Developed Countries

The S&P air freight & logistics index has been in a long relative performance funk, during which time valuations have been squeezed down to very attractive levels at a time when fundamentals should begin to improve. Business sales are rising relative to inventory. The top panel shows that when inventories are falling relative to GDP, it provides a tailwind to relative performance. Tight inventories intensify the need for rapid delivery services to ensure optimal supply chain management. When inventories are plentiful, there is less need for high-priced, just-in-time, air freight services. Thus, the rundown in inventories is a positive sign for future revenue growth. Even emerging markets are likely to contribute. Asian manufacturing inventories are being depleted, heralding an improvement in Asian air freight growth. Nevertheless, it is important to keep expectations in check, because deleveraging, protectionist/anti-globalization sentiment and low productivity growth globally will cap global trade growth potential. Still, burgeoning online retail sales growth is a boon for package delivery. While some large retailers may take delivery in-house, spillover onto traditional carriers is inevitable. The latest surge in online sales bodes well for an end to industry deflation. We upgraded this group to overweight, please see yesterday's Special Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD.

In a Special Report published yesterday, we showed that the transport relative performance bear market and valuation squeeze had already matched what has typically occurred during a recession. Consequently, any stabilization in underlying drivers of global trade could produce a positive share price outcome. Evidence supports the view that the long slump in world export growth is ending. Export volume growth in many emerging countries has climbed back into positive territory. These regions have been the epicenter of global goods production. Global export price deflation has eased, suggesting that some sort of new equilibrium has been established. Importantly, an inventory restocking phase could provide a fillip to overall export growth. Inventories have been rundown in the U.S. and other developed countries, while inventory-to-sales ratios in a number of developing countries have also rolled over. Inventory cycles are fleeting, and investment decisions should key off of overall final demand, but at current valuations, even small amounts of good news could lift the sector. Against a backdrop of productivity and profit margin resilience, the likelihood of a playable advance in the transport sector has increased, particularly in the S&P air freight index. The ticker symbols for the stocks in this index are: BLBG: S5TRAN - UNP, UPS, FDX, DAL, NSC, CSX, LUV, AAL, UAL, KSU, CHRW, EXPD, ALK, JBHT, R.

With recent comments strongly hinting that the Fed is on track for a rate hike in December, the dy-namics of the Fed Policy Loop make spread product appear extremely vulnerable.

Special Report

Transport stocks have discounted a recession, trading below trough bear market relative valuations. That is too cheap given signs of stabilization in global export growth.

The August payrolls report did not change our view that a Fed rate hike is likely in December, but not before that.

Yesterday we showed an Insight with financial sector relative performance and the yield curve, with the message that the sector's more defensive components outperform while the curve is flattening, as is currently the case. We view the consumer finance group as a positive exception. An extremely attractive valuation starting point and a low correlation between the industry's net interest margins and the government yield curve provide confidence that a new bull run is getting underway. Indeed, the chart shows that the credit card interest rate spread has widened in recent months, even as the Treasury curve has narrowed. Importantly, the personal savings rate has room to decline (top panel), if a decent job market continues to lift consumer income expectations (bottom panel). That will support ongoing growth in revolving consumer credit and low delinquencies, two critical profit drivers. The bottom line is that consumer finance stocks should follow a similar bullish path to the consumer discretionary, media and most domestic consumption-oriented plays, and we reiterate an overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5CFIN - AXP, COF, DFS, SYF, NAVI.

The dollar is likely to enter the bubbly stage of its bull market within the next 12 months. The key culprit for this move will not be the Fed, but easing by non-U.S. central banks. The euro area economy could enter a temporary soft patch, but this will not result in an imminent easing by the ECB.

The neutral real rate of interest, r*, is likely to remain depressed for the foreseeable future. The Fed is likely to take additional incremental measures to boost long-term inflation expectations, including allowing inflation to overshoot its 2% target more frequently. This should be enough to keep long-term Treasury yields on a gradual upward trajectory.

The financial sector has enjoyed a modest respite as the market has pulled forward Fed rate hike expectations. However, we doubt that will last long if the yield curve continues to narrow and the U.S dollar firms, importing deflationary pressures into the U.S. Historically, a flat yield curve has signaled that monetary policy is too tight and that an economic downturn loomed. An inverted yield curve accurately predicted major market tops in 2000 and 2007, as well as shorter but sharp market declines in 1990 and 1998. The yield curve continues to narrow as the Fed lowers its terminal rate forecast and the insatiable global search for yield persists. It will not take many Fed rate hikes for the yield curve to completely flatten or invert. As such, we continue to deemphasize the overall financial sector, preferring its less cyclical components such as REITs and insurance, which stand a better chance of outperforming as the curve flattens.

If the Fed convinces markets it is on track to lift rates this year and a couple of times next year, we expect a 10% appreciation of the USD over the next 12 months. This would be extremely bearish for commodities.