Equities

The Chinese manufacturing sector has remained under downward pressure, but the stress level has alleviated compared to a few months ago. The Chinese labor market will likely continue to deteriorate, which will force policymakers to stay accommodative. Despite the recent rally, Chinese investable stocks remain exceptionally cheap.

We are recommending profit taking in gold shares after a dramatic surge since our overweight call earlier this year. The long-term outlook for gold remains appealing, given the need for low or even negative real interest rates for a prolonged period in order to restore global growth to trend or above-trend levels. Nevertheless, on an intermediate-term basis, we are concerned that a rise in the U.S. dollar could cap the upside in bullion and related-share prices. Evidence of speculative zeal is mounting. ETF gold holdings have skyrocketed since late-2015, reflecting massive inflows into related funds. Net speculative positions have surged as a percent of open interest (third panel), underscoring that momentum and performance-chasing have turbo-charged the yellow metal's advance. Sentiment toward gold has also spiked. Importantly, relative stock price performance has become extremely overbought. The 52-week rate of change has soared to its highest level in decades. While that upsurge partially reflects a lasting cyclical and structural trend change, an intermediate-term digestion phase is inevitable to relieve overbought conditions in the coming months, with a stronger currency the most likely catalyst. Take profits of 45% and downshift to neutral.

Stocks remain well bid despite the questionable fundamental rationale for price gains. The run to new highs has been driven by renewed valuation expansion a dubious trend given the lack of profit growth, the likelihood that the Fed will resume hiking interest rates this autumn and the potential for the U.S. dollar to climb anew. Still, abundant liquidity expectations are trumping earnings risks in the near run. Nominal GDP growth remains above long-term Treasury yields, a simple yet reliable measure of excess liquidity. Meanwhile, money growth is accelerating relative to output growth. When this occurs, history shows that defensive sectors outperform the broad market (top panel). Deep cyclicals underperform until after economic activity picks up enough to drain excess liquidity from the market (deep cyclicals are inversely correlated with our liquidity gauge, bottom panel). Consequently, we continue to emphasize non-cyclical sectors and groups in our portfolio strategy, with a splash of beta coming from the interest rate-sensitive consumer discretionary sector.

The GAA DM Equity Country Allocation model is updated as of July 29, 2016. The non-U.S. (level 2) model made some changes by increasing the overweight in Sweden and Italy while reducing the overweight in Netherland and Germany such that now Germany is in underweight position.

The odds of an inflation "mini-scare" are rising, although deflationary tail risks from abroad cannot be dismissed.

It is dangerous to equate recent equity strength with economic vitality, as history shows that liquidity-fueled equity advances favor non-cyclicals over deep cyclicals. Take profits in gold, buy rails and sell industrial machinery.

In July, the model outperformed both global equities and the S&P 500 in local-currency terms, while underperforming in U.S. dollar terms. For the monthly of August, the model made no changes to overall risk exposure.

The recent rally in risk assets is walking a very fine line. If the Fed turns more hawkish, or U.S. growth slows, it could fall over.

The S&P restaurants index continues to deflate in relative performance terms and downside risks remain intact. The top panel of the chart shows that the Restaurant Performance Index (RPI, courtesy of the National Restaurant Association) has taken a turn for the worse. Historically, momentum in the RPI has been an excellent leading indicator of relative share prices. The RPI is picking up the downtrend in top-line performance, as measured by restaurant retail sales. The latter warn that relative forward earnings momentum is headed lower. To make matters worse, slow traffic is limiting pricing power gains, which are lagging badly behind a soaring wage bill (fourth panel). Bottom Line: While we have recently boosted the S&P consumer discretionary index to overweight, stick with a below benchmark allocation in the S&P restaurants sub-index. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI.

We are delighted to announce the launch of our newest sector publication, Energy Sector Strategy (NRG). The new Energy Sector Strategy will be complementary to BCA's Commodity & Energy Strategy (CES) and U.S. Equity Strategy (USES) services. NRG will expand our energy-related research into more granular investment themes that are beyond the scope of CES/USES and extend these conclusions to specific equity investment recommendations. The U.S. horizontal rig count (unconventional/shale drilling) has begun to recover in response to oil prices rising off of an oversold trough, but still remains well below the level that would be sufficient to prevent continuing production declines. Capital availability and rising service costs will be moderating factors on the pace of a drilling recovery, but the completion of drilled but uncompleted wells (DUCs) will allow operators to bring on some additional production faster and cheaper than organic drilling programs. Without the impact of the DUCs, we estimate U.S. shale production would continue to decline through mid-2017; with an aggressive DUC completion program (100 wells per month over the course of a year, starting now), overall production would stabilize 3-6 months sooner and at a higher level (300,000-400,000 b/d) than drilling alone. In this environment, we recommend financially strong oil shale producers who will be able to ramp-up reinvestment fastest (EOG, PXD, PE, FANG), as well as the completion and service companies (HAL, SLB, SLCA) that will benefit from the increased oilfield investment more than drillers. To learn more about this new service, please contact Chris Cook (Chrisc@bcaresearch.com).