Equities
Underweight For most of this decade, U.S. airline pricing power and the price of jet fuel have moved in lockstep (second panel) i.e.: airlines have been able to pass through their primary input cost. However, this relationship has broken down since the end of 2016 as the industry has been locked in a price war between low cost carriers and the largely-restructured legacy airlines. The result has been a coincident fall in operating margins (bottom panel). The disruption to U.S. refining capacity and distribution of refined products from Hurricane Harvey seems likely to keep the price of jet fuel elevated and exacerbate the decline in near-term operating margins. Until recently, investors have shrugged off tumbling margins with expanding valuation multiples (bottom panel), though that appears to have turned early this summer; the S&P500 airlines index has been in freefall since. With higher costs a certainty in Q3, no relief from aggressive pricing and the longevity of higher jet fuel prices an unknown, it still doesn't pay to be long airlines. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL: LUV, ALK, AAL, UAL, DAL.
Feature Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report written by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst. Mark makes a compelling case that the deflationary effects of the "Amazon economy" are overstated. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Chart 1September Is Generally ##br##Not A Good Time Of Year For Stocks My colleagues and I convened a meeting earlier this week to discuss whether to abandon our long-standing cyclically bullish view towards risk assets. Several of them felt it was time to turn more cautious. I am sympathetic to their concerns: Valuations are stretched, volatility is low, and geopolitical risks (most notably North Korea) are on the rise. Profit growth is likely to decelerate later this year, as the easy comps stemming from the depressed level of earnings in the first half of 2016 vanish. Meanwhile, stocks are entering the volatile early autumn months, a period which has historically seen poor returns (Chart 1). Nevertheless, at times like these, it is useful to fall back on our time-tested indicators. Bear markets have almost always coincided with economic recessions, with the latter usually causing the former (Chart 2). None of our recession-timing signals are flashing red: To cite just a few examples, ISM manufacturing new orders are strong, initial unemployment claims are low, core capital goods orders are accelerating, and the yield curve is not in any immediate risk of inverting (Chart 3). Chart 2Recessions And Bear Markets Usually Overlap Chart 3No Warnings Of Recession Here U.S. financial conditions have eased sharply this year, which should support growth over the next few quarters (Chart 4). A recent IMF report highlighted that easier U.S. financial conditions tend to generate positive spillovers onto other countries.1 The fact that all 45 countries monitored by the OECD are on track to grow this year - the first time this has happened since 2007 - is a testament to the strong fundamentals underpinning the global economy. Chart 4Easing Financial Conditions Bode Well For Growth The Fed's Dot Problem In this light, the Fed's projection that the unemployment rate will end this year at 4.3% and only fall to 4.2% by end-2018 no longer looks credible. If U.S. GDP growth remains above trend, as we expect, the unemployment rate could fall below its 2000 low of 3.8% by next summer. That will be enough to prompt investors to price in a few more rate hikes. Considering that the market expects just 22 basis points in hikes through to end-2018, this is not a high bar to clear. A bit more fiscal stimulus would add to the pressure to tighten monetary policy. While any meaningful progress on tax reform will be difficult to achieve, the odds are good that Congress will agree to cut statutory corporate and personal tax rates, with the latter focusing mainly on middle-income earners. Failure to raise the debt ceiling or extend federal spending authority beyond the current budget window could scuttle the benefits from lower tax rates. Fortunately, the risks of such an outcome have receded. If there is a silver lining from Hurricane Harvey, it is that the disaster could at least temporarily overcome the political impasse in Washington. Congress will need to appropriate additional disaster relief funds over the coming weeks. Politicians who are seen as creating roadblocks to such funding will face the electorate's wrath. The odds of an infrastructure bill passing through Congress have also risen. All recoveries eventually run out of steam, but this one can last at least until the second half of 2019, which will make it the longest U.S. expansion on record. As we discussed several weeks ago, the next recession is likely to be triggered by the Fed scrambling to hike rates in response to rising inflation.2 This is not an immediate concern, given that it usually takes a while for an overheated economy to generate inflation - especially since the U.S. currently can satisfy rising domestic demand with higher imports. However, the risks of overheating will increase as unemployment falls further and excess capacity elsewhere in the world is absorbed. Draghi After Jackson Hole Chart 5A Stronger Euro Is Deflationary Textbook economic theory states that a shift in consumption towards imported goods requires a real appreciation of the currency. The dollar, of course, has done exactly the opposite of that, depreciating by 6.6% in trade-weighted terms since the start of the year. The euro, in particular, has gained significant ground against the greenback, rising above $1.20 at one point this week. Mario Draghi's failure to express concerns about the resurgent euro during his Jackson Hole address was construed by many market participants as a green light for further currency strength. We are skeptical of this "saying nothing means you are saying something" interpretation. Draghi wanted to acknowledge (and partly take credit for) the recovery across the euro area, but he is cognizant of the problems posed by a stronger euro. The ECB's June forecast showed inflation rising to only 1.6% in 2019. In the period since those forecasts were compiled, the trade-weighted euro has appreciated by 3.9%, bringing the year-to-date gain to 6.2% (Chart 5). ECB staff calculations, which Draghi has approvingly quoted, show that a 10% appreciation in the euro would reduce inflation by 0.2 percentage points in the first year and 0.6-to-0.8 points in the subsequent two years.3 Better-than-expected growth since the June forecasts will offset some of the deflationary impact from the stronger euro, but probably not by much, given that the Phillips curve is quite flat at high-to-moderate levels of spare capacity. With labor market slack across the euro area still 3.2 percentage points higher today than in 2008 (and 6.7 points higher outside of Germany), it will be a while before stronger growth generates markedly higher inflation. We expect the ECB to reduce its 2018/2019 inflation forecast by 0.1-to-0.2 percentage points next week. It would be awkward for the central bank to play up the prospect of monetary policy normalization while it is simultaneously trimming its inflation projections. This suggests that the ECB's communications could turn more dovish, thereby limiting further upside for the euro. EUR/USD is currently trading near the top of the $1.10-to-$1.20 range that we foresee lasting for the next 10 months. Thus, our expectation is that the euro will weaken over the next few months, ending the year near $1.15, and potentially moving back towards its 2017 lows in the second half of next year, as an overheated U.S. economy forces the Fed to pick up the pace of rate hikes. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, (Chapter 3), (April 2017). 2 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery to Retro-Recession?" dated August 18, 2017. 3 Please see European Central Bank, "March 2017 ECB Staff Macroeconomic Projections For The Euro Area." APPENDIX 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models favor global equities over bonds over a three-month horizon (Appendix Table 1). Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Our business cycle equity indicators remain in bullish territory, as reflected in strong global growth and rising corporate earnings. Our monetary and financial indicators are also generally supportive. In contrast, our sentiment readings are sending mixed signals. On the one hand, implied equity volatility remains low and institutional exposure to stocks is quite high. On the other hand, surveys of retail investors show a healthy skepticism towards the bull market, which is a positive contrarian indicator. As has been the case for some time, our valuation measures are signaling that stocks are expensive, but these are typically useful only over horizons beyond one or two years. As we flagged last month, stocks tend to do poorly in August and September, which may hurt returns over the next few weeks. The stronger euro will negatively impact earnings in the euro area. This has caused our models to suggest a slight downgrade to European equities. However, we are inclined to fade this signal, given our expectation that the euro will give up some of its recent gains. Japanese stocks continue to score well on our metrics, buoyed by strengthening corporate profits and attractive valuations. Emerging market equities are fairly valued, although China still appears cheap. The rally in U.S. Treasurys has caused the gap between the 10-year yield and our model's fair value estimate to widen to around 50 basis points, the highest since last September. European and Japanese bonds also look somewhat overvalued, although the latter will continue to receive support from the BoJ's yield curve targeting operations. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Neutral When we upgraded the unloved telecom services index to neutral last month, we noted that a point would eventually be reached when selling prices would no longer contract. Yesterday's personal consumption expenditure data indicates the inflection point may have been reached as U.S. consumer spending on telecom services has surged faster than at any point in the past decade (second panel). Positive consumption data is not yet reflected in EPS growth estimates, where the telecom services index remains the GICS 1 industry laggard of the S&P 500 (third panel). Nor is it reflected in industry valuation multiples, which look to have bottomed on very weak earnings (bottom panel). It is too early to for us assess the durability of the growth in consumer telecom outlays and hence to become more constructive on telecom earnings growth relative to the S&P500. However, we are gaining confidence at least that the slide has been arrested. We reiterate our neutral call. The ticker symbols for the stocks in this index are: T, VZ, LVLT, CTL.
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 30th, 2017. The model has continued to reduce its allocation to the U.S. driven by worsening liquidity condition, and it's the second consecutive month that the U.S. allocation is the largest underweight. Australia is downgraded to neutral on concern of valuation. Germany and Netherland continued to receive more allocation and Canada's underweight is reduced as well, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 18 bps in August, entirely due to the 43 bps outperformance of Level 2 model where the overweight in Italy and Germany versus the underweight in Japan, Spain and Canada worked very well. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of August 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model is optimistic on global growth and maintains in cyclical tilt. However, the magnitude of overweight in cyclical sectors has reduced on the back of momentum indicators. The biggest change has been utilities which has moved from a 2% underweight to a 1.7% overweight. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Chart 2Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM Chart 7EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation
Highlights Financial markets have slipped into a 'risk off' phase. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events. Equity bear markets are usually associated with recessions. On that score, we do not see any warning signs of an economic downturn. However, geopolitical risks are rising at a time when valuation measures suggest that risk assets are vulnerable. We do not see the debt ceiling or the failure of movement on U.S. tax reform as posing large risks for financial markets. However, trade protectionism and, especially, North Korea are major wildcards. We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. BCA Strategists debated trimming equity exposure to neutral. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. On a positive note, we have upgraded our EPS growth forecasts, except in the Eurozone where currency strength will be a significant drag in the near term. The Fed faced a similar low inflation/tight labor market environment in 1999. Policymakers acted pre-emptively and began to tighten before inflation turned up. This time, the FOMC will want to see at least a small increase in inflation just to be sure. Wages may be a lagging indicator for inflation in this cycle. Watch a handful of other indicators we identify that led inflection points in inflation in previous long economic expansions. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook, which has led to very lopsided rate expectations. Keep duration short. Feature Chart I-1Trump Popularity Headwind For Tax Reform A 'risk off' flavor swept over financial markets in August. The upbeat second quarter earnings season in the U.S., Japan and the Eurozone was overwhelmed by a number of negative events, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to North Korean tensions to the Texas flood and the terror attack in Spain. Trump's popularity rating is steadily declining, even now among Republican voters (Chart I-1). This has raised concerns that none of his business-friendly policies, tax cuts or initiatives to boost growth will be successfully enacted. It is even possible that the debt ceiling will be used as a bargaining chip among the various Republican factions. The political risks are multiplying at a time when the equity and corporate bond markets are pricey. Valuation measures do not help with timing, but they do inform on the potential downside risk if things head south. At the moment, we do not see any single risk as justifying a full retreat into safe havens and a cut in risk asset allocation to neutral or below. Nonetheless, there is certainly a case to be cautious and hold some traditional safe haven assets. Timing The Next Equity Bear Market It is rare to have an equity bear market without a recession in the U.S. There have been plenty of market setbacks that did not quite meet the 20% bear-market threshold, but were nonetheless painful even in the absence of recession (Black Monday, LTCM crisis, U.S. debt ceiling showdown and euro crises). Unfortunately, these corrections are very difficult to predict. At least with recessions, investors have a fighting chance in timing the exit from risk exposure. The slope of the yield curve and the Leading Economic Indicator (LEI) are classic recession indicators, and for good reason (Chart I-2). Over the past 50 years they have both successfully called all seven recessions with just one false positive. We can eliminate the false positive signals by combining the two indicators and follow a rule that both must be in the red to herald a recession.1 Chart I-2The Traditional Recession Indicators Have Worked Well It will be almost impossible for the yield curve to invert until the fed funds rate is significantly higher than it is today. Thus, it may be the case that a negative reading on the LEI, together with a flattening (but not yet inverted) yield curve, will be a powerful signal that a recession is on the way. Neither of these two indicators are warning of a recession. Global PMIs are hovering at a level that is consistent with robust growth. The erosion in the Global ZEW and the drop in the diffusion index of the Global LEI are worrying signs, but at the moment are consistent with a growth slowdown at worst (Chart I-3). Financial conditions remain growth-friendly and subdued inflation is allowing central banks to proceed cautiously when tightening (in the case of the Fed and Bank of Canada) or tapering (ECB). As highlighted in last month's Overview, the global economy has entered a synchronized upturn that should persist for the next year. The U.S. will be the first major economy to enter the next recession, but that should not occur until 2019 or 2020, barring any shocks in the near term. That said, risk asset prices have been bid up sharply and are therefore vulnerable to a correction. Below, we discuss five key risks to the equity bull market. (1) Is All Lost For U.S. Tax Cuts? Our recent client meetings highlight that investors are skeptical that any fiscal stimulus or tax cuts will see the light of day in the U.S. Tax cuts and infrastructure spending appear to have been priced out of the equity market, according to the index ratios shown in Chart I-4. We still expect a modest package to eventually be passed, although time is running out for this year. Tax reform is a major component of Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Chart I-3Some Worrying Signs On Growth Chart I-4Fiscal Stimulus Largely Priced Out One implication of Tropical Storm Harvey is that it might force Democrats and Republicans to cooperate on an infrastructure bill for rebuilding. Even a modest spending boost or tax reduction would be equity-market positive given that so little is currently discounted. The dollar should also receive a lift, especially given that the Fed might respond to any fiscally-driven growth impulse with higher interest rates. (2) Who Will Lead The Fed? There is a significant chance that either Yellen will refuse to stay on when her term expires next February or that Trump will appoint someone else anyway. In this case, we would expect the President to do everything he can to ensure that the Fed retains its dovish bias. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. Cohn could not arrive at the Fed and change the course of monetary policy on day one. The FOMC votes on rate changes, but in reality decisions are formed by consensus (with one or two dissents). The only way Cohn could implement an abrupt change in policy is if the Administration stacks the Fed Governors with appointees that are prepared to "toe the line" (the Administration does not appoint Regional Fed Presidents). Stacking the Governorships would take time. Nonetheless, it is not clear why President Trump would take a heavy hand in monetary policy when the current FOMC has been very cautious in tightening policy. The bottom line is that we would not see Cohn's appointment to the Fed Chair as signaling a major shift in monetary policy one way or the other. (3) The Debt Ceiling A more immediate threat is the debt ceiling. Recent fights over Obamacare and tax reform have pit fiscally conservative Republicans against the moderates, and it is possible that the debt ceiling is used as a bargaining chip in this battle. While government shutdowns have occurred in the past, the debt ceiling has never been breached. At the end of the day, the debt ceiling will always be raised because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors or a halt to other entitlement programs. Even the Freedom Caucus, the most fiscally conservative grouping in the House, is considerably divided on the issue. This augurs well for a clean bill to raise the debt ceiling as the Republican majority in the House is 22 and the Freedom Caucus has 31 members. Democrats will not stand in the way of passage in the Senate. The worst-case scenario for the market would be a two-week shutdown in the first half of October, just before the debt ceiling is hit. We would not expect a shutdown to have any lasting impact on the economy, although it could provide an excuse for the equity market to correct. That said, the risk of even a shutdown has been diminished by events in Houston. It would be very difficult and damaging politically to shut down the government during a humanitarian emergency. (4) Trade And Protectionism The removal of White House Chief Strategist Stephen Bannon signals a shift in power toward the Goldman clique within the Trump Administration. National Economic Council President Gary Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross are now firmly in charge of economic policy. The mainstream media has interpreted this shift within the Administration as reducing the risk of trade friction. We do not see it that way. President Trump still sounds hawkish on trade, particularly with respect to China. Our geopolitical experts point out that there are few constraints on the President to imposing trade sanctions on China or other countries. He could use such action to boost his popularity among his base heading into next year's midterm elections. On NAFTA, the Administration took a hard line as negotiations kicked off in August. This could be no more than a negotiating tactic. Our base case is that it will be some time before investors find out if negotiations are going off the rails. That said, the situation is volatile for both NAFTA and China, and we can't rule out a trade-related risk-off phase in financial markets over the next year. (5) North Korea North Korea's missile launch over Japan highlights that the tense situation is a long way from a resolution. The U.S. is unlikely to use military force to resolve the standoff. There are long-standing constraints to war, including the likelihood of a high death toll in Seoul. Moreover, China is unlikely to remain neutral in any conflict. However, the U.S. will attempt to establish a credible threat in order to contain Kim Jong-un. From an investor's perspective, it will be difficult to gauge whether the brinkmanship and military displays are simply posturing or evidence of real preparations for war.2 We don't believe the tensions in the Korean peninsula will end the cyclical bull market in global equities. Nonetheless, investors should expect to be tested numerous times over the next year to 18 months. Adding it all up, there is no shortage of things to keep investors awake at night. We would be de-risking our recommended portfolio were it not for the favorable earnings backdrop in the major advanced economies. Profit Outlook Update Chart I-5EPS Growth Outlook Second quarter earnings season came in even stronger than our upbeat models suggested in the U.S., Eurozone and Japan. This led to upward revisions to our EPS growth forecast, except in the Eurozone where currency strength will be a significant drag in the near term. The U.S. equity market enjoyed another quarter of margin expansion in Q2 2017 and the good news was broadly based. Earnings per share were higher versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Looking ahead, an update of our top-down model suggests the EPS growth will peak just under 20% late this year on a 4-quarter moving average basis, before falling to mid-single digits by the end of 2018 (Chart I-5). The peak is predicted to be a little higher than we previously forecast largely due to the feed-through of this year's pullback in the dollar. In Japan, a solid 70% of reporting firms beat estimates. Chart I-6 shows that Japan led all other major stock markets in positive earnings surprises in the second quarter. Manufacturing sectors, such as iron & steel, chemicals and machinery & electronics, were particularly impressive in the quarter, reflecting yen weakness and robust overseas demand. Japanese earnings are highly geared to the rebound in global industrial production. Moreover, Japan's nominal GDP growth accelerated in the second quarter and the latest PPI report suggested that corporate pricing power has improved. Twelve-month forward EPS estimates have risen to fresh all times highs, and have outperformed the U.S. in local currencies so far this year. Corporate governance reform - a key element of Abenomics - can take some credit for the good news on earnings. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. We expect trailing EPS growth to peak at about 25% in the first half of 2018 on a 4-quarter moving total basis, before edging lower by the end of the year. This is one reason why we like the Japanese market over the U.S. in local currency terms. Second quarter results in the Eurozone were solid, although not as impressive as in the U.S. and Japan. The 6% rise in the trade-weighted euro this year has resulted in a drop in the earnings revisions ratio into negative territory. Our previous forecast pointed to a continued rise in the 4-quarter moving average growth rate into the first half of 2018. However, we now expect the growth rate to dip by year end, before picking up somewhat next year. If the euro is flat from today's level, our model suggests that the drag on EPS growth will hover at 3-4 percentage points through the first half of next year as the negative impact feeds through (Chart I-7, bottom panel). Chart I-6Japan Led In Q2 Earning Surprises Chart I-7Currency Effects On Eurozone EPS Our top-down EPS model highlights that Eurozone earnings are quite sensitive to swings in the currency. In Chart I-7, we present alternative scenarios based on the euro weakening to EUR/USD 1.10 and strengthening to EUR/USD 1.30. For demonstration purposes we make the extreme assumption that the trade-weighted value of the euro rises and falls by the same amount in percentage terms. Profit growth decelerates by the end of 2017 in all three scenarios because of the lagged effect of currency swings. The projections begin to diverge only in 2018. EPS growth surges to around 20% by the end of next year in the euro-bear case, as the tailwind from the weakening currency combines with continuing robust economic growth. Conversely, trailing earnings growth hovers in the 5-8% range in the euro bull scenario, which is substantially less than we expect in the U.S. and Japan over the next year. EPS growth remains in positive territory because the assumed strength in European and global growth dominates the drag from the euro. The strong euro scenario would be negative for Eurozone equity relative performance versus global stocks in local currencies, although Europe might outperform on a common currency basis. The bottom line is that 12-month forward earnings estimates should remain in an uptrend in the three major economies. This means that, absent a negative political shock, the equity bull phase should resume in the coming months. Monetary policy is unlikely to spoil the party for risk assets, although the bond market is a source of risk because investors seem unprepared for even a modest rise in inflation. FOMC Has Seen This Before The Minutes from the July FOMC meeting highlighted that the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike and how policy should adjust to changing financial conditions. Chart I-8The FOMC Has Been Here Before The majority of policymakers are willing for now to believe that this year's soft inflation readings are driven largely by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excess risk taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. The hawks are thus anxious to resume tightening, despite current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. In this month's Special Report beginning on page 18, we have a close look at the impact of "Amazonification" in holding down overall inflation. We do not find the evidence regarding e-commerce compelling, but the jury is still out on the impact of other technologies. If robots and new business strategies are indeed weighing on inflation, it would mean that the Phillips curve is very flat or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. The last time the Fed was perplexed by a low level of inflation despite a tight labor market was in the late 1990s (Chart I-8). The FOMC cut rates following the LTCM financial crisis in late 1998, and then held the fed funds rate unchanged at 4¾% until June 1999. Core inflation was roughly flat during the on-hold period at 1% to 1½%, even as the unemployment rate steadily declined and various measures pointed to growing labor shortages. The FOMC 's internal debate in the first half of 1999 sounded very familiar. The minutes from meetings at that time noted that some policymakers pointed to the widespread inability of firms to raise prices because of strong competitive pressures in domestic and global markets. Some argued that significant cost saving efforts and new technologies also contributed to the low inflation environment for both consumer prices and wages. One difference from today is that productivity growth was solid at that time. The FOMC decided to hike rates in June 1999 by a quarter point, despite the absence of any clear indication that inflation had turned up. Policymakers described the tightening as "a small preemptive move... (that) would provide a degree of insurance against worsening inflation later". The Fed went on to lift the fed funds rate to 6½% by May 2000. Interestingly, the unemployment rate in June 1999 was 4.3%, exactly the same as the current rate. There are undoubtedly important differences in today's macro backdrop. The Fed is also more fearful of making a policy mistake in the aftermath of the Great Recession and financial crisis. Nonetheless, the point is that the Fed has faced a similar low inflation/tight labor market environment before, but in the end patience ran out and policymakers acted pre-emptively. Inflation Warning Signs During Long-Expansions We have noted in previous research that inflation pressures are slower to emerge in 'slow burn' recoveries, such as the 1980s and 1990s. In Chart I-9, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth was a lagging indicator. Economic commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. This is not to say that we should totally disregard wage information. But it does mean that we must keep an eye on a wider set of data. Indicators that provided some leading information in the previous two long cycles are shown in Chart I-10. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart I-10 because it does not have enough history. At the moment, the headline PPI, ISM Prices Paid and BCA's pipeline inflation pressure index are all warning that inflation pressures are gradually building. However, this message is not confirmed by the St. Louis Fed's index and corporate selling prices. We are also watching the velocity of money, which has been a reasonably good leading indicator for U.S. inflation since 2000 (Chart I-11). Chart I-9In The 80s & 90s Wage Growth ##br##Gave No Early Warning On Inflation Chart I-10Leading Indicators Of Inflation ##br##In "Slow Burn" Recoveries Chart I-11Money Velocity And Inflation Our Fed view remains unchanged from last month; the FOMC will announce its balance sheet diet plan in September and the next rate hike will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation edges higher in the coming months. Some indicators are pointing in that direction and recent dollar weakness will help. Wake Me When Inflation Picks Up Investors seem to be taking an "I'll believe it when I see it" attitude toward the U.S. inflation outlook. They also believe that persistent economic headwinds mean that monetary policy will need to stay highly accommodative for a very long time. Only one Fed rate hike is discounted between now and the end of 2018, and implied forward real short-term rates are negative until 2022. While we do not foresee surging inflation, the risks for market expectations appear quite lopsided. We expect one rate hike by year end, followed by at least another 50 basis points of tightening in 2018. The U.S. 10-year yield is also about almost 50 basis points below our short-term fair value estimate (Chart I-12). Moreover, over the medium- and long-term, reduced central bank bond purchases will impart gentle upward pressure on equilibrium bond yields. Twenty-eighteen will be the first time in four years in which the net supply of government bonds available to private investors will rise, taking the U.S., U.K., Eurozone and Japanese markets as a group. This year's euro strength is unlikely to delay the next installment of ECB tapering, which we expect in early in 2018. The currency appreciation will keep a lid on inflation in the near term. However, we see the euro's ascent as reflective of the booming economy, rather than a major headwind that will derail the growth story. Overall financial conditions have tightened this year, but only back to levels that persisted through 2016 (Chart I-13). Chart I-12U.S. 10-year Yield Is Below Fair Value Chart I-13Financial Conditions It will take clear signs that the economy is being negatively affected by currency strength for the ECB to back away from tapering. Indeed, the central bank has little choice because the bond buying program is approaching important technical limits. European corporate and peripheral bond spreads are likely to widen versus bunds as a result. The implication is that global yields have significant upside potential relative to forward rates, especially in the U.S. market. Duration should be kept short. JGBs are the only safe place to hide if global yields shift up because the Bank of Japan is a long way from abandoning its 10-year yield peg. Treasury yields should lead the way higher, which will finally place a bottom under the beleaguered dollar. Nonetheless, we are tactically at neutral on the greenback. Conclusions Chart I-14Gold Loves Geopolitical Crises In light of rising geopolitical risk, the BCA Strategists recently debated trimming equity exposure to neutral. Some argued that the risk/reward balance has deteriorated; the upside is limited by poor valuation, while there is significant downside potential if the North Korean situation deteriorates alarmingly. However, the majority felt that, while there will be near-term volatility, the main equity indexes are likely to be higher on a 6-12 month horizon. Riding out the volatility is a better approach than trying to time the short-term ups and downs. That said, it appears prudent to be well shy of max overweight positions and to hold some safe haven assets within diversified portfolios. BCA research has demonstrated that U.S. Treasurys, Swiss bonds and JGBs have been the best performers in times of crisis (Chart I-14).3 The same is true for the Swiss franc and the Japanese yen, such that the currency exposure should not be hedged in these cases. The dollar is more nuanced. It tends to perform well during financial crises, but not in geopolitical crises or recessions. Gold has tended to perform well in geopolitical events and recessions, although not in financial crises. We continue to prefer Japanese to U.S. stocks in local currency terms, given that EPS growth will likely peak in the U.S. first. Japanese stocks are also better valued. Europe is a tough call because this year's currency strength will weigh on earnings in the next quarter or two. However, the negative impact on earnings will reverse if the euro retraces as we expect. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. Our dollar and duration positions have been disappointing so far this year. Much hinges on U.S. inflation. Investors appear to have adopted the idea that structural headwinds to inflation will forever dominate the cyclical pressures. This means that the bond market is totally unprepared for any upside surprises on the inflation landscape. Admittedly, a rise in bond yields may not be imminent, but the risks appear to us to be predominantly to the upside. Lastly, crude oil inventories are shrinking as our commodity strategists predicted. They remain bullish, with a price target of USD60/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst August 31, 2017 Next Report: September 28, 2017 1 Please see BCA Global ETF Strategy, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com 3 Please see BCA Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com II. Did Amazon Kill The Phillips Curve? A "culture of profound cost reduction" has gripped the business sector since the GFC according to one school of thought, permanently changing the relationship between labor market slack and wages or inflation. If true, it could mean that central banks are almost powerless to reach their inflation targets. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. In theory, positive supply shocks should not have more than a temporary impact on inflation if the price level is indeed a monetary phenomenon in the long term. But a series of positive supply shocks could make it appear for quite a while that low inflation is structural in nature. We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence at the macro level. The admittedly inadequate measures of online prices available today do not suggest that e-commerce sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points. Moreover, it does not appear that the disinflationary impact of competition in the retail sector has intensified over the years. Today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. However, the fact that retail margins are near secular highs outside of department stores argues against this thesis. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High profit margins for the overall corporate sector and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. Anecdotal evidence is all around us. The global economy is evolving and it seems that all of the major changes are deflationary. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. Central banks in the major advanced economies are having difficulty meeting their inflation targets, even in the U.S. where the labor market is tight by historical standards. Based on the depressed level of bond yields, it appears that the majority of investors believe that inflation headwinds will remain formidable for a long time. One school of thought is that low inflation reflects a lack of demand growth in the post-Great Financial Crisis (GFC) period. Another school points to the supply side of the economy. A recent report by Prudential Financial highlights "...obvious examples of ... new business models and new organizational structures, whereby higher-cost traditional methods of production, transportation, and distribution are displaced by more nontraditional cost-effective ways of conducting business."1 A "culture of profound cost reduction" has gripped the business sector since the GFC according to this school, permanently changing the relationship between labor market slack and wages or inflation (i.e., the Phillips Curve). Employees are less aggressive in their wage demands in a world where robots are threatening humans in a broadening array of industrial categories. Many feel lucky just to have a job. In a highly sensationalized article called "How The Internet Economy Killed Inflation," Forbes argued that "the internet has reduced many of the traditional barriers to entry that protect companies from competition and created a race to the bottom for prices in a number of categories." Forbes believes that new technologies are placing downward pressure on inflation by depressing wages, increasing productivity and encouraging competition. There are many factors that have the potential to weigh on prices, but analysts are mainly focusing on e-commerce, robotics, artificial intelligence, and the gig economy. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. The latter refers to the advent of new business models that cut out layers of middlemen between producers and consumers. Amazonification E-commerce has grown at a compound annual rate of more than 9% over the past 15 years, and now accounts for about 8½% of total U.S. retail sales (Chart II-1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart II-2). Amazon's business model not only cuts costs by eliminating middlemen and (until recently) avoiding expensive showrooms, but it also provides a platform for improved price discovery on an extremely broad array of goods. In 2013, Amazon carried 230 million items for sale in the United States, nearly 30 times the number sold by Walmart, one of the largest retailers in the world. Chart II-1E-Commerce: Steady Increase In Market Share Chart II-2Amazon Dominates With the use of a smartphone, consumers can check the price of an item on Amazon while shopping in a physical store. Studies show that it does not require a large price gap for shoppers to buy online rather than in-store. Amazon appears to be impacting other retailers' ability to pass though cost increases, leading to a rash of retail outlet closings. Sears alone announced the closure of 300 retail outlets this year. The devastation that Amazon inflicted on the book industry is well known. It is no wonder then, that Amazon's purchase of Whole Foods Market, a grocery chain, sent shivers down the spines of CEOs not only in the food industry, but in the broader retail industry as well. What would prevent Amazon from applying its model to furniture and appliances, electronics or drugstores? It seems that no retail space is safe. A Little Theory Before we turn to the evidence, let's review the macro theory related to positive supply shocks. The internet could be lowering prices by moving product markets toward the "perfect competition" model. The internet trims search costs, improves price transparency and reduces barriers to entry. The internet also allows for shorter supply chains, as layers of wholesalers and other intermediaries are removed and e-commerce companies allow more direct contact between consumers and producers. Fewer inventories and a smaller "brick and mortar" infrastructure take additional costs out of the system. Economic theory suggests that the result of this positive supply shock will be greater product market competition, increased productivity and reduced profitability. In the long run, workers should benefit from the productivity boost via real wage gains (even if nominal wage growth is lackluster). Workers may lower their reservation wage if they feel that increased competitive pressures or technology threaten their jobs. The internet is also likely to improve job matching between the unemployed and available vacancies, which should lead to a fall in the full-employment level of unemployment (NAIRU). Nonetheless, the internet should not have a permanent impact on inflation. The lower level of NAIRU and the direct effects of the internet on consumer prices discussed above allow inflation to fall below the central bank's target. The bank responds by lowering interest rates, stimulating demand and thereby driving unemployment down to the new lower level of NAIRU. Over time, inflation will drift back up toward target. In other words, a greater degree of the competition should boost the supply side of the economy and lower NAIRU, but it should not result in a permanently lower rate of inflation if inflation is indeed a monetary phenomenon and central banks strive to meet their targets. Still, one could imagine a series of supply shocks that are spread out over time, with each having a temporary negative impact on prices such that it appears for a while that inflation has been permanently depressed. This could be an accurate description of the current situation in the U.S. and some of the other major countries. We have sympathy for the view that the internet and new business models are increasing competition, cutting costs and thereby limiting price increases in some areas. But is there any hard evidence? Is the competitive effect that large, and is it any more intense than in the past? There are a number of reasons to be skeptical because most of the evidence does not support Forbes' claim that the internet has killed inflation. (1) E-commerce affects only a small part of the Consumer Price Index As mentioned above, online shopping for goods represents 8.5% of total retail sales in the U.S. E-commerce is concentrated in four kinds of businesses (Table II-1): Furniture & Home Furnishings (7% of total retail sales), Electronics & Appliances (20%), Health & Personal Care (15%), and Clothing (10%). Since goods make up 40% of the CPI, then 3.2% (8% times 40%) is a ballpark estimate for the size of goods e-commerce in the CPI. Table II-1E-Commerce Market Share Of Goods Sector (2015) Table II-2 shows the relative size of e-commerce in the service sector. The analysis is complicated by the fact that the data on services includes B-to-B sales in addition to B-to-C.2 However, e-commerce represents almost 4% of total sales for the service categories tracked by the BLS. Services make up 60% of the CPI, but the size drops to 26% if we exclude shelter (which is probably not affected by online shopping). Thus, e-commerce in the service sector likely affects 1% (3.9% times 26%) of the CPI. Table II-2E-Commerce Market Share Of Service Sector (2015) Adding goods and services, online shopping affects about 4.2% of the CPI index at most. The bottom line is that the relatively small size of e-commerce at the consumer level limits any estimate of the impact of online sales on the broad inflation rate. (2) Most of the deceleration in inflation since 2007 has been in areas unaffected by e-commerce Table II-3 compares the average contribution to annual average CPI inflation during 2000-2007 with that of 2007-2016. Average annual inflation fell from 2.9% in the seven years before the Great Recession to 1.8% after, for a total decline of just over 1 percentage point. The deceleration is almost fully explained by Energy, Food and Owners' Equivalent Rent. The bottom part of Table II-3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table II-3Comparison Of Pre- and Post-Lehman Inflation Rates (3) The cost advantages for online sellers are overstated Bain & Company, a U.S. consultancy, argues that e-commerce will not grow in importance indefinitely and come to dominate consumer spending.3 E-commerce sales are already slowing. Market share is following a classic S-shaped curve that, Bain estimates, will top out at under 30% by 2030. First, not everyone wants to buy everything online. Products that are well known to consumers and purchased on a regular basis are well suited to online shopping. But for many other products, consumers need to see and feel the product in person before making a purchase. Second, the cost savings of online selling versus traditional brick and mortar stores is not as great as many believe. Bain claims that many e-commerce businesses struggle to make a profit. The information technology, distribution centers, shipping, and returns processing required by e-commerce companies can cost as much as running physical stores in some cases. E-tailers often cannot ship directly from manufacturers to consumers; they need large and expensive fulfillment centers and a very generous returns policy. Moreover, online and offline sales models are becoming blurred. Retailers with physical stores are growing their e-commerce operations, while previously pure e-commerce plays are adding stores or negotiating space in other retailers' stores. Even Amazon now has storefronts. The shift toward an "multichannel" selling model underscores that there are benefits to traditional brick-and-mortar stores that will ensure that they will not completely disappear. (4) E-commerce is not the first revolution in the retail sector The retail sector has changed significantly over the decades and it is not clear that the disinflationary effect of the latest revolution, e-commerce, is any more intense than in the past. Economists at Goldman Sachs point out that the growth of Amazon's market share in recent years still lags that of Walmart and other "big box" stores in the 1990s (Chart II-3).4 This fact suggests that "Amazonification" may not be as disinflationary as the previous big-box revolution. (5) Weak productivity growth and high profit margins are inconsistent with a large supply-side benefit from e-commerce As discussed above, economic theory suggests that a positive supply shock that cuts costs and boosts competition should trim profit margins and lift productivity. The problem is that the margins and productivity have moved in the opposite direction that economic theory would suggest (Chart II-4). Chart II-3Amazon Vs. Walmart: ##br##Who's More Deflationary? Chart II-4Incompatible With A Supply Shock By definition, productivity rises when firms can produce the same output with fewer or cheaper inputs. However, it is well documented that productivity growth has been in a downtrend since the 1990s, and has been dismally low since the Great Recession. A Special Report from BCA's Global Investment Strategy5 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, in many industries it appears that productivity is over-estimated. If e-commerce is big enough to "move the dial" on overall inflation, it should be big enough to see in the aggregate productivity figures. Chart II-5Retail Margin Squeeze ##br##Only In Department Stores One would also expect to see a margin squeeze across industries if e-commerce is indeed generating a lot of deflationary competitive pressure. Despite dismally depressed productivity, however, corporate profit margins are at the high end of the historical range across most of the sectors of the S&P 500. This is the case even in the retailing sector outside of department stores (Chart II-5). These facts argue against the idea that the internet has moved the economy further toward a disinflationary "perfect competition" model. (6) Online price setting is characterized by frictions comparable to traditional retail We would expect to observe a low price dispersion across online vendors since the internet has apparently lowered the cost of monitoring competitors' prices and the cost of searching for the lowest price. We would also expect to see fairly synchronized price adjustments; if one vendor adjusts its price due to changing market conditions, then the rest should quickly follow to avoid suffering a massive loss of market share. However, a recent study of price-setting practices in the U.S. and U.K. found that this is not the case.6 The dataset covered a broad spectrum of consumer goods and sellers over a two-year period, comparing online with offline prices. The researchers found that market pricing "frictions" are surprisingly elevated in the online world. Price dispersion is high in absolute terms and on par with offline pricing. Academics for years have puzzled over high price rigidities and dispersion in retail stores in the context of an apparently stiff competitive environment, and it appears that online pricing is not much better. The study did not cover a long enough period to see if frictions were even worse in the past. Nonetheless, the evidence available suggests that the lower cost of monitoring prices afforded by the internet has not led to significant price convergence across sellers online or offline. Another study compared online and offline prices for multichannel retailers, using the massive database provided by the Billion Prices Project at MIT.7 The database covers prices across 10 countries. The study found that retailers charged the same price online as in-store in 72% of cases. The average discount was 4% for those cases in which there was a markdown online. If the observations with identical prices are included, the average online/offline price difference was just 1%. (7) Some measures of online prices have grown at about the same pace as the CPI index The U.S. Bureau of Labor Statistics does include online sales when constructing the Consumer Price Index. It even includes peer-to-peer sales by companies such as Airbnb and Uber. However, the BLS admits that its sample lags the popularity of such services by a few years. Moreover, while the BLS is trying to capture the rising proportion of sales done via e-commerce, "outlet bias" means that the CPI does not capture the price effect in cases where consumers are finding cheaper prices online. This is because the BLS weights the growth rate of online and offline prices, not the price levels. While there may be level differences, there is no reason to believe that the inflation rates for similar goods sold online and offline differ significantly. If the inflation rates are close, then the growing share of online sales will not affect overall inflation based on the BLS methodology. The BLS argues that any bias in the CPI due to outlet bias is mitigated to the extent that physical stores offer a higher level of service. Thus, price differences may not be that great after quality-adjustment. All this suggests that the actual consumer price inflation rate could be somewhat lower than the official rate. Nonetheless, it does not necessarily mean that inflation, properly measured, is being depressed by e-commerce to a meaningful extent. Indeed, Chart II-6 highlights that the U.S. component of the Billion Prices Index rose at a faster pace than the overall CPI between 2009 and 2014. The Online Price Index fell in absolute and relative terms from 2014 to mid-2016, but rose sharply toward the end of 2016. Applying our guesstimate of the weight of e-commerce in the CPI (3.2% for goods), online price inflation added to overall annual CPI inflation by about 0.3 percentage points in 2016 (bottom panel of Chart II-6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart II-7). Online prices fell relative to the overall CPI for most of the time since the early 1990s, with the relative price decline accelerating since the GFC. However, our estimate of the contribution to overall annual CPI inflation is only about -0.15 percentage points in June 2017, and has never been more than -0.3 percentage points. This could be an underestimate because it does not include the impact of services, although the service e-commerce share of the CPI is very small. Chart II-6Online Price Index Chart II-7Electronic Shopping Price Index Another way to approach this question is to focus on the parts of the CPI that are most exposed to e-commerce. It is impossible to separate the effect of e-commerce on inflation from other drivers of productivity. Nonetheless, if online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. We combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure according to the BLS' annual Retail Survey (Chart II-8). The sectors in our aggregate e-commerce price proxy include hotels/motels, taxicabs, books & magazines, clothing, computer hardware, drugs, health & beauty aids, electronics & appliances, alcoholic beverages, furniture & home furnishings, sporting goods, air transportation, travel arrangement and reservation services, educational services and other merchandise. The sectors are weighted based on their respective weights in the CPI. Our e-commerce price proxy has generally fallen relative to the overall CPI index since 2000. However, while the average contribution of these sectors to the overall annual CPI inflation rate has fallen in the post GFC period relative to the 2000-2007 period, the average difference is only 0.2 percentage points. The contribution has hovered around the zero mark for the past 2½ years. Surprisingly, price indexes have increased by more than the overall CPI since 2000 in some sectors where one would have expected to see significant relative price deflation, such as taxis, hotels, travel arrangement and even books. One could argue that significant measurement error must be a factor. How could the price of books have gone up faster than the CPI? Sectors displaying the most relative price declines are clothing, computers, electronics, furniture, sporting goods, air travel and other goods. We recalculated our e-commerce proxy using only these deflating sectors, but we boosted their weights such that the overall weight of the proxy in the CPI is kept the same as our full e-commerce proxy discussed above. In other words, this approach implicitly assumes that the excluded sectors (taxis, books, hotels and travel arrangement) actually deflated at the average pace of the sectors that remain in the index. Our adjusted e-commerce proxy suggests that online pricing reduced overall CPI inflation by about 0.1-to-0.2 percentage points in recent years (Chart II-9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart II-8BCA E-Commerce Proxy Price Index Chart II-9BCA E-Commerce Adjusted Proxy Price Index Admittedly, data limitations mean that all of the above estimates of the impact of e-commerce are ballpark figures. Conclusions We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence. The available data are admittedly far from ideal for confirming or disproving the "Amazonification" thesis. Perhaps better measures of e-commerce pricing will emerge in the future. Nonetheless, the measures available today do not suggest that online sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points, and it does not appear that the disinflationary impact has intensified by much. One could argue that lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. Nonetheless, if this were the case, then we would expect to see significant margin compression in the retail sector. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High corporate profit margins and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Finally, today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. Rising online activity means that we need fewer shopping malls and big box outlets to support a given level of consumer spending. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. To the extent that central banks were slow to recognize that equilibrium rates had fallen to extremely low levels, then policy was behind the curve and this might have contributed to the current low inflation environment. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Robert F. DeLucia, "Economic Perspective: A Nontraditional Analysis Of Inflation," Prudential Capital Group (August 21, 2017). 2 Business to business, and business to consumer. 3 Aaron Cheris, Darrell Rigby and Suzanne Tager, "The Power Of Omnichannel Stores," Bain & Company Insights: Retail Holiday Newsletter 2016-2017 (December 19, 2016). 4 "US Daily: The Internet And Inflation: How Big Is The Amazon Effect?" Goldman Sachs Economic Research (August 2, 2017). 5 Please see Global Investment Strategy Weekly Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 6 Yuriy Gorodnichenko, Viacheslav Sheremirov, and Oleksandr Talavera, "Price Setting In Online Markets: Does IT Click?" Journal of the European Economic Association (July 2016). 7 Alberto Cavallo, "Are Online And Offline Prices Similar? Evidence From Large Multi-Channel Retailers," NBER Working Paper No. 22142 (March 2016). III. Indicators And Reference Charts Stocks struggled in August on the back of intensifying geopolitical risks, such that equity returns slipped versus bonds in the month. The earnings backdrop remains constructive for global stocks. In the U.S., 12-month forward EPS estimates continue to climb, in line with upbeat net revisions and earnings surprises. Nonetheless, the risk/reward balance has deteriorated due to escalating risks inside and outside of the U.S. Allocation to risk assets should still exceed benchmark, but should be shy of maximum settings. It is prudent to hold some of the traditional safe haven assets, including gold. Our new Revealed Preference Indicator (RPI) remained at 100% in August, sending a bullish message for equities. We introduced the RPI in the July report. Quite simply, it 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. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. WTP topped out in June and the same occurred in August for the Japan and the Eurozone indexes. While the indicators are still bullish, they highlight that flows into the equity markets in the major countries are beginning to moderate. These indicators would have to clearly turn lower to provide a bearish signal for stocks. The VIX increased last month, but remains depressed by historical standards. This implies that the equity market is vulnerable to bad news. However, investor sentiment is close to neutral and our speculation index has pulled back from previously elevated levels. These suggest that investors are not overly long at the moment. Our monetary indicator is only slightly negative, but the equity technical indicator is close to breaking below the 9-month moving average (a negative technical sign). Bond valuation continues to hover near fair value, according to our long-standing model that is based on a simple regression of the nominal 10-year yield on short-term real interest rates and a moving average of inflation. Another model, presented in the Overview section, estimates fair value based on dollar sentiment, a measure of policy uncertainty and the global PMI. This model suggests that the 10-year yield is almost 50 basis points on the expensive side. We think that Fed rate expectations are far too benign, suggesting that bond yields will rise. 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 ##br##Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators 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
Highlights A broad survey on various valuation ratios suggests that Chinese investable equities' exceptional cheapness in the past several years has essentially vanished. Valuation is no longer a compelling reason for staying positive. Multiples of Chinese equities have been rerated in the past two years. This asset class is currently trading at a slight premium over its historical norms as well as other emerging markets, but it is still at discounts to developed bourses and the all-country-world averages. Remain bullish on Chinese investable equities due to our positive stance on the cyclical outlook of economy and profits. Feature Chinese industrial profits increased by 16.5% in July from a year ago, as released early this week. This is a mild deceleration compared with the 19.1% pace a month earlier, which the authorities attributed to temporary factory shutdowns due to extreme summer heat. Irrespective, the latest profit numbers confirm that the economy is passing its peak growth rate in this mini cycle upturn, but overall business activity remain fairly robust. Looking forward, we see limited downside in China's cyclical growth outlook, as discussed in various recent reports.1 Chinese equities have also experienced a mini melt-up in recent weeks. So far this year, Chinese investable stocks, measured by the MSCI China Free index, have rallied by almost 40% in dollar-terms, significantly outpacing all major global and EM benchmarks. Importantly, the total return index of Chinese investable stocks, price appreciation and dividend income combined has recently broken above a long-term resistance, reaching an all-time high (Chart 1). While the strong performance of Chinese equities has validated our positive stance on China's growth and profit profile, the sharp rally in prices also raises a red flag on potential froth and complacency. A closer look at the valuation picture of Chinese equities is well warranted. Conventional Valuation Indicators At the onset, conventional valuation indicators for the broad Chinese investable equity universe currently do not look demanding compared with historical norms (Chart 1, bottom panel). Our composite valuation indicator, which combines several conventional yardsticks such as trailing and forward price-to-earnings, price-to-book, price-to-cash and dividend yield, has crawled out of the "undervalued" extreme that lasted for several years, but it is not yet overvalued. Most conventional valuation indicators are currently roughly in line with their respective long-term averages (Chart 2). Chart 1Chinese Investable Stocks Are No Longer ##br##Exceptionally Cheap Chart 2Most Valuation Indicators ##br##Are Back To Historical Means Compared with other emerging bourses, Chinese investable equities have also been re-rated. In fact, Chinese equities' outperformance against the EM benchmark since mid-last year has been entirely driven by relative multiples expansion (Chart 3). Our relative composite valuation indicator suggests Chinese investable equities are trading at a moderate premium over the EM benchmark, after a few years of deep discount. Most valuation indicators of Chinese equities are slightly higher than the EM benchmark, but are still significantly lower than their peers in the developed market (Chart 4). Chart 3Chinese Equities Have Been Rerated ##br##Against EM Chart 4Chinese Equities Are Trading At Premium##br## Against EM, But Not DM Weight-Adjusted Valuation Indicators A major issue of conducting historical and cross-country comparisons of valuation indicators is the ever-changing constituents in the indexes. The benchmark to evaluate P/B ratios of tech companies should be categorically different from those of banks, as should the price-to-cash ratios for retailers and utility firms. A simple lump-sum aggregate of a conventional valuation indicator ignores the different sector weights among different markets, which could be misleading. This is particularly important for China, as its juvenile equity universe is constantly evolving and rapidly changing (Chart 5). The largest sector by weight in the Chinese investable market in the past 10 years has shifted from telecom to energy to banks, with the baton more recently being passed to information technology. Currently, IT firms account for over 40% of the MSCI China Free index, up from less than 10% three years ago, while banks have dropped from a peak of 44% to 25% currently. The shifting sector weights within the Chinese equity universe also reflect the rapidly changing structure of the underlying Chinese economy. Chart 5Chinese Investable Equities Sector Breakdown One way to deal with this issue is some sort of "controlled weight" valuation indicator by holding sector weights constant. Chart 6 shows the simple averages of various valuation ratios of the 10 Global Industry Classification Standard (GICS) sectors.2 With the exception of dividend yield, the equal-weighted valuation indicators are more expensive than their respective market weight-based versions, according to our calculation. This means that some smaller-weight sectors are more dearly valued compared with the large weights, particularly banks. However, none of the valuation ratios appear extreme in a historical context. How do Chinese equities compare with other markets? Table 1 summarizes equal-sector-weight valuation indicators. Overall, Chinese equities are trading at a slight premium over emerging markets, but are still at 10-20% discounts to developed bourses and the all-country-world averages. Table 1 Cyclically-Adjusted P/E Ratios The Cyclically Adjusted Price Earnings (CAPE) multiple (also known as the Shiller P/E) compares the equity price to the earnings in a full business cycle extended over many years, rather than just one random year. Typically, CAPEs are calculated by dividing the equity price by the 10-year average of real earnings, which smooths out the business cycle and theoretically better captures what equity investors are paying for companies' long term earning streams. Chart 7 shows that CAPEs are well above 20 times for the U.S. and Japanese markets, and around 16 times for U.K. and euro area stocks - all have experienced some multiples expansion since the global financial crisis. In China's case, the CAPE for investable equities has been hovering at around 10 times, near a record low and significantly below the level of the other major indexes. In fact, the CAPE of investable Chinese shares has barely stopped falling amid the rally in prices. Chart 6Average Versus Market-Weight Valuation Ratios Chart 7Cyclically Adjusted P/E: A Global Comparison Investment Conclusions Taken together, the valuation picture of Chinese investable stocks has become mixed, as its total return index has reached an all-time high. This asset class is no longer obviously undervalued compared with both historical norms and its EM peers. Some viewed Chinese equities' exceptional cheapness in the past several years as a "value-trap," which has proven to be a costly mistake and has been discredited. Now the "easy trade" is over, and valuation is no longer a compelling reason for staying positive on Chinese equities. On the other hand, a broad survey on various valuation ratios does yet not conjure up images of an overly extended market, both compared with historical averages and other global benchmarks, particularly DM bourses. Lack of valuation froth means Chinese investable shares are not yet subject to the pull of mean reversion. Cyclically, we remain optimistic on China's growth and earnings outlook, which should continue to push up stock prices. Valuation indicators are never good timing tools, but they should be closely monitored going forward to assess the risk-return tradeoff of holding Chinese equities. We will dig deeper into domestic A shares in an upcoming report. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Monitoring Chinese Capital Outflows And The RMB Internationalization Process", dated August 24, 2017, available at cis.bcaresearch.com. 2 Includes Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services and Utilities. Real Estate is included in Financials, due to its limited data availability as a stand-alone GICS sector. Cyclical Investment Stance Equity Sector Recommendations
Neutral At the beginning of the summer, we downgraded the S&P health care equipment (HCE) index to neutral for three main reasons: valuations had shot higher, demand had downshifted and pricing had cooled substantially. Relative valuations have since fallen back (top panel), but the operating environment has worsened, providing confirmation that our downgrade was well-timed. Both HCE orders and production crested in the middle of 2016 and have been falling since, production precipitously so (second panel). At the same time, medical equipment relative selling prices have been contracting (third panel), indicating the industry could be in oversupply despite slowing production. The likely result is contracting margins and valuation multiples. Still, the news is not all bad. New health care facility construction has recovered recently and investment in medical equipment may follow suit (bottom panel), potentially portending a resurgence in demand. On balance, we think it prudent to sit on the sidelines and wait for evidence of a recovery in pricing power before reentering the fray; stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: ABT, BAX, BCR, BDX, BSX, DHR, EW, HOLX, IDXX, ISRG, MDT, RMD, SYK, VAR, ZBH.