Asset Allocation
Please note that analysis on India is published below. Highlights This report reviews several financial market-based indicators and price signals from various corners of global markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these indicators and price actions is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities, and EM assets are all at risk of plunging. Beware of reigning complacency in EM sovereign and corporate credit markets. Various indicators point to wider EM credit spreads. Feature EM risk assets appear to be on the brink of a breakdown. This week we review various market-based indicators that are telegraphing a relapse in both EM risk assets and commodities. The relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months. As always, we monitor economic data extremely closely. However, one cannot rely solely on economic data to predict directional changes in financial markets. Turning points of economic indicators and data often lag those of financial markets. In fact, one can make reliable economic forecasts based on the performance of financial markets. For example, the relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months (Chart I-1). Chart I-1EM Stocks Signal No Improvement In Global Industrial Cycle Over the years, we have devised and tracked several market-based indicators that have a good track record of identifying trends in EM risk assets. In addition, we constantly monitor price signals from various corners of financial markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these market-based indicators is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities and EM are all at risk of plunging. Our Reflation Indicator Our Reflation Indicator is calculated as an equal-weighted average of the London Industrial Metals Price Index (LMEX), platinum prices and U.S. lumber prices. The LMEX index is used as a proxy for Chinese growth, while U.S. lumber prices reflect cyclical growth conditions in the American economy. We use platinum prices as a global reflation proxy; this semi-precious metal is sensitive to the global industrial cycle in addition to benefitting from easy U.S. dollar liquidity. The Reflation Indicator has failed to advance above its long-term moving average and has broken down. Chart I-2Our Reflation Indicator Presages No Reflation Chart I-2 illustrates that the Reflation Indicator has failed to advance above its long-term moving average and has broken down. Typically, such a technical profile is worrisome and is often followed by a significant drop. In addition, the Reflation Indicator rolled over at its previous highs last year, another bearish technical signal. Investors should heed signals from this indicator as it correlates well with EM share prices in U.S. dollar terms as well as EM sovereign and corporate credit spreads (Chart I-3). EM credit spreads are shown inverted in the middle and bottom panels. An examination of the individual components of the Reflation Indicator reveals the following: Industrial metals prices in general and copper prices in particular have formed a classic head-and-shoulders pattern (Chart I-4, top panel). As and when the neckline of this pattern is broken, a major downward gap is likely to ensue. Platinum prices have reverted from their key technical resistance levels (Chart I-4, middle panel). This constitutes a bearish technical configuration, and odds are that platinum prices will be in freefall. Finally, lumber prices have failed to punch above their 200-day moving average and have broken below their 3-year moving average (Chart I-4, bottom panel). Chart I-3Reflation Indicator And EM Chart I-4Beware Of Breakdowns In Commodities Prices These technical signals are in accordance with our qualitative assessment of global growth conditions. The global industrial cycle remains very weak, and a recovery is not yet imminent. Meanwhile, the U.S. is the least exposed to the ongoing global trade recession because manufacturing and exports each represent only about 12% of the U.S. economy. Remarkably, economic weakness in Asian export-dependent economies has so far been driven by retrenching demand in China – not the U.S. As Chart I-5 reveals, aggregate exports to China from Korea, Japan, Taiwan and Singapore were still contracting at a 9% pace in April from a year ago, while their shipments to the U.S. grew at a respectable 7% rate. Chart I-5Asian Exports To China And To U.S Chart I-6Global Steel And Energy Stocks Are Breaking Down Commodities: Hanging By A Thread? Some commodity-related markets are also exhibiting configurations that are consistent with a breakdown. Specifically: Global steel stocks as well as oil and gas share prices have formed a head-and-shoulders pattern, and are breaking below their necklines (Chart I-6). Such a technical configuration foreshadows major downside. Shares of Glencore – a major player in the commodities space – have dropped below their three-year moving average which has served as a support a couple of times in recent years (Chart I-7). Crucially, this stock has also exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads U.S. manufacturing cycles, and has formed a similar configuration to Glencore’s (Chart I-8). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Chart I-7A Head-And-Shoulders Pattern In Glencore Stock... Chart I-8...And In Kennametal (High-Beta U.S. Industrial Stock) Finally, three-year forward oil prices are breaking below their three-year moving averages (Chart I-9). A drop below this technical support will probably mark a major downleg in crude prices. Bottom Line: Commodities and related equity sectors appear vulnerable to the downside. Meanwhile, the U.S. dollar is exhibiting a bullish technical pattern and will likely grind higher, as we discussed in last week’s report titled, The RMB: Depreciation Time? (Chart I-10). Chart I-9Forward Oil Prices Are Much Weaker Than Spot Chart I-10The U.S. Dollar Is Heading Higher EM Equities: A Make-It-Or-Break-It Moment Chart I-11EM Stock Indexes: Sitting On Edge Of A Cliff The MSCI EM Overall Equity Index is at an important technical support level (Chart I-11, top panel). If this support is violated, a major downleg will likely ensue. In addition to the above indicators, the following observations also suggest that this support level will be broken and that a gap-down phase will transpire. Both the EM small-cap and equal-weighted equity indexes have been unable to advance above their respective three-year moving averages and are now breaking down (Chart I-11, middle and bottom panels). This could be a precursor for the overall EM stock index to tumble through defense lines, and drop well below its December lows. Our Risk-On/Safe-Haven Currency ratio also points to lower EM share prices (Chart I-12). This indicator is constructed using relative total returns of commodity related (cyclical) currencies such as the AUD, NZD, CAD, BRL, CLP and ZAR against safe-haven currencies such as the JPY and CHF. Importantly, as with EM stocks, this market-based indicator has failed to break above highs reached over the past 10 years. This is in spite of negative interest rates in both Japan and Switzerland that have eroded the latter’s total returns in local currency terms. This ratio has also formed a head-and-shoulders pattern, and may be on the edge of breaking below its neckline. A move lower will spell trouble for EM financial markets. EM corporate profits are shrinking in U.S. dollar terms, and the pace of contraction will continue to deepen through the end of the year. The U.S.-China confrontation is not the only reason behind the EM selloff. In fact, the EM equity rebound early this year was not supported by improving profits. Not surprisingly, the EM equity rebound has quickly faded as investor sentiment deteriorated in response to rising trade tensions. Global semiconductor share prices have made a double top and are falling sharply. Importantly, prices for semiconductors (DRAM and NAND) have not recovered since early this year. The ongoing downdraft in the global semiconductor industry will continue to weigh on the emerging Asian Equity Index. Finally, the relative performance of emerging Asian equities versus DM ones has retreated from its major resistance level (Chart I-13). Odds are that it will break below its recent lows. Chart I-12Risk-On/Safe-Haven Currency Ratio And EM Equities Chart I-13Emerging Asian Stocks Versus Developed Markets Bottom Line: EM share prices are sitting on the edge of a cliff. Further weakness will likely lead to investor capitulation and a major selloff. EM Credit Markets: Reigning Complacency? One asset class in the EM space that has so far held up relatively well is sovereign and especially corporate credit. EM sovereign bonds’ excess returns correlate with EM currencies and industrial metals prices, as shown in Chart I-14. So far, material EM currency depreciation and a drop in industrial metals prices have generated only a mild selloff in EM sovereign credit. Lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Excess returns on EM corporate bonds track the global business cycle closely (Chart I-15). The current divergence between EM corporates’ excess returns and the global manufacturing PMI is unprecedented. Chart I-14EM Sovereign Credit Market Is Complacent... Chart I-15...As Is EM Corporate Credit Market Our expectation that EM credit spreads will widen is not contingent on a massive default cycle unravelling across the EM credit space. However, lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Chart I-16 illustrates that swings in cash flow from operations (CFO) among EM ex-financials and technology companies correlate with other global business cycle indicators such as Germany’s IFO manufacturing index. Chart I-16EM Corporate Cash Flow Fluctuates With Global Manufacturing Cycle Chart I-17EM Corporate Spreads Are Too Narrow Given Their Financial Health The lingering weakness in the global business cycle will likely lead to shrinking CFOs among EM companies, and hence warrants wider corporate credit spreads. Concerning valuations, EM corporate bonds are not cheap at all when their fundamentals are taken into account. Chart I-17 demonstrates two vital debt-servicing ratios for EM ex-financials and technology companies: interest expense-to-CFO and net debt-to-CFO. Both measures have improved only marginally in recent years, yet corporate spreads are not far from their all-time lows (Chart I-17, bottom panel). We are aware that with DM bond yields at very low levels - and in many cases even negative - the appeal of EM credit markets has risen. We are also cognizant that some investors are expecting to hold these bonds to maturity and earn a reasonable yield. Such a strategy has largely paid off in recent years. Nevertheless, if the selloff in EM financial markets escalates – as we expect – EM credit markets will be hit hard as well. To this end, it makes sense to step aside and wait for a better entry point. For dedicated fixed-income portfolios, we continue to recommend underweighting EM sovereign and corporate credit versus U.S. investment-grade credit. Finally, to identify relative value within EM sovereign credit spreads, we plot, each country’s foreign debt obligations as a share of annual exports on the X axis against sovereign spreads on the Y axis (Chart I-18). This scatter plot reveals that Russia and Mexico offer the best relative value in the EM sovereign space. As such, we are reiterating our high-conviction overweight position in these sovereign credit markets as well as in Hungary, Poland, Chile and Colombia. South Africa and Brazil appear attractive as well, but we are underweight these two sovereign credits. The basis for our pessimistic outlook is due to the unsustainable public debt dynamics in these two countries, as we discussed in our Special Report from April 23. Other underweights within the EM sovereign credit space include Indonesia, the Philippines, Malaysia, Turkey and Argentina. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com India: How Sustainable Is A 2.0 Modi Rally? Prime Minister Narendra Modi, and his party – the Bharatiya Janata Party – have won a strong majority in the Indian general election this month. Indian stocks surged in the past month as evidence was emerging that Modi was in the lead. Chart II-1Facing Resistance? Yet this Modi 2.0 rally is unlikely to last for too long. First, as EM stocks continue selling off, Indian share prices will not defy gravity and will fall in absolute terms. Interestingly, the Indian stock market has hit its previous highs – levels at which it failed to break above in the past 12 years (Chart II-1, top panel). We expect this resistance line to hold this time around too. Likewise, we are still reluctant to upgrade this bourse on a relative basis as it has reached its previous highs. This level will likely prove to be a hindrance, at least for the time being (Chart II-1, bottom panel). The basis for betting against a break out in Indian equity prices in both absolute terms and relative to the EM benchmark over the next couple of months is because of the following: Domestic Growth Weakness: India’s domestic growth has been decelerating sharply. The top two panels of Chart II-2 illustrate that manufacturing and intermediate goods production as well as capital goods production growth are all either contracting or on the verge of shrinking. Similarly, domestic orders-to-inventories ratio for businesses is pointing to a further growth slump according to a survey conducted by Dun & Bradstreet (Chart II-2, bottom panel). Furthermore, sales growth of all types of vehicles are either contracting or have stalled (Chart II-3). Chart II-2Business Cycle Is Weak Chart II-3Domestic Demand Is Fragile Regarding the financial sector, Indian banks – encouraged by a more permissive and forbearing central bank on the recognition of non-performing loans – have recently lowered provisions to boost their earnings (Chart II-4). Share prices should not normally react to such accounting changes. Banks either do carry these NPLs or do not. Therefore, the stock price of a bank should not fluctuate much if a central bank is forcing it to recognize those NPLs or if the latter is relaxing recognition and provisioning standards. Chart II-4Less Provisions = More Paper Profit Chart II-5Very Weak Equity Breadth In brief, we are skeptical about the sustainability of the current rally in bank share prices based on the relaxation of some accounting rules. Unfavorable Technicals & Valuations: Technicals for India’s stock market are precarious. Participation in this rally has been very slim. Indian small cap stocks have not rallied much, lagging dramatically behind large-cap stocks (Chart II-5, top panel). Our proxy for market breadth – the ratio of equal-weighted stocks to market-cap weighted stocks – has also been deteriorating and is sending a very bearish signal for the overall stock market (Chart II-5, bottom panel). Finally, the Indian stock market is overbought and vulnerable to a general selloff in EM stocks. Namely, foreign investors have rushed into Indian equities as of late. This raises the risk of a pullout as foreign investors become disappointed by India’s dismal corporate earnings and outflows from EM funds leads them to pare their holdings. As for valuations, the Indian stock market is still quite expensive both in absolute and relative terms. Oil Prices: Although oil prices will likely drop,1 Indian stocks could still underperform the EM equity benchmark in the near term. Chart II-6India Versus EM & Oil Prices The rationale for this is that Indian equities have brushed off the rise in oil prices since the beginning of the year and outperformed the majority of other EM bourses (Chart II-6). By extension, Indian equities could ignore lower oil prices for a while and underperform the EM benchmark in the near term. Beyond near term underperformance, however, India will likely resume its outperformance. First, sustainably lower oil prices will begin to help the Indian stock market later this year. Second, the growth impact of ongoing fiscal and monetary easing will become visible toward the end of this year. Meanwhile, food prices are starting to pickup and this will support rural income and spending. Finally, the Indian economy is much less vulnerable to a slowdown in global trade because Indian exports make only 13% of the country's GDP. Bottom Line: We are maintaining our underweight stance in Indian equities for tactical considerations, but are putting this bourse on an upgrade watch-list. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes 1 The view on commodities of BCA’s Emerging Markets Strategy service is different from BCA’s house view due to the difference on the view on the global business cycle and Chinese demand. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The Federal Reserve’s monetary policy stance is slightly accommodative for the U.S., but it is too tight for the rest of the world. Inflation is likely to slow further before making a durable bottom toward year-end. The Fed will remain on an extended pause, maybe all the way through to December 2020. The trade war is not going away, and investors should not be complacent. However, it also guarantees that Chinese policymakers will redouble on their reflationary efforts. As a result, global growth is still set to improve in the second half of 2019. The dollar rally is in its last innings; the greenback will depreciate in the second half of this year. Treasury yields have limited downside and their recent breakdown is likely to be a fake-out. Use any strength in bond prices to further curtail portfolio duration. The correction in stocks is not over. However, the cycle’s highs still lie ahead. Feature Ongoing Sino-U.S. tensions and weakness in global growth are taking their toll. The S&P 500 has broken below its crucial 2,800 level, EM equities are quickly approaching their fourth-quarter 2018 lows, U.S. bond yields have fallen to their lowest readings since 2017, copper has erased all of its 2019 gains and the dollar is attempting to break out. In response, futures markets are now pricing in interest rate cuts by the Fed of 54 bps and 64 bps, over the next 12 and 24 months, respectively. Will the Fed ratify these expectations? Last week’s release of the most recent Fed’s Federal Open Market Committee meeting minutes, as well as comments from FOMC members ranging from Jerome Powell to Richard Clarida, are all adamantly clear: U.S. monetary policy is appropriate, and a rate cut is not on the table for now. However, the avowed data-dependency of the Fed implies that if economic conditions warrant, the FOMC will capitulate and cut rates. Even as U.S. inflation slows, a recession is unlikely. Moreover, the Sino-U.S. trade war will catalyze additional reflationary policy from China, putting a floor under global growth. In this context, the Fed is likely to stay put for an extended period, but will not cut rates. While the S&P 500 is likely to fall toward 2,600, the high for the cycle is still ahead. We therefore maintain our positive cyclical equity view, especially relative to government bonds, but we are hedging tactical risk. Fed Policy Is Neutral For The U.S…. If the fed funds rate was above the neutral rate – the so-called R-star – we would be more inclined to agree with interest rate markets and bet on a lower fed funds rate this year. However, it is not clear that this is the case. Chart I-1Mixed Message From The R-Star Indicator Admittedly, the inversion of the 10-year/3-month yield curve is worrisome, but other key variables are not validating this message. Currently, our R-star indicator, based on M1, bank liquidity, consumer credit, and the BCA Fed monitor, is only in neutral territory (Chart I-1). Moreover, we built a model based on the behavior of the dollar, yield curve, S&P homebuilding relative to the broad market and initial UI claims that gauges the probability that the fed funds rate is above R-star. Currently, the model gives a roughly 40% chance that U.S. monetary policy is tight (Chart I-2). Historically, such a reading was consistent with a neutral policy stance. Chart I-2Today, Fed Policy Is At Neutral Models can be deceiving, so it is important to ensure that facts on the ground match their insights. Historically, housing is the sector most sensitive to monetary policy.1 Key forward-looking activity measures are not showing signs of stress: mortgage applications for purchases have jumped to new cyclical highs, and the NAHB homebuilders confidence index has smartly rebounded after weakening last year (Chart I-3). Also, homebuilder stocks have been in a steady uptrend relative to the S&P 500 since last October (Chart I-3, bottom panel). These three developments are not consistent with tight monetary policy. Chart I-3This Would Not Happen If Policy Were Tight The corporate sector confirms the message from the housing sector. While capex intentions have weakened, they remain at elevated levels, despite slowing profit growth and elevated global uncertainty. Moreover, the latest Fed Senior Loan Officer Survey shows that banks have again eased credit standards for commercial and industrial loans. Netting out all these factors, we are inclined to agree with the Fed that monetary policy in the U.S. is broadly neutral. If anything, the rebound in leading indicators of residential activity would argue that policy is even slightly accommodative. … But Not For The Rest Of The World Congress gave the Fed a U.S.-only mandate, but the U.S. dollar is the global reserve currency. Because the dollar is the keystone of the global financial architecture, between US$12 trillion and US$14 trillion of foreign-currency debt is issued in USDs, and the greenback is used as a medium of exchange in roughly US$800 trillion worth of transaction per year.2 Therefore, the Fed may target U.S. monetary conditions, but it sets the cost of money for the entire world. While U.S. monetary conditions may be appropriate for the U.S., they are not entirely appropriate for the world as a whole. Indeed, the green shoots of growth we highlighted two months ago are rapidly turning brown: Korean and Taiwanese exports, which are highly sensitive to the global and Asian business cycles, are still contracting at a brisk pace (Chart I-4, top panel). Japan, an economy whose variance in GDP mostly reflects global gyrations, is weakening. Exports are contracting at a 4.3% yearly pace, machine tool orders are plunging at a 33% annual rate and the coincident indicator is below 100 – a sign of shrinking activity. The semiconductor space is plunging (Chart I-4, second panel). Our EM Asia diffusion index, which tallies 23 variables, is near record lows (Chart I-4, third panel). Europe too is feeling the pain, led by Germany, another economy deeply dependent on global activity. The flash estimate for the euro area manufacturing PMI fell to 47.7 and plunged to 44.3 in Germany, its lowest level since July 2012 (Chart I-4, bottom panel). These developments show that the world economy remains weak, in part because the Chinese economy has yet to meaningfully regain any traction. The rebound in Chinese PMI in March proved short lived; in April, both the NBS and Caixin measures fell back to near the 50 boom/bust line. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor. A strong dollar is a natural consequence of an outperforming U.S. economy, especially when global growth weakens. Thus, the rally in the Fed’s nominal trade-weighted dollar to its highest level since March 2002 is unsurprising (Chart I-5). A strong Greenback will have implications for inflation, and thus the Fed. Chart I-4Global Growth: No Green Shoots Here Chart I-5A Strong Dollar Is A Natural Consequence Of Weak Growth Transitory Inflation Weakness Is Not Over The Fed believes the current inflation slowdown is transitory. We agree. With a tight labor market and rising wages, the question is not if inflation will rise, but when. In the current context, it could take some time. As Chart I-6 shows, inflation has been stable for more than 20 years. From 1996 to today, core PCE has oscillated between 0.9% and 2.6%, while core CPI has hovered between 0.6% and 2.9%, with the peaks and troughs determined by the ebbs and flows of global growth. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor, likely around 1.3% and 1.5% for core PCE and core CPI, respectively. Chart I-6Stable U.S. Inflation Since 1996 A few dynamics strengthen this judgment: The strength in the dollar is deflationary (Chart I-7, top panel). Not only does an appreciating greenback depress import prices, it tightens U.S. and global financial conditions. It also undermines dollar-based liquidity, especially if EM central banks try to fight weakness in their own currencies. All these forces harm growth, commodity prices and ultimately, inflation. Chart I-7More Downside Ahead In Inflation For Now After adjusting for their disparate variance, the performance of EM stocks relative to EM bonds is an excellent leading indicator of global core inflation (Chart I-7, second panel). This ratio is impacted by EM financial conditions, explaining its forecasting power for prices. Since goods inflation – which disproportionally contributes to overall variations in core CPI – is globally determined, U.S. inflation will suffer as well. U.S. capacity utilization is declining (Chart I-7, third panel). The U.S. just underwent a mini inventory cycle. The 12-month moving averages of the Philadelphia Fed and Empire State surveys’ inventory indexes still stand above their long-term averages. U.S. firms will likely use discounts to entice customers, especially as a strong dollar and weak global growth point to limited foreign outlets for this excess capacity. Finally, the growth in U.S. unit labor costs is slowing sharply, which normally leads inflation lower (Chart I-7, bottom panel). Average hourly earnings may now be growing at a 3.2% annual pace, but productivity rebounded to a 2.4% year-on-year rate in the first quarter, damping the impact of higher salaries on costs. If global growth is weak and U.S. inflation decelerates further, the Fed is unlikely to raise interest rates anytime soon. As the Fed policy remains modestly accommodative and the labor market is at full employment, the balance of probability favors an extended pause over a cut. But keep in mind, next year’s elections may mean this pause could last all the way to December 2020. How Does The Trade War Fit In? An additional irritant has been added to the mix: the growing trade tensions between the U.S. and China. The trade war has resurrected fears of a repeat of the 1930 Smoot-Hawley tariffs, which prompted a wave of retaliatory actions, worsening the massive economic contraction of the Great Depression. There is indeed plenty to worry about. Today, global trade represents 25% of global GDP, compared to 12% in the late 1920s. Global growth would be highly vulnerable to a freeze in world trade. Besides, global supply chains are extremely integrated, with intra-company exports having grown from 7% of global GDP to 16% between 1993 and 2013. If a full-blown trade war were to flare up, much of the capital invested abroad by large multinationals might become uneconomic. As markets price in this probability, stock prices would be dragged down. Chart I-8Trade Uncertainty Alone Will Delay The Recovery The fear of a full-fledged trade war is already affecting the global economy. The fall in asset prices to reflect the risk of stranded capital is tightening financial conditions and hurting growth. Moreover, the rise in U.S. and global economic uncertainty is depressing capex intentions (Chart I-8). Since capex intentions are a leading variable for actual capex, global exports and manufacturing activity, the trade war is deepening and lengthening the current soft patch. Markets need to be wary of pricing in a quick end to the Sino-U.S. trade conflict. Table I-1 presents BCA’s Geopolitical Strategist Matt Gertken’s odds of various outcomes to the trade negotiations and their implications for stocks. Matt assigns only a 5% probability to a grand compromise between the U.S. and China on trade and tech. He also foresees a 35% chance that a deal on trade excluding an agreement on tech will be reached this year. This leaves 10% odds that the two sides agree to extend the negotiation deadline beyond June, 20% odds of no deal at all and a minor escalation, and 30% odds of a major escalation. In other words, BCA is currently assigning 60% odds of a market-unfriendly outcome, and only a 40% chance of a genuinely market-friendly one.3 Why the gloom? The U.S. and China are geopolitical rivals in a deadlock. Moreover, both parties are feeling increasingly emboldened to play hardball. On the U.S. side, President Donald Trump has threatened to expand his tariffs to all of China’s exports to the U.S., which would represent a major escalation in both the conflict and its cost (Chart I-9). However, despite the scale of the threat, even if it were fully borne by U.S. households, its impact should be kept in perspective. Imports of consumer goods from China only represent 2% of total household spending (Chart I-10, top panel). Moreover, households are not currently overly concerned with inflation, as goods prices are already muted (Chart I-10, middle panel) and family income is still growing (Chart I-10, bottom panel). Finally, a weak deal could easily be decried as a failure in the 2020 election. On the Chinese side, the 9.5% fall in the yuan is already absorbing some of the costs of the tariffs, and the RMB will depreciate further if the trade war escalates. Additionally, Chinese exports to the U.S. represent 3.4% of GDP, while household and capital spending equals 81% of output. China can support its domestic economy via fiscal and credit policy, greatly mitigating the blow from the trade war. The outlook for Chinese reflationary efforts is therefore paramount. In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. Not only do Chinese policymakers have the room to stimulate, they also have the will. In the first four months of 2019, Chinese total social financing flows have amounted to CNY 9.6 trillion, which compares favorably to the same period during the 2016 reflation campaign. Yet, the economy has not fully responded to the injection of credit and previously implemented tax cuts amounting to CNY 1.3 trillion or 1.4% of GDP. Consequently, GDP per capita is now lagging well behind the required path to hit the government’s 2020 development targets (Chart I-11). Moreover, Chinese policymakers’ recent comments have increasingly emphasized protecting employment. This combination raises the likelihood of additional stimulus in the months ahead. Chart I-10...But Do Not Overstate Trump's Constraints Chart I-11Chinese Stimulus: Scope And Willingness Therein lies the paradox of the trade war. While its immediate effect on world growth is negative, it also increases the chance that Chinese authorities pull all the levers to support domestic growth. A greater reflationary push would thus address the strongest headwind shaking the global economy. It could take two to six more months before the Chinese economy fully responds and lifts global growth. Ultimately, it will. Hence, even as the trade war continues, we remain skeptical that the Fed will cut interest rates as the market is discounting. We are therefore sticking to our call that the Fed will not cut rates over the next 12 months and will instead stay on an extended pause. Investment Conclusions The Dollar So long as global growth remains soft, the dollar is likely to rally further. That being said, the pace of the decline in global growth is decelerating. As a corollary, the fastest pace of appreciation for the greenback is behind us (see Chart I-5 on page 6). The risk to this view is that the previous strength in the dollar has already unleashed a vicious cycle whereby global financial conditions have tightened enough to cause another precipitous fall in world growth. The dollar’s strong sensitivity to momentum would then kick in, fomenting additional dollar strength in response to the greater growth slowdown. In this environment, the Fed would have no choice but to cut interest rates. However, growing reflationary efforts around the world currently confine this scenario to being a risk, not a central case. Additional factors also limit how far the dollar can rally. Speculators have already aggressively bought the greenback (Chart I-12). The implication is that buyers have moved in to take advantage of the dollar-friendly fundamentals. When looking at the euro, which can be thought of as the anti-dollar, investors are imputing a large discount in euro area stocks relative to U.S. ones, pointing to elevated pessimism on non-U.S. growth (Chart I-13). It would therefore require a much graver outcome in global growth to cause investors to further downgrade the outlook for the rest of the world relative to the U.S. and bring in new buyers of greenbacks. Chart I-12USD: Supportive Fundamentals Are Already Reflected Chart I-13Plenty Of Pessimism In European Assets... In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. The same factors that are currently putting the brakes on the dollar’s rise will fuel its eventual downturn. As global growth bounces, a liquidation of stale long-dollar bets will ensue. European growth will also rebound (Chart I-14), and euro pessimism will turn into positive surprises. European assets will be bought, and the euro will rise, deepening the dollar’s demise. We are closely following the Chinese and global manufacturing PMIs to gauge when global growth exits its funk. At this point, it will be time to sell the USD. Government Bonds Bonds are caught between strong crosscurrents. On the one hand, rising economic uncertainty caused by the trade war, slowing global economic activity and decelerating inflation are all bond-bullish. On the other hand, bond prices already reflect these tailwinds. The OIS curve is baking in 54 basis points of Fed cuts over the next 12 months, as well as a further 10 basis points over the following 12 months (Chart I-15, top panel). Meanwhile, term premia across many major bond markets are very negative (Chart I-15, middle panel). Finally, fixed-income investors have pushed their portfolio duration to extremely high levels relative to their benchmark (Chart I-15, bottom panel). Chart I-14...Creates Scope For Positive Surprises Chart I-15Fade The Treasury Rally Last week, Treasury yields broke down below 2.34%. For this technical break to trigger a new down-leg in yields, investors must curtail their already-depressed expectations of the fed funds rate in 12-months’ time. However, the fed funds rate is not yet restrictive, and global growth should soon find a floor in response to expanding Chinese stimulus. Under these circumstances, the Fed is unlikely to cut rates, and will continue to telegraph its intentions not to do so. Hence, unless the S&P 500 or the ISM manufacturing fall below 2,500 and 50, respectively, any move lower in yields is likely to be transitory and shallow. Cyclically, yields should instead move higher. Our Global Fixed Income Strategy service’s duration indicator has already turned the corner (Chart I-16). Moreover, in the post-war period, Treasury yields have, on average, bottomed a year before inflation. Expecting an inflation trough in late 2019 or even early 2020 is therefore consistent with higher yields by year-end. Finally, when the Fed does not cut interest rates as much as the markets had been anticipating 12-months’ prior, Treasurys underperform cash. This is exactly BCA’s current Fed forecast. Chart I-16Global Yields Now Have More Upside Than Downside While we expect the bond-bearish forces to emerge victorious, yields may only rise slowly. The list of aforementioned supports for Treasury prices is long, the equity market will remain volatile and has yet to trough, and the trade war is likely to linger. We continue to closely monitor the AUD, the SEK versus the EUR, and copper to gauge if our view is wrong. These three markets are tightly linked to Chinese growth. If China’s stimulus is working, these three variables will rebound, and our bond view will be validated. If these three variables fall much further, U.S. yields could experience significantly more downside. Equities Equities are at a difficult juncture. The trade war is a bigger problem for Wall Street than for Main Street, as 43.6% sales of the S&P 500’s are sourced abroad. Moreover, the main mechanism through which trade tensions impact the stock market is through the threat that capital will be stranded – and thus worthless. This is a direct hit to the S&P 500, especially as global growth has yet to clearly stabilize and the Chinese are only beginning to make clearer retaliatory threats. Oil could also hurt stocks. Energy prices have proven resilient, despite weaker global economic activity. OPEC and Russia have been laser-focused on curtailing global crude inventories; even after the U.S. declined to extend waivers on Iranian exports, the swing oil producers have not meaningfully increased supply. Problems in Venezuela, Libya, and potential Iranian adventurism in Iraq could easily send oil prices sharply higher, especially as the U.S. does not have the export capacity to fulfill foreign demand. Thus, the oil market could suddenly tighten and create a large drag on global growth. This backdrop also warrants remaining overweight the energy sector. Stocks remain technically vulnerable. Global and U.S. stock market breadth has deteriorated significantly, as shown by the number of countries and stocks above their 200-day moving averages (Chart I-17). Moreover, since March, the strength in the S&P 500 has been very narrow, as shown by the very poor performance of the Value Line Geometric Average Index (Chart I-18). Meanwhile, the poor relative performance of small-cap stocks in an environment where the dollar is strong, where U.S. growth is holding steady compared to the rest of the world and where multinationals have the most to lose from a trade war, is perplexing. Chart I-17Stocks Remain Technically Fragile Chart I-18Dangerous Internal Dynamics The U.S. stock market has the most downside potential in the weeks ahead. Like last summer, U.S. equity prices remain near record highs while EM and European stocks, many commodities and bond yields have been very weak. Moreover, the broad tech sector, the U.S.’s largest overweight, has defied gravity, despite weakness in the semiconductor sector, the entire industry’s large exposure to foreign markets, and the consequential slowdown in our U.S. Equity Strategy service's EPS model (Chart I-19).4 Thus, any bad news on the trade front or any additional strength in the dollar could prove especially painful for tech. This would handicap U.S. equities more than their already beaten-up foreign counterparts. Chart I-19The Tech Sector Profit Outlook Remains Poor These forces mean that the global equity correction will last longer, and that U.S. equities could suffer more than other DM markets. However, we do not see the S&P falling much beyond the 2,700 to 2,600 zone. Again, the fed funds rate is slightly accommodative and a U.S. recession – a prerequisite for a bear market (Chart I-20) – is unlikely over the coming 12 months. Moreover, global growth should soon recover, especially if China’s reflationary push gathers force. Additionally, an end to the dollar’s rally would create another welcomed relief valve for stocks. Chart I-20The Absence Of A Recession Means This Is A Correction, Not A Bear Market In this context, we recommend investors keep a cyclical overweight stance on stocks. Balanced portfolios should also overweight stocks relative to government bonds. However, the near-term risks highlighted above remain significant. Consequently, we also recommend investors hedge tactical equity risks, a position implemented by BCA’s Global Investment Strategy service three weeks ago.5 As a corollary, if stocks correct sharply, the associated rise in implied volatility will also cause a violent but short-lived pick up in credit spreads. In Section II, we look beyond the short-term gyrations. One of BCA’s long-term views is that inflation is slowly embarking on a structural uptrend. An environment of rising long-term inflation is unfamiliar to the vast majority of investors. In this piece, Juan-Manuel Correa, of our Global Asset Allocation team, shows which assets offer the best inflation protection under various states of rising consumer and producer prices. Mathieu Savary Vice President The Bank Credit Analyst May 30, 2019 Next Report: June 27, 2019 II. Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I) 2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4 BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2. However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3. Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4. When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5. When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. U.S. Treasuries U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. U.S. REITs While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Commodity Futures Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. U.S. Inflation-Protected Bonds While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Sub-Asset Classes Global Equity Sectors For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel). Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation III. Indicators And Reference Charts Last month, we argued that the S&P 500 would most likely enter a period of digestion after its furious gains from December to April. This corrective episode is now upon us as the S&P 500 is breaking below the crucial 2,800 level. Moreover, our short-term technical indicators are deteriorating, as the number of stocks above their 30-week and 10-week moving averages have rolled over after hitting elevated levels, but have yet to hit levels consistent with a durable trough. This vulnerability is especially worrisome in a context where pressure will continue to build, as Beijing is only beginning to retaliate to the U.S.’s trade belligerence. Our Revealed Preference Indicator (RPI) is not flashing a buy signal either. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. It will require either cheaper valuations, a pick-up in global growth or further policy easing before stocks can resume their ascent. On the plus side, our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Hence, stock weaknesses are likely to prompt buy-the-dip behaviors by investors. Therefore, the expected downdraft will remain a correction and stocks have more cyclical upside. Our Monetary Indicator remains in stimulative territory, supporting our cyclical constructive equity view. The Fed is firmly on hold and global central banks have been opening the monetary spigots, thus monetary conditions should stay supportive. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message of our Monetary Indicator, especially as our Composite Technical Indicator has moved back above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are slightly expensive. Moreover, our technical indicator flags a similar picture. However, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Taking this positioning into account, BCA’s economic view is consistent with limited yield downside in the short-run, and higher yields on a 6 to 12 month basis. On a PPP basis, the U.S. dollar is only getting ever more expensive. Additionally, our Composite Technical Indicator is not only in overbought territory, it is also starting to diverge from prices. Normally, this technical action points to a possible trend reversal, especially when valuations are so demanding. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Edward E. Leamer, "Housing is the business cycle," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 149-233, 2007. 2 This includes both real and financial transactions. 3 Please see Geopolitical Strategy Weekly Report, “How Trump Became A War President,” dated May 17, 2019, available at gps.bcaresearch.com 4 Please see Global Investment Strategy Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 5 Please see U.S. Equity Strategy Weekly Report, “Trader's Paradise,” dated January 28, 2019, available at uses.bcaresearch.com 6 Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 7 Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 8 We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 9 Excess returns are defined as asset return relative to a 3-month Treasury bill. 10 Sector classification does not take into account GICS changes prior to December 2018. 11 Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 12 It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 13 We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:
Highlights Portfolio Strategy The risk/reward equity market tradeoff is to the downside and we remain tactically cautious. The trade war re-escalation risks pushing out the global growth recovery to early-2020 and has shaken our confidence in our cyclically constructive equity market view. An enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profit expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retail (HIR) index has ample downside. Recent Changes Lift the S&P telecom services index to neutral for a gain of 6% since inception. Early last week we got stopped out of our S&P homebuilding overweight recommendation, which is now back to neutral, and booked profits of 10% since inception relative to the SPX. Table 1 Feature Equities continued to whipsaw last week and lacked clear direction as the dust from President Trump’s May 5 tariff tweet has still not settled. While the trade talks could go either way, we are reluctant to take a stance and would rather err on the side of caution. Clearly the SPX wants to spring higher and craves a U.S./China trade deal, but our geopolitical strategists believe the trade talks have taken a turn for the worse and the odds of a positive trade resolution are falling quickly. We remain cautious on the short-term equity market outlook and are now increasingly worried that our sanguine cyclical posture is in jeopardy. Worrisomely, the stock-to-bond (S/B) ratio is sounding the alarm and is now part of the slew of indicators we track that have rolled over decisively (Chart 1). The S/B ratio has formed a bearish head and shoulders trading pattern and suggests that the SPX is at risk of a further pullback. While up to very recently falling bond yields were an undoubtedly equity market recovery pillar, any further melting in the 10-year Treasury yield would exert downward pull on the equity market. There are other signs that the U.S. equity market may be hanging by a thread. The average stock has failed to make new all-time highs using the Value Line Arithmetic Index as a gauge. The median U.S. stock is also suffering the same fate, again according to the Value Line Geometric Index (middle & bottom panels, Chart 2). Chart 1Tread Carefully Chart 2More Non-Confirming Indicators The trade-weighted U.S. dollar is also sending a deflationary impulse signal and likely reflects a continued global growth deceleration (top panel, Chart 2). This is a net negative for EPS especially for internationally exposed SPX constituents. Thus, this week we are further de-risking our portfolio by crystalizing gains in a defensive high-yielding communications services sub-index and lifting exposure to neutral from underweight. In addition, we update our bearish view on an early-cyclical subgroup and continue to protect the portfolio by adding trailing stops. Meanwhile, taking the pulse of global bourses is disconcerting. With the exception of the S&P 500 and the NASDAQ, no other stock market (in USD terms) confirms the SPX’s breakout to all-time highs. Highs were either hit in 2006-2007 or in early 2018. Now a big gulf has opened up, reminiscent of last year’s late-summer dichotomies when the SPX vaulted to fresh highs, but none of the other major global bourses confirmed the September highs (Charts 3 & 4). There are rising odds that a repeat may be unfolding. Chart 3I Know What You Did Last Summer Chart 4I Still Know What You Did Last Summer In our view, what explains the reversal of fortunes that led to a U.S. market dominating outperformance since early 2017 has been the massive fiscal injection the Trump administration undertook (Chart 5), with rising fiscal deficits three years running (an unprecedented backdrop during expansions). Chart 6 puts this easing in fiscal policy in a global perspective and shows the average fiscal balance from 2017-2020 using the IMF’s WEO April 2019 dataset that includes projections. The delta in the U.S.’s fiscal largess is quite significant. Our worry is that this is unsustainable and, similar to last fall/winter, the rest of the world may pull down the U.S. stock market until at least there are clear signs of a positive resolution in the U.S./China trade dispute. Adding it all up, the equity market’s risk/reward tradeoff is poor and we remain tactically cautious. The trade war re-escalation risks pushing out the global growth recovery to early-2020 and has shaken our confidence in our cyclically constructive equity market view. Thus, this week we are further de-risking our portfolio by crystalizing gains in a defensive high-yielding communications services sub-index and lifting exposure to neutral from underweight. In addition, we update our bearish view on an early-cyclical subgroup and continue to protect the portfolio by adding trailing stops. Chart 5Explaining U.S. Outperformance Dialing Up Profits In the context of a further de-risking of the portfolio, we are monetizing our gains of 6% since inception in our underweight recommendation in the S&P telecom services index and are upgrading this high yielding sector to neutral (bottom panel, Chart 7). Not only have bond yields plunged of late, raising the allure of fixed income equity proxies, but the recent escalation of the trade spat has caused U.S. manufacturers to pull in their horns. Markit’s flash manufacturing PMI survey that took place post the May 5 Trump tweet fell to 50.6 the lowest level since the history of the data. It is surprising that this latest reading near the 50 boom/bust line is below the late-2015/early 2016 level when global trade came to an abrupt halt. Historically, relative share price momentum has moved inversely with the annual change in this series and the current message is to expect a sustained rebound in the former (middle panel, Chart 7). Beyond this enticing macro backdrop for defensive equities, firming operating metrics also suggest that it no longer pays to be bearish telecom services stocks. Industry CEOs have shown labor restraint of late, at a time when selling prices are on the verge of expanding (middle & bottom panels, Chart 8). While the dust has yet to settle on the T-Mobile/Sprint saga, any reduction in supply should prove positive at the margin for industry selling prices. Chart 7Macro Headwinds Beneficiary Chart 8Firming Operating Metrics Tack on a tick up in consumer outlays on telecom services and this likely troughing in demand will also boost the sector’s revenue growth prospects (top panel, Chart 8). In sum, an enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profits expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Meanwhile, bombed out profit expectations, suggest that the bar is set extremely low for incumbents and is likely a precursor of positive surprises. In fact, the five year out profit bearishness is unprecedented: telecom carriers are expected to trail the broad market by 13 percentage points (third panel, Chart 9). Despite this downbeat EPS message, relative share prices have fallen even faster, pushing the 12-month forward P/E multiple to multi-decade lows (bottom panel, Chart 9). Nevertheless, we refrain from bumping this niche safe haven index to overweight given some structural negative balance sheet issues. Chart 10 shows that telecom services debt burden is deteriorating. Net debt-to-EBITDA is pushing 3x versus below 2x for the broad market, and the interest coverage ratio is sinking steadily. Chart 9Bombed Out EPS Prospects And Valuations Chart 10Balance Sheet Trouble In sum, an enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profits expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Bottom Line: Lift the S&P telecom services index to neutral and lock in gains of 6% since inception. The ticker symbols for the stocks in this index are: BLBG: S5TELSX – VZ, T, CTL. Home Improvement Retailers: Timber Alert While our high-conviction underweight call in the S&P home improvement retail index is slightly in the red, our confidence has increased that these hard line retailers are about to get chopped. Netting it all out, waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retailing index has ample downside. First, the latest GDP release as it pertains to housing made for grim reading: residential fixed investment is in retreat. Big Box DIY retailers are highly levered to this type of housing activity and the prognosis is negative. Residential fixed investment has subtracted from real GDP growth for five consecutive quarters, which is unprecedented outside of a recession (top panel, Chart 11). Chart 11Time To Converge Lower... Residential investment is on the verge of contracting in absolute terms, a feat already achieved compared to GDP growth (bottom panel, Chart 11). The direct link to HIR typically comes via existing home sales. In other words, when a home changes ownership, typically some renovation activity goes into that newly purchased home (second panel, Chart 12). Thus, any sustained softness in existing home sales especially given heightened competition from the newly built housing stock, will weigh on residential investment. Against such a backdrop, top line growth for building & supply stores will likely remain subdued (third panel, Chart 12). Second, the recently announced tariffs and the specter of additional tariffs on the remaining U.S./China trade balance will also weigh on home improvement retailers' margins and profits. While management teams have yet to pencil in the direct input cost increase hit to future profitability, as revealed in recent HD and LOW conference calls, if all of the cost is passed on to the consumer then sales will suffer the most. Put simply, at the margin, some remodeling projects would have to get trimmed or get postponed, warning that HIR same-store sales will remain under pressure (second panel, Chart 13). Chart 12...To Falling Residential Investment Chart 13Lumber Price Blues Third, lumber prices continue to crumble and, given that HIR makes a set margin on lumber sales, HIR profits will likely underwhelm (third panel, Chart 13). Finally, a buildup in industry inventories at a time when demand is easing has pummeled the sales-to-inventories ratio, warning that the path of least resistance for HIR profitability remains lower (bottom panel, Chart 13). Our HIR model does an excellent job in capturing most of these macro and operating headwinds, and suggests that a felling in the relative share price ratio looms (Chart 14). What is disquieting is that there is no real valuation cushion for these priced-to-perfection retailers to absorb any future profit hiccups that we anticipate in the coming quarters. Our sense is that the de-rating phase that commenced in early 2019 will gain steam in the back half of the year and a premium-to-discount valuation reversal would not surprise us at all (bottom panel, Chart 12). Netting it all out, waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retailing index has ample downside. Bottom Line: We reiterate our high-conviction underweight status in the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Chart 14Model Says Shy Away Housekeeping Early last week we obeyed our stop and booked profits in the S&P homebuilding index of 10% versus the S&P 500 since inception; we also downgraded this niche consumer discretionary index from previously overweight to currently neutral. We are taking this opportunity of de-risking our portfolio to add another trailing stop at 10% to a related market-neutral trade: long S&P homebuilding/short S&P HIR that has recently cleared the 13% return mark since inception. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Corporate Bonds: Corporate bond spreads have been slow to price-in the escalation of the U.S./China trade dispute. Nimble investors should take steps to mitigate their near-term (0-3 month) exposure to credit spreads, but remain overweight corporate bonds (both investment grade and high-yield) on a 6-12 month investment horizon. Duration: With 50 bps of rate cuts already priced into the market for the next 12 months, there is very little money to be made from extending duration and potentially a lot of money to be made by keeping duration low. This is especially true given that the Fed has so far done nothing to suggest that rate cuts are on the table. TIPS: Long-maturity TIPS breakeven inflation rates look cheap on our model, and the core PCE deflator’s sharp drop probably overstates the deflationary pressures in the economy. Maintain an overweight allocation to TIPS versus nominal Treasuries in U.S. bond portfolios. Feature Concerns that the ongoing U.S./China trade war will exacerbate the decline in global growth flared again last week, and our geopolitical strategists see high odds of further near-term escalation.1 For starters, China has not yet retaliated to the U.S. Commerce Department’s blacklisting of Huawei and a handful of other Chinese tech firms. Meanwhile, the U.S. stands ready to extend tariffs across the full slate of imported Chinese goods. To cap it all off, there are currently no firm plans for the resumption of talks between the countries’ respective negotiating teams, and no assurance that Presidents Donald Trump and Xi Jinping will speak to each other at the G20 Summit in Japan on June 28-29. Credit Spreads Are Too Complacent Chart 1Corporate Bonds At Risk While Treasury yields responded to the turmoil by dropping for the second consecutive week, the spillover to corporate bond markets has been less severe. Chart 1 on page 1 shows that corporate bond excess returns have de-coupled from the CRB Raw Industrials index during the past 12 months. The CRB Raw Industrials index tracks a broad basket of commodity prices, making it an excellent real-time indicator of the market’s assessment of global growth. Like Treasury yields, the CRB index has fallen sharply during the past two weeks. The wide gulf between corporate bond and commodity returns suggests that we will soon see either a sell-off in the corporate bond market or a positive re-rating of global growth that sends the CRB index higher. Recent history provides examples of both cases (Chart 2). The CRB index rose to meet corporate bond returns in 2012, but dragged corporate bond returns lower in 2014. Given the long list of potential negative trade catalysts, some near-term downside for corporate bond excess returns appears more likely. But it’s not just political headlines that make us cautious about the near-term outlook for credit spreads. The uncertainty created by the U.S./China trade dispute is now finding its way into the economic survey data. Flash Manufacturing PMIs for the U.S., Eurozone and Japan all fell in May, with respondents quick to blame the decline on global trade tensions. Much like the CRB index, PMI readings are sending a starkly different message than credit spreads. Either trade tensions will ease during the next couple of months, sending PMIs higher, or corporate bond spreads will widen. A model of U.S. capacity utilization based on lagged junk spreads predicts that capacity utilization will rise from its current 78% to 80% during the next six months (Chart 3). However, both the Markit and ISM Manufacturing PMIs suggest a further decline is more likely. Once again, either trade tensions will ease during the next couple of months, sending the PMIs higher, or corporate bond spreads will widen. Chart 2Position For Reconvergence Chart 3Capacity Utilization & Junk Spreads We recommend that investors take measures to limit their near-term (~3-month) exposure to corporate spread risk. Stay Positive On A Cyclical (6-12 Month) Horizon Chart 4Expect More Stimulus From China While near-term caution is warranted, we would still position for positive corporate bond excess returns (both investment grade & high-yield) on a 6-12 month investment horizon. Ultimately, the U.S. and China will navigate toward some sort of truce, and the negative impact from tariffs is unlikely to derail the U.S. economic recovery.2 What’s more, Chinese policymakers will accelerate their stimulus efforts to mitigate the negative impact of higher tariffs. Our China Investment Strategy service tracks a composite of six money and credit growth indicators that lead Chinese economic activity. This leading indicator has already bottomed, and our strategists anticipate a return to stimulus levels reminiscent of mid-2016 (Chart 4).3 As long as a U.S. recession is avoided, corporate bond spreads will eventually settle near levels seen in the late stages of previous economic cycles (Chart 5A & Chart 5B).4 Chart 5AInvestment Grade Spread Targets Chart 5BHigh-Yield Spread Targets Bottom Line: Corporate bond spreads have been slow to price-in the escalation of the U.S./China trade dispute. Nimble investors should take steps to mitigate their near-term (0-3 month) exposure to credit spreads, but remain overweight corporate bonds (both investment grade and high-yield) on a 6-12 month investment horizon. Risk & Reward In The Treasury Market Unlike credit spreads, Treasury yields have responded aggressively to the negative news flow. The 10-year Treasury yield currently sits at 2.32%, 7 bps lower than at this time last week. Meanwhile, the overnight index swap curve is priced for two full 25 basis point rate cuts over the next 12 months. Interestingly, while market prices imply 50 bps of rate cuts during the next year, the New York Fed’s Survey of Market Participants shows that, as of the May FOMC meeting, investors didn’t actually expect rate cuts any time soon. The shaded region in Chart 6 shows the interquartile range of the surveyed investors’ fed funds rate forecasts, while the dashed black line shows the median forecast. The survey responses convey widespread consensus that the fed funds rate will remain flat until the end of the year – the 25th percentile, median and 75th percentile are all equal until the end of 2019. Then, heading into 2020, the 75th percentile of the distribution starts to forecast rate hikes. The 25th percentile doesn’t move in the direction of rate cuts until Q4 2020, and the median forecaster sees the fed funds rate staying put at least through the second half of 2021. Chart 6Market And Survey Expectations Differ Why would market prices imply a much lower path for the fed funds rate than actual investor survey responses? The most likely reason relates to assessments about the balance of risks. When responding to surveys, investors will usually provide their modal (or most likely) outcome. However, investor bets in financial markets will reflect a dollar-weighted average of different possible scenarios. It’s possible that while investors think a flat fed funds rate is the most likely outcome, they also view rate cuts as a higher probability tail risk than rate hikes. They therefore invest some of their money to hedge that risk, even if it does not reflect their base case view. The intuition that rate cuts remain a “tail risk” is confirmed by another question from the survey. This question asks investors to consider a time period between now and the end of the year, and then attach a probability to the Fed’s next move i.e. whether it will be hike, a cut, or whether there will be no change in the funds rate until the end of 2019 (Chart 7). As of the April/May survey, market participants thought the odds of a hike were 23%, odds of a cut were 17% and the odds of flat rates until the end of the year were 59%. Before the Fed meeting in March, investors saw 50% chance of a hike, 13% chance of a cut, and 37% chance of no change. The overall message is that investors continue to view a 2019 rate cut as a tail risk, but one that’s perceived probability is rising. In any event, for our purposes it doesn’t really matter how investors respond to surveys. According to our Golden Rule of Bond Investing, if the actual change in the fed funds rate over the next 12 months exceeds what is currently priced into the OIS curve for that period, then below-benchmark portfolio duration positions will pay off.5 In fact, the Golden Rule even gives us a framework for translating different rate hike/cut scenarios into expected 12-month Treasury returns (Table 1). Table 1The Golden Rule Of Bond Investing Based on current prices, if the fed funds rate holds steady for the next 12 months – as the median market participant expects – we calculate that the Bloomberg Barclays Treasury Master Index will lose between 1.98% and 2.41% relative to cash. Even in the scenario where the Fed delivers two rate cuts during the next 12 months, we would still expect Treasury index returns to lag cash by 12-13 bps. Negative excess returns in the “two rate cut” scenario are due to the negative carry in the Treasury index. Capital gains/losses would be close to zero in that scenario, since the change in the fed funds rate is exactly equal to the market’s expectations. Investors continue to view a 2019 rate cut as a tail risk, but one that’s perceived probability is rising. What’s evident from those figures is that there is currently very little money to be made betting on rate cuts, and quite a bit to be made betting on rate hikes. The risk/reward balance in the Treasury market clearly favors keeping portfolio duration low. But What Will The Fed Actually Do? The minutes from the last FOMC meeting show broad consensus around the Fed’s current “on hold” policy stance, though it’s notable that “a few” participants thought rate hikes would be appropriate if the economy evolved in line with their expectations. The minutes contain no mention of a possible rate cut. Our sense is that it would require a further sharp tightening of financial conditions or significantly worse economic data before the Fed seriously considers cutting rates. Our Fed Monitor – an aggregate indicator that measures economic growth, inflation and financial conditions – is currently very close to the zero line, a level consistent with the Fed’s “on hold” stance (Chart 8). The ISM Manufacturing PMI is also firmly above the 50 boom/bust line. Historically, Fed rate cuts are usually preceded by a negative reading from our Fed Monitor and a sub-50 PMI. We would be looking for those two signals before expecting the Fed to cut rates. Chart 8Sub-50 ISM Required Before The Fed Cuts Rates Bottom Line: With 50 bps of rate cuts already priced into the market for the next 12 months, there is very little money to be made from extending duration and potentially a lot of money to be made by keeping duration low. This is especially true given that the Fed has so far done nothing to suggest that rate cuts are on the table. Inflation & TIPS Chart 9Adaptive Expectations Model It’s not just nominal Treasury yields that dropped during the past two weeks. Long-maturity TIPS breakeven inflation rates – the spread between nominal Treasury yields and TIPS yields – also fell precipitously. The 10-year TIPS breakeven inflation rate is currently 1.76% and the 5-year/5-year forward breakeven is only 1.9%. These figures suggest that the market does not trust the Fed to meet its inflation target in the long-run. Our main valuation tool for the 10-year TIPS breakeven rate is our Adaptive Expectations Model.6 It derives a fair value for the 10-year breakeven based on: The 10-year rate of change in the core consumer price index The 12-month rate of change in the headline consumer price index The New York Fed’s Underlying Inflation Gauge At present, the 10-year TIPS breakeven rate is 20 bps below the model’s fair value (Chart 9). It shouldn’t be too surprising that TIPS look cheap relative to nominals. Recent inflation data have been weak and the Fed has written off the weakness as “transitory”, leading to doubts about whether it will keep rates low enough to meet its target. For our part, we think investors should take advantage of low breakevens and overweight TIPS versus nominal Treasuries in U.S. bond portfolios. In fact, the Fed’s characterization of low inflation as “transitory” seems correct. Chart 10 shows both the core and trimmed mean PCE deflators. The dramatic fall in the core measure, which strips out food and energy prices from the headline number, is what has caught the market’s attention. But it’s important to note that trimmed mean PCE inflation has not confirmed the decline. In fact, it remains in a multi-year uptrend. Recent inflation data have been weak, but the Fed has written off the weakness as “transitory”. Chart 10Low Inflation Looks "Transitory" This is the third time during this cycle that core PCE inflation has diverged negatively from the trimmed mean. Core eventually rebounded and re-converged with the trimmed mean in both of the prior two episodes. The Fed is banking on the third time playing out the same way, and we think it would be unwise to bet against them. Recently released research from the Federal Reserve Bank of Dallas shows that trimmed mean PCE inflation provides a less-biased real-time estimate of the headline figure than the traditional core measure. The latter tends to run too low. The trimmed mean is also more closely related to labor market slack.7 Bottom Line: Long-maturity TIPS breakeven inflation rates look cheap on our model, and the core PCE deflator’s sharp drop probably overstates the deflationary pressures in the economy. Maintain an overweight allocation to TIPS versus nominal Treasuries in U.S. bond portfolios. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, “Is Trump Ready For The New Long March?” dated May 24, 2019, available at gps.bcaresearch.com 2 The potential economic impact from tariffs is discussed in Global Investment Strategy Weekly Report, “Tarrified,” dated May 16, 2019, available at gis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com 4 For details on how we determine the spread targets shown in Charts 5A & 5B, please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 6 For details on the model’s construction please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market,” dated November 20, 2018, available at usbs.bcaresearch.com 7 https://www.dallasfed.org/-/media/Documents/research/papers/2019/wp1903… Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Falling Yields: There have been three main drivers of the latest decline in global bond yields: slower global growth, softer inflation expectations and increased safe-haven demand for bonds given the intensifying U.S.-China trade conflict. The first two are more than fully discounted in current yield levels, but the latter is likely to persist in the near-term with no resolution of the trade conflict in sight. Model Portfolio Adjustments: We are tactically reducing the sizes of the overall strategic tilts in our model bond portfolio – below-benchmark duration exposure and overweight global corporates vs. governments. There is a growing risk of deeper selloffs in global equity and credit markets if the June G-20 meeting produces no positive signals on ending the trade dispute. We do not yet see a case to position more defensively on a medium-term horizon, however, given the pickup in “early” global leading economic indicators. Feature Chart of the WeekYields Discount A Lot Of Bad News The investment backdrop at the moment – slowing global growth momentum, softening inflation expectations, an increasingly prolonged U.S.-China trade dispute with no immediate sign of resolution, and a strengthening U.S. dollar– is fairly bond bullish. Unsurprisingly, government bond yields in the developed markets have fallen to levels more consistent with a less certain macro environment. At one point last week, the 10-year U.S. Treasury yield dipped as low as 2.30%, while the 10-year German Bund fell deeper into negative territory at -0.13%. There are now expectations of easier monetary policy discounted in yield curves of several countries, most notably the U.S. where markets are priced for 50bps of Fed rate cuts over the next year – despite no indication from the Fed that cuts are coming anytime soon. From a valuation perspective, bond yields are starting to look a bit stretched to the downside (Chart of the Week). The term premium component of yields has fallen to near post-crisis lows in the majority of countries, while the U.S. dollar has surged despite lower U.S. interest rate expectations – both indications of investors driving up the value of traditional safe-havens at a time of uncertainty. Looking purely at the growth side of the equation, the downward momentum in bond yields should start to fade with the global leading economic indicator now in the process of bottoming out. That does not mean, however, that yields could not fall further in the near-term if the trade headlines get worse and risk assets sell off more meaningfully – an outcome that grows increasingly likely as the two sides in the trade war seem to be digging in for a longer battle. The State Of The World Since The “TTT” Our colleagues at BCA Geopolitical Strategy now believe that there is only a 40% chance of a U.S.-China trade deal by the end of June. This could trigger a deeper selloff in global equity and credit markets if investors begin to price in a larger and more prolonged hit to economic growth and corporate profits from the U.S. tariffs. This would trigger even greater safe-haven flows into government bonds, pushing yields lower through a more negative term premium. The much lower level of U.S. Treasury yields has helped limit the hit to risk asset prices from the elevated uncertainty over global trade. Since the “Trump Tariff Tweet” (TTT) of May 5, when the new round of tariffs on U.S. imports from China was announced which sparked the new leg of the trade war, the fall in benchmark 10-year government bond yields across the developed world can be fully explained by the fall in the term premium (Table 1). For example, the 10-year U.S. Treasury yield has fallen -14bps since the TTT, while our estimate of the term premium on the 10-year Treasury as decreased by -20bps. Over the same time period, 10-year U.S. inflation expectations have also fallen -11bps, but the market has only priced in an additional -5bps of Fed rate cuts over the next year according to our Fed Discounter. Table 1Decomposing 10-Year Government Bond Yield Changes Since The "Trump Tariff Tweet" The big difference between last December and today is the much lower level of U.S. Treasury yields. Lower yields have helped mute the hit to risk asset prices from the elevated uncertainty over global trade since the TTT (Chart 2). The Fed’s more dovish pivot in the early months of 2019 has helped push Treasury yields lower as investors have moved from pricing in rate hikes to discounting rate cuts. Even traditional “risk-off” measures like the VIX, U.S. TED spreads, the price of gold and the Japanese yen have only risen modestly since the TTT compared to the big moves seen back in December when investors feared that the Fed would tighten right into a U.S. recession (Chart 3). Chart 2Risk Assets Remain Relatively Calm Chart 3Falling Bond Yields Helping Keep Vol Subdued Easier monetary policy, if delivered, can help underwrite a rebound in equity and credit markets. When looking across the array of financial market returns since the TTT (Table 2), the only developed economies that have seen equities appreciate are Australia and New Zealand – countries where rate cuts are being signaled by policymakers (or already delivered, in the case of New Zealand). Table 2Asset Returns By Country Since The "Trump Tariff Tweet" In the case of the U.S., however, numerous Fed officials have stated recently that no changes to U.S. monetary policy are likely without decisive evidence that the new round of China tariffs and trade uncertainty was having a major negative impact on U.S. growth. On that front, forward-looking measures of U.S. economic activity, like the Conference Board leading economic indicator or our models for U.S. employment and capital spending, are not pointing to an imminent sharp slowing of U.S. growth (Chart 4). At the same time, leading indicators like our global LEI diffusion index and the China credit impulse are both signaling that global growth momentum may soon start surprising to the upside (Chart 5). Chart 4No U.S. Recession Signal Yet From These Indicators Chart 5Some Reasons For Optimism On Global Growth If the Fed does not see a case to deliver the rate cuts that are now discounted, or even to just signal to the markets that easier policy is coming soon, then there is a greater chance of a deeper pullback in U.S. equity and credit markets from any new negative news on trade. This suggests that the risk-aversion bid for U.S. Treasuries will result in an even more deeply negative U.S. term premium and lower bond yields. Easier monetary policy, if delivered, can help underwrite a rebound in equity and credit markets. Already, we are seeing such increasingly negative correlations between returns on equities and government bonds across the major developed markets. In Charts 6 & 7, we show the rolling 52-week correlation between local government bond and equity returns for the U.S., euro area, Japan, U.K., Canada and Australia. For each country, we also plot that correlation versus our estimate of the term premium on 10-year government bond yields. Chart 6Safe Haven Demand For Bonds ... Chart 7... Helping Drive Down Term Premia It is clear that there is a significant “risk-aversion bid” for government bonds right now, given the increasingly negative stock/bond correlations and falling term premia. One possible interpretation is that falling bond yields are being driven more by fears of a risk-off selloff in global equity and credit markets rather than rational pricing of future monetary policy or inflation expectations because of slowing growth. Interestingly, Australia – where the central bank has been signaling that rate cuts are imminent – is the only exception in this list of countries where the stock/bond correlation is not negative. There, the deeply negative term premium is more about weakening growth and low inflation expectations, which is forcing a dovish response from the Reserve Bank of Australia, rather than a risk aversion bid for safe assets from investors. It is clear that there is a significant “risk-aversion bid” for government bonds right now, given the increasingly negative stock/bond correlations and falling term premia. Net-net, while bond yields discount a lot of bad news and now look too low compared to tentative signs of improving global growth, it is hard to build a case for an imminent rebound in global bond yields without signs that U.S. and China are getting closer to a trade deal. Bottom Line: There have been three main drivers of the latest decline in global bond yields: slower global growth, softer inflation expectations and increased safe-haven demand for bonds given the intensifying U.S.-China trade conflict. The first two are more than fully discounted in current yield levels, but the latter is likely to persist in the near-term with no resolution of the trade conflict in sight. Tactical Risk-Reduction Adjustments To Our Model Bond Portfolio Chart 8Easier Monetary Policy Required In Europe & Australia Given the growing potential for a larger selloff in global risk assets if no U.S.-China trade deal comes out of next month’s G-20 meeting (where Presidents Trump and Xi will both be in attendance), we think it is prudent to make some tactical adjustments to the recommended weightings within our model bond portfolio. These moves will provide a partial hedge against any near-term widening of global credit spreads or further reduction in government bond yields in the event of a complete breakdown of the trade talks. Specifically, we are making the following changes: Duration Exposure: We are increasing the overall duration of the model bond portfolio by 0.5 years, which still leaves a duration position that is 0.5 years below the custom benchmark index of the portfolio. We are doing this by increasing allocations to the longer maturity buckets in the U.S., Japan and France. Credit Exposure: We are cutting the sizes of our recommended overweight tilts for U.S. corporates in half for both investment grade and high-yield. This is a combined reduction of nearly 4% of the portfolio that will be used to fund the increase in duration on the government bond side. We are making no other changes to our government bond country allocations, staying overweight in core Europe (Germany plus France), Japan and Australia where our Central Bank Monitors are calling for a need for easier monetary policy (Chart 8). We are also staying overweight U.K. Gilts, where yields continue to trade more off Brexit uncertainty than domestic economic growth or inflation pressures. We are not making any changes to the model bond portfolio exposure to euro area corporate debt or Italian governments, riskier spread products where we are already underweight. We are, however, maintaining our weightings for U.S. dollar denominated EM sovereign and corporate debt at neutral. EM debt has performed relatively well versus developed market equivalents since the May 5 “Trump Tariff Tweet” (TTT). We understand that not downgrading EM seems counterintuitive when we are trying to position more defensively in the model portfolio. We prefer to reduce exposure to U.S. credit, however, given that EM debt has performed relatively well versus developed market equivalents since the May 5 TTT (Table 3), and with EM spreads now at more attractive levels relative to U.S. investment grade (Chart 9). In addition, EM credit tends to perform better during periods when Chinese credit growth is accelerating, as is currently the case (bottom panel) – and which may continue if China’s policymakers eventually turn to more domestic stimulus measures to combat the effects of U.S. tariffs, as seems likely. Table 3Credit Market Performance Since The "Trump Tariff Tweet" Chart 9EM Credit Offers Value Versus U.S. Corporates Importantly, these are all only tactical changes to our model portfolio to partially protect against the risk of U.S. credit spread widening in the event of more negative news on the U.S.-China trade front. We still have not changed our strategic (6-12 month) views on global bond yields (higher) and global corporates (outperforming government bonds) given the tentative signs of improving global growth from the leading indicators. Bottom Line: We are tactically reducing the sizes of the overall strategic tilts in our model bond portfolio – below-benchmark duration exposure and overweight global corporates vs. governments. There is a growing risk of deeper selloffs in global equity and credit markets if the June G20 meeting produces no positive signals on ending the trade dispute. We do not yet see a case to position more defensively on a medium-term horizon, however, given the pickup in “early” global leading economic indicators. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights In the second half of 2019, economic growth will stop accelerating… …but an underpinning of equity valuations will limit sell-off magnitudes to around 10 percent or so, rather than deeper sustained plunges. The equity market will end up in a sideways channel… …but defensives, such as healthcare, will outperform economically-sensitive sectors. Overweight Euro Stoxx 50 versus Shanghai Composite. Overweight the JPY. Bitcoin is due another technical correction. Feature The 2019 playbook for economies and markets is playing out exactly as we predicted. In our first report of this year we wrote that 2019 would be the economic and investment opposite of 2018. Opposite to 2018 because the first half of 2019 would see inflation fade, and growth accelerate. And opposite to 2018 because the second half of 2019 would see inflation stop fading, and growth stop accelerating (Chart of the Week). Chart of the WeekIn The First Half Of 2019, Inflation Faded, Growth Accelerated Inflation Faded, Growth Accelerated Back in early January, we wrote: “Inflation is set to disappoint as the recent near-halving of the crude oil price feeds into both headline and core consumer price indexes. With central banks now promising even greater ‘dependence on the incoming data’, this unfolding dynamic will force them to temper any hawkish intentions and rhetoric, limiting the extent of upside in bond yields.” This was a controversial view at the time. Yet within a month of writing, the Federal Reserve had stopped hiking interest rates, while the ECB and other major central banks had also pivoted to more dovish. We also wrote: “Germany should benefit from another support to growth. Last year, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German motor vehicle exports suffered a €20 billion hit which shaved 0.6 percent from Germany’s €3.4 trillion economy (Chart I-2). Now, if auto exports stabilize, this drag will disappear. And if auto exports recover to the pre-WLTP level after this one-off and temporary shock, Germany will receive a 0.6% mirror-image boost to growth.” 1 2019 is the economic and investment opposite of 2018. We now know that the German economy accelerated to a close-to-trend 1.7% clip in the second quarter, up from a -0.8 percent rate of contraction in the third quarter of 2018 (Chart I-3). This is not just due to relief in the auto sector. Growth in other European economies has also rebounded, so the acceleration in growth has a broader foundation, and is now beyond doubt. Given the openness of the European economy, it is also inconceivable that this growth pick-up does not reflect a more generalized acceleration in global activity.2 Chart I-2The WTLP Drag On German Auto Exports Is Over Chart I-3German GDP Growth Accelerated To A 1.7 Percent Clip To repeat, the 2019 playbook for economies and financial markets is playing out exactly as expected; in the first half of the year, inflation faded while growth accelerated. The question is: what happens next? Growth Will Struggle To Accelerate Further Clients ask us an important theoretical question: what is the most important driver for the economy and financial markets; is it the change in the bond yield (or interest rate) or is it the level of the bond yield? The answer is that both the change and the level of the bond yield are important in their different ways. The German economy accelerated to a close-to-trend 1.7% clip in the second quarter. When it comes to accelerations and decelerations in credit creation, it is the change in the bond yield that is the most important. Remember, GDP is a flow statistic, which means that GDP growth is a change of flow statistic receiving contributions from the change of flow of credit. As changes in the flow of credit result from the change in the bond yield – all else being equal – it is the change in the bond yield that drives GDP growth. If all of this sounds somewhat confusing, then Chart I-4 should make the point crystal clear. Chart I-4The Change In The Bond Yield Drives GDP Growth Since last November, high-quality 10-year bond yields have plunged 70 bps, and this collapse in yields helped to provide a strong impulse to growth in the first half of 2019. To receive the same impulse again in the second half, bond yields would have to plunge another 70 bps. But with the German 10-year bund yield already at -0.1 percent, the same rate of decline seems highly unlikely, if not mathematically impossible. The upshot is that the growth impulse from declining bond yields can only fade in the second half of this year. However, when it comes to valuations and solvencies in the financial markets, it is the level of the bond yield that is the most important. Essentially, at a tipping point, higher bond yields can suddenly and viciously undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse on the economy. The growth impulse from declining bond yields can only fade in the second half of this year. How can we sense this tipping point? It broadly equates to when the sum of the 10-year yields on the T-bond, German bund, and JGB is at 4 percent, the ‘rule of 4’ (Chart I-5). Conversely, when the sum is below 3 percent, the ‘rule of 3’, – as it is now – the seemingly rich valuation of equities versus bonds is broadly justified (Chart I-6).3 Chart I-5When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent Chart I-6The Rule Of 4, And The Rule Of 3 The upshot is that in the second half of 2019, economic growth will stop accelerating, but the support to equity valuations will limit sell-off magnitudes to around 10 percent or so, rather than deeper sustained plunges (Chart I-7). In aggregate, the equity market will end up in a sideways channel, but defensives, such as healthcare, will outperform economically-sensitive sectors. Chart I-7The Low Expected Return On Equities Is Justified When Bond Yields Are Ultra-Low How Did We Do? In our first report of the year, we also made (or reiterated) five investment recommendations. Today, we will review whether they worked or not, and what to do with them now. 1. Own a 25:75 combination of European banks relative to market, plus U.S. T-bonds. Chart I-8Banks Didn’t Outperform, But Bonds Did! Did it work? Yes. Although European banks underperformed the market, this was more than offset by the huge rally in T-bonds that resulted from the Fed going on hold (Chart I-8). Hence, the position is up 1 percent this year and 3.5 percent since its inception last November with the added advantage of negligible volatility. What to do now. Take profits. 2. Overweight EM versus DM. Did it work? No. EM has underperformed DM this year, though the position is broadly flat since its inception in November. What to do now. Close this position and switch into overweight Euro Stoxx 50 versus Shanghai Composite. 3. Overweight European versus U.S. equities. Did it work? The position is flat this year, though modestly up since its inception in November. What to do now. Maintain the position for a little while longer, as an expected short-term underperformance of the tech sector should benefit the tech-lite European equity market. 4. Overweight Italian assets versus European assets. Did it work? The position is broadly flat this year for both Italian equities and bonds relative to their European benchmarks. What to do now. Close any cyclical exposure to Italy, but maintain a structural exposure to Italian BTPs either in absolute or relative terms. 5. Overweight the JPY. Chart I-9In Japan And Europe, The Expected Interest Rate Cannot Go Much Lower Did it work? Yes. The broad trade-weighted JPY has outperformed this year, and especially so the JPY/EUR cross. What to do now. Maintain the position. When the expected interest rate is at its lower bound, then it is difficult for the central bank to hurt its currency. In technical terms, the currency possesses a highly attractive payoff profile called positive skew (Chart I-9). Of course, there are plenty of currencies whose interest rates are near the technical lower bound, but we like the JPY because it has less political risk than the others. So for the moment, remain overweight the JPY. Fractal Trading System* This week we note that after a 100 percent rally in a near straight line, bitcoin’s 65-day fractal dimension is at the lower bound that has reliably signaled previous technical corrections. On that basis, this week’s recommended trade is short bitcoin, setting the profit target and symmetrical stop-loss at 27 percent. Also, we are very pleased to report that short tech versus healthcare quickly achieved its 6.5 percent profit target and is now closed. This leaves four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 German auto net exports and GDP are quoted at annualized rates. The Worldwide Harmonized Light Vehicle test Procedure (WLTP) is a new standard for auto emissions that took effect on September 1 2018. 2 Quarter-on-quarter real GDP growth at annualized rates. 3 Please see the European Investment Strategy Weekly Report “The Rule of 4 Becomes the Rule of 3” dated March 21, 2019 available at eis.bcaresearch.com. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Portfolio Strategy Macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Downgrade to a below benchmark allocation. At the margin deteriorating domestic conditions, along with a sustained softness in global growth indicators that are prone to an additional setback given the rising trade policy uncertainty suggest that it is prudent to move to the sidelines on the long materials/short utilities pair trade. Recent Changes Downgrade the S&P chemicals index to underweight, today. This also pushes the S&P materials sector’s weight back down to neutral. Close the long S&P materials/short S&P utilities pair trade, today. Table 1 Feature The SPX suffered its first 5% pullback for the year early last week, and now that President Trump has opened Pandora’s Box, there are high odds that equities will continue to seesaw, at least, until the late-June G20 meeting when the heads of states meet again. Since early-March we have been, and remain, cautious on the short-term equity market outlook as a slew of our tactical indicators have soured. Chart 1 shows three additional non-confirming equity market breakout indicators that are exerting downward pull on the SPX. Stock correlations have increased (shown inverted, top panel, Chart 1), junk spreads have widened (shown inverted, middle panel, Chart 1) and the NYSE’s FANG+ Index has run out of steam (bottom panel, Chart 1). Now the risk is, as we first highlighted in the middle of last week, that the back half of the year global growth reacceleration phase goes on hiatus as this trade policy uncertainty further shatters CEO confidence and global exports remain downbeat (Chart 2). Chart 1Non-Confirming Indicators Chart 2Stalled Export Engine Worrisomely, a number of our cyclical indicators are also firing warning shots. Not only did the ISM’s manufacturing new orders-to-inventories ratio breach parity, but also BCA’s boom/bust indicator took a turn for the worse (Chart 3). Importantly, while a lot of ink is spent on how the U.S. economy is beyond full employment, labor markets are tight and the output gap has closed, resource utilization has petered out – interestingly at a lower high compared with the previous two peaks. This backdrop points to more stock market turmoil in the coming months, similar to the mid-2015 message (Chart 4). Chart 3Cyclical Trouble Brewing Chart 4No Tightness Here Tack on China’s cresting credit impulse and factors are falling into place for a tumultuous back half of the year (bottom panel, Chart 3). Keep in mind that the two ultimate “risk off” indicators we track remain tame and underscore that investor complacency remains elevated: the TED spread is at 16bps and the Japanese yen has barely budged of late. This is worrying and suggests that investors expect a positive U.S./China trade resolution (USD/JPY shown inverted, Chart 5). Chart 5No Real Risk Off Phase Yet Were the equity markets to spin out of control however, the “Fed put” remains in place and would save the day. While the Fed has taken down the median dots and projects no hikes for the rest of the year and a single hike next year, the message from the bond market is diametrically opposite. Thus, we are de-risking our portfolio and this week we are downgrading a deep cyclical sector to neutral and also closing an explicit cyclical/defensive pair trade. Chart 6 shows that over 40bps of cuts are priced in by May 2020, according to the OIS curve. Historically, this has been an excellent leading indicator of the annual delta in the fed funds rate. Our takeaway is that the Fed remains the only game in town and were another mini-riot point to occur, then the Fed would not hesitate to step in and put a floor under the equity market. Chart 6The Bond Market Has The Stock Market’s Back In sum, the risks are rising for a prolonged consolidation phase in equities on the back of a trade war escalation that pushes out the global growth recovery to early-2020. Thus, we are de-risking our portfolio and this week we are downgrading a deep cyclical sector to neutral and also closing an explicit cyclical/defensive pair trade. Chemical Reaction We have been on the sidelines on the heavyweight S&P chemicals index of late (it comprises 74% of the S&P materials sector), but factors have now fallen into place and warrant a below benchmark allocation. First, global macro headwinds will continue to weigh on this deep cyclical index as the risk of a full blown trade war will likely take a bite out of final demand. Chemical producers garner 60% of their revenues from abroad (a full 20 percentage points higher than the SPX) and thus are extremely sensitive to the ebbs and flows of emerging markets economic growth in general and China in particular. Adding it all up, macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Chart 7 shows that U.S. chemical products exports are contracting and if the greenback sustains its recent upward trajectory given heightened global trade policy uncertainty, further global market share losses are likely at a time when the overall chemicals market will be shrinking. With regard to China specifically, the recent drop in the credit impulse is far from reassuring (bottom panel, Chart 3) and, assuming that the Chinese authorities will await a riot point prior to really opening up the credit spigots, more pain lies ahead for U.S. chemical exports. Second, the picture is not brighter on the domestic front. Importantly, the American Chemical Council’s Chemical Activity Barometer is nil, warning that domestic end-demand is also ailing (Chart 8). Chart 7Hazard Warning Chart 8Toxic Profit Prospects Tack on a surprisingly persistent jump in industry headcount (bottom panel, Chart 9), and the implication is that waning productivity will slash chemicals profits (bottom panel, Chart 8). Finally, a number of other operating metrics are languishing. Chemicals railcar loads are outright contracting and the softening ISM manufacturing survey points to further downside in the coming months (middle panel, Chart 9). The chemicals shipments-to-inventories ratio is also in contraction territory as this downbeat demand has been met with a buildup in inventories both at the wholesale and manufacturing levels. As a result, a liquidation phase has ensued and chemicals selling prices have sunk into the deflation zone (middle & bottom panels, Chart 10). Chart 9Deficient Demand Chart 10Liquidation Phase Adding it all up, macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Bottom Line: Trim the S&P chemicals index to underweight. Given the 74% weight chemicals stock have in the S&P materials sector, this move also pushes the S&P materials sector’s (Chart 11) weight to neutral from overweight, and we crystalize modest losses of 5.2% in this niche deep cyclical sector. The ticker symbols for the stocks in the S&P chemicals index are: BLBG: S5CHEM – DWDP, ECL, SHW, PPG, IFF, CE, ALB, LIN, APD, DOW, LYB, FMC, CF, MOS, EMN. Chart 11Trim Materials Back Down To Neutral Materials/Utilities: Move To The Sidelines While we were early in identifying a reflationary impulse from the Chinese authorities and put on an explicit cyclicals/defensives pair trade to capitalize on this opportunity at the end of January, the long materials/short utilities pair trade has failed to live up to its expectations, and today we recommend moving to the sidelines. Such a move is part of our de-risking of the portfolio given the rising global macro headwinds on the horizon we identified earlier. More specifically on the domestic front, our Economic Impulse Indicator (EII) suggests that beneath the surface some cracks are appearing in the U.S. economy. The EII encapsulates six parts of the U.S. economy and on a second derivative basis, softness is apparent (top panel, Chart 12). The ISM manufacturing survey corroborates this message and is also flirting with the boom/bust 50 line, signaling that it is prudent to take some risk off the table (bottom panel, Chart 12). The bond market is sniffing out this deteriorating domestic backdrop and the recent 25bs drop in the 10-year Treasury yield has breathed life into utilities and sucked the oxygen out of materials. Fixed income proxies are also benefiting from the drubbing in Citi’s Economic Surprise Index to the detriment of growth-sensitive deep cyclicals. The melting stock-to-bond ratio reflects all these domestic forces and warns against preferring materials to utilities stocks (Chart 13). Chart 12Move To The Sidelines Chart 13Mushrooming Domestic… The specter of a re-escalation in the trade war will not only continue to weigh on some domestic indicators, but gauges monitoring the health of the global economy will also suffer a setback. Already, our Global Activity Indicator has lost its spark, underscoring that global export volumes will continue to contract. King Dollar is also flexing its muscles, especially versus vulnerable twin deficit emerging market countries which saps economic growth. Tack on the derivative deflationary effect the appreciating greenback has on the commodity complex and materials stocks are at a great disadvantage versus domestic focused utilities (Chart 14). A number of additional global growth indicators are waning and signal that relative profitability will move in favor of utilities and at the expense of materials in the coming months. BCA’s global synchronicity indicator, which gauges the number of countries with a PMI above versus below 50 is sinking like a stone. In fact, the overall global manufacturing PMI is just barely above the expansion/contraction line and global industrial production is decelerating. All of this is a net negative for the deep cyclical materials sector, but a net positive for defensive utilities stocks that sport nil foreign sales exposure (Chart 15). Chart 14…And Global Growth… Chart 15…Worries But before getting outright bearish on this pair, there is a powerful offset. Likely, most of the bad news is reflected in bombed out relative valuations and oversold technicals. This actually also prevents us from fully reversing the trade and buying utilities at the expense of materials. A move to the sidelines is more appropriate (Chart 16). At the margin deteriorating domestic conditions, along with a sustained softness in global growth indicators that are prone to an additional setback given the rising trade policy uncertainty suggest that it is prudent to move to the sidelines on the long materials/short utilities pair trade. Bottom Line: Book losses of 5.3% in the long S&P materials/short S&P utilities pair trade and move to the sidelines. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Chart 16Saving Grace Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
While we remain bullish on global equities and other risk assets over 12 months, we went tactically short the S&P 500 last Friday following the market’s complacent reaction to the Trump Administration’s further tariffs increases on Chinese imports. While a moderate trade war would still produce more economic damage than standard economic models imply, this would be greatly mitigated by significant Chinese economic stimulus and a Fed that is in no hurry to raise rates and could even cut rates. Barring any further major developments, we recommend investors start increasing risk exposure if the S&P 500 falls to 2711. A dip in global bourses would also create an opportunity to go overweight EM/European equities. Favor gold over government bonds as a low-cost hedge against trade war risks for now.