fixed income proxied equities, given that, by construction, REITs are high dividend yielding. Thus, a tightening monetary backdrop serves as a noose around their necks (top panel). Not only is the Fed slated to raise interest rates two or three more times this year, but FOMC median projections also assume an additional two to three hikes in 2019. At the margin, competing higher yielding risk free assets will eat into demand for REITs. On the operating front, a number of indicators we track are sending an outright bearish signal for the commercial real estate (CRE) sector. The occupancy rate has crested just shy of 90% or 160bps below the previous cycle's peak. Rising vacancies are emblematic of decreasing rents and thus CRE related cash flows (second panel). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel). Adding it all up, our S&P real estate profit growth model does an excellent job encapsulating all of these forces, and it is currently sending an unambiguous sell signal (bottom panel). Bottom Line: Downgrade the niche S&P real estate index to a below benchmark allocation; see yesterday's Weekly Report for more details.
Highlights Portfolio Strategy Expensive valuations leave no room to maneuver in the S&P real estate index that has to contend with a higher interest rate backdrop and deteriorating cash flow growth fundamentals. Trim to underweight. In contrast, capital markets stocks are firing on all cylinders and the return of animal spirits, the capex upcycle, booming M&A activity and a brighter operating backdrop auger well for this highly cyclical financials sub-index. Stay overweight. Recent Changes S&P Real Estate - Downgrade to underweight today. Table 1 Feature Equities rebounded in the past two weeks, as earnings took center stage and they delivered beyond expectations. Impressively, the blended Q1 EPS growth rate is running at 20% (versus 18.5% expected on April 1) with roughly 18% of the S&P 500 constituents reporting profit numbers. This earnings validation served as a catalyst for the SPX to briefly reclaim the key 50-day moving average and, most importantly, the Advance/Decline (A/D) line hit fresh all-time highs. Historically, the A/D line and the S&P 500 move hand-in-hand and there is a high chance that the SPX will follow suit in the coming quarters (top panel, Chart 1). Our upbeat cyclical 9-12 month equity market view remains intact, as the odds of a recession are close to nil. Despite fears of a generalized global trade war, global trade volumes have been resilient vaulting to multi-year highs on a short-term rate of change basis (middle panel, Chart 2). While a global growth soft patch cannot be ruled out, as long as manufacturing PMIs can stay above the 50 boom/bust line, synchronized global growth will remain the dominant macro theme. Chart 1New Highs Ahead? Chart 2What Slowdown? The IMF concurred in its April, 2018 World Economic Outlook: "The global economic upswing that began around mid-2016 has become broader and stronger. This new World Economic Outlook report projects that advanced economies as a group will continue to expand above their potential growth rates this year and next before decelerating, while growth in emerging market and developing economies will rise before leveling off." 1 The bond market is also not sending a distress signal as very sensitive junk bond spreads have nosedived of late (shown inverted, bottom panel, Chart 1). Under such a backdrop, EPS will continue to shine and underpin stocks (Chart 2). Nevertheless, steeply decelerating money supply growth is slightly disconcerting. This is not only a U.S. only phenomenon, but G7 money supply growth is also losing momentum. Chinese and overall emerging markets money growth numbers are also stuck in a rut (Chart 3). While this could be the precursor to a global growth slowdown, we would expect commodity prices to be the first to sniff it out (Chart 4). Clearly this is not the case as commodities spiked last week. Moreover, keep in mind that money growth tends to peak before recessions and what we are currently observing is likely a typical late cycle phenomenon. We will continue to closely monitor money growth around the globe, as this steep deceleration represents a risk to our sanguine equity market view. This week we are updating our corporate pricing power indicators. Chart 5 shows that our corporate sector pricing power proxy and our diffusion index are holding on to recent gains. On the labor front, the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report ticked lower (fourth panel, Chart 5). Chart 3Money Growth Yellow Flag... Chart 4... But Commodities Are Resilient Chart 5No Margin Trouble Yet However, the spread between job switchers and stayers (courtesy of the Atlanta Fed Wage Growth Tracker) suggests that wage inflation should pick up steam in the coming months. While rising pay would eat into profit margins and thus dent profits ceteris paribus, this would be problematic only if businesses failed to lift selling prices in the coming months. We assign low odds to this outcome as domestic (and global) final demand is firm, suggesting that companies will manage to pass on rising input prices either down the supply channel, to the government and/or the consumer. Table 2Industry Group Pricing Power Table 2 summarizes the sectorial results. We calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 6Cyclicals Have The Upper Hand Over 83% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is a slight improvement compared with our late-January report The number of outright deflating sectors dropped by three to 10 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, on par with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 6). Improving global trade dynamics and sustained softness in the greenback are behind the commodity complex's ability to increase prices. In contrast, tech, telecom, autos and airlines populate the bottom ranks of Table 2. In sum, firming corporate sector pricing power will continue to boost sales growth for the rest of the year. Tack on operating leverage kicking into higher gear at this stage of the cycle, especially for the high fixed cost deep cyclical businesses, and still modest wage inflation, and profit margins and EPS growth will remain upbeat. This week we downgrade a niche interest rate-sensitive sector and update our view on a very cyclical financials sub-sector. DowngREITing There are good odds that laggard REITs will suffer the same fate as telecom services and utilities stocks and plumb relative all-time lows, breaching the early 2000s nadir (Chart 7). A higher interest rate backdrop, a key BCA theme for 2018, along with deteriorating profit fundamentals compel us to downgrade the niche S&P real estate sector to an underweight stance. Real estate stocks are behaving like fixed income proxied equities, given that, by construction, REITs are high dividend yielding. Thus, a tightening monetary backdrop serves as a noose around their necks (top panel, Chart 8). Not only is the Fed slated to raise interest rates two or three more times this year, but FOMC median projections also assume an additional two to three hikes in 2019. At the margin, competing higher yielding risk free assets will eat into demand for REITs. On the operating front, a number of indicators we track are sending an outright bearish signal for the commercial real estate (CRE) sector. The occupancy rate has crested just shy of 90% or 160bps below the previous cycle's peak. Rising vacancies are emblematic of decreasing rents and thus CRE related cash flows (middle panel, Chart 8). Chart 7New Lows Looming Chart 8Rental Deflation Alert Importantly, CRE prices continue to defy gravity and are steeply deviating from our petered out occupancy rate composite (bottom panel, Chart 8). This supply/demand imbalance typically resolves itself via deflating prices. Industry overbuilding explains this disequilibrium, as ZIRP and loose credit standards encouraged a construction boom. Overall non-residential construction is probing all-time highs and multi-family housing starts are expanding close to 400K/annum, a level that has coincided with previous peaks in the CRE market (third & fourth panels, Chart 9). This industry oversupply should weigh heavily on rents especially given the slackening demand backdrop, according to the message from our REITs Demand Indicator (RDI). The softening RDI reading also bodes ill for CRE price inflation (bottom panel, Chart 10). The latest Fed Senior Loan Officer Survey (FSLOS) corroborates that demand for CRE loans is in a steady decline and bankers are not willing extenders of CRE credit, exerting a downward pull on CRE prices (middle panel, Chart 10). Chart 9Rents Are Under Attack Chart 10CRE Prices Skating On Thin Ice Historically, demand for CRE loans as per the FSLOS has been an excellent leading indicator of actual CRE loan growth, and the current message is grim (second panel, Chart 11). It would be unprecedented for another upleg to take root in the CRE market with the absence of credit growth to fuel such an overshoot phase. Worrisomely, there is no valuation cushion to absorb the plethora of possible CRE mishaps. Cap rates have troughed for the cycle and a rising interest rate backdrop warns that a de-rating in expensive valuations is looming (third panel, Chart 11). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (bottom panel, Chart 11). Adding it all up, our S&P real estate profit growth model does an excellent job encapsulating all of these forces, and it is currently sending an unambiguous sell signal (Chart 12). Chart 11Happy Days Are Over Chart 12Model Says Sell Bottom Line: Downgrade the niche S&P real estate index to a below benchmark allocation. Capital Markets: Stay The Bull Course We upgraded capital markets stocks to an above benchmark allocation mid-May last year. Our thesis, recovering overall market top and bottom line growth would prolong the overshoot phase in equities at a time when monetary conditions would stay sufficiently loose, has panned out and this hyper sensitive early-cyclical index has added alpha to our portfolio raising the question: is it time to book profits or are there more gains in store? The short answer is that it is too soon to crystalize gains. This financials sub-index thrives when animal spirits are rising, CEOs embrace an expansionary mindset, and investor risk appetites are healthy. The opposite is also true. We first started exploring the underappreciated global capex upcycle theme in mid-October2 and by late-November it became one of our two core themes for 2018 (rising interest rate backdrop is the other).3 The second panel of Chart 13 shows that capex intentions move in tandem with relative EPS and are pointing toward a profit reacceleration in the coming months. Bankers are also willing extenders of credit, a necessary fuel for the capex upcycle phase, and demand for loans is upbeat as per our commercial loans & leases model. Historically, such a macro backdrop has been a sweet spot for capital markets stocks (Chart 13). Not only business, but investor confidence is also sky high. Junk bond spreads have once again plumbed multi-year lows and even investment grade bond spreads are tight (high-yield spread shown inverted, Chart 1). Corporate bond issuance remains resilient. The Equity Risk Premium has also narrowed by 200bps since the end of the manufacturing recession (shown inverted, top panel, Chart 14), reducing the cost of equity capital. This is fertile ground both for IPOs and secondary stock offerings. Chart 13Solid Foundation Chart 14Enticing Operating Backdrop Meanwhile, the return of volatility has caused revenue generating equity trading desks to breathe a huge sigh of relief, as we had posited in early March,4 and this earnings season made abundantly clear. Trading volumes have soared and margin debt continues to climb both in absolute terms and relative to GDP (Chart 14). If volatility stays elevated as the year progresses, as we expect, then more gains are likely for investment bank trading desks. The upshot is that the capital markets' EPS upswing is in the early innings. Another key earnings driver, M&A activity, is booming around the globe. Still sloshing global liquidity with near generationally low interest rates is fueling an M&A spree. In the U.S. alone, M&A has hit a fresh cycle high and is running near $3.1Tn/annum. Even relative to output, M&A has returned to the previous cycle's peak (bottom panel, Chart 14), and is music to the ears of investment bankers. The implication is that a capital markets ROE expansion phase looms (bottom panel, Chart 15). On the operating front, capital markets employment is hyper-cyclical. Investment banks are quick to slash labor costs during a downturn and equally swift to expand headcount in anticipation of good times. Currently, industry payrolls are rising steadily and outpacing overall non-farm payroll growth, and represent a positive backdrop (Chart 16). Chart 15M&A Fever Is Positive... Chart 16...And So Is Rising Headcount Sell-side analysts have taken notice and EPS pessimism has violently swung into extreme optimism in the past 18 months. Granted, President Trump's election and tax reform euphoria are part of the slingshot recovery in EPS expectations. However, firming industry-specific EPS growth prospects are also driving analysts' upward revisions (bottom panel, Chart 16). Bottom Line: We recommend an above benchmark allocation in the still compellingly valued S&P investment banks & brokers index. The ticker symbols for the stocks in this index are: BLBG: S5INBK - ETFC, GS, MS, RJF, SCHW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 http://www.imf.org/en/Publications/WEO/Issues/2018/03/20/world-economic-outlook-april-2018 2 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We still Like Banks," dated March 5, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)
Highlights Key Portfolio Highlights Our portfolio positioning remains firmly behind cyclicals over defensives, driven principally by our key 2018 investment themes: synchronized global capex growth (Chart 1A) and higher interest rates on the back of a pickup in inflation (Chart 1B). The positioning has been lifted by synchronized global growth and a soft U.S. dollar (Chart 1C), while the key risk to our portfolio of a hard landing in China looks to be mitigated (Chart 1D). A return of volatility, spurred on by Fed tightening (Chart 1E), caused an SPX pullback in February, and while the market pushed through that rough patch, it has since been replaced with fears of a trade war, exacerbated by musical chairs in the Trump administration (Chart 1F). Our buy-the-dip strategy remains appropriate on a cyclical time horizon (Chart 1G), given a dearth of evidence of a recession in the next year. SPX forward EPS estimates still show near-20% increases this calendar year (corroborated by our EPS growth model, Chart 1H) which should underpin outsized equity returns in the absence of a major valuation rerating. Still, the return of volatility warrants a review of our macro, valuation and technical indicators. The best combination in our review is S&P financials (Overweight) with an elevated and accelerating cyclical macro indicator (CMI), fed by both of our key capex growth and rising interest rate themes, combined with a modest undervaluation. The worst combination is S&P telecom services (Underweight, high-conviction), whose CMI recently touched a 30-year low as sector deflation hit acute levels. Valuations make the sector look cheap, but every indication is that telecoms are a value trap. Chart 1AGlobal Trade Is Rising... Chart 1B...But So Too Is Inflation Chart 1CA Weaker Dollar Is A Boon To Growth Chart 1DSoft Landing In China Seems Likely Chart 1EThe Return Of Vol May Spoil The Party... Chart 1F...And Policy Uncertainty Doesnt Help Chart 1GBuy The Dip Has Worked Out Nicely Chart 1HHeed The Message From A Booming EPS Model Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI, Chart 2) has climbed to new cyclical highs with significant upward momentum, driven by broad improvement in virtually all of its underlying components. More than any other variable, rising yields and the accompanying higher price of credit are a boon to financials. Higher interest rates is one of BCA's key themes for 2018 and an ongoing selloff in the bond market bodes well for profits in the heavyweight banks sub-index and should deliver the next up leg in bank stocks performance (top panel, Chart 3). Another of BCA's key themes for 2018 is a global capex upcycle; higher demand for capital goods should drive outsized capital formation in the year to come. Our U.S. commercial banks loans and leases model echoes this positive outlook, pointing to the best loan growth of the past 30 years (middle panel, Chart 3). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 3). Despite the much-improved cyclical outlook and a revival of overall animal spirits, our valuation indicator (VI) suggests that financials are modestly undervalued. At this point in the cycle, we would expect a modest overvaluation; the implication is that financials should be a core portfolio overweight. Our technical indicator (TI) has approached overbought levels several times over the course of this bull market, though history suggests it can stay at elevated levels for a considerable time. Chart 2S&P Financials (Overweight) Chart 3RS1 Rising Yields Are A Boon To Financials Earnings S&P Industrials (Overweight) Our industrials CMI (Chart 4) has gone vertical and is very near its all-time high. A combination of a supportive currency, a recovery in commodity prices and synchronized global growth are responsible for the rise. A falling U.S. dollar and capital goods producers' top line growth acceleration have historically moved hand-in-hand as this group is one of the most international of the S&P 500. The trade-weighted U.S. dollar has fallen by more than 10% from its most recent peak at the end of 2016 which suggests U.S. industrials should have a leg up in sales for the year to come (top panel, Chart 5). The slide in the U.S. dollar is coming at an opportune time; global growth is remarkably synchronized (and remains a key BCA theme for 2018) and has proven an excellent harbinger of industrials margins (bottom panel, Chart 5). Overall, an expanding top line and widening margins imply solid relative EPS gains. Our valuation gauge is near the neutral zone, where it has been for much of the past 3 years as the market has failed to capture the sector's outlook strength. Our TI echoes the neutral message, having unwound a significant overbought position at the beginning of last year. Chart 4S&P Industrials (Overweight) Chart 5Global Euphoria Should Lift Industrials S&P Energy (Overweight) Our energy CMI (Chart 6) has maintained its upward trajectory after bouncing off all-time lows last year. Importantly, the relative share performance does not yet reflect the drastically improved cyclical conditions, underpinning our overweight recommendation. Falling oil inventories and rising prices (top and second panel, Chart 7) combined with solid gains in domestic production underlie the CMI recovery. Our key themes for 2018 of a global capex expansion and synchronized global growth should be the most important drivers for energy stocks this year. With respect to the former, the capex intentions from the Dallas Fed survey hit their highest level in a decade, which usually presages domestic oil patch expansion and energy stock outperformance (third panel, Chart 7) With respect to global growth, emerging markets/Chinese demand is the swing determinant of overall oil demand, and non-OECD demand has been moving higher for most of the past year (bottom panel, Chart 7). Our VI has retreated far into undervalued territory, a result of the aforementioned failure of stocks to react to the enticing macro outlook. The TI too is in deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are so appealing. Chart 6S&P Energy (Overweight) Chart 7Energy Share Prices Have Trailed Oils Recovery S&P Consumer Staples (Overweight) Our consumer staples CMI (Chart 8) has turned up recently, following a two year decline. Strong employment gains and positive retail sales are the key pillars underlying the modest recovery. The euphoric consumer continues to push our consumer staples EPS model higher, now pointing to the best earnings growth of the past 5 years (middle panel, Chart 9). Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (bottom panel, Chart 9). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put our positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. Further, our VI is waving a green flag as consumer staples are now nearly two standard deviations below their 30-year mean valuation. Technical conditions too are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 8S&P Consumer Staples (Overweight) Chart 9Robust Consumer Confidence Bodes Well S&P Utilities (Neutral) Our utilities CMI (Chart 10) has spent the last decade in a long-term downtrend, albeit one with periodic countertrend moves. The key underlying factors are natural gas prices and relative spending on utilities, both of which have been retreating since 2008 (middle panel, Chart 11). Encouragingly, the sector's wage bill has slowed from punitively high levels, though pricing power has followed it down, implying muted margin changes (bottom panel, Chart 11). Like other defensive sectors, utilities have underperformed cyclical sectors in the last year; utilities equities trade as fixed income proxies, and a rising interest rate environment is punitive. As a result of the underperformance and relatively constant earnings, valuations have collapsed to the neutral zone. We reacted by booking solid gains and upgrading to a benchmark allocation earlier this year; synchronized global growth and higher interest rates are headwinds for this niche defensive sector and prevent us from lifting positions further. Our TI has fallen steeply over the past year and is now closing in on two standard deviations below the 30-year average. Chart 10S&P Utilities (Neutral) Chart 11Pricing Is Falling But Margins Look Neutral S&P Real Estate (Neutral) Our real estate CMI (Chart 12) has been in decline since its most recent peak at the end of 2016. This is confirmed by a darkened outlook for REITs; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (top panel, Chart 13). Further, bankers appear less willing to extend commercial real estate credit, despite recent stability in underlying prices; declines in credit availability will directly impact REIT valuations (bottom panel, Chart 13). Our VI is consistent with BCA's Treasury bond indicator (not shown), indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 12S&P Real Estate (Neutral) Chart 13Peaking Rents and Tight Credit Are Headwinds S&P Materials (Neutral) Our materials CMI (Chart 14) has maintained its downward trajectory, largely due to the ongoing Fed tightening cycle. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as rates are moving higher (top panel, Chart 15). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018, representing a substantial headwind to sector performance. Still, the news is not all negative. Exceptionally strong global demand growth has revitalized chemicals prices (bottom panel, Chart 15). Combined with the industry's relatively newfound restraint, capacity has not overextended and the resulting productivity gains bode well for earnings growth. Despite the improving outlook, valuations have been retreating for much of the past year and our VI has fallen back to the neutral zone. Our TI has been hovering near the neutral line for the past year, though a recent hook downward indicates a loss of momentum and downside relative performance risks. Chart 14S&P Materials (Neutral) Chart 15Rising Rates Are Offset By Improving Demand S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI (Chart 16) has fallen back after reaching highs earlier in 2017, though remains elevated relative to the long term trend. Rising interest rates (top panel, Chart 17) are more than offsetting higher home prices and real wage growth, both have which have recently stalled. This rising short-term interest rate backdrop is not conducive to owning the extremely interest rate-sensitive equities that fall into the S&P consumer discretionary index. Both the household financial obligation ratio and household debt service payments have bottomed and are actually increasing. A higher interest rate backdrop will sustain the upward pressure on both and likely weigh on consumer discretionary relative share prices (third and bottom panels, Chart 17). This underpins our recent downgrade to a below benchmark allocation. Elevated valuations support our negative thesis as our valuation indicator has been rising recently out of the neutral zone. Our TI has fully recovered from oversold levels, and is now well into overbought territory, though historically this indicator has been excessively volatile. Chart 16S&P Consumer Discretionary (Underweight) Chart 17Higher Borrowing Costs Bode Ill For Consumer Discretionary S&P Health Care (Underweight) Our health care CMI (Chart 18) rolled over last year and has been treading water at these lower levels, driven by weak fundamentals in the key pharmaceuticals sector. Poor pricing power, a soft spending backdrop and a depreciating U.S. dollar have been pressuring the sector and keeping a tight lid on the CMI (top and second panels, Chart 19). Other non-pharma indicators are mixed as lower healthcare consumer spending is offset by a tick up in overall pricing power. Relative valuations have fallen deep into undervalued territory and are approaching one standard deviation below the 25 year average. Our TI too has reversed course and is well into oversold territory. However, the message from our health care earnings model is that sector earnings will continue to decelerate; this environment in not conducive for a sector re-rating (bottom panel, Chart 19). Chart 18S&P Health Care (Underweight) Chart 19Pharma Pricing Power Continues To Collapse S&P Telecommunication Services (Underweight) Our telecom services CMI (Chart 20), after moving sideways for much of the past decade, has recently fallen to a new 30-year low. Extreme deflation continues to reign in the beleaguered sector as relative consumer outlays on telecom services have nosedived (top panel, Chart 21) which is broadly matched by melting selling prices (middle panel, Chart 21) as demand contracts. This is reflected in our S&P telecom services revenue growth model, which remains deep in contractionary territory (bottom panel, Chart 21). The sector remains chronically cheap, exacerbated by the recent sell-off, and is currently as cheap as it has ever been. Still, given the brutal operating environment, we think such valuations have created a value trap. Our Technical Indicator has sunk but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. We recently downgraded the sector to underweight and added it to our high-conviction underweight list based on the factors noted above.1 Chart 20S&P Telecommunication Services (Underweight) Chart 21Telecom Services Remain A Value Trap S&P Technology (Underweight, Upgrade Alert) The technology CMI (Chart 22) has been falling for the past three years, driven by ongoing relative pricing power declines and new order weakness. However, the sector has proven resilient, at least until recently, as a handful of stocks (the FANGs, excluding the consumer discretionary components) and the red-hot semiconductor group have provided support. Still, market euphoria aside, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods; inflation is gradually rising after a prolonged disinflationary period (bottom panel, Chart 23). Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is extremely overbought, though it has been at this high level for several years. Chart 22S&P Technology (Underweight, Upgrade ALert) Chart 23Inflation Is No Friend To Tech Size Indicator (Neutral Small Vs. Large Caps) Our size CMI (Chart 24) has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher (top panel, Chart 25). A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. Earlier this year, we downgraded our recommendation on small caps vs. large caps to a neutral allocation, based on a deterioration in small cap margins and too-high leverage.2 Recent NFIB surveys would suggest this move was prescient; firms reporting planned labor compensation increases have steadied near a two decade high, while price increases are trailing far behind (middle panel, Chart 25). With "quality of labor" having overtaken "taxes" as the single most important problem facing businesses, labor compensation growth seems likely to continue moving up at an elevated pace and small cap margins should likely continue to trail large cap peers (bottom panel, Chart 25). Valuations have improved and small caps are relatively undervalued, though our TI echoes a neutral message. Chart 24Size Indicator (Neutral Small Vs. Large Caps) Chart 25Small Businesses Remain Exceptionally Confident Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.