Developed Countries
Highlights The U.S. has outperformed most major stock markets over the past few years largely because U.S. earnings have increased more rapidly than earnings abroad. U.S. companies will continue to deliver superior earnings growth during the remainder of this year. However, profit growth is likely to slow in 2019 owing to a larger wage bill, a stronger dollar, and a sluggish global economy. The efficacy of buybacks in boosting earnings-per-share is waning due to soaring valuations and rising interest rates. For the time being, asset allocators should maintain a neutral weighting to global equities, while favoring developed market stocks over emerging markets and overweighting defensive sectors relative to cyclical ones. Within the developed market equity space, the U.S. will outperform over the coming months in dollar terms, but will trade broadly in line with Europe and Japan in local-currency terms. Longer term, odds are high that earnings growth in the rest of the world will catch up with that of the U.S. Feature There Is No Mystery As To Why U.S. Stocks Have Outperformed The stock market is influenced by many variables, but in the end, the one that matters most is earnings. The U.S. has outperformed most major stock markets during the past few years largely because U.S. earnings have increased more rapidly than earnings abroad. Stronger earnings growth, in turn, has caused investors to assign a higher earnings multiple to the U.S. in comparison to other regions. This has given U.S. stocks a further lift (Chart 1). Differences in sector weights have helped flatter overall U.S. earnings to some extent. Globally, earnings in the tech and health care sectors have grown much more quickly than earnings in the financials and materials sectors (Chart 2). The former sectors have large weights in U.S. indices, while the latter are overrepresented in overseas indices (Table 1). Still, our analysis suggests that most of the outperformance of U.S. firms can be explained by their superior earnings growth within sectors (Chart 3). Chart 1U.S. Stocks Have Outperformed ##br##Thanks To Faster Earnings Growth Chart 2Global Earnings Sector Breakdown Table 1Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials ##br##And Materials Are Overrepresented In Markets Outside The U.S. Chart 3AU.S. Earnings Have Risen Faster ##br##Within Each Equity Sector (I) Chart 3BU.S. Earnings Have Risen Faster ##br##Within Each Equity Sector (II) We do not expect U.S. corporate earnings growth to slow sharply this year. In fact, our margin proxy points to a slight increase in profit margins in the second half of the year (Chart 4). Nevertheless, there are four reasons why U.S. earnings growth will decelerate in 2019 and beyond: Wage growth is likely to pick up. Chart 5 shows that there is an almost perfect correlation between profit margins and the ratio of selling prices-to-unit labor costs. A variety of surveys suggest that U.S. firms are struggling to find qualified workers (Chart 6). This is confirmed both by the most recent Fed Beige Book and by firms' Q2 earnings conference calls. A stronger dollar will eat into earnings. A reasonable rule of thumb is that every 5% appreciation in the broad trade-weighted dollar reduces S&P 500 earnings by 1% over the course of the ensuing 12-to-18 months. The broad trade-weighted dollar has risen 6.2% so far this year and we expect further strength in the months ahead. Global growth will weaken further. The U.S. is increasingly running out of spare capacity, which is limiting domestic growth prospects. Emerging markets are struggling, with the crises in Turkey and Argentina likely to spread to bigger players such as Brazil and South Africa. A major Chinese stimulus package would help reboot global growth, but concerns about high debt levels, overcapacity, and an overheated housing market will limit the response. The policy environment will become more challenging. Corporate tax cuts helped boost earnings earlier this year. However, the regulatory landscape is likely to turn less benign over the next few years. The tech sector is facing increased scrutiny.1 New EU privacy rules came into effect in May, which will limit the ability of internet companies to harvest personal data. The Trump Administration is also increasingly targeting social media companies for allegedly suppressing conservative voices. In addition, our geopolitical strategists expect U.S.-China trade tensions to remain elevated, with the U.S. likely to impose tariffs on an additional $200 billion worth of Chinese imports. Meanwhile, a trade deal with Canada is no slam dunk. President Trump has even reiterated that he would be willing to exit the World Trade Organization. Chart 4Margins Could Rise A Bit More ##br##In The Near Term Chart 5Higher Wage Growth Will Undermine Profit Margins Chart 6U.S. Firms Are Having Difficulty ##br##Finding Qualified Workers Diminishing Returns From Buybacks U.S. companies are on track to spend a record amount of money buying back shares in 2018, with tech companies accounting for about 40% of all shares repurchased. While this may seem very bullish for stocks, one should keep in mind that the prior peak in share buybacks occurred in 2007. Companies are not particularly adept at timing the stock market, even when it is their own shares they are purchasing. Moreover, U.S. stock market capitalization has doubled since 2007. As a share of market cap, today's pace of buybacks is high, but not exceptionally so (Chart 7). To state the obvious, the more expensive stocks get, the more money it takes to purchase the same number of shares. U.S. equity valuations are quite stretched by historic standards (Chart 8). On a price-to-sales basis, U.S. stocks are now as expensive as they were in 2000. Our estimate of the U.S. equity risk premium - calculated as the difference between the cyclically-adjusted earnings yield and the average expected short-term real interest rate over the next decade - is well below its historic average (Chart 9). Chart 7Buybacks As A Share Of Market Cap: Fairly Muted Chart 8U.S. Equities Are Trading At Lofty Valuations Chart 9The U.S. Equity Risk Premium Is Well Below Its Historic Average It is also important to remember that share repurchases will only boost EPS if the interest rate that companies receive on their cash balances is below their earnings yield. To see this, consider a simple example where the earnings yield and the interest rate are the same. Specifically, suppose that a company has a market cap of $1 billion, $20 million in earnings, and earns 2% on its cash holdings. If the company buys back $100 million in shares, its share count will decline by 10%, but the interest payments that it receives will fall by $2 million, pushing profits down by 10% from $20 million to $18 million. The net result is no change in EPS. As U.S. interest rates continue to increase, companies will see ever-smaller benefits to their bottom lines from share buybacks. Where's The Earnings Growth Going To Come From? The foregoing discussion raises another point, which is that buybacks, by their very nature, leave companies with less cash to invest in future growth. This issue is quite relevant for the current environment. Analysts today expect the average S&P 500 company to grow earnings at an annual rate of 16.6% over the next 3-to-5 years (Chart 10). This is wildly optimistic. It is six points higher than the long-term earnings growth rate they expected just three years ago. Indeed, it is only topped by the euphoric projection of 18.7% reached in 2000 - just before the stock market came crashing down. Apparently, on Wall Street, companies can have their cake and eat it too. Chart 10Analyst Expectations Are Too Optimistic Creative Accounting? Earnings are earnings, correct? Actually, no. What constitutes earnings has changed over the years. Up until the 1990s, companies generally reported GAAP earnings - earnings based on Generally Accepted Accounting Principles. Over the past two decades, however, companies have moved towards reporting so-called "pro forma" or "operating" earnings. Unlike GAAP earnings, there is no codified set of rules governing the definition of operating earnings. Conceptually, companies are supposed to exclude both one-off losses and gains when calculating operating earnings in order to give shareholders a better sense of the underlying trend in profits. In practice, they tend to exclude the former much more often than the latter. This problem has gotten worse over time, so much so that an apples-to-apples comparison now requires that we reduce earnings today by about 15% in order to compare them with earnings in the early 1980s (Chart 11). More ominously, it is possible that even GAAP earnings are currently overstated. Chart 12 shows that EBITDA profit margins, which are generally more difficult to fudge, have fallen over the past decade, while operating margins have risen. Economy-wide profit margins, as measured in the national accounts, have also increased much more slowly than S&P 500 operating margins (Chart 13). Chart 11A Bull Market In Creative Accounting? Chart 12S&P 500 Operating Margins Have Risen Much More Than EBITDA Margins Chart 13Profit Margins, As Measured In The National Accounts, Have Fallen Relative To S&P 500 Margins This raises the risk that we will see more earning restatements - or at the very least, earnings disappointments - in the years ahead as companies run out of magic asterisks to pull out of their bag of accounting tricks. Investment Conclusions Corporate earnings are highly correlated with the state of the business cycle (Chart 14). We do not expect the U.S. to enter a recession at least until 2020. Thus, it is doubtful that U.S. earnings will suffer a sharp decline before then. Nevertheless, as this report argues, earnings growth is likely to decelerate early next year. Investors have a lot riding on the assumption that earnings growth will hold up. U.S. households owned nearly $30 trillion of equities in Q1 of 2018, or 25% of total household assets, the highest level since 2000 (Chart 15). The monthly asset allocation survey published by the Association of Individual Investors (AAII) shows that stocks comprised 68.5% of investors' portfolios in August (Chart 16). While this is below the peak of 77% reached in March 2000, it is still more than seven points above the post-1987 average of 61%, putting it in the 84th percentile of the historic distribution. Chart 14Earnings Are Highly Correlated ##br##With The Business Cycle Chart 15Households Are Loaded Up On Stocks Which... Chart 16...Comprise A Big Chunk Of Their Portfolios If earnings growth slows significantly, investors could end up deciding to cut their exposure to the stock market. Since for every buyer there must be a seller, the only way for investors to collectively reduce the value of their equity holdings is if share prices decline. U.S. equities account for 55% of global stock market capitalization (Chart 17). Thus, if U.S. earnings begin to stagnate, this will limit the upside for global equity indices. Chart 17U.S. Equities Account For More Than Half Of Global Stock Market Capitalization Chart 18Earnings In Other Regions Will Eventually Catch Up With The U.S. Does this mean that investors should look for greener pastures abroad? Not yet. We expect the dollar to strengthen and global growth to slow further over the coming months. This will put downward pressure on cyclical stocks, which are overrepresented in foreign indices. For the time being, asset allocators should maintain a neutral weighting to global equities, favoring developed market stocks over emerging markets. Within the DM space, the U.S. will outperform in dollar terms, but will trade broadly in line with Europe and Japan in local-currency terms. Longer term, we are more sanguine about the prospects for non-U.S. stocks. The outperformance of U.S. equities over the past decade follows a decade of underperformance. In fact, EPS in Europe and emerging markets actually grew more rapidly between 1990 and 2007 than in the United States (Chart 18). Historically, the relative growth of earnings across different regions follows multi-year cycles, and there is no reason to think that this will change. As such, it is likely that earnings growth in the rest of the world will begin to outstrip the U.S. once the problems plaguing emerging markets have been flushed out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see U.S. Equity Strategy, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
The S&P communications equipment index received a substantial leg up in the past month as the quarterly results issued by index giant Cisco proved more resilient than anticipated and growth surpassed analyst expectations. However, on the earnings call management noted that pricing power continued to erode in the quarter and margins were under pressure from rising input costs. This is corroborated by the macro data we track which shows that communications equipment pricing power remains stubbornly in decline; the recent collapse in Asian currencies points to more of the same. Further, the industry wage bill is rapidly moving in the opposite direction of pricing power, pointing to a margin squeeze. Tack on valuations that have fully recovered and the message comes through clearly: stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, JNPR, FFIV.
Overweight It has been in vogue to be bearish on industrials this year as they are relatively easy targets for investors fearful of a blowback over trade rhetoric. We think a negative positioning is not constructive. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (second panel). Domestic ex-tech output is firing on all cylinders (third panel), which has helped to drive firming pricing power (bottom panel). Tack on the reacceleration in our U.S. capital expenditure indicator - capex upcycle remains a key BCA theme for the remainder of 2018 - and industrials sector stars are aligned. The upshot is that depressed relative profit growth will easily surprise to the upside. While we caution a rising U.S. dollar presents a risk to our sanguine view on industrials, a sturdily supportive macro view puts the chips squarely in the overweight column. Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technical suggest that the path of least resistance is higher for the S&P industrials sector. Please see this week's Weekly Report for more details.
Highlights Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. Feature How long and how deep will the selloff in emerging markets (EM) be? There are many factors that investors should be watching to gauge potential for further downside in the EM universe, and to exercise judgement about a bottom. These include the business cycle trajectory, policy actions and shifts, market technicals, liquidity, valuations and other fundamental variables. Not all of preconditions typically need to be satisfied before a major bottom emerges. What's more, not all bottoms are identical and contingent on the same factors. Hence, there is no magical formula for calling a bottom or top in any financial market. Today we revisit some of the variables that, in our opinion, are worth monitoring in terms of gauging a bottom. To begin, we address a currently popular narrative within the investment industry, which contends the following: EM woes are primarily being driven by Federal Reserve tightening. According to this view, when the Fed halts its tightening campaign, the skies will clear for EM risk assets. By and large, we disagree with this narrative. EM And The Fed: Let's Get Things Straight Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary drivers of EM economies are domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed (Chart 1). On this chart, we shaded the periods in which EM stocks rallied, despite a rising fed funds rate. Chart 1EM Equity Prices And Fed Funds Rate: Mixed Correlation There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits, pegged exchange rates, and so on. Importantly, EM stocks and currencies did well during other periods of a rising fed funds rate: in 1983-1984, 1988-1989, 1999-2000 and 2017, as illustrated by the shaded periods in Chart 1. Hence, statistically there is no case that EMs plunge when the Fed is tightening policy. Why did the behavior of EM risk assets during various Fed tightening episodes differ? The key was EM fundamentals at the time: When fundamentals were healthy, EM managed to rally, despite Fed tightening; when fundamentals were flawed, EM markets relapsed regardless of the Fed's policy stance. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Notably, U.S. and EU growth were booming and U.S. bond yields were dropping in 1997-'98. Specifically, U.S. and EU import volumes were growing at double-digit rates but this did not preclude EM crises, including in export-dependent Asian economies such as Korea, Malaysia and Thailand (Chart 2). It is critical to emphasize that China was not an economic superpower in the late 1990s. EM economic dependence on the U.S. and European economies was much greater than it is today. Yet neither booming demand in the U.S. and EU nor falling U.S. government bond yields prevented the Asian/EM crises from rolling across the globe in 1997-'98 (Chart 3A). Moreover, the S&P 500 was in a bull market in the second half of 1990s, as it is today (Chart 3B), but it did not help EM either. Chart 2Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Chart 3AAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Chart 3BAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Hence, we can safely conclude that the EM fallout in 1997-'98 was due to EM domestic fundamentals - not developed market dynamics in general and Fed tightening in particular. An essential question is: Why are EM risk assets currently plunging while U.S. stocks and credit markets are holding up just fine? The U.S. economy is much more exposed to rising U.S. borrowing costs than EM. Despite this, the American economy, U.S. share prices and corporate bonds have been performing very well. In our view, this also stipulates that the core root for the current EM bear market is EM fundamentals. As we have repeatedly noted in various reports,1 EM fundamentals have been very frail, and the end of easy Fed monetary policy has not helped. The Fed's tightening can be regarded as the trigger - not the cause - of the EM bear market. The cause is weak EM fundamentals, such as credit excesses, low return on capital, weakening productivity growth and, in some cases, inflation and dependence on external funding. Importantly, the dependence of EM countries on the Chinese economy is presently greater than their dependence on the U.S. as shown in Table 1. Further, mainland growth is decelerating. Adding it all up, it is not surprising to us that EM financial markets are in turmoil. Table 1Many Emerging Economies Sell More##br## To China Than to The U.S. Our bearish view on EM has not been based on a negative view on U.S./EU growth. On the contrary, we have been bearish on EM/China and positive on domestic demand in the U.S. and the EU. Early this year, we promoted the theme of tectonic macro shifts,2 arguing that China/EM growth would slump and the U.S. economy would accelerate - and that such dynamics would propel the U.S. dollar higher. In turn, a firm dollar would inflict substantial pain on EM. Bottom Line: Rising U.S. interest rates, in and of itself, is neither a necessary nor a sufficient condition for EM to sell off. Consequently, the Fed adopting an easier policy stance or lower U.S. Treasury yields may not, in and of themselves, create sufficient conditions for a reversal in EM financial markets, unless they coincide with a turnaround in other variables that matter for EM. What Matters For EM? As of now, we do not think sufficient conditions exist for a bottom in EM financial markets because of several pertinent factors: The most important factor for EM assets in the medium term is the direction of the business cycle in EM in general, and in China in particular. The EM business cycle is still decelerating, as evidenced by falling manufacturing PMI indexes in EM ex-China and China (Chart 4). Consistently, corporate earnings growth is decelerating for EM non-financial companies and Chinese non-financial A-share corporates (Chart 5). The rationale for our focus on non-financial corporate earnings is that non-performing loans are usually not recognized and provisioned for by banks in a timely way to reflect their true profitability. Typically, banks' earnings cycle lags the real economy. When the real economy is slowing, banks' profits typically deteriorate with a time lag. Chart 4Manufacturing Is Slowing In China And EM Ex-China Chart 5EM/China Corporate Profit Growth Is Decelerating Corporate profits in China and in EM have not yet contracted, but our view is that there will be a meaningful profit contraction in this downturn. As and when corporate earnings shrink, share prices will sell off. In brief, we are not out of the woods yet. In China, the industrial part of the economy continues to weaken, as evidenced by the slump in the total freight index and electricity consumption by manufacturing and resource sectors (Chart 6). So far, the cumulative impact of policy easing in China has not been sufficient to reverse its business cycle. As we discussed in our prior report,3 money/credit impulses lead China's industrial sector by nine months or so. Even if the government's recent stimulus initiatives cause money/credit impulses to improve materially today (which we still doubt), the impact on growth will be felt only next year. While financial markets are forward-looking, they are unlikely to bottom a full six months before the bottom in the real economy. Hence, we are currently in the window where China plays in financial markets remain at risk. Global trade is also weakening, as evidenced by falling semiconductor prices (Chart 7) and industrial metals. Similarly, the container freight index at Chinese ports is sluggish, and broader Asian export volumes are slowing (Chart 8). Chart 6Signs Of Industrial Slowdown In China Chart 7Semiconductor Prices Are Plunging Chart 8Asian Export To Slow Further Regarding liquidity, there are various definitions and ways to measure liquidity. One measure of EM liquidity is EM local interest rates. Chart 9A and 9B shows that interbank rates in various EM countries are rising due to the ongoing currency weakness. EM benchmark local currency bond yields are also under upward pressure (Chart 10, top panel). These are all signs of tightening liquidity. The ramifications of higher interest rates will be a slowdown in money and credit, and consequently a slump in domestic demand. Chart 9AEM: Interbank Rates##br## Are Rising Chart 9BEM: Interbank Rates##br## Are Rising Chart 10EM: Local Currency Bonds Yields##br## And Narrow Money Growth Chart 10 illustrates that local bond yields negatively correlate with narrow money growth in EM ex-China, Korea, Taiwan and India. These four markets are not included in the EM GBI local bond index; to maintain consistency, we have removed them from the money supply aggregate. EM sovereign and corporate bond yields continue to rise. As we have shown numerous times in previous reports, EM share prices do not bottom until EM corporate and sovereign bond yields roll over on a sustainable basis. Finally, we discussed EM equity and currency valuations in our August 23 report. We maintain that aggregate EM equity and currency valuations are not yet cheap enough to warrant bottom-fishing. Bottom Line: The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. 6 September 2018 The list of our trades and country allocation is always presented at the end of each report (please see page 10-11). Specifically, we continue shorting BRL, CLP, ZAR, IDR and MYR versus the U.S. dollar. Within the equity space, our overweights are Taiwan, Korea, Thailand, Chile, India, Mexico and central Europe; and underweights are Brazil, Peru, Malaysia, Indonesia, and South Africa. Among local currency bonds we are overweight Russia, Korea, Mexico, Thailand, and central Europe and underweight Brazil, South Africa, Turkey, Malaysia, and Indonesia. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," July 19, 2018. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Two Tectonic Macro Shifts," January 31, 2018. 3 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Do Note Catch A Falling Knife," August 23, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights German real estate and real estate equities remain a worthwhile multi-year position, especially in relative terms. The dominant stocks are Vonovia, Deutsche Wohnen, LEG, and GSW. Swedish real estate and real estate equities are likely to face harder times. The dominant stocks are Lundbergforetagen, Castellum, Fastighets, and Fabege. The structural pair-trade is long German real estate equities, short Swedish real estate equities. Italian real estate offers distressed opportunities. The long-term equity play is Covivio. We remain reluctant to own U.K. residential real estate or real estate equities. Chart of the WeekExtremes In European Real Estate Feature Nowadays, the best way to play the relative performance of an individual economy is through real estate. Indeed, European real estate offers compelling structural opportunities for investors who want to go long, and for investors who want to go short. By contrast, the opportunities to play intra-European economic divergences through other asset-classes have become limited. Nineteen European countries share one currency and one policy interest rate; and the mega-cap companies that drive the major equity indexes are multinationals exposed to the global economy. Meaning that a stock market's relative performance is no longer defined by its home economy; it is now defined instead by its dominant sectors and stocks.1 This leaves real estate as the purest play on the domestic economy. The evidence comes from the huge divergences in real estate market performances across Europe through the past two decades (Chart I-2-Chart I-4). While house prices in Sweden and Norway have more than trebled in real terms, house prices in Germany and Italy are at the same real level today as in 1995 (Chart of the Week). Chart I-2Winners And Losers In##br## European Real Estate Chart I-3Winners And Losers In##br## European Real Estate Chart I-4Winners And Losers In##br## European Real Estate How can German real estate be such a massive structural underperformer when the German economy has been one of Europe's star performers? The answer is that house prices take their cue from wages. German wages were suppressed for more than a decade, from which they are now playing a long catch up. A Tale Of Two Real Estate Markets: Germany And Sweden The two long-term drivers of house prices, assuming no supply bottlenecks, are: Real wages. The availability and price of bank credit. Real rents should trend higher to reflect the increasing quality of accommodation. For example, kitchens and bathrooms, heating and cooling systems and home security should all get better. In essence, the quality of accommodation benefits from productivity improvements. Of course, such improvements require investment expenditure. But a real estate investor requires a return on this investment. Therefore, rents - even after expenses - should increase in real terms. Given that house prices must maintain some long-term connection with rents, house prices should also trend higher in real terms, reflecting the improvements in home quality. But if real wages are not rising, it is impossible for tenants to absorb higher real rents, and so real rents and house prices stagnate. This describes the situation in Germany through 1995-2010 when labour market reforms resulted in real wages going nowhere, despite major gains in workers' real productivity (Chart I-5). Furthermore, as nominal adjustments to rents occur infrequently, German real rents and house prices actually fell through this extended period (Chart I-6). Chart I-5Through 1995-2010 German##br## Real Wages Stagnated... Chart I-6...So German Real Rents And ##br##House Prices Declined Since 2010, the dynamic has reversed. Needing to catch up with the economic fundamentals, German real wages, real rents and house prices have all rebounded very strongly. Nevertheless, based on the long-term connection with real productivity gains, German real rents and house prices have considerable further catch up potential. Just fifty miles across the Baltic Sea, the opposite is true. In Sweden - and Norway - house prices appear to have run well ahead of the economic fundamentals. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that the flood of bank credit has been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated bank credit fuelled bubbles... albeit in Sweden and Norway. Real estate equities are just a leveraged play on rents - and thereby real estate capital values - because the companies take on debt to finance their property portfolios. This means that in the short term, they are (inversely) sensitive to bond yields, but in the long term the main driver is rental growth. Hence, in the German real estate market's post-2011 rebound, German real estate equities - now dominated by Vonovia, Deutsche Wohnen, LEG, and GSW - have trebled (Chart I-7), and the market relative trade is up a very pleasing 75 percent since we initiated it. Any rise in bond yields would be a short term drag, but given that real rents and house prices have further catch-up potential, the sector remains a worthwhile multi-year position, especially in relative terms. Chart I-7German Real Estate Equities ##br##Have Trebled Since 2012 Interestingly, Swedish real estate equities have also trebled in the post-2011 period (Chart I-8). But in Sweden's case, house prices are extended relative to the economic fundamentals. Swedish real estate equities - now dominated by Lundbergforetagen, Castellum, Fastighets, and Fabege - are likely to face harder times. Chart I-8Swedish Real Estate Equities ##br##Have Also Trebled Since 2012 Hence, the structural pair-trade is long German real estate equities, short Swedish real estate equities. Italian Real Estate Offers Distressed Opportunities Turning to Italian real estate, it has exhibited the mirror-image pattern of Germany. From the late nineties to 2008, Italian house prices almost doubled in real terms - only then to enter a ten year bear market. In recent years, Italian real wages have been growing again, raising the question: what is holding back Italian house prices? The answer is a banking system that will not lend, making it difficult for anybody to finance a house purchase (Chart I-9). Chart I-9Italian Banks Haven't Been Lending... This lack of bank financing means that the natural flow of real estate that has to find a new owner is not receiving any bids. The upshot is that a long-term investor who can access financing can pick up property at highly distressed valuations, often at a fraction of the market price a few years ago. Some investors cannot remove a nagging fear about an 'Italexit' from the monetary union and the deep crisis that would follow. It is precisely because of the deep crisis that would ensue from a euro breakup that its likelihood remains low - though admittedly not zero. But even in that extreme eventuality, as long as Italy did not become an outlaw state in which property rights were dismantled, a long-term investor might still fare well. Because he would own a real asset bought at a very distressed price. Within the stock market, the real estate equity sector in Italy - just as in Germany and Sweden - has been a leveraged play on the house price cycle (Chart I-10). But there are two caveats: the sector is tiny with one dominant company, Beni Stabili; and Beni Stabili has just been taken over by the French property company Covivio. Still, now that Covivio owns a large portfolio of Italian real estate assets, it would be the appropriate equity to play this multi-year theme. And the bonus is that it offers a dividend yield of 5 percent. Chart I-10...Creating Distressed Opportunities In Italian Real Estate U.K. Real Estate Faces Headwinds Finally, the recent pressure on U.K. house prices is likely to persist (Chart I-11) - with the housing market facing at least one of three potential headwinds: Chart I-11U.K. Real Estate Faces Headwinds A disorderly Brexit, though not our central case, would pose a huge risk for the U.K. economy. On the other hand, an orderly and smooth transition to Brexit would liberate the Bank of England to hike interest rates further in 2019. Bear in mind that in the U.K., wage pressures and CPI inflation are not dissimilar to those in the U.S., where the Federal Reserve has already hiked the policy rate seven times. So it is largely the uncertainties surrounding Brexit that are staying the BoE's hands. The precarious path to leaving the EU on March 29 2019 is littered with landmines for Theresa May. Any of these landmines could trigger a snap General Election, a Jeremy Corbyn led Labour government, and the spectre of a high-end 'land value' tax. Hence, we remain reluctant to own U.K. residential real estate or real estate equities. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For the compelling evidence, please see Charts 1-6 in the European Investment Strategy Weekly Report 'The Eight Components Of Equity Market Allocation' July 26 2018 available at eis.bcaresearch.com. Fractal Trading Model* The 30% outperformance of India versus China during the recent EM shock is technically stretched, hitting a fractal dimension that signals a potential reversal, assuming no further deterioration in news flow. On this technical basis, the countertrend trade would be long China/short India with a profit target of 9% and symmetrical stop-loss. In other trades, long platinum/short nickel reached the end of its 65 day holding period very comfortably in profit. However, short consumer services versus consumer goods hit its stop-loss. This leaves five open trades. 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-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - 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
Most FOMC participants currently think that r-star is somewhere between 2.75% and 3%. If this is correct, it means that the Fed's current 25 basis point per quarter hike pace will cause the funds rate to reach neutral by the middle of next year. This is…
In a report in May of this year, we examined how the market performed after the peak of the ISM manufacturing composite index.1 Our research showed that, in seven iterations since the 1960's, the S&P 500 has risen by an average of 25% from the peak of the ISM to the peak of the S&P 500. At the time, we posited that the ISM had peaked in February and our research supported a cyclically overweight portfolio bent. It appears that we were too early to make that call as yesterday's ISM report bested even the February high. The implication is that, according to our research, the fattest returns of the bull market remain ahead of, not behind, the S&P 500. Bottom Line: We maintain our upbeat cyclical (9-12 month horizon) SPX view, and our price target for 2019 remains 10% higher. Our thesis relies on EPS doing the heavy lifting, which the latest ISM data goes a long way toward reinforcing, and assuming the multiple moves sideways. For sector specific details, please see our Special Report. 1 Please see BCA U.S. Equity Strategy Special Report, "Portfolio Positioning For A Late Cycle Surge," dated May 22, 2018, available at uses.bcaresearch.com
Highlights Portfolio Strategy Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. A looming positive global growth impulse, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuations all suggest that now is not the time to throw in the towel on the S&P construction machinery & heavy truck (CMHT) index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Chart 1All-time Highs Everywhere The SPX catapulted to fresh all-time highs last week following an eight month hiatus, as a de-escalation in the global trade war gained further traction. Chart 1 shows that this is a broad based equity market advance as a slew of major equity market indexes have simultaneously vaulted to new highs. Even the high-yield corporate bond market confirms this breakout with the total return index also vaulting to new all-time highs (not shown). Any further moderation in trade rhetoric from the U.S. administration could serve as a catalyst for additional gains in the SPX, and trade-affected sectors would likely lead the charge, especially post the mid-term elections.1 While the U.S./China trade spat will prove the ultimate equity market litmus test, the longevity and magnitude of the profit upcycle remain the key equity market advance pillars. On that front, a deeper dive into profit margins is in order. The S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018. Nevertheless, it is important to remember that this year's strong profits are not the result of any massaging from CEOs/CFOs of the share count. In other words, profit margins (earnings per share / sales per share) are not impacted by changes in the number of shares outstanding, unlike simple EPS growth. Chart 2 shows that SPX margins recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's mid-2007 peak. While we are not fans of excluding sectors from our analysis, the sheer size and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years as tech giants are flexing their oligopolistic/monopolistic muscle. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing most of the heavy lifting given the high profit and market cap weight in the SPX. Keep in mind that the commodity complex in general and energy in particular are also adding to the recent margin euphoria. The late-2015/early-2016 global manufacturing recession-induced collapse in margins is now re-normalizing across basic resources, with margins in the S&P energy sector increasing by 11 percentage points since the Q2 2016 trough (Chart 2). Beyond the sector-related margin implications, from a macro point of view, U.S. stock market-reported employment has also been a significant contributor to the phenomenal profit margin expansion phase. Typically, stock market constituents reported job count growth peaks right before the NBER designated recession commences, on average at over an 8% year-over-year growth rate. The current labor market, while vibrant, has been trailing previous cycles by a wide margin. The most recent year-over-year growth rate clocked in at 3.5% (second panel, Chart 3). Chart 2Tech Margins Leading##br## The Pack Chart 3Smaller Than Usual Labor Footprint##br## Is A Boon For Margins National accounts data also corroborate this enticing profit margin backdrop. Average hourly earnings (AHE) have crested north of 4% in the past three cyclical peaks. Currently AHE are 130bps below that level (top panel, Chart 3). The implication is that as long as top line growth remains solid and corporate pricing power stays upbeat, profit margins will continue to underpin profits. Unlike the tech sector's excessive contribution to the SPX profit margin, the opposite rings true with regard to analysts' forward profit projections. Both on a 12-month and 5-year forward basis the S&P tech sector is trailing the SPX (Chart 4). Importantly, the latter has been at the center of a healthy debate within BCA, and decomposing this seemingly high number is instructive. A 16% long-term EPS growth rate is a tall order. However, sell-side analysts never get the shorter-term, let alone longer-term, forecasts correct. In hindsight, analysts' 5-year forward EPS growth forecasts back in 2016 sunk to an all-time low, even lower than the depths of the Great Recession (top panel, Chart 4). Currently, all we are experiencing is a move from one extreme to the other, and while we are clearly in overshoot territory, it is impossible to predict where this number will peak. Decomposing the broad market's projected long-term EPS growth rate is revealing. First, we note that the tech sector is projected to grow at half the rate predicted during the tech bubble. Second, four sectors comprise the outliers (i.e. forecast to surpass the 16% SPX growth rate) and such a breakneck pace will surely fail to materialize. Another common characteristic these four sectors share is that they all surpassed their tech bubble peak rates, something that the broad market has yet to achieve. Thus, consumer discretionary, financials, industrials and especially energy are in uncharted territory (Chart 5). On the opposite end of the spectrum, Chart 6 highlights the sectors that have yet to overtake their respective peaks and are sporting long-term EPS growth rates below the broad market. Chart 4Putting Tech Long-term Profit##br## Growth Rate In Context Chart 5Decomposing... Chart 6...Long-Term EPS Growth Netting it all out, we continue to have a sanguine cyclical (9-12 month horizon) SPX view, and our price target for 2019 remains 10% higher, assuming the multiple moves sideways leaving the onus on EPS to do all the heavy lifting.2 The week we are highlighting a deep cyclical sector that can benefit from a further de-escalation of the trade war and update one of its key subcomponents that remains a high-conviction overweight. Are Industrials Running On Empty? Last week, in a Special Report on President Trump's trade rhetoric impact on equity markets, we showed that trade policy uncertainty has risen to the highest level with the exception of the 1994 Clinton-era trade spat with the Japanese.3 While U.S. stocks have come out on top versus their global peers, within the U.S. equity market industrials have borne the brunt of the President's trade wrath (Chart 7). Chart 7Trade Uncertainty Weighing On Industrials In more detail, since peaking on January 26th, 2018, two stocks explain over 62% of the S&P industrials sector's fall: GE and MMM, two industrial conglomerates highly exposed to global trade. However, transports in general and rails in particular have been rising smartly almost entirely offsetting the industrial conglomerates' weakness. As a reminder, we are overweight the rails and air freight & logistics, underweight the airlines, neutral on industrial conglomerates and remain comfortable with that intra-sector positioning. Importantly, green shoots are emerging, warning that it does not pay to become bearish on this deep cyclical sector. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (Chart 8). Domestic ex-tech output is firing on all cylinders (Chart 8), a message reviving core capital goods orders corroborate (Chart 9). All of this has resulted in firming pricing power. Tack on the reacceleration in our U.S. capital expenditure indicator (second panel, Chart 8) - capex upcycle remains a key BCA theme for the remainder of 2018 - and industrials sector stars are aligned. The upshot is that depressed relative profit growth will easily surprise to the upside (bottom panel, Chart 8). Chart 8Green Shoots... Chart 9...Appearing Not only are there U.S. macro tailwinds, but also a global growth recovery is in the offing that will herald a snapback in relative share prices. The global manufacturing PMI remains squarely above the 50 boom/bust line (fourth panel, Chart 9), and there are early signs of a budding recovery in China. The Li-Keqiang index is ticking higher, Chinese monetary conditions have eased significantly via a depreciating currency and a drop in interest rates, excavator sales continue to expand at a healthy clip, industrial profits are reaccelerating and even Chinese share prices have likely troughed. Expanding Chinese wholesale selling prices also suggest that a reflationary impulse is looming (bottom panel, Chart 9). Were trade tensions to further de-escalate, especially post the midterm elections that could serve as a powerful tonic for relative share prices. Our Industrials EPS growth model does an excellent job in capturing all these forces and is currently signaling that profits will continue to grow into 2019 (Chart 10). Valuations have returned to the neutral zone, but technicals have plunged to one standard deviation below the mean, a level that has historically been associated with playable rallies (bottom panel, Chart 10). One key risk to our optimistic take on the S&P industrials sector is the U.S. dollar. Chart 11 highlights that capital goods revenues, exports and multiples are in jeopardy if the greenback continues to appreciate. Add to that a full blown trade war between the U.S. and China - which is dollar positive - and industrials stocks would suffer another blow. Chart 10Great Entry Point Chart 11Further U.S. Dollar Appreciation Is A Risk Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. What To Do With Construction Machinery? Early in the year, following our risk management implementation of a 10% stop on our high conviction call list, we got stopped out with a 10% gain from the high-conviction overweight call in the S&P CMHT index. We were subsequently compelled to reinstitute this high-conviction call as all of the fundamental drivers remained in place. However, our timing was not perfect, and given that bellwether Caterpillar has a near 60% foreign sourced revenue exposure, this industrial subsector also bore the brunt of the President's hawkish trade rhetoric. The key question currently is: does it still make sense to be overweight this highly cyclical industrials sub group? The short answer is yes. First, while global growth has decelerated, global trade is still expanding and the signal from the Baltic Dry Index is that the risk of an abrupt halt in global trade similar to the late-2015/early-2016 episode is small (second panel, Chart 12). In addition, the global capex upcycle remains in place and is one of BCA's two themes we continue to explore for the rest of the year. The upshot is that it still pays to remain invested in the S&P CMHT index. Demand for machinery remains upbeat across the globe. Both our global exports and orders proxies for machinery continue to grow, underscoring that a profit-led recovery in construction machinery stocks is looming (third & fourth panels, Chart 12). Second, while China is the administration's primary trade target, easy monetary conditions there will provide much needed breathing room for the Chinese economy. Already, Chinese housing construction data and the rebounding Li-Keqiang Index are pointing to a brighter backdrop for relative share prices (top two panels, Chart 13). Moreover, Chinese excavator sales are advancing at a brisk year-over-year rate, highlighting that construction machinery end-demand remains solid. Chart 12Global Growth & CAPEX Are Tailwinds... Chart 13...And So Is The Troughing Chinese Economy Third, the key energy end-market shows no signs of deceleration. The steeply recovering global oil rig count on the back of a $78 Brent crude oil price suggests that demand for oil & gas field machinery remains on the recovery path and is a harbinger of a rising relative share price ratio (Chart 14). Fourth, industry operating metrics are overheating and signal that profits will continue to surprise to the upside. Rising capex budgets have reduced industry slack (second & third panels, Chart 15). As a result, machinery selling prices have soared to the highest level since the Great Recession (bottom panel, Chart 15) and will underpin industry profits. Chart 14Energy End-market To The Rescue? Chart 15Vibrant Operating Metrics Finally, relative valuations have plunged to near one standard deviation below the average and so have relative technicals. While both can sink further, we would be taking a punt here (Chart 16). Despite our optimistic view on the S&P CMHT index's profit prospects, the appreciating U.S. dollar and recent cresting in the CRB raw industrials index represent key downside risks to our overweight call. This commodity price index is a crucial input to our machinery EPS growth model that has petered out, but at a high level. Any further steep appreciation in the greenback will likely deal a blow to the commodity complex and jeopardize the virtuous machinery profit upcycle (Chart 17). Chart 16Compelling Valuations And Washed Out Technicals Chart 17Risk To Monitor: Commodity Price Relapse Adding it up, a looming global growth pick up, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuation and technical conditions all suggest that now is not the time to throw in the towel in the S&P CMHT index. Bottom Line: Were we not overweight already we would not hesitate to initiate a new above benchmark position in the S&P CMHT index. We reiterate our high-conviction overweight status. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target" dated April 30, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades