Developed Countries

Highlights Huge imbalance #1 is the euro area’s $150 billion trade surplus with the United States. Huge imbalance #1 has resulted from the ECB holding interest rates at the lower bound while the Fed tightened policy. The upshot is that the Fed now has the scope to cut rates while the ECB does not. Huge imbalance #2 is the euro area’s €1.5 trillion TARGET2 banking imbalance. Huge imbalance #2 means that Germany effectively has hundreds of billions of ‘Italian’ euro assets, making a euro break-up unthinkable for the euro area’s dominant economy. New structural recommendation for bond investors: overweight a 50:50 portfolio of U.S. T-bonds and Italian BTPs versus a 50:50 portfolio of German bunds and Spanish Bonos. Feature Huge Imbalance #1: The Euro Area’s $150 Billion Trade Surplus With The United States While the recent focus has been on the brewing trade war between the United States and China, trade tensions between the U.S. and Europe have also been escalating. The euro area trade surplus with the U.S. – standing near an all-time high of $150 billion – is extreme; and it is extreme because the undervaluation of the euro has made the euro area grossly over-competitive vis-à-vis the U.S., as claimed by the ECB’s own analysis (Chart I-2 and Chart I-3)! Chart of the WeekThe U.S./Euro Area Trade Imbalance Is A Near-Perfect Function Of Relative Monetary Policy Chart I-2Relative Monetary Policy Has Driven The Euro's Undervaluation... Chart I-3...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance A common counterargument is that the euro area trade surplus is simply a structural issue. If a country, such as Germany, consistently consumes less than it produces, it must show up as a structural surplus. This argument is flawed. At least half of the surplus, including for Germany, has appeared since 2014, meaning it cannot be a structural issue (Chart I-4). In any case, if an economy consumes less than it produces, a higher exchange rate should help to facilitate the adjustment, encouraging under-consuming households to buy more imports, and discouraging over-producing firms from selling into foreign markets. Chart I-4Half Of Germany's Export Surplus Appeared After 2014 The Chart of the Week shows the true and damning reason for the trade imbalance. The euro area’s surplus with the U.S. is a near-perfect function of relative monetary policy. To be clear, the ECB is not explicitly depressing the exchange rate to make the euro area over-competitive, the ECB is just targeting its definition of price stability. However, the ECB’s definition of price stability omits owner-occupied housing (OOH) costs, and thereby understates true euro area inflation by 0.5 percent. To the extent that the ECB thinks in terms of real interest rates based on seemingly low (excluding OOH) inflation, this means that the ECB is setting real interest rates that are far too low for the euro area economy including OOH. This has resulted in the grossly over-competitive euro and the associated $150 billion surplus with the United States. The euro area trade surplus with the U.S. is a near-perfect function of relative monetary policy. Still, for 85 percent of the euro area, even inflation excluding OOH is reliably running within a 1.5-2 percent range, very close to the ECB’s definition of price stability. And bank lending is growing at a very healthy clip. For this vast majority of the bloc, the ECB’s zero and negative interest rate policy is wholly inappropriate. However, for the 15 percent of the euro area that is called Italy, ultra-loose monetary policy does seem more appropriate. Inflation is struggling to stay above 1 percent, and bank lending is still failing to gain traction (Chart I-5 and Chart I-6). Chart I-5Italian Inflation Is Struggling To Stay Above 1 Percent Chart I-6Italian Banks Have Not ##br##Been Lending Therefore, an important way of thinking of the ECB’s stance is one of self-preservation – protecting the euro area’s obvious source of fissure. Effectively, the ECB is setting policy for the weakest link in the euro area, even if that policy means exacerbating strains outside the euro area – specifically, by generating a huge trade surplus with the United States. But in the interests of self-preservation, the external strain is a price worth paying. This leads us to believe that the inevitable convergence of euro area and U.S. monetary policies is now much more likely to happen via the Federal Reserve ultimately cutting rates, than by the ECB raising rates. Huge Imbalance #2: The Euro Area’s €1.5 Trillion TARGET2 Imbalance The euro area Target2 banking imbalance now stands close to €1.5 trillion (Chart I-7). What is this huge imbalance (Box 1), and why does it matter? Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability vis-à-vis the ECB. Target2 balances therefore show the cumulative net payment flows within the euro area.   The ECB delegated its QE sovereign bond purchases to the respective national central banks. In the case of Italian BTPs, Italian investors sold their bonds to the Bank of Italy and deposited the cash in banks healthier than those in Italy – for example, in Germany. Strictly speaking, this outflow of Italian cash to German banks is not the same as the deposit flight during the depths of the euro debt crisis in 2012. Rather, we might call it precautionary cash management. Nevertheless, in Eurosystem accounting terms it still means that the Bank of Italy has a new asset – the BTP – denominated in ‘Italian’ euros, while the Bundesbank has a new liability to German banks denominated in ‘German’ euros. The Target2 imbalance is the aggregate of such mismatches between Eurosystem assets denominated in ‘Italian and other periphery’ euros and liabilities denominated in ‘German and other core’ euros. If Italy owes Germany half a trillion euros then it is Germany that has the problem. Does the €1.5 trillion imbalance really matter? No, as long as an ‘Italian’ euro equals a ‘German’ euro, the imbalance is just an accounting identity within the Eurosystem. But if Italy and Germany started using different currencies, then suddenly it would matter with a vengeance. The Bank of Italy asset would be redenominated into lira, while the Bundesbank liability to German banks would be redenominated into deutschemarks. Thereby the ECB would end up with fewer assets than liabilities, and a solvency shortfall potentially equivalent to hundreds of billions of euros would end up on the shoulders of the ECB’s shareholders – largely, German taxpayers. To paraphrase John Maynard Keynes, if Italy owes Germany half a billion euros, then Italy has a problem; but if Italy owes Germany half a trillion euros, then it is Germany that has the problem (Chart I-8 and Chart I-9). In effect, the Target2 huge imbalance is a huge force for euro area self-preservation – because break-up means mutually assured destruction. Chart I-8The Target2 Imbalance Reflects The Cross-Border Flow Of Italian Investor Cash... Chart I-9...To German##br## Banks A New Structural Recommendation For Bond Investors To sum up, the euro area has two huge imbalances: one external, the other internal. The external imbalance is the $150 billion trade surplus with the United States. This huge imbalance has resulted from the ECB holding interest rates at the lower bound while the Fed tightened policy. The upshot is that the Fed now has the scope to cut rates while the ECB does not. And this makes the U.S. T-bond a much better haven asset than the German bund. The Target2 imbalance is a huge force for euro area self-preservation. The internal imbalance is the €1.5 trillion euro area Target2 imbalance. This huge imbalance means that Germany effectively has hundreds of billions of Italian ‘euro’ assets, making a euro break-up unthinkable for the euro area’s dominant economy. On this premise, the Italian BTP – which is offering a generous yield premium for such a break-up risk – is a good structural investment. Therefore, our new structural recommendation for bond investors is to overweight: A 50:50 portfolio of U.S. T-bonds and Italian BTPs Versus A 50:50 portfolio of German bunds and Spanish Bonos. Since 2018, the T-bond/BTP combination has underperformed by 20 percent and has considerable scope for ultimate catch-up one way or another (Chart I-10). Chart I-10A U.S. T-Bond/Italian BTP Combo Can Catch Up With A German Bund/Spanish Bono Combo Fractal Trading System * There are no new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

The risk/reward equity market tradeoff is to the downside and we remain tactically cautious. The trade war re-escalation risks pushing out the global growth recovery to early-2020 and has shaken our confidence in our cyclically constructive equity market view. The stock-to-bond (S/B) ratio is sounding the alarm and is now part of the slew of indicators we track that have rolled over decisively. The S/B ratio has formed a bearish head and shoulders trading pattern and suggests that the SPX is at risk of a further pullback (see chart). While up to very recently falling bond yields were an undoubtedly equity market recovery pillar, any further melting in the 10-year Treasury yield would exert downward pull on the equity market. Bottom Line: We remain tactically cautious and continue de-risking our portfolio. Please see our Weekly Report published yesterday for additional details.

Highlights Portfolio Strategy The risk/reward equity market tradeoff is to the downside and we remain tactically cautious. The trade war re-escalation risks pushing out the global growth recovery to early-2020 and has shaken our confidence in our cyclically constructive equity market view. An enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profit expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retail (HIR) index has ample downside. Recent Changes Lift the S&P telecom services index to neutral for a gain of 6% since inception. Early last week we got stopped out of our S&P homebuilding overweight recommendation, which is now back to neutral, and booked profits of 10% since inception relative to the SPX. Table 1 Feature Equities continued to whipsaw last week and lacked clear direction as the dust from President Trump’s May 5 tariff tweet has still not settled. While the trade talks could go either way, we are reluctant to take a stance and would rather err on the side of caution. Clearly the SPX wants to spring higher and craves a U.S./China trade deal, but our geopolitical strategists believe the trade talks have taken a turn for the worse and the odds of a positive trade resolution are falling quickly. We remain cautious on the short-term equity market outlook and are now increasingly worried that our sanguine cyclical posture is in jeopardy. Worrisomely, the stock-to-bond (S/B) ratio is sounding the alarm and is now part of the slew of indicators we track that have rolled over decisively (Chart 1). The S/B ratio has formed a bearish head and shoulders trading pattern and suggests that the SPX is at risk of a further pullback. While up to very recently falling bond yields were an undoubtedly equity market recovery pillar, any further melting in the 10-year Treasury yield would exert downward pull on the equity market. There are other signs that the U.S. equity market may be hanging by a thread. The average stock has failed to make new all-time highs using the Value Line Arithmetic Index as a gauge. The median U.S. stock is also suffering the same fate, again according to the Value Line Geometric Index (middle & bottom panels, Chart 2). Chart 1Tread Carefully Chart 2More Non-Confirming Indicators The trade-weighted U.S. dollar is also sending a deflationary impulse signal and likely reflects a continued global growth deceleration (top panel, Chart 2). This is a net negative for EPS especially for internationally exposed SPX constituents. Thus, this week we are further de-risking our portfolio by crystalizing gains in a defensive high-yielding communications services sub-index and lifting exposure to neutral from underweight. In addition, we update our bearish view on an early-cyclical subgroup and continue to protect the portfolio by adding trailing stops. Meanwhile, taking the pulse of global bourses is disconcerting. With the exception of the S&P 500 and the NASDAQ, no other stock market (in USD terms) confirms the SPX’s breakout to all-time highs. Highs were either hit in 2006-2007 or in early 2018. Now a big gulf has opened up, reminiscent of last year’s late-summer dichotomies when the SPX vaulted to fresh highs, but none of the other major global bourses confirmed the September highs (Charts 3 &  4). There are rising odds that a repeat may be unfolding. Chart 3I Know What You Did Last Summer Chart 4I Still Know What You Did Last Summer In our view, what explains the reversal of fortunes that led to a U.S. market dominating outperformance since early 2017 has been the massive fiscal injection the Trump administration undertook (Chart 5), with rising fiscal deficits three years running (an unprecedented backdrop during expansions). Chart 6 puts this easing in fiscal policy in a global perspective and shows the average fiscal balance from 2017-2020 using the IMF’s WEO April 2019 dataset that includes projections. The delta in the U.S.’s fiscal largess is quite significant. Our worry is that this is unsustainable and, similar to last fall/winter, the rest of the world may pull down the U.S. stock market until at least there are clear signs of a positive resolution in the U.S./China trade dispute. Adding it all up, the equity market’s risk/reward tradeoff is poor and we remain tactically cautious. The trade war re-escalation risks pushing out the global growth recovery to early-2020 and has shaken our confidence in our cyclically constructive equity market view. Thus, this week we are further de-risking our portfolio by crystalizing gains in a defensive high-yielding communications services sub-index and lifting exposure to neutral from underweight. In addition, we update our bearish view on an early-cyclical subgroup and continue to protect the portfolio by adding trailing stops. Chart 5Explaining U.S. Outperformance Dialing Up Profits In the context of a further de-risking of the portfolio, we are monetizing our gains of 6% since inception in our underweight recommendation in the S&P telecom services index and are upgrading this high yielding sector to neutral (bottom panel, Chart 7). Not only have bond yields plunged of late, raising the allure of fixed income equity proxies, but the recent escalation of the trade spat has caused U.S. manufacturers to pull in their horns. Markit’s flash manufacturing PMI survey that took place post the May 5 Trump tweet fell to 50.6 the lowest level since the history of the data. It is surprising that this latest reading near the 50 boom/bust line is below the late-2015/early 2016 level when global trade came to an abrupt halt. Historically, relative share price momentum has moved inversely with the annual change in this series and the current message is to expect a sustained rebound in the former (middle panel, Chart 7). Beyond this enticing macro backdrop for defensive equities, firming operating metrics also suggest that it no longer pays to be bearish telecom services stocks. Industry CEOs have shown labor restraint of late, at a time when selling prices are on the verge of expanding (middle & bottom panels, Chart 8). While the dust has yet to settle on the T-Mobile/Sprint saga, any reduction in supply should prove positive at the margin for industry selling prices. Chart 7Macro Headwinds Beneficiary Chart 8Firming Operating Metrics Tack on a tick up in consumer outlays on telecom services and this likely troughing in demand will also boost the sector’s revenue growth prospects (top panel, Chart 8). In sum, an enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profits expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Meanwhile, bombed out profit expectations, suggest that the bar is set extremely low for incumbents and is likely a precursor of positive surprises. In fact, the five year out profit bearishness is unprecedented: telecom carriers are expected to trail the broad market by 13 percentage points (third panel, Chart 9). Despite this downbeat EPS message, relative share prices have fallen even faster, pushing the 12-month forward P/E multiple to multi-decade lows (bottom panel, Chart 9). Nevertheless, we refrain from bumping this niche safe haven index to overweight given some structural negative balance sheet issues. Chart 10 shows that telecom services debt burden is deteriorating. Net debt-to-EBITDA is pushing 3x versus below 2x for the broad market, and the interest coverage ratio is sinking steadily. Chart 9Bombed Out EPS Prospects And Valuations Chart 10Balance Sheet Trouble In sum, an enticing safe-haven macro backdrop, firming industry operating metrics and rock-bottom profits expectations and valuations all signal that it no longer pays to be underweight the S&P telecom services index. Bottom Line: Lift the S&P telecom services index to neutral and lock in gains of 6% since inception. The ticker symbols for the stocks in this index are: BLBG: S5TELSX – VZ, T, CTL. Home Improvement Retailers: Timber Alert   While our high-conviction underweight call in the S&P home improvement retail index is slightly in the red, our confidence has increased that these hard line retailers are about to get chopped. Netting it all out, waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retailing index has ample downside. First, the latest GDP release as it pertains to housing made for grim reading: residential fixed investment is in retreat. Big Box DIY retailers are highly levered to this type of housing activity and the prognosis is negative. Residential fixed investment has subtracted from real GDP growth for five consecutive quarters, which is unprecedented outside of a recession (top panel, Chart 11). Chart 11Time To Converge Lower... Residential investment is on the verge of contracting in absolute terms, a feat already achieved compared to GDP growth (bottom panel, Chart 11). The direct link to HIR typically comes via existing home sales. In other words, when a home changes ownership, typically some renovation activity goes into that newly purchased home (second panel, Chart 12). Thus, any sustained softness in existing home sales especially given heightened competition from the newly built housing stock, will weigh on residential investment. Against such a backdrop, top line growth for building & supply stores will likely remain subdued (third panel, Chart 12). Second, the recently announced tariffs and the specter of additional tariffs on the remaining U.S./China trade balance will also weigh on home improvement retailers' margins and profits. While management teams have yet to pencil in the direct input cost increase hit to future profitability, as revealed in recent HD and LOW conference calls, if all of the cost is passed on to the consumer then sales will suffer the most. Put simply, at the margin, some remodeling projects would have to get trimmed or get postponed, warning that HIR same-store sales will remain under pressure (second panel, Chart 13). Chart 12...To Falling Residential Investment Chart 13Lumber Price Blues Third, lumber prices continue to crumble and, given that HIR makes a set margin on lumber sales, HIR profits will likely underwhelm (third panel, Chart 13). Finally, a buildup in industry inventories at a time when demand is easing has pummeled the sales-to-inventories ratio, warning that the path of least resistance for HIR profitability remains lower (bottom panel, Chart 13). Our HIR model does an excellent job in capturing most of these macro and operating headwinds, and suggests that a felling in the relative share price ratio looms (Chart 14). What is disquieting is that there is no real valuation cushion for these priced-to-perfection retailers to absorb any future profit hiccups that we anticipate in the coming quarters. Our sense is that the de-rating phase that commenced in early 2019 will gain steam in the back half of the year and a premium-to-discount valuation reversal would not surprise us at all (bottom panel, Chart 12). Netting it all out, waning residential investment, the recent flare up in the U.S./China trade tussle, crumbling lumber prices and adverse supply/demand dynamics warn that the S&P home improvement retailing index has ample downside. Bottom Line: We reiterate our high-conviction underweight status in the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.     Anastasios Avgeriou,  U.S. Equity Strategist anastasios@bcaresearch.com Chart 14Model Says Shy Away Housekeeping Early last week we obeyed our stop and booked profits in the S&P homebuilding index of 10% versus the S&P 500 since inception; we also downgraded this niche consumer discretionary index from previously overweight to currently neutral. We are taking this opportunity of de-risking our portfolio to add another trailing stop at 10% to a related market-neutral trade: long S&P homebuilding/short S&P HIR that has recently cleared the 13% return mark since inception.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps