Developed Countries
The model has not made significant changes in the country allocation. It continues to keep its largest overweight in the U.S. equities.
In March we recommended doubling down on our overweight S&P consumer finance index call, because company-specific factors had caused relative performance to undershoot the bulk of our macro indicators. Since then, the share price ratio has climbed, aided by the largest monthly gain in revolving consumer credit growth in well over a decade (second panel). However, the latest consumer confidence survey showed that consumer income expectations have receded, which may forewarn of a cooling in rapid debt growth. This bears close attention, as rising credit card receivables are a major profit lever. Still, consumers are in much better financial shape than the business sector, and banks remain willing to extend consumer credit, especially relative to corporate sector loans, underscoring that revolving credit growth should remain robust. Importantly, the narrowing Treasury yield curve is not having a negative impact on industry earnings, as the credit card interest rate spread is widening anew. Against a backdrop of attractive relative valuations, we continue to recommend an overweight position, as well as a long/short position vs. the S&P bank index. The ticker symbols for the stocks in this index are: BLBG: S5CFIN - AXP, COF, SYF, DFS, NAVI.
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.
While the Fed's recent forward guidance leading markets to increase the odds of a policy-rate hike earlier than previously expected will restrain the recovery in crude oil prices, fundamentals will dominate price formation now that markets have rebalanced.
Gold is correcting short-term overbought conditions on the back of a more hawkish Fed and rise in the U.S. dollar, but we doubt any correction will constitute a trend change. The big picture is increasingly shifting toward even more policy unorthodoxy. If central banks ultimately get their way, gold's appeal as an inflation hedge will eventually increase. In the meantime, real interest rates, the opportunity cost of holding a zero-yielding asset like gold, have slipped back into negative territory, and may need to fall further to reverse chronically subpar economic performance. Gold shares can take their cue from balance sheet flexibility (Corporate Health Monitor shown advanced, bottom panel), as increasing rigidness often breeds business cycle and financial market volatility, which boosts the appeal of gold, and vice versa. BCA's Cyclical Gold Indicator has an excellent long-term track record in forecasting gold stock price trends. It is currently signaling that while gold prices may be overbought on a short-term basis, cyclical conditions remain extremely bright (top panel). Keep in mind that gold sentiment is still not overly bullish, despite this year's rally, suggesting that the surprise may be resilience in gold prices and gold stock relative performance on a cyclical horizon. We are sticking with an above-benchmark allocation. The ticker symbols for the stocks in the S&P 1500 gold index are: BLBG: S15GOLD - NEM, RGLD.
While the financial sector relief bounce is likely to peter out as the Fed threatens to tighten monetary conditions during a profit recession, the more defensive REIT sub-component should continue to outperform. REITs are still not overvalued, despite the relentless decline in yields on competing assets. While Fed rate hikes could be construed as an impediment if they lift the cost of capital, REITs have not typically run into trouble until policy has tightened by enough to cause a trifecta of headwinds: a cresting in commercial real estate prices, a peak in occupancy rates and by extension, a downturn in the CPI for rental inflation. Once these factors turn bearish, upward pressure on cap rates materializes. None of these concerns currently exist. Keep in mind that with QE and NIRP, there is still a massive search for yield in global financial markets. Roughly $9T of global bonds trade at a negative yield, a massive increase from only two years ago, which should sustain the secular advance in REITs. Moreover, REITs are slated to become a new GICS1 sector on August 31, a new classification that has the potential to augment investor interest. Adding it up, the security, safety and yield appeal of REITs should remain intact regardless of the Fed's near-term zigs and zags, unlike the overall financials sector. Stay overweight and see yesterday's Weekly Report for more details.
A Fed rate hike in June, July or September is likely to send our 12-month fed funds discounter toward 70bps by the date of the next hike. This re-rating of rate expectations will cause significant flattening at the long-end of the curve. Investors should enter a 5/30 flattener to profit.
There is a risk that global bond yields move higher in the near term, although we prefer to position for that move <i>via</i> cross-market spread, yield curve and inflation trades.
Markets will remain stuck in a trading range, driven by two policy feedback loops: the Fed's and China's.