Developed Countries

Dear Clients, This week we have an abbreviated Weekly Report followed by a Special Report penned by my colleagues Jeremie Peloso and Arseniy Urazov on the Fed’s “mid-cycle adjustment” and sector performance. I hope you will find this report insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist Highlights Portfolio Strategy The 10/2 yield curve inversion, the outright collapse in long term bond yields, prospects for heightened volatility and renewed trade uncertainty that is weighing on SPX EPS, all signal that investors should avoid buying the dips and instead be fading the rallies. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Chart 1Repricing To Lower EPS Backdrop Has Started The SPX took it to the chin last week, but managed to recover some of the losses by Friday’s close. It appears as though equity investors are slowly becoming thick skinned to President Trump’s tweets and instead starting to focus on softening earnings fundamentals. Last week we showed that SPX EPS are at stall speed, having a tough time surpassing the $165/share mark, eerily reminiscent of the 2014-16 episode when they hit a wall near $118/share.1 Importantly, sell-side analysts are trimming Q3/2019, Q4/2019 and calendar 2020 EPS estimates and investors need to be patient and wait out this shake out period that will be full of bearish undertones (Chart 1). U.S. Equity Strategy’s view remains cautious on a 3-12 month horizon on the prospects of the broad equity market, which stands in contrast to BCA’s sanguine cyclical equity market house view.   Another similarity with the 2015/2016 manufacturing recession episode is the Chinese renminbi devaluation on August 11, 2015 and subsequent parabolic move in the VIX above 50 on August 24, 2015. There are high odds that the SPX will succumb to the renminbi’s recent devaluation (Chart 2) and volatility will surge further in coming months as the trade war outcome is highly uncertain. Indeed, a number of internal equity market indicators suggest that the volatility spike has yet to run its course (Chart 3). Chart 2The Yuan To Watch Chart 3Vol Is Primed To Spike Beyond the heightened volatility, the brief 10/2 yield curve slope inversion last week was unnerving and a reason to remain cyclically cautious on the overall equity market outlook (Chart 4). As a reminder, the yield curve inversion signals additional Fed interest rate cuts and, historically, that has been a bearish backdrop for stocks as we highlighted in recent research (please see Chart 1 from the July 29th Weekly Report). In addition, the collapse in long term interest rates is cause for concern as it suggests that growth will be scarce in coming quarters. While stocks have been benefiting from lower interest rates via higher valuation multiples as theory would suggest, our sense is that a tipping point likely occurred last week. The implication is that stocks will likely heed the bearish message bonds are sending and converge to the steeply declining 10-year nominal and real yields (Chart 5).   Chart 4Another Bad Omen Chart 5Time To Get Back Together   Adding it up, the 10/2 yield curve inversion, the outright collapse in long term bond yields, prospects for heightened volatility and renewed trade uncertainty that is weighing on SPX EPS, all signal that investors should avoid buying the dips and instead be fading the rallies.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Insight Report, “Trump Backpedals, Again” dated August 14, 2019, available at uses.bcaresearch.com.

Special Report

Feature Chart 1A Feeling Of Deja Vu? Chair Powell described the recent rate cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. This mid-cycle reference was most likely intended to leave the door open for (i) additional “insurance cuts”, likely as soon as September,1 and (ii) the tightening cycle that began at the end of 2015 to eventually resume. Needless to say the market – and President Trump –did not appreciate the hawkish tone of the latter. Importantly, it shows that the current cycle is very similar to the one in the mid-90s (Chart 1). Back then, following the post-Mexican peso devaluation (Tequila Crisis) in December 1994, the bond market started pricing three Fed cuts while the stock market was rebounding in Q1/1995 from the previous quarter’s drawdown (Chart 1, panel 2). Further, the Fed rate cuts in the mid-90s came in response to persistently low and weakening U.S. inflation (Chart 1, panel 3) amidst slowing growth in the rest of the world (Chart 1, panel 4). Bear with us, there is more to it. Former President Clinton was up for reelection the year following the first rate cut in July 1995, at a time that would later be painted as one of “irrational exuberance” in financial markets by then-Chairman Alan Greenspan. In other words, the Fed acted to sustain that economic expansion, respond to the deflationary pressures and mitigate international developments. Sound familiar?  Table 1Run-Up To The First Rate Cut: Now Vs. 1995 As a result, we decided to follow-up on the Special Report published in May when we examined which sectors performed best during Fed loosening cycles leading to recessions.2 In this issue, we delve a little deeper and – in light of all the similarities mentioned above – only look at the sectors’ relative performance following “mid-cycle adjustments” in the post-war era or, broadly speaking, the six loosening cycles that did not morph into a recession. We first isolate the 1995 episode, as the similarities in the stock market’s behavior between now and then are uncanny (Table 1). The S&P returned 18.6% and 17.3% in the six months leading to the 1995 and 2019 initial rate cuts, respectively. In relative terms, seven of the 10 sectors actually performed in a similar fashion over these two periods.3 Further, we broaden out our analysis by including six such non-recessionary loosening episodes, as highlighted in Chart 2. We omit the short-lived tightening in monetary policy both in 1976 and 1986 and instead look at the broader loosening trend. Chart 2Post-War Era Mid-Cycle Adjustments Table 2 displays the results of our analysis of the sectors’ relative average performance during “mid-cycle adjustments.” Table 2Sector Relative Performance And Non-Recessionary Fed Rate Cuts The average performance of the broad market registers negative returns ahead of the first rate cut followed by strong 6-, 12- and 24-month positive returns given the more supportive monetary backdrop and the absence of a dreaded recession. What follows in Charts A, B, C and D, is the sectors’ relative performance in the four different timeframes. The rate-sensitive sectors – S&P utilities, telecoms, consumer discretionary and financials – underperform early before they outperform once the Fed has started to ease with the exception of the S&P utilities which initially delivers low but positive returns and continue to underperform up to two years after the beginning of the “mid-cycle adjustments.” Chart 3Defying Gravity Similarly, we find that most of the deep cyclicals underperform in the run-up to the first rate cut and usually outperform subsequently. The S&P energy is an exception as it outperformed heading into the cutting cycle and then underperformed 6 to 12 months after the first rate cut. Admittedly, we cannot yet rule out the possibility Jay Powell and the Fed might very well be wrong and that the July cut will turn out to be more than just a “mid-cycle adjustment.”  After all, various slopes of the yield curve have already inverted (Chart 2, bottom panel) and the probability that the U.S. might enter into a recession 12 months from now reached 31.5% at the end of July, according to the New York Fed probit model based on the 3-month/10-year Treasury slope (Chart 3). Besides, that was before the yield curve underwent a roughly parallel shift lower of about 30 bps in a few days earlier this month, following the FOMC meeting and news about the escalation in Sino-U.S. trade tensions. Chart 3 shows our probit forecast taking into account the recent further yield curve inversion. What we know is that the current loosening episode is likely to run at least for the rest of the year. Market participants still expect at least three additional rate cuts from the Fed over the next 12 months (Chart 1, panel 2) and, as a reminder, the “mid-cycle adjustments” in the past all provided more than one interest rate cut. While we use this Special Report as a roadmap to sector performance before and after a “mid-cycle adjustment,” our view remains that a recession looms in the coming 18 months and, as such, we continue to decrease cyclical sector exposure and to add defensive exposure.4 (For purposes of completeness, we included reference charts in Appendix A showing individual sector relative performance since 1960 with the non-recessionary Fed rate cut episodes highlighted.) Finally, for those interested in how the yield curve reacts to such “mid-cycle adjustments,” our U.S. Bond Strategists5 performed a similar exercise and found that the 10-year Treasury yield has a tendency to rise following non-recessionary rate cuts and decline following rate cuts that led to a U.S. recession. They also document an interesting yield curve pattern: the curve tends to steepen quite sharply in the aftermath of a non-recessionary rate cut, before starting to flatten after a few months. Appendix A  Chart 4A Chart 4B Chart 4C Chart 4D Chart 4E Chart 4F Chart 4G Chart 4H Chart 4I Chart 4J   Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1 As we go to press, the probability of a 25 bps rate cut for the September FOMC meeting is 74.2% and of 25.8% for a 50 bps rate cut, based on CME FedWatch Tool. 2 Please see U.S. Equity Strategy Special Report, “Sector Performance And Fed Loosening Cycles: A Historical Roadmap”, dated May 6, 2019, available at uses.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment”, dated June 10, 2019, available at uses.bcaresearch.com 4 Please see U.S. Equity Strategy Weekly Report, “The Fed Apotheosis”, dated July 29, 2019, available at uses.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Track Records”, dated June 18, 2019, available at usbs.bcaresearch.com