Developed Countries

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.

Deutsche Bank's woes highlight a much wider malaise within European banks: under-capitalisation and under-profitability. We explain why getting the banks right is crucial to a successful investment strategy in equity, bond and currency markets.

Special Report

This week, we are reviewing all of our active trades discussed in the last twelve months, which are intended to be an overlay to our recommended fixed income portfolio.

U.S. bank stocks have been joined at the hip with the expected 12-month change in the Fed funds rate since 2014, based on the notion that a rate hike will boost net interest margins. However, even if the Fed hikes rates, that may do little to help bank profits. The lesson from the dismal performance of Japanese bank stocks in their era of extraordinarily low interest rates is that outperformance has only occurred within the context of a steepening yield curve. We place low odds on a steepening in the U.S. yield curve if the Fed raises interest rates, given the softening in leading economic and employment indicators, not to mention the anchoring of U.S. long-term Treasurys by the shortage of global government bonds. Instead, an end to the long-term U.S. bank share underperformance phase requires broad-based economic reacceleration that drives an upturn in credit growth, stabilization in deteriorating credit quality and steeper yield curve. Until then, stay underweight and please see yesterday's Special Report on bank stocks for more details.

There are two key risks that could derail a bear-flattening of the yield curve. The first is a Trump election victory, the second is a flaring of stress in the non-U.S. banking sector.

Special Report

Since 2014, market expectations of the Fed funds rate has been the primary driver of banks stock performance. Investors' heightened focus about the positive role of interest rate hikes on bank profitability has some merit because when interest rates are near the zero lower bound, net interest margins are unduly suppressed. However, a breakout in bank stocks requires much more than a hawkish Fed outlook: without a significant pick-up in top-line growth, there is no impetus for bank stocks to sustain rallies.

The DM Country Model favors the U.S., with Japan and U.K. being the two large underweights. The Sector Model continues to recommend a cyclical tilt.

Special Report

In a February <i>Special Report</i> titled "Assessing Fair Value In FX Markets" we introduced a set of long-term valuation models based on various fundamentals. We have updated the results and added KRW, INR, PHP, HKD, CLP and COP to our analysis. The dollar still remains expensive, albeit with no signs of a dangerous overvaluation. The yuan is now at its cheapest level since 2009.