Equities

Special Report

We are pleased to share this <i>Special Report</i> rolling out our Global ETF Strategy (GETF) service's model ETF portfolios.
We are in the latter stages of developing the digital interface that will serve as the central nervous system for the GETF service and are excited to be rolling it out next month. In the meantime, the GETF team has embarked on its regular bi-weekly publication schedule. An ETF Primer <i>Special Report</i> will follow on October 26. It will discuss ETF architecture, operation and trading, and is meant to help investors determine how they can best deploy ETFs to accomplish their tactical and strategic goals.

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

The U.S. dollar's corrective/consolidation phase is over, and it is about to rally. The risk-reward for EM stocks and currencies is extremely unattractive. We are reiterating our recommendation to short a basket of ZAR, BRL, TRY, MYR, IDR and CLP versus the U.S. dollar. There is a value opportunity in the Mexican peso. Go long MXN versus ZAR. Also, double down on the long MXN / short BRL trade.

We recommend deploying the proceeds of our E&P downgrade into oil & gas field services. The typical conditions required for energy services share price outperformance are falling into place. First, oil consumption is growing relative to production. OPEC production has continued climbing even as non-OPEC output has contracted, underscoring that a deal to curb future output should ensure that the consumption/production ratio stays in an uptrend. Recent strength in emerging market (EM) currencies signals that non-OECD oil consumption can continue to grow via better purchasing power, and also reduces the odds of an EM financial credit accident. Second, OECD oil supply growth rates appear to have peaked. Third, oil & gas field services pricing power has troughed. We doubt there is much upside given the scale of the excess capacity that was built up in the last decade, but an end to deflation would take away a large negative. Finally, the rig count has ticked higher, and has more upside if firms shift out of maximum retrenchment mode. Relative valuations are sufficiently cheap enough to expect that even a modest increase in the rig count could spur a re-rating. Boost the S&P oil & gas field services index to overweight.

The energy sector is up marginally from its lows when compared with the overall market, an abysmal performance given the rally in crude oil and natural gas. Our strategy has been to keep only a market neutral weight on the overall sector this year via an overweight in oil & gas producers and underweight in refiners. While this has served our portfolio well, we are fine-tuning our intra-sector exposure. OPEC recently agreed to make a modest production curtailment. Whether members adhere to quotas and/or actually reduce output remains to be seen, but the more important point may be that the quest to drive down prices to cause financial pain for high cost producers appears to have come to an end. BCA's Energy Strategy Service believes that despite significant improvements in drilling efficiency and productivity during the downturn, current drilling levels are 30-40% lower than needed just to stem production declines. Re-inflating the rig count to an expansionary level will take time (~6 months), and then realized production will lag the rig count by 4-6 months. Renewed acceleration in drilling and completion activity will create inflationary pressures: pricing power will shift in favor of services firms relative to producers at a time when oil & gas extraction labor cost inflation has spiked to double-digit rates (third panel). If commodity prices are flat, it will be difficult for E&P firms to grow cash flow unless production is on the upswing. Take profits of 15% and downgrade the S&P oil & gas exploration & production index to neutral, funneling the proceeds into energy services firms, see the next Insight.

The mini-consolidation in equities reflects the ongoing tension between market-supportive liquidity and a sketchy corporate profit backdrop.

Our <i>Fourth Quarter Strategy Outlook</i> presents the major investment themes and views we see playing out for the rest of the year and beyond.

Gold prices and gold-related equities have been caught in a sharp selloff. The motivation behind our early-August profit-taking stemmed from extremely overheated sentiment at a time when the yellow metal was vulnerable to an increasingly more hawkish Fed. Despite rumblings about asset purchase tapering at the ECB and Bank of Japan, we continue to see gold as an excellent long-term play given the likelihood of a prolonged period of depressed real interest rates. We are looking for an opportunity to return to an overweight position, but are reluctant to add just yet given that the Fed still seems intent on tightening policy, which could support U.S. dollar strength. In addition, neither technically overbought conditions nor extreme bullishness have been fully unwound. The bottom line is that near-term policy threats may keep gold and gold shares in consolidation mode for a while longer. Stay neutral, but be prepared to lift positions in the coming months.

Fixed income proxies have been pummeled recently, with the S&P utilities underperforming the S&P 500 by nearly 14% since the mid-year relative performance peak, on a mere 32bps jump in 10-year U.S. Treasury yields (UST). Since 2010 there have been three iterations of meaningful bond market selloffs, with yields rising by an average of 120bps (see table). Relative utilities returns in these iterations fell by an average of over 18% (top three panels). Utilities have already sold off by nearly 75% of the average bond yield selloff, even though long-term yields have barely budged. The implication is that a large yield back up has already been discounted and now is not the time to rush for the exits. In fact, our inclination is to look for buying opportunities, given that we do not envision much upside in government bond yields. Stay neutral, but look to buy when value improves. Table 1

The transport group is a positive exception to our otherwise downbeat view on the relative performance prospects of the overall industrials sector. We expect consumption to continue outpacing capital spending, because corporate sector free cash flow is waning and balance sheets are suspect. The railroad group in particular has room for upside surprises. Expectations have been reduced considerably, yet leading revenue indicators have perked up. Our rail freight diffusion index has been holding above the key 50 level for several months, heralding increased traffic. Importantly, the heavyweight intermodal segment should soon recover, based on the message from rising consumer income expectations. Importantly, pricing power has climbed out of the deflation zone, a critical milestone for profitability. We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL-UNP, CSX, NSC, KSU.