Equities

The RMB has been steadily depreciating versus the U.S. dollar and has dropped to a new cyclical low versus its trade-weighted basket. All the while, Chinese domestic interest rates have lately drifted higher. When global investors wake up to these dynamics, global share prices and EM risk assets will likely sell off anew. In Mexico, initiate a new yield curve trade: receive 10-year / pay 1-year swap rates.

Since downshifting from favoring growth over value to a neutral style bias at the beginning of this year, the growth/value (G/V) ratio has corrected sharply. While this recommendation shift was timely, at issue is whether a major cyclical trend change is underway, or if a resumption of the advance lies ahead, and/or another style switch is appropriate. Before making any decisions, it is critical to understand the driving forces behind the last few months' price action. Growth indexes have a hefty non-cyclical element compared with value benchmarks. In addition, growth is tech-heavy while value is dominated by financials. Thus, the rebound in cyclical sectors alongside the gentle depreciation in the U.S. dollar and oil price recovery provided a good reason for value-oriented stocks to rebound. However, that rally has not been accompanied by any real improvement in the global business cycle. Now that U.S. employment is starting to soften, concerns about the health of the expansion may broaden. Growth indices have a strong track record of outperformance when economic expectations are weak, as proxied by declining global government bond yields (shown inverted, top panel). The surge in the S&P dividend aristocrats index is also consistent with a safety bid rather than a return to 'risk on'. For these and other reasons outlined in yesterday's Weekly Report, we recommend returning to a growth vs. value bias.

While we continue to maintain a defensive over cyclical portfolio structure, yesterday's Weekly Report identified a number of catalysts that could eventually change our view: broad-based and sustained U.S. dollar weakness, particularly against a basket of EM currencies in countries with large current account deficits would, the Chinese manufacturing sector stops deflating, global PMIs firm, global export volumes and prices top contracting, an end to U.S. over global profit dominance and/or inflation expectations turn higher around the world. So far, these potential catalysts have only shown signs of stabilization rather than strength, underscoring that it is premature to position for a recovery in cyclical sector profits. Stay defensive, and please see yesterday's Weekly Report for more details.

Last week's soft employment report reinforced our defensive vs. cyclical portfolio bias, as firms appear to be slowing hiring in response to the broad-based profit squeeze. That is a plus for non-cyclical sectors, as defensive sector profits have steadily outperformed in the last two years, supporting share price outperformance. The opposite is true for cyclical sectors, notwithstanding the bounce earlier this year. At some point, the tide will turn in favor of cyclical sectors, but a number of factors argue against making such a leap of faith at the moment, please see the next Insight.

Economic disappointment will become the key theme in the second half of the year, driving a return to non-cyclical market leadership and a recovery in the growth vs. value ratio.

Weak employment will push out the timing of rate hikes to something closer to BCA's view of a September increase. It is also supportive of our asset allocation call two weeks ago to overweight Treasuries.

All three of Trump's signature policy proposals - increased deficit-financed infrastructure spending, a more restrictive immigration policy, and trade protectionism - are dollar bullish. These policies could cause the U.S. economy to overheat, forcing the Fed to raise real rates more than it otherwise would. Equities could rally in the near term following a Trump victory, but are likely to face stiff longer-term headwinds. Treasurys would still suffer modest losses, while, ironically, the one asset that could suffer the most from a Trump victory is gold.

The model has not made significant changes in the country allocation. It continues to keep its largest overweight in the U.S. equities.

Despite the broad market's rebound toward the top end of the 18-month long trading range, defensive sectors have held their own against cyclical sectors of late. We expect non-cyclical dominance to reassert itself, regardless of the short-term direction of the overall market. Financial conditions are tighter than warranted by underlying economic activity, as demonstrated by the Chicago Fed's Financial Conditions Index. Ergo, positioning for economic reacceleration is high risk. Moreover, the yield curve continues to narrow (second panel, curve shown as 2 minus the 10-year Treasury yield), reinforcing that growth rates will stay too low to lift the deflationary pall over cyclical sectors, particularly if the Fed retains its tightening bias. Even the global manufacturing surveys continue to underwhelm (bottom panel). Overall, the message is that the uptrend since 2011 in the defensive/cyclical share price ratio will remain intact.

A Spanish bull, a euro bull, and an equity bear.