Developed Countries

Special Report

Feature This publication’s approach to bond investing is based on an expectations view of the yield curve. We project the future path of Fed policy and compare our forecast to what is priced into the market.1 In other words, we tend to eschew investment approaches that involve forecasting ex-ante supply and demand flows in the Treasury market. That being said, it is still important to understand the details of the markets we study. In this Special Report we get closer to that understanding by looking at the major sources of demand for U.S. Treasuries. We consider what motivates each market actor’s Treasury ownership, and how their presence in the market might evolve in the years to come. The bulk of Treasury ownership is split between six market players (Chart 1):   Foreign official and private entities (aka rest of the world, 36%) Pension funds (14%) The Federal Reserve (13%) Open-ended mutual funds, ETFs & money market funds (12%) Households (12%) Private depositary institutions (aka banks, 4%) We consider each source of Treasury demand in turn. Rest Of The World Foreign Treasury holdings are split between official (i.e. central banks) and private entities, with central banks accounting for roughly two thirds of overall foreign demand. Official foreign entities became a major holder of Treasuries after the abandonment of Bretton Woods in 1971. By ending the U.S. dollar’s convertibility to gold, the former became the global reserve currency and Treasuries the most-demanded foreign reserve in the world. Foreign Treasury holdings then surged a second time in the late 1990s, after a series of financial crises prompted many emerging market economies to shift from being net importers of capital to net exporters. A shift that caused Ben Bernanke to coin the term “global savings glut” in 2005.2  Pension fund Treasury holdings, in the aggregate, are principally determined by demographics and pension plan funded status. Bernanke’s global savings glut refers to the export-oriented growth strategies pursued by many emerging market economies in the 1990s and 2000s. These nations commonly had high domestic savings rates and a lack of internal investment opportunities. This manifested in growing emerging market current account surpluses that were offset by an expanding U.S. current account deficit. The imbalance led to a massive build-up of emerging market foreign-exchange reserves that was funneled back into the U.S. Treasury market (Chart 2). Chart 2Globalization Has Peaked, So Have ##br##Foreign Treasury Holdings Although it is still early in the process, global exports peaked relative to GDP in 2014. Average tariffs have increased since then and, according to the World Trade Organization, the number of new trade restrictions exceeded the number of trade liberalizing initiatives in 2016. As can be seen in Chart 2, the rollback of globalization implies that global current account imbalances will slowly fade during the next few years. Foreigners will therefore have less of a need to own U.S. Treasuries. In other words, foreign holdings of Treasuries have probably already peaked.  Bottom Line: The apex of globalization is likely behind us. Going forward, protectionist trade policies will drive global exports lower as a share of GDP. As a result, foreign holdings of Treasuries have peaked, and although the foreign sector will remain the largest player in the Treasury market for quite some time, its importance will slowly fade. Pension Funds Chart 3Pension Funds Do Not Weigh As Much Pension funds, regardless of their status (private vs. public) or design (defined benefit vs. defined contribution plans), have liability structures that require matched assets on the other side of their balance sheets. In the past, pension funds accomplished this by holding mostly Treasuries and corporate bonds. Then, regulations in the 80s and 90s led to a softening of the constraints placed on pension funds, effectively giving them more latitude to reallocate away from fixed income securities. In the early 2000s, pension funds owned more than 25% of the Treasury market, compared to 14% today (Chart 3). As is explained below, pension fund Treasury holdings, in the aggregate, are principally determined by demographics and pension plan funded status. Funded Status Chart 4It's All About Funded Status For Pension Funds Pension plan funded status represents the difference between the present value of pension fund liabilities and assets. Ideally, funded status should remain close to 100%, but it has deteriorated during the past 20 years. When the funded status is lower, pensions often choose to take more risk in the hopes of “catching up”. “Catching up” means that pensions will decrease their holdings of Treasuries in order to invest more in riskier assets (Chart 4). On the flipside, funded status improvements cause pensions to de-risk their portfolios by moving back into the safety of U.S. Treasuries. Chart 4 shows that pension funded status and pension fund Treasury holdings are positively correlated over time. Interest rates are an important determinant of funded status. Lower (higher) interest rates lead to deteriorating (improving) funded ratios. This correlation holds for two reasons. Low interest rates mean that plans earn less income from their asset portfolios, and they also inflate the present value of plan liabilities. Conversely, high interest rates increase plan investment returns and dampen the present value of plan liabilities. The relationship means that pensions tend to increase their Treasury holdings as rates rise and decrease their holdings as rates fall.  Outside of interest rates, stock market performance is the most important determinant of plan funded status. Pension funds usually maintain something close to a 60/40 split between equities and bonds. As such, equity market outperformance forces pension funds to buy more Treasuries in order to keep these weights balanced. Periods of strong stock market performance also improve plan funded status, leading to even more Treasury buying. Demographics Demographic trends dictate the amount of assets that pension funds have to invest in the first place. Arguably the most important demographic trend is the ratio of retirees to workers. When that ratio is low, many more people are paying into pensions than are withdrawing money, leading to greater pension fund security holdings – including Treasuries. Conversely, a higher ratio of retirees to workers means that pension funds have fewer assets to invest. For many years, the ratio of retirees to workers had been flat, around 15%, before it started to rise rapidly when the first baby boomers started retiring around 2009 (Chart 4, bottom panel). Projections show the ratio continuing to increase through 2050, suggesting that demographics are no longer a tailwind for pension fund Treasury holdings.  The Fed will always be a source of demand for Treasuries. The ratio of retirees to workers also impacts pension plan funded status. The increasing number of retirees relative to workers means pension funds are experiencing more cash outflows, from more individuals tapping into their plans, than inflows from the working population. All else equal, this translates into more underfunded pensions. Notice how the pick-up in old-age dependency ratio coincides with the deterioration in plan funded status (Chart 4, panels 1 & 4). Bottom Line: Pension funds will probably increase their Treasury purchases between now and the end of the economic recovery. The Fed will need to deliver further rate hikes before the next recession hits, and higher interest rates along with continued stock market gains will lead to an improvement in plan funded status on a cyclical horizon. But structurally, demographic trends point to fewer pension fund assets under management and worse plan funded status in the long-run. Pension fund Treasury demand should be lower during the next economic recovery than it is during the present one. Federal Reserve Chart 5Normalization Under Way: Do Not Disturb The Fed has always been an important actor in the Treasury market, though historically it focused mostly on T-bills. But the extraordinary measures taken during the Great Financial Crisis significantly increased the size of the Fed’s balance sheet and made it a major market player. The Fed’s Treasury holdings peaked at 19% of the market in 2015 (Chart 5). In October 2017, the Fed started unwinding its balance sheet by gradually letting its assets – essentially Treasuries and Agency MBS - mature without reinvesting the proceeds. The amount of assets that could leave the balance sheet that way followed predetermined monthly caps, which reached $30 billion for Treasuries and $20 billion for MBS in October 2018. So far, $371 billion of Treasuries and $245 billion of MBS have left the Fed’s balance sheet since the beginning of the runoff. But now, the Fed’s balance sheet run-off is nearly complete, and last March the Fed provided a detailed roadmap for its final stages. Beginning in October 2019, the Fed will maintain its overall assets constant, which we project should be in the vicinity of $3.54 trillion (Table 1).3 Meantime, MBS will continue to run off, but this time, the proceeds will be reinvested into Treasuries. Put differently, the Fed will once again become an active buyer of Treasuries, by the amount of MBS that runs off, which will be no more than $20 billion per month. Table 1Simplied Fed Balance Sheet Projections The policy of keeping its assets constant ensures that the supply of bank reserves will continue to shrink. This is because the Fed’s other non-reserve liabilities – mostly currency in circulation – will continue to grow. If we assume that (i) the Fed allows bank reserves to shrink until the end of 2020, (ii) MBS run off the balance sheet at a pace of $15 billion per month and (iii) currency in circulation grows by 5% per year, then we calculate that the Fed will add close to $200 billion of Treasuries by the end of next year. Alternatively, the Fed could decide much earlier that bank reserves have shrunk to an appropriate level. In that case, Treasury buying would be higher. For example, if the Fed decides to keep the supply of reserves flat as of the end of Q1 2020, we calculate that it would buy $267 billion of Treasuries between now and the end of 2020. In the very long run, the Fed’s balance sheet normalization plan also involves transitioning back to a Treasury-only portfolio. While it will take years to implement, it means that, ultimately, the $1,484 billion of MBS currently on the balance sheet will be converted into Treasuries. Bottom Line: The Fed will always be a source of demand for Treasuries. The normalization process that was initiated back in 2017 is now almost complete, and the Fed will start increasing its Treasury holdings in October. Treasury purchases will be modest at first, limited to the amount of MBS that runs off the Fed’s balance sheet, but they will accelerate once the Fed decides that enough bank reserves have been drained from the system. That decision could come as early as next year. Open-Ended Mutual Funds, ETFs & Money Market Funds Chart 6Growing Presence The combined Treasury holdings of open-ended mutual funds, ETFs and money market funds make them the fourth largest actor in the market, representing 12% of total supply (Chart 6).  Open-Ended Mutual Funds Bond mutual funds make up 28% of open-ended mutual funds total net assets (ex. money market funds). Following the financial crisis, the sustained shift into bond funds from equity funds and the growth of passive investing have been two of the major trends for the sector (Chart 7). According to the Investment Company Institute, actively managed equity mutual funds have experienced negative cumulative flows of $1.4 trillion post-crisis, while bond funds and passive equity funds registered $2.2 billion and $1.6 of inflows over the same period, respectively. Further, net new cash flows to bond mutual funds tend to correlate with bond market total return performance (Chart 7, bottom panel). Chart 7Bond Mutual Funds As Popular As Ever Finally, the fact that fixed-income funds are usually popular with retirees – who are more risk averse and are looking for a steady cash flow – ensures that there is still more upside in the Treasury buying of these funds, based on aging population and the baby boomers retiring. Exchange-Traded Funds (ETFs) The growth of passive investing, driven by lower fees, has benefitted ETFs. They now hold 1% of the Treasury market, driven by bond ETFs’ net assets growing at double digits since the end of the financial crisis. We expect this trend will continue and for ETFs to become a more active Treasury buyer. Money Market Funds Money market funds invest in very short-term assets and are divided into two broad categories: government money market funds that can only invest in government debt, and prime funds that can also invest in high-quality corporate debt. In October 2016, sweeping reforms on liquidity and maturity provisions adopted by the SEC resulted in prime funds becoming much less attractive to investors, leading to an increase in demand for government money market funds and thus indirectly raising the demand for Treasuries (Chart 8, top panel). Chart 8Money Market Funds' Drivers With that information in hand, we can turn to who invests in money market funds to assess what the demand for Treasuries will be. Households own 59% of money market fund shares, with nonfinancial corporations far behind with 15%. Money market funds experience inflows during tightening cycles, as short-term yields become more attractive (Chart 8, bottom panel). Periods of expensive equity valuation also coincide with more inflows, as individual investors put money on the sidelines (not shown). Bottom Line: Open-ended mutual funds, ETFs and money market funds have become major actors in the Treasury market. The rapid growth of ETFs, the shift to bond funds from equity funds and, more structurally, changing demographics, are all contributing trends that should not fade anytime soon;  expect more Treasury buying. Household Sector Chart 9Once Bitten Twice Shy? Household ownership has declined over time. In the early 1950s, households accounted for about 30% of Treasury ownership but that has fallen to a meagre 2% by 2007. Households have been buying Treasuries again since the financial crisis, and now hold 12% of the market (Chart 9). As would be expected, household Treasury ownership is highly correlated with the personal savings rate. A falling savings rate during the 1980s, 1990s and 2000s caused Treasury holdings to decline, but the shock of the financial crisis has led to more conservative household behavior and greater Treasury ownership. We should note that Federal Reserve data on household Treasury ownership includes some institutional investors such as onshore hedge funds. It is conceivable that the financial crisis has permanently shifted household preferences, leading to a much higher savings rate than in prior recoveries. However, high household wealth and elevated consumer sentiment suggest that the savings rate is more likely to fall than rise during the next couple of years (Chart 9, bottom 2 panels). We don’t see much more upside in household Treasury ownership. Bottom Line: Households have added to their Treasury holdings since the financial crisis. But as of today, the savings rate is more likely to fall than rise further. Expect household Treasury ownership to remain low for the next few years. Banks Chart 10Banks Haven't Been Active Buyers...Until Recently In the early 50s, banks accounted for more than 30% of Treasury ownership. Since then, it has steadily declined and now barely amounts to 5% of total securities outstanding (Chart 10). Simply put, banks haven’t been active buyers of Treasuries. But this is starting to change, albeit slowly, due to the regulatory burdens that have been imposed since the Financial crisis. Under Basel III, large U.S. banks are mandated to hold enough high-quality liquid assets (HQLAs) to cover 30 days worth of net cash outflows in a stressed scenario. The ratio between HQLAs and potential net cash outflows is called the Liquidity Coverage Ratio (LCR), and banks must maintain a LCR of at least 100%. HQLAs consist of Level 1 assets and Level 2 assets (which cannot exceed 40% of HQLA). Level 1 assets are bank reserves, cash and Treasury securities, and Level 2 assets are riskier securities such as Agency MBS and corporate bonds. A haircut is applied to level 2 assets for calculating HQLA. With reserves and Treasuries being interchangeable from the perspective of the HQLA calculation, the fact that the Fed is currently shrinking the supply of reserves means that banks might need to increase their Treasury buying to compensate for it. A great deal of Treasury buying will probably not be necessary to compensate for the Fed shrinking the supply of reserves. Based on disclosures from the eight U.S. Systemically Important Financial Institutions (SIFIs) – who have close to $500 billion of reserves held at the Fed – a great deal of Treasury buying is probably not necessary. As shown in Table 2, although these banks display a large degree of heterogeneity in their approaches to meeting their LCR requirements, they all enjoy decent buffers above the 100% minimum requirement. In other words, they can allow the supply of bank reserves to shrink and still maintain LCR compliance with minimal Treasury buying. Table 2 also shows that, on average, reserves represent 19% of the SIFIs’ eligible HQLA, implying these banks are not overly dependent on reserves to comply with Basel III. Table 2Simplied Fed Balance Sheet Projections In a 2017 paper, Ihrig, Kim, Kumbhat and Vohtech4 observed the following: [D]uring the run-up to becoming LCR compliant, banks in aggregate took on a significant quantity of excess reserves. However, after becoming compliant, many such banks adjusted their liquid holdings, reducing their stocks of reserve balances and raising their holdings of other HQLA components, presumably to achieve a more optimal configuration. Table 3Factors Affecting Demand For Reserves This suggests that, subsequent to LCR implementation, decisions regarding reserve holdings for banks may either be tied to daily business operations or rely on a risk-return decision framework. These findings are corroborated by the answers provided by the 51 banks surveyed by the Federal Reserve in the Senior Financial Officer Survey published last September. As shown in Table 3, the factors affecting their respective demand for reserves ranked as “important” or “very important” have to do with self-imposed and internal controls or daily business operations. Only 37% of the respondents ranked the HQLA requirement as an important factor. Bottom Line: The shrinking supply of bank reserves will probably lead to greater Treasury buying from banks, but a surge in bank Treasury demand is unlikely. Banks are already compliant with the Liquidity Coverage Ratio, and their High-Quality Liquid Asset balances are not overly dependent on reserves. Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm  3 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcarsearch.com 4 https://files.stlouisfed.org/files/htdocs/publications/review/2019/07/12/how-have-banks-been-managing-the-composition-of-high-quality-liquid-assets.pdf

While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (see chart). Bottom Line: On a cyclical 3-12 month time horizon we remain cautious on the broad equity market.

Highlights Portfolio Strategy Despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (Chart 1). Chart 1Mind The Positive Correlation As we highlighted recently, we remain perplexed that stocks are diverging from earnings.1 Anticipating a flush global liquidity backdrop (i.e. global central banks increasing their reflationary efforts) likely explains this dynamic as the former should ultimately rekindle economic growth, which in turn should boost profit growth. However, the disinflationary fallout from the ongoing manufacturing recession and the petering out in the global credit impulse signal that the liquidity pipes remain clogged. We recently read and re-read the Bank For International Settlements (BIS) Hyun Song Shin’s “What is behind the recent slowdown” speech where he eloquently argues that the global trade deceleration predates last spring’s U.S./China trade dispute.2 Shin has a compelling argument blaming the growth deceleration on the drop in manufactured goods global value chains (GVC) and he depicts this as global trade trailing global GDP (top panel, Chart 2). Interestingly, despite the V-shaped recovery following the Great Recession, global trade never really regained its footing, failing to surpass the 2007 peak. Shin then links this slowdown in global supply chains to financial conditions and the role that banking plays in global trade financing. The middle panel of Chart 2 shows that the GVC move with the ebbs and flows of global banks. In other words, healthy banks tend to boost global trade and vice versa. Finally, given that most trade financing is conducted in U.S. dollars, the greenback’s recent appreciation also explains trade blues. Simply put, decreased availability of U.S. dollar denominated bank credit as a result of a rising greenback is another culprit (U.S. dollar shown inverted, bottom panel, Chart 2). Ergo, there is no miracle cure for the sputtering world economy, especially given the recent re-escalation in global trade tensions and the stubbornly high U.S. dollar, and the gap between buoyant share prices and poor profit performance is likely to narrow via a fall in the former. Two weeks ago we highlighted that foreign sourced profits for U.S. multinationals are under attack as BCA’s global ex-U.S. ZEW survey ticked down anew (top panel, Chart 3). Tack on the global race to ZIRP (and in some cases further into NIRP) and it is crystal clear that the profit recession has yet to run its course. Chart 2Grim Trade Backdrop... Chart 3...Will Continue To Weigh On Foreign Sourced Profits   Meanwhile, China is likely exporting its deflation to the rest of the world and until its business sector regains pricing power, U.S. profits will continue to suffer (bottom panel, Chart 3). Turning over to U.S. shores and domestic corporate pricing power, the news is equally grim. Our pricing power proxy is outright contracting and warns that revenue growth is also under duress for U.S. corporates. Similarly, the ISM manufacturing prices paid subcomponent fell below the 50 boom/bust line and steeply contracting raw industrials commodities are signaling that 6%/annum top line growth for the SPX is unsustainable (Chart 4). On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Chart 4Sales Pressures... Chart 5...Are Building Rapidly Melting inflation expectations and the NY Fed’s softening Underlying Inflation Gauge (UIG) best encapsulate this softening revenue backdrop and warn that any further letdown in inflation risks sinking S&P 500 sales growth below the zero line (Chart 5).   Netting it all out, despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. What follows is a recap of recent (mostly) defensive moves in the health care, consumer staples, materials, tech, consumer discretionary and communication services sectors.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   S&P Health Care (Overweight) Upgraded from Neutral S&P Health Care Equipment (Overweight) Upgraded from Neutral Fear-based sell-off created a buying opportunity in the U.S. health care equipment index as fundamentals remain upbeat. Rising U.S. medical equipment exports are a tailwind for this health care subgroup as 60% of its revenues are generated outside the United States (second panel). The EM demographic shift (not shown) represents yet another boost to the sector as U.S. companies are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Our move to upgrade the S&P health care equipment index also pushed the entire health care sector from neutral to overweight (bottom panel). S&P Health Care S&P Managed Health Care (Overweight) Upgraded from Neutral The Bernie Sanders “Medicare For All” bill reintroduction created a buying opportunity in the S&P managed health care index and we were swift to act on it in mid-April. Contained industry cost factors including wages staying at the 2% mark help preserve industry margins (bottom panel). Melting medical cost inflation signals that HMO profit margins will likely expand (third panel). Overall healthy labor market conditions with unemployment insurance claims probing 60-year lows should underpin managed health care enrollment (top & second panels). S&P Managed Health Care   S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight A deteriorating macro landscape reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. Treasury yield and melting inflation make a compelling case for an overweight stance in the S&P Hypermarkets index (top & second panels). Similarly, safe haven soft drinks stocks shine when economic conditions are deteriorating (third panel). This defensive pure-play consumer goods sub-sector is also enjoying a rebound in operating metrics, and thus it no longer pays to stay bearish. We lifted exposure to neutral last week, locking in gains of 5.5% since inception. S&P Hypermarkets   S&P Materials (Neutral) Downgraded from Overweight S&P Chemicals (Underweight) Downgraded from Neutral Global macro headwinds continue to weigh on this deep cyclical sub-index as the risks of a full-blown trade war will likely take a bite out of final demand (third panel). Chemical producers garner 60% of their revenues from abroad and falling U.S. chemical exports are troublesome for this index (top & second panels). Given that chemicals have a 74% market cap weight in the S&P materials index, our move to underweight on the sub-index level also pushed the entire S&P materials index to neutral from overweight. S&P Materials   S&P Technology (Neutral) Downgrade Alert S&P Software (Overweight) Lifted trailing stops As a part of our portfolio de-risking measures, we put a 27% profit-taking stop loss on our overweight S&P software index call on June 10. Once triggered, a downgrade to neutral in the S&P software index would also push our S&P tech sector weight to a below benchmark allocation. Meanwhile, our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). S&P Technology   S&P Technology Hardware, Storage & Peripherals (Neutral) Downgraded from Overweight As nearly 60% of the revenues for the S&P technology hardware, storage & peripherals (THS&P) index are sourced from abroad, deflating EM currencies sap foreign consumer purchasing power and weigh on the industry’s exports (third panel). Global export volumes have sunk into contractionary territory, to a level last seen during the Great Recession (not shown) and underscore that industry exports will remain under pressure. The IFO World Economic Survey confirms this challenging export backdrop as it is still pointing toward sustained global export ails (second panel). As a result, all of this has shaken our confidence in an overweight stance in the S&P THS&P and we were compelled to move to the sidelines in early June for a modest relative loss since inception. S&P Technology Hardware, Storage & Peripherals S&P Consumer Discretionary (Underweight) Upgrade Alert S&P Home Improvement Retail (Neutral) Upgraded from underweight In the July 8 Weekly Report, we put the S&P consumer discretionary sector on an upgrade alert as this early-cyclical sector benefits the most from lower interest rates (bottom panel). The way we will execute this upgrade will be by triggering the upgrade alert on the S&P internet retail index. Melting interest rates and rebounding lumber prices are a boon for home improvement retailers (HIR, second & third panels). Tack on profit-augmenting industry productivity gains and it no longer pays to be bearish HIR. S&P Consumer Discretionary S&P Homebuilders (Neutral) Downgraded from overweight Long S&P Homebuilders / Short S&P Home Improvement Retail Booked Profits Lumber represents an input cost to homebuilders (we booked profits of 10% in our overweight recommendation on May 22 and downgraded to neutral) whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it (third panel). On June 18, as part of our de-risking strategy, we locked in 10% gains in the long S&P homebuilders/short S&P home improvement retail trade that hit our stop loss and we moved to the sidelines. S&P Homebuilders S&P Telecommunication Services (Neutral) Upgraded from Underweight The recent escalation of the trade spat has pushed July’s Markit’s flash U.S. manufacturing PMI reading to 50 - the lowest level since the history of the data. Historically, relative S&P telecom services share price momentum has moved inversely with the manufacturing PMI and the current message is to expect a sustained rebound in the former (bottom panel). Rock bottom profit expectations and firming industry operating metrics signal that most of the grim news is priced in bombed out telecom services valuations (middle panel), and it no longer pays to be underweight. In late-May, we lifted exposure to neutral for 6% relative gains since inception. S&P Telecommunication Services S&P Movies & Entertainment (Overweight) Upgraded from Neutral Structural shifts in the streaming services industry marked a start of a pricing war with incumbents and new entrants fighting for market share, as evidenced by DIS’s pricing of their upcoming Disney+ service. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative S&P movies & entertainment share prices will narrow via a rise in the latter (top panel). Moreover, more dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. S&P Movies & Entertainment   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 2      https://www.bis.org/speeches/sp190514.pdf   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

The long global gold miners/short S&P oil & gas exploration & production pair trade hit our recently augmented trailing stop intraday yesterday, and we obeyed this stop and locked in gains of 12% since its July 15th inception. As a reminder, we have been increasingly using risk management techniques to protect our portfolio from the late cycle market turbulence.  Our view on the pair trade, first articulated in mid-July, has not changed and we remain cautious on the U.S. and global growth prospects. As such, more gains are expected in the long global gold miners/short U.S. oil producers pair trade, but not before a much needed breather. We will be looking to re-initiate this market-neutral trade once overbought conditions have been worked off and a better entry point emerges.  Bottom Line: Lock in the gains of 12% in the long global gold miners/short S&P oil & gas exploration & production pair trade via the long GDX:US/short XOP:US exchange traded funds and move to the sidelines for now, but stay tuned. 

Recently BCA editors hotly debated the interplay between the ISM manufacturing and ISM services surveys and the implications for the economy and most importantly for the equity market. While the ISM manufacturing is at best coincident with SPX momentum, the difference between ISM manufacturing and ISM services appears to have leading properties with regard to the stock market especially since the onset of the GFC. Manufacturing leads services as the former is the most cyclical and hyper sensitive part of the U.S. economy despite the 10% weight in GDP most developed markets’ manufacturing bases have. Such cyclicality is most evident in the relative survey results. In other words when manufacturing trails services, stocks suffer and vice versa (see chart). Recently the gulf between the surveys has been widening warning that equities will soon run out of steam. Bottom Line: Resist the temptation to add risk to your portfolio by chasing this market.  A cautious broad market cyclical (3-12 month horizon) stance is still warranted.

Highlights The global manufacturing cycle has averaged about three years in length (peak-to-peak). We are near the bottom of the current cycle, which should set the stage for a recovery phase lasting around 18 months. The global economy will start to slow in 2021, culminating in a recession in 2022. The long-term global disinflationary cycle is drawing to a close. Investors should remain bullish on risk assets for the next two years, but expect subpar returns over a longer-term horizon.  Feature The Wheels Are Turning BCA Research has a long and proud history of analyzing economic and financial market cycles. Three types of cycles, in particular, have proven to be important to investors: Short-term manufacturing cycles lasting roughly three years. Medium-term business cycles affecting the entire economy. Long-term supercycles that can span decades. These often involve significant economic, social and political changes. What Really Caused The Global Manufacturing Downturn? The latest global manufacturing downturn has been widely attributed to the escalation of the trade war, the Chinese deleveraging campaign, and the end of the “sugar rush” from the Trump tax cuts. We have no doubt that all these factors exacerbated the downturn. However, it is not clear whether they caused it. As Chart 1 illustrates, the Chinese deleveraging campaign began in late 2016, more than a year before the global manufacturing sector peaked. The trade war only heated up in the spring of last year, after manufacturing activity had already begun to roll over. The jury is still out on the extent to which U.S. corporate tax cuts spurred capital spending, as opposed to being funnelled into retained earnings and share buybacks. Regardless, the fact that capex has weakened less in the U.S. than abroad over the past 18 months suggests that the fading impact from U.S. tax cuts was not the main culprit (Chart 2). Chart 1Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chart 2The Capex Slowdown Has Been Less Severe In The U.S.   A Predictable Cycle Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom Lost in the discussion over the cause of the slowdown is that global manufacturing activity follows a fairly predictable three-year growth cycle: up for the first 18 months, down for the second 18 months (Chart 3). This is not an immutable law of nature, but it is a handy rule of thumb. The last growth cycle began in the late spring of 2016 and reached a crescendo in December 2017 (based on the global manufacturing PMI). For now, the global manufacturing sector remains in the doldrums, with this week’s worse-than-expected Markit PMI readings for both the U.S. and the euro area being prime examples. However, if history is any guide, activity should begin to rebound over the coming months. Global manufacturing activity follows a fairly predictable three-year growth cycle. The large improvement in the Philly Fed manufacturing PMI – arguably the most important of all the regional Fed manufacturing surveys1 – in July, strong U.S. core capital goods orders, as well as the slight uptick in Korean exports on a month-over-month basis, are positive signs in that regard. The same goes for the sales outlook of two manufacturing bellwether companies which reported earnings this week: United Technologies and Texas Instruments. The former manufactures Otis elevators, Carrier air conditioning/HVAC, and Pratt & Whitney jet engines. The latter’s components are widely used throughout the global semiconductor industry. Chart 4 shows that the semiconductor cycle closely tracks the overall manufacturing cycle. Chart 4Semiconductor And Manufacturing Cycles Tend To Overlap Cycles And Feedback Loops What drives the short-term manufacturing cycle? The answer is the same thing that drives all cycles: The existence of self-limiting feedback loops. In the case of the manufacturing cycle, the feedback loop is fairly straightforward to describe. A pickup in manufacturing sales boosts profits and creates new jobs. This causes consumer and business confidence to rise. Improving confidence leads to more sales, which generates even higher confidence. If that were all there was to the story, this virtuous cycle would never end. This is where the “self-limiting” part comes in. Most manufactured goods are durable goods, meaning that they retain value for some time after they are purchased. When spending on, say, automobiles or computers rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. This, in turn, will generate a negative feedback loop where falling sales lead to lower confidence and so forth. The glut will eventually shrink. Once enough pent-up demand has accumulated, a new upcycle will begin.  The Role Of Finance Banks and other financial institutions play a critical role in both perpetuating, and ultimately short-circuiting, the feedback loop described above. Business lending tends to ebb and flow with capital spending (Chart 5). It is not so much that one causes the other. It is better to think of the two as locked in a self-reinforcing tango: Faster output growth leads to more lending, and more lending leads to faster output growth. Chart 5The Ebb And Flow Of Lending And Capex Go Hand In Hand The amount of time it takes for the music to end, and for the dancers to part ways, varies from episode to episode. If both lenders and borrowers are feeling skittish, the party may never reach a fever pitch. While that may sound like a bad thing, it has the redeeming feature that imbalances never get a chance to reach critical levels. This brings us to today: Unlike in the pre-financial crisis period, when banks held Chuck Prince’s view that “as long as the music is playing, you’ve got to get up and dance,” lenders are more circumspect. This is a critical reason why we think the next U.S. recession is not imminent. Private-Sector Imbalances Remain Low In The United States Despite this being the longest U.S. expansion on record, the ratio of private debt-to-GDP is still well below where it was at the start of the decade (Chart 6). Chart 6U.S. Private Sector Leverage Remains Below Its Previous Peak Granted, corporate debt levels have scaled new highs. However, thanks to low interest rates, interest coverage ratios remain above their post-1980 average. This is true for the economy as a whole, as well as for the broad equity market (Chart 7). Chart 7AInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Chart 7BInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Spending on business equipment, new homes, and consumer durables also remains restrained. This explains why the average age of the U.S. capital stock has increased sharply since the Great Recession (Chart 8). Chart 8The Capital Stock Is Aging Public-Sector Imbalances On The Rise, But Not Yet At Critical Levels Chart 9The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The one area where clear imbalances in the U.S. are present is in public finances. The tentative deal between the Trump Administration and Congress to raise spending caps and increase the debt ceiling ensures that fiscal policy will stay accommodative for the foreseeable future. Unfortunately, the cost of this fiscal largesse is a budget deficit that is set to swell to $1 trillion (4.5% of GDP) in FY2020, up from $586 billion (3.2% of GDP) in FY2016. Financing this deficit over the next few years is unlikely to pose serious challenges because the private sector remains an ample source of savings (Chart 9). However, once this reservoir of savings starts to recede, bond yields could rise sharply.   Chinese Imbalances: How Much Of A Concern? Economic and financial imbalances are more pronounced abroad. In China, fixed investment spending has averaged 44% of GDP over the past decade. Debt levels have soared over this period. That said, much of this debt-financed investment should be regarded as a form of stimulus for an economy that suffers from a chronic shortfall of consumption. So far this year, the decline in Chinese private-sector fixed-asset investment has been counterbalanced by an increase in infrastructure spending (Chart 10). As in the U.S. and many other economies, abundant Chinese savings have allowed interest rates to stay low, thereby ensuring that borrowers are able to tap credit at favorable terms. We expect the Chinese authorities to continue stimulating their economy. Unlike in early 2017, credit growth is only modestly above trend nominal GDP growth (Chart 11). In addition, a stronger economy would give the Chinese government more leverage over trade negotiations. Chart 10China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending Chart 11China: The Deleveraging Campaign Has Been Put On The Backburner   A Turn In The Long-Term Inflationary Cycle? While the unemployment rate has returned to pre-recession levels in many economies, the scars from the Great Recession still remain. Nowhere is this more manifest than in the hypersensitivity that central banks have displayed towards bad economic news. Just as central bankers in the 1960s were fixated on avoiding the mass unemployment that accompanied the Great Depression, today’s central bankers are laser-focused on propping up demand at all costs. The new conventional wisdom is that the Phillips curve is dead. Chart 12 casts doubt on this assertion: It shows that the relationship between wage growth and various measures of labor market slack still seems very much alive and well. Chart 12A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... Chart 13...But No Imminent Threat Of A Wage-Price Inflationary Spiral Admittedly, faster wage growth has failed to push up inflation. However, this may be simply because productivity growth has sped up. In the U.S., unit labor cost inflation has actually decelerated sharply since late 2017 (Chart 13). If wage growth continues to grind higher, firms will have no choice but to start raising prices. This could set the stage for an upleg in the longer-term inflationary cycle.   Structural Forces: Not So Deflationary Anymore Once inflation starts to move higher, a number of structural forces could help it along. The period of hyperglobalization, which began with the collapse of the Soviet Union and the integration of China into the global economy, is over. The ratio of global trade-to-GDP has been flat for over a decade (Chart 14).  Chart 14Globalization Has Peaked Demographic trends are shifting from deflationary to inflationary. Now that baby boomers are starting to retire, they will begin running down their savings. Chart 15 shows that ratio of workers-to-consumers globally has begun to fall after a four-decade ascent. Chart 15The Worker-To-Consumer Ratio Has Started Shrinking Globally As more people retire, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The political winds are also blowing in the direction of higher inflation. Populism is on the rise. Whether it be right-wing populism or left-wing populism, the result is usually bloated budget deficits, compromised central bank independence, and productivity-reducing policies. Stagflation may once again rear its head. Investment Conclusions The path to higher interest rates is paved with lower rates, meaning that the longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. We expect the Fed to cut rates by 25 basis points next week, with another cut possible in September. The ECB and most other central banks are also in easing mode. The good news is that inflation is a notoriously lagging indicator (Chart 16). It will probably take at least a year for clear evidence of overheating to emerge in the U.S., and even longer abroad. The bad news is that once inflation breaks out, it could do so quite dramatically. The market is not prepared for this (Chart 17).     Investors should maintain a bullish stance towards risk assets for the next 12-to-18 months, before starting to scale back exposure. Not only are central banks becoming more dovish, but the global manufacturing cycle is about to turn up. Stronger global growth will lead to a weaker U.S. dollar (Chart 18). EM and European stocks will start to outperform U.S. stocks (Chart 19). Cyclicals will trump defensives. Chart 18The Dollar Is A Countercyclical Currency Chart 19EM And Euro Area Equities Outperform When Global Growth Improves     As global yield curves steepen anew, bank stocks will power higher. U.S. small caps, with their relatively high weighting in regional banks, will outperform their large cap brethren (Chart 20). Chart 20Big Has Crushed Small   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1    The manufacturing segment in the region covered by the Philadelphia Fed is representative of the national manufacturing sector and hence tracks the ISM manufacturing index better than the other regional Fed surveys. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades