Developed Countries

Overweight While our overweight S&P health care equipment (HCE) call has given up some of its gains since inception, profit fundamentals have not changed and we continue to recommend an above benchmark allocation in this defensive sector. US medical equipment manufacturers are world leaders in supplying hospitals with quality equipment, and given that BCA’s house view for 2020 calls for a weaker dollar, HCE exporters have a bright future (middle panel, real trade-weighted dollar shown inverted). Further, the industry also showcases some of its defensive characteristics that are similar to its parent GICS1 health care sector, and in light of the recent disappointing ISM manufacturing PMI print, the path of least resistance is higher for relative share prices (bottom panel, ISM manufacturing index shown inverted). Bottom Line: We stand by our overweight S&P health care equipment call. The ticker symbols for the stocks in the index are: BLBG: S5HCEP – ABT, MDT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMD, TFX, HOLX, ABMD, VAR, STE.   ​​​​​​​

Highlights Stock markets begin 2020 with fragile short-term fractal structures, which means there is a two in three chance of a tactical reversal. The bond yield impulse is now a strong headwind, which reliably predicts that bond yields are not far from a near-term peak. The oil price tailwind impulse is fading. German and European growth will lose some momentum in the first and/or second quarters of 2020. Tactically underweight equities versus bonds. But on a longer-term horizon, the low level of bond yields justifies and underpins exponentially elevated equity market valuations. Markets Are Fractally Fragile Stock markets begin 2020 with fragile short-term fractal structures. In plain English, this means that usually cautious value investors have become momentum traders, and their buy orders have fuelled a strong short-term trend. But the danger is that when everybody becomes a momentum trader, liquidity evaporates and the market loses its stability. After all, when everybody agrees, who will take the other side of the trade without destabilising the price? When everybody becomes a momentum trader, liquidity evaporates and the market loses its stability.  When a fractal structure is fragile the tiniest of straws can break the camel’s back. But the straw is simply the catalyst for a potential market reversal. The straw could be, say, US/Iran geopolitical tensions escalating, or it could be something else, or there might be no straw needed at all. The underlying cause of the potential reversal is the market’s fragile fractal structure and its associated illiquidity and instability (Chart of the Week). Chart of the WeekStock Markets Are Fractally Fragile Investment presents no certainties, only probabilities. Successful investing is about identifying and playing those probabilities right. When the market’s fractal structure is at its limit of fragility, the probability that the short-term trend reverses by a third rises to two in three, while the probability that the short-term trend continues uninterrupted drops to one in three. Hence, a fractal warning of a reversal will be right two times out of three, but it will be wrong one time out of three. Still, we can accept being wrong one time out of three if it means we are right the other two times! For further details please revisit our recent Special Report ‘Fractals: The Competitive Advantage In Investing’.1 Translating all of this into current index levels, there is a two in three probability that over the next three months the Euro Stoxx 600 sees 405 before it sees 435. Across the Atlantic, there is a two in three probability that the S&P500 sees 3150 before it sees 3400 (Chart I-2). Nevertheless, a better tactical trade might be to play a short-term reversal in stocks in relative terms versus bonds. Chart I-2Stock Markets Are Fractally Fragile The Bond Yield Impulse Is Now A Strong Headwind A commonly held belief is that a decline in bond yields causes economic growth to accelerate. For example, we frequently hear bold claims such as: financial conditions have eased, so economic growth is likely to pick up. Unfortunately, the commonly held belief is wrong. What causes growth to accelerate or decelerate is not the change in financial conditions but rather the change in the change – the impulse. If the decline in the bond yield is the same in two successive periods, growth will not accelerate. For example, a 0.5 percent decline in the bond yield will trigger new borrowing through an increase in credit demand. The new borrowing will add to spending, meaning it will generate growth. But in the following period, all else being equal, a further 0.5 percent decline in the bond yield will generate the same additional new borrowing and thereby exactly the same growth rate. Therefore, what matters for a growth acceleration or deceleration is whether the bond yield change in the second period is greater or less than that in the first period. In other words, what matters is the bond yield impulse. A bond yield impulse at +1 percent constitutes a strong headwind to short-term growth.  Now look at the actual numbers. The euro area 10-year bond yield stands at a lowly 0.45 percent and the 6-month change is a seemingly benign +0.2 percent. Nothing to worry about, right? Wrong. The crucial 6-month impulse equals a severe +1 percent, because the +0.2 percent rise in yields followed a sharp -0.8 percent drop in the preceding period (Chart I-3). A similar story holds in the US, where the bond yield 6-month impulse now equals +0.5 percent, the highest level in two years (Chart I-4). Chart I-3The Euro Area Bond Yield Impulse Is Now A Strong Headwind Chart I-4The US Bond Yield Impulse Is A Headwind Too A bond yield impulse at +1 percent constitutes a strong headwind to short-term growth. Hence, through the past decade, this impulse level has reliably predicted that bond yields are not far from a near-term peak (Chart I-5). Combined with fractally fragile stock markets, there is a two in three chance that equities underperform bonds by about 4 percent on a three month tactical horizon. Chart I-5When The Bond Yield Impulse Is A Strong Headwind, Bond Yields Are Near A Local Peak Yet on a longer horizon, the low level of bond yields also provides comfort to equity investors by underpinning elevated valuations. At ultra-low yields, bonds become a risky ‘lose-lose’ proposition: prices can no longer rise much, but they can fall a lot. As bonds become riskier, the much higher return required on formerly riskier assets – such as equities – collapses to the feeble return offered on equally-risky bonds (Chart I-6). Meaning that the valuation of equities resets at an exponentially higher level. Chart I-6Ultra-Low Bond Yields Justify Ultra-Low Returns From Equities As long as bond yields stay near current levels, long-term investors should prefer equities over bonds. The Oil Price Tailwind Impulse Is Fading The preceding discussion on the bond yield impulse applies equally to how the oil price can catalyse growth accelerations and decelerations. For the impact on inflation, what matters is the oil price change. But for the impact on growth accelerations and decelerations what matters is the oil price impulse. The German economy is especially sensitive to the oil price impulse. The German economy is especially sensitive to the oil price impulse. This is because its decentralized ‘hub and spoke’ structure requires a lot of criss-crossing of road traffic that relies on imported oil. Hence, when the oil price falls it subtracts from imports and thereby adds to Germany’s net exports, and vice versa (Chart I-7). But just as for the bond yield, what matters for a growth acceleration or deceleration is whether the oil price change in a given 6-month period is greater or less than that in the preceding 6-month period. In other words, the evolution of the oil price 6-month impulse. Chart I-7The Oil Price Explains Swings In Germany's Net Exports Oscillations in the oil price 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with an uncanny precision. The first half of 2019 constituted a severe headwind impulse, because a 30 percent increase in the oil price followed a 40 percent decline in the previous period, equating to a severe headwind impulse of 70 percent.2 But as the oil price stabilized in the second half of 2019, this flipped into a tailwind impulse of 30 percent (Chart I-8). Chart I-8The Oil Price Tailwind Impulse Is Fading Allowing for typical lags of a few months, this severe headwind impulse followed by a tailwind impulse explains why Germany experienced a sharp slowdown in the middle of 2019 followed by a healthy rebound which continued through the fourth quarter (Chart I-9). Chart I-9The Oil Price Impulse Explains Oscillations In German Growth However, even without any escalation of US/Iran tensions, the oil price 6-month impulse is now fading. Combined with the headwind from the bond yield 6-month impulse it is highly likely that German and European growth will lose some momentum in the first and/or second quarters of 2020. Next week, we will explain what all of this means for sector, country, and regional equity allocation in the first half of 2020. Stay tuned. Fractal Trading System* To repeat the main theme of the week, all of the major stock markets are fractally fragile. Play this by going tactically short stocks versus bonds. Our preferred expression of this is short the S&P500 versus the 10-year T-bond. Set the profit target at 5 percent with a symmetrical stop-loss. Chart I-10EUROSTOXX 600 In other trades, short GBP/NOK achieved its 2.5 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 62 percent comprising 19.7 wins and 12.0 losses. 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. * 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 Please see the European Investment Strategy Special Report ‘Fractals: The Competitive Advantage In Investing’, October 10, 2019 available at eis.bcaresearch.com. 2 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading System   Cyclical Recommendations Structural Recommendations 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 The US and Iran are not rushing into a full-scale war for the moment – and yet the bull market in US-Iran tensions will continue for at least the next 2-3 years (Chart 1). This means that while global risk assets can take a breather from Iran geopolitical risk – if not other risks to the heady rally – the breather is not a fundamental resolution and Iran will remain market-relevant in 2020. A Reprieve … Chart 1Bull Market In US-Iran Tensions On January 8 President Donald Trump spoke at the White House in response to a barrage of missiles fired by the Iranian Revolutionary Guards Corps (IRGC) at bases with US troops in al-Asad and Erbil, Iraq. Trump remarked that Iran “appears to be standing down,” judging by the fact that the missile strikes did not kill American citizens – Trump’s explicit red line – or cause any significant casualties or damage. Iran’s Foreign Minister Javad Zarif claimed that Iran’s strikes “concluded proportionate measures” in response to the US killing of Quds Force chief Qassem Soleimani in Baghdad on January 3, which itself followed unrest at the US embassy in Baghdad and American strikes on Iran-backed Iraqi militias (Map 1). Supreme Leader Ayatollah Ali Khamenei gave ambivalent comments, saying military operations were not in themselves sufficient but that Iran must focus on removing the US presence from the region. Map 1US And Iran Sparring Across The Region President Trump’s speech was transparently a campaign speech, not a war speech. He did not imply in any way that the US military would retaliate to the missile strikes, but said Americans should be “grateful and happy” that Iran did a “good thing” for the world by refraining from drawing American blood. Instead Trump focused on Iran’s nuclear program, denouncing the 2015 nuclear deal with Iran (the Joint Comprehensive Plan of Action or JCPA). He implored the parties of that agreement – the UK, Germany, France, Russia, and China – to join him in negotiating a new deal to replace it. The goal of the new negotiations would be to prevent Iran from ever obtaining a nuclear weapon and to halt its sponsorship of regional militants in exchange for economic development and opening up to the outside world. He called for NATO to take a more active role in the Middle East and he highlighted the US’s shared interest with Iran in combating the Islamic State in Iraq and Syria. The takeaway is that the Trump administration is not pursuing regime change but rather nuclear non-proliferation and a change in Iran’s regional behavior. The administration has often said as much, but the assassination of Soleimani escalated tensions and called into question Trump’s intentions. Financial markets will cheer the successful reestablishment of US deterrence vis-à-vis Iran, as it makes Iran less likely to retaliate to US pressure in ways that lead to a major military confrontation. The near-term risk of a massive oil supply shock will decline. Oil prices have already fallen back to where they stood before Soleimani’s death. … Amid A Bull Market In US-Iran Tensions Yet the saga does not end here. Iran’s ineffectual military strike could have been a feint, or Iran could follow up with more consequential retaliation later. Chart 2US Strategic Deleveraging From The Middle East Iran has the ability to dial up its nuclear program step by step, sponsor regional attacks with plausible deniability, and foment regional unrest in important oil-producing countries. It can do these things in ways that do not clearly cross America’s red lines but still cause market-relevant tensions or disrupt oil supply. After all, Iran is still under punitive sanctions and desirous of demoralizing the US to hasten its departure from the region. So far Iran has not irreversibly abandoned its nuclear commitments or crossed any red lines regarding levels of uranium enrichment, but we fully expect it to threaten to do so and use its nuclear program to build up negotiating leverage. We doubt any serious US-Iran negotiations will take shape until 2021 at the earliest – and any negotiations could fail and lead to another, more serious round of military exchanges. This means that today’s reprieve may be tomorrow’s negative surprise for the markets. The fundamental basis for this bull market in US-Iran tensions is that the US is seeking to withdraw its strategic commitment to the region to counter China (Chart 2), yet Iran is filling the power vacuum and could conceivably create a regional empire (Map 2). President Trump will not want to appear to have been chased out of Iraq in an election year, even if he is in favor of strategic deleveraging, but Iran may try to do exactly that. Iran will also try to solidify its influence among those left exposed by the US’s deleveraging, namely in Iraq. Map 2Iran's Strategic 'Land Bridge' To The Mediterranean Chart 3A Succession Crisis Looms Moreover President Donald Trump’s withdrawal from the 2015 nuclear deal sowed deep distrust between the US and Iran and discredited the reformist faction in Tehran, which faces a tough election in February. This makes it difficult for the two countries to find a new equilibrium anytime soon. The Iranian regime is at a crossroads. It has a large and restless youth population (Chart 3), an economy under crippling sanctions, and faces a leadership succession in the coming years that brings enormous uncertainties about economic policy and regime survival. At the same time, President Trump is a historically unpopular president who is being impeached and believes that showing a strong hand against terrorism – under which the US classifies Iran’s Revolutionary Guard as well as the Islamic State – is an important key to being re-elected in November. Terrorism and immigration are in fact the two clearest issues that got him elected (Chart 4). Economic growth is a necessary but not sufficient condition for his reelection. US-Iran tensions will persist at least until the US election is settled and likely beyond. The result is a cyclical increase in tensions between the two countries that will persist at least until after the US election is settled. The Iranians are loathe to reward President Trump for his tactics – it would be better for Tehran if Washington changed parties again. After November, the US and Iran will recalibrate. Ultimately, in the coming years, either President Trump will get a new deal, or a new Democratic administration will reinitiate diplomacy to update the JCPA, or “maximum pressure” tactics will persist and increase the odds of a major military conflict. There is room for many negative surprises in this time frame as the US and Iran jockey for better positioning. The writing on the wall is that the United States is deleveraging and this creates a transition period in which regional instability will rise. Even within 2020 the current de-escalation could prove short-lived. The US president has enormous leeway in foreign policy and even the economic constraint is limited. The US economy is less oil intensive and less dependent on imports for its energy, while households have ample savings and spend less of their disposable income on energy. While this may ultimately serve as a basis for withdrawing from the Middle East, it also enables the US president to take greater risks in the region. Even within 2020 the current de-escalation could prove short-lived. The Iranians would have to create and maintain an oil supply shock the size of the September attack in Saudi Arabia for four months in order to ensure that American voters would feel the negative impact at the gas station by the time of the election. Chart 5 illustrates this point by simulating a 5.7 million barrel-per-day oil outage for different time periods. The chart overstates the impact on gasoline prices because it does not take into account the inevitable release of global strategic petroleum reserves. In other words, Trump may believe he has a sufficient buffer for the economy – and he clearly believes saber-rattling is worth the risk amid impeachment and election campaigning. Chart 4Trump Benefits From Fighting Iran-Backed Militants Chart 5Gasoline Price Cushion Could Embolden Trump   Investment Conclusions Chart 6Close Long EM Oil Producer Trade The past month’s events have reached a crisis point and are tentatively de-escalating. We are booking gains on our tactical long Brent crude trade and our long emerging market energy producers trade (Chart 6). We are not changing our constructive view on China stimulus, commodities, and the global business cycle. Following BCA Research’s commodity strategists, we recommend going long Brent crude H2 2020 versus H2 2021 on the expectation that production will remain constrained, inventories will fall, and prices will backwardate further. The underlying US-Iran conflict will persist and create volatility in oil markets in 2020 and beyond. We also remain on guard for ways in which the Iran dynamic could affect Trump’s reelection odds and hence US policy and the markets over the coming year.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com  

Overweight The S&P energy index is sitting at a multi-decade low that has also served as support for the relative share price ratio (top panel). Importantly, two key macro drivers argue that investors favor energy stocks rather than throw in the towel. First, the greenback has given up its 2019 gains and is currently sitting flat on year-over-year basis. BCA’s 2020 house view calls for a lower US dollar that should pump energy stocks higher (second panel, trade-weighted dollar shown inverted). Second, the divergence between crude oil and relative share prices is unsustainable and there are high odds that a catch up phase materializes in the latter (third panel). Moreover, our relative earnings growth model that aggregates all the key drivers for the sector also reveals that the multi-decade support should hold and serve as a springboard for energy stocks.  Besides the promising macro data, rising geopolitical risk-related premia in oil due to increasing Middle East tensions could serve as a catalyst to unlock excellent value in the S&P energy space. Bottom Line: We reiterate our overweight call on the S&P energy sector.  ​​​​​​​

Overweight On January 3rd, the United States conducted a drone strike against two high-level targets near the Baghdad International Airport further fueling the tensions in the region. The US President has also warned that should Iran retaliate, death of an American citizen or an attack on US assets is a redline that cannot be crossed. While, at the margin, this new geopolitical risk should refocus investors’ minds and lead to a rise in risk premia, it foreshadows a favorable backdrop for our long-held cyclical and secular overweight in BCA’s Defense Index. As a reminder, the position is currently up nearly 17% since inception. Industry level data corroborates the message from the geopolitical front as the US is projected to continue ramping up its defense spending (middle & bottom panels). Bottom Line: We reiterate our overweight call on the BCA Defense index in light of the increasing geopolitical tensions. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY.