Sectors

Neutral In a report late last month, we noted that our overweight recommendation on S&P homebuilders had generated alpha in excess of 10% for our portfolio, despite being offside early. However, we further noted a softening in some housing related data that gave us pause, particularly in the context of a trade that had provided outstanding gains, and we added a downgrade alert and set a stop sell order at the 10% relative return mark. That mark was breached on Monday; accordingly, and in a continuation of our progressive derisking of the portfolio, we have lowered our recommendation on the S&P homebuilders index to neutral. We continue to fear that if a generalized risk-off phase materializes, yields will fall but homebuilders will not participate in the bond rally. That is not to say we have grown negative on U.S. housing in general; on the contrary, we continue to explore a bullish housing view via our long S&P homebuilders/short S&P home improvement retailers pair trade. Clients should look forward to next week’s Weekly Report for an update on the latter of these sectors. Bottom Line: Downgrade S&P homebuilders to neutral, crystalizing gains of 10%. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, DHI, PHM.

Highlights Portfolio Strategy Macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Downgrade to a below benchmark allocation. At the margin deteriorating domestic conditions, along with a sustained softness in global growth indicators that are prone to an additional setback given the rising trade policy uncertainty suggest that it is prudent to move to the sidelines on the long materials/short utilities pair trade. Recent Changes Downgrade the S&P chemicals index to underweight, today. This also pushes the S&P materials sector’s weight back down to neutral. Close the long S&P materials/short S&P utilities pair trade, today. Table 1 Feature The SPX suffered its first 5% pullback for the year early last week, and now that President Trump has opened Pandora’s Box, there are high odds that equities will continue to seesaw, at least, until the late-June G20 meeting when the heads of states meet again. Since early-March we have been, and remain, cautious on the short-term equity market outlook as a slew of our tactical indicators have soured. Chart 1 shows three additional non-confirming equity market breakout indicators that are exerting downward pull on the SPX. Stock correlations have increased (shown inverted, top panel, Chart 1), junk spreads have widened (shown inverted, middle panel, Chart 1) and the NYSE’s FANG+ Index has run out of steam (bottom panel, Chart 1). Now the risk is, as we first highlighted in the middle of last week, that the back half of the year global growth reacceleration phase goes on hiatus as this trade policy uncertainty further shatters CEO confidence and global exports remain downbeat (Chart 2). Chart 1Non-Confirming Indicators   Chart 2Stalled Export Engine Worrisomely, a number of our cyclical indicators are also firing warning shots. Not only did the ISM’s manufacturing new orders-to-inventories ratio breach parity, but also BCA’s boom/bust indicator took a turn for the worse (Chart 3). Importantly, while a lot of ink is spent on how the U.S. economy is beyond full employment, labor markets are tight and the output gap has closed, resource utilization has petered out – interestingly at a lower high compared with the previous two peaks. This backdrop points to more stock market turmoil in the coming months, similar to the mid-2015 message (Chart 4). Chart 3Cyclical Trouble Brewing   Chart 4No Tightness Here Tack on China’s cresting credit impulse and factors are falling into place for a tumultuous back half of the year (bottom panel, Chart 3). Keep in mind that the two ultimate “risk off” indicators we track remain tame and underscore that investor complacency remains elevated: the TED spread is at 16bps and the Japanese yen has barely budged of late. This is worrying and suggests that investors expect a positive U.S./China trade resolution (USD/JPY shown inverted, Chart 5). Chart 5No Real Risk Off Phase Yet Were the equity markets to spin out of control however, the “Fed put” remains in place and would save the day. While the Fed has taken down the median dots and projects no hikes for the rest of the year and a single hike next year, the message from the bond market is diametrically opposite. Thus, we are de-risking our portfolio and this week we are downgrading a deep cyclical sector to neutral and also closing an explicit cyclical/defensive pair trade. Chart 6 shows that over 40bps of cuts are priced in by May 2020, according to the OIS curve. Historically, this has been an excellent leading indicator of the annual delta in the fed funds rate. Our takeaway is that the Fed remains the only game in town and were another mini-riot point to occur, then the Fed would not hesitate to step in and put a floor under the equity market. Chart 6The Bond Market Has The Stock Market’s Back In sum, the risks are rising for a prolonged consolidation phase in equities on the back of a trade war escalation that pushes out the global growth recovery to early-2020. Thus, we are de-risking our portfolio and this week we are downgrading a deep cyclical sector to neutral and also closing an explicit cyclical/defensive pair trade. Chemical Reaction We have been on the sidelines on the heavyweight S&P chemicals index of late (it comprises 74% of the S&P materials sector), but factors have now fallen into place and warrant a below benchmark allocation. First, global macro headwinds will continue to weigh on this deep cyclical index as the risk of a full blown trade war will likely take a bite out of final demand. Chemical producers garner 60% of their revenues from abroad (a full 20 percentage points higher than the SPX) and thus are extremely sensitive to the ebbs and flows of emerging markets economic growth in general and China in particular. Adding it all up, macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Chart 7 shows that U.S. chemical products exports are contracting and if the greenback sustains its recent upward trajectory given heightened global trade policy uncertainty, further global market share losses are likely at a time when the overall chemicals market will be shrinking. With regard to China specifically, the recent drop in the credit impulse is far from reassuring (bottom panel, Chart 3) and, assuming that the Chinese authorities will await a riot point prior to really opening up the credit spigots, more pain lies ahead for U.S. chemical exports. Second, the picture is not brighter on the domestic front. Importantly, the American Chemical Council’s Chemical Activity Barometer is nil, warning that domestic end-demand is also ailing (Chart 8). Chart 7Hazard Warning Chart 8Toxic Profit Prospects Tack on a surprisingly persistent jump in industry headcount (bottom panel, Chart 9), and the implication is that waning productivity will slash chemicals profits (bottom panel, Chart 8). Finally, a number of other operating metrics are languishing. Chemicals railcar loads are outright contracting and the softening ISM manufacturing survey points to further downside in the coming months (middle panel, Chart 9). The chemicals shipments-to-inventories ratio is also in contraction territory as this downbeat demand has been met with a buildup in inventories both at the wholesale and manufacturing levels. As a result, a liquidation phase has ensued and chemicals selling prices have sunk into the deflation zone (middle & bottom panels, Chart 10). Chart 9Deficient Demand Chart 10Liquidation Phase Adding it all up, macro headwinds, deficient demand along with rising chemicals stockpiles that have dealt a blow to industry pricing power warn that chemicals stocks are on the verge of a breakdown. Bottom Line: Trim the S&P chemicals index to underweight. Given the 74% weight chemicals stock have in the S&P materials sector, this move also pushes the S&P materials sector’s (Chart 11) weight to neutral from overweight, and we crystalize modest losses of 5.2% in this niche deep cyclical sector. The ticker symbols for the stocks in the S&P chemicals index are: BLBG: S5CHEM – DWDP, ECL, SHW, PPG, IFF, CE, ALB, LIN, APD, DOW, LYB, FMC, CF, MOS, EMN. Chart 11Trim Materials Back Down To Neutral Materials/Utilities: Move To The Sidelines While we were early in identifying a reflationary impulse from the Chinese authorities and put on an explicit cyclicals/defensives pair trade to capitalize on this opportunity at the end of January, the long materials/short utilities pair trade has failed to live up to its expectations, and today we recommend moving to the sidelines. Such a move is part of our de-risking of the portfolio given the rising global macro headwinds on the horizon we identified earlier. More specifically on the domestic front, our Economic Impulse Indicator (EII) suggests that beneath the surface some cracks are appearing in the U.S. economy. The EII encapsulates six parts of the U.S. economy and on a second derivative basis, softness is apparent (top panel, Chart 12). The ISM manufacturing survey corroborates this message and is also flirting with the boom/bust 50 line, signaling that it is prudent to take some risk off the table (bottom panel, Chart 12). The bond market is sniffing out this deteriorating domestic backdrop and the recent 25bs drop in the 10-year Treasury yield has breathed life into utilities and sucked the oxygen out of materials. Fixed income proxies are also benefiting from the drubbing in Citi’s Economic Surprise Index to the detriment of growth-sensitive deep cyclicals. The melting stock-to-bond ratio reflects all these domestic forces and warns against preferring materials to utilities stocks (Chart 13). Chart 12Move To The Sidelines Chart 13Mushrooming Domestic… The specter of a re-escalation in the trade war will not only continue to weigh on some domestic indicators, but gauges monitoring the health of the global economy will also suffer a setback. Already, our Global Activity Indicator has lost its spark, underscoring that global export volumes will continue to contract. King Dollar is also flexing its muscles, especially versus vulnerable twin deficit emerging market countries which saps economic growth. Tack on the derivative deflationary effect the appreciating greenback has on the commodity complex and materials stocks are at a great disadvantage versus domestic focused utilities (Chart 14). A number of additional global growth indicators are waning and signal that relative profitability will move in favor of utilities and at the expense of materials in the coming months. BCA’s global synchronicity indicator, which gauges the number of countries with a PMI above versus below 50 is sinking like a stone. In fact, the overall global manufacturing PMI is just barely above the expansion/contraction line and global industrial production is decelerating. All of this is a net negative for the deep cyclical materials sector, but a net positive for defensive utilities stocks that sport nil foreign sales exposure (Chart 15). Chart 14…And Global Growth… Chart 15…Worries But before getting outright bearish on this pair, there is a powerful offset. Likely, most of the bad news is reflected in bombed out relative valuations and oversold technicals. This actually also prevents us from fully reversing the trade and buying utilities at the expense of materials. A move to the sidelines is more appropriate (Chart 16). At the margin deteriorating domestic conditions, along with a sustained softness in global growth indicators that are prone to an additional setback given the rising trade policy uncertainty suggest that it is prudent to move to the sidelines on the long materials/short utilities pair trade. Bottom Line: Book losses of 5.3% in the long S&P materials/short S&P utilities pair trade and move to the sidelines.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Chart 16Saving Grace   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

In late-January we put on a market, sector and subindustry neutral trade preferring homebuilders to home improvement retailers (HIR) as a way to benefit from the increase in residential construction at the expense of residential investment. This trade moved in the black from the get-go and is now generating alpha to the tune of 10% since inception, but more gains are in store in the coming months. President Trump’s hawkish tariff rhetoric should keep interest rates at bay, at least for a short while, and bond market nervousness is more of a boon to homebuilders than to HIR (top panel). The drop in the price of mortgage credit along with minor price concessions from homebuilders are causing sales of new homes to take off versus existing home sales (middle panel). Granted, bankers remain willing extenders of residential loans and the latest Fed Senior Loan Officer Opinion Survey revealed that demand for residential credit is making a comeback following a near yearlong decline (not shown). As a result, relative loan growth metrics also underpin the relative share price ratio (bottom panel). Bottom Line: Stick with a long S&P homebuilders/short S&P HIR pair trade and please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in the S&P homebuilding and S&P HIR indexes are: BLBG: S5HOME – PHM, DHI, LEN and BLBG: S5HOMI – HD, LOW, respectively.    

While we remain bullish on global equities and other risk assets over 12 months, we went tactically short the S&P 500 last Friday following the market’s complacent reaction to the Trump Administration’s further tariffs increases on Chinese imports. While a moderate trade war would still produce more economic damage than standard economic models imply, this would be greatly mitigated by significant Chinese economic stimulus and a Fed that is in no hurry to raise rates and could even cut rates. Barring any further major developments, we recommend investors start increasing risk exposure if the S&P 500 falls to 2711. A dip in global bourses would also create an opportunity to go overweight EM/European equities. Favor gold over government bonds as a low-cost hedge against trade war risks for now.

While health care and tech stocks started the year on a similar footing, a wide gulf has opened that is likely to, at least partially, reverse in the back half of the year. This dichotomy is most evident at the subsector level where managed health care stocks are still down in absolute terms for the year, whereas chip stocks are up roughly 20% year-to-date. This is an exploitable gap and on Monday, we suggested a new pair trade: long S&P managed health care/short S&P semiconductors. With regard to relative macro drivers, managed health care has the upper hand. The chart at the side shows that relative demand dynamics clearly favor HMOs and are working against chip stocks. Non-farm payroll growth is trouncing global semi billings (second panel). The message from the small business sector is similar with the labor market upbeat compared with declining global semi revenues (third panel). Finally, on the relative pricing power gauge front, overall wage inflation is outpacing DRAM prices (bottom panel). Bottom Line: We initiated a long S&P managed health care/short S&P semis pair trade on Monday with a stop loss at the -7% mark; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively.

Highlights The trade war escalation is just the catalyst and not the cause of the market correction. This year’s absolute double-digit returns have most likely already been made during the early-2019 star alignment of near-perfect conditions for investors. The remainder of the year is likely to be a much tougher going for all the major asset-classes. Short a 30:60:10 portfolio of equities, bonds, and oil, setting the profit target and stop-loss at 3 percent. In the second half of the year, the big story will be sector rotation. Healthcare is likely to flip from underperformer to outperformer versus technology. Given their sector skews, it follows that European equities are likely to outperform Chinese equities. Feature A star alignment of near-perfect conditions lifted the entire financial market complex in the early part of the year. For investors, pretty much everything that could go right did go right! (Chart of the Week). Chart of the WeekIn Near-Perfect Conditions, European Equities Performed Very Well... But Chinese Equities Performed Even Better The Federal Reserve stopped hiking interest rates; the ECB and other major central banks also pivoted to dovish; Brexit was delayed; the Italy versus Brussels spat over fiscal policy de-escalated; the drag from new emissions standards on German auto production eased; the trade war threat seemed to recede; and crucially, economic activity accelerated sharply (more about this later). A Rare Star Alignment… Which Cannot Last There was another rare star alignment: equities, bonds, and crude oil generated simultaneous strong rallies (Chart I-2). Such a star alignment is almost unheard of, because there are no set of economic circumstances that should benefit all three asset-classes at the same time. For example, if the oil price surge is inflationary – or at least less deflationary – then it should hurt bonds; if the surge is deflationary on real demand, then it should hurt equities. Equities, bonds, and oil should not surge together. Equities, bonds, and oil should not surge together, and on the extremely rare occasions they do, the simultaneous rally soon breaks down. Consider a €100 investment portfolio consisting of €30 equities, €60 long-dated bonds, and €10 crude oil. At the start of this year, the portfolio returned 10 percent in just three months. This is extremely rare, and has happened on only two other occasions in the past 25 years, in 2009 and 2016 (Chart I-3). Chart I-2A Rare Star Alignment:##br## Equities, Bonds, And Oil Surged ##br##Simultaneously Chart I-3A Rare Star Alignment: A 30:60:10 Portfolio of Equities: Bonds: Oil Gained 10 Percent In 3 Months On both previous occasions, the simultaneous rally broke down, and the portfolio went on to lose a large chunk of its 10 percent gain. Hence, at our quarterly webcast last week, we initiated a new investment recommendation: to short a 30:60:10 portfolio of equities, bonds, and oil, setting the profit target and stop-loss at 3 percent.1 When conditions are perfect, they are vulnerable to the tiniest setback. But the vulnerability emanates from the fragility of the perfect conditions, and not the precise setback. As an analogy, visualize a tree bedecked in its beautiful foliage in the autumn, and imagine you gently shake the tree. The gentlest of shakes will make the leaves collapse. At first glance, your shake caused the collapse, but in truth, your shake was just the catalyst; the underlying cause was the fragility of the autumnal foliage. Another catalyst, say a puff of wind, could have equally triggered the same collapse. When conditions are perfect, they are vulnerable to the tiniest setback. The re-escalation of the trade war has dominated the recent column inches and investment analyst missives. But just like the gentle shake of the tree, it is just a catalyst for the market correction. The underlying cause was that the simultaneous and strong rallies in all financial assets, based on a star alignment of near-perfect conditions, was vulnerable to the first blemish to the perfection. And the blemish could have been anything. Economic Activity Has Undoubtedly Accelerated… One of the things that drove up equity markets was the acceleration in economic activity. This acceleration is beyond doubt: euro area GDP prints show that growth picked up to 1.6 percent in the first quarter of 2019 from a low of 0.6 percent in the third quarter of 2018 (Chart I-4). Given the openness of the euro area economy, it is inconceivable that this growth pick-up does not reflect a more generalized acceleration in global activity.2 Chart I-4Euro Area GDP Growth Accelerated To 1.6 Percent The trouble is that we do not receive these GDP prints in real-time. From the mid-point of the quarter to which the GDP prints refer to their release date around one month after the quarter end, there is a two and a half month delay. To proxy activity in real-time, we must look at current activity indicators (CAIs) which gauge GDP growth, but are available without much of a delay. While several such indicators exist, we have found that the ZEW economic sentiment indicator (not to be confused with the current situation indicator) does the job extremely well in real-time. Current activity indicators do not help equity investors. Having said that, current activity indicators do not help equity investors. The simple reason is that the equity market is a current activity indicator itself, and it would be absurd to expect one CAI to predict another CAI! In fact, the best current activity indicator is not the equity market taken as a whole. This is because the aggregate equity market can move as a result of drivers other than current economic activity, most notably central bank policy. Therefore, it turns out that the very best current activity indicator is found within the equity market: specifically, the performance of economically sensitive equity sectors – such as industrials and financials – relative to the aggregate market (Chart I-5 and Chart I-6). Both this and the ZEW economic sentiment indicator confirm that economic activity has accelerated sharply since late last year, but has suffered a slight setback in the last month. Chart I-5The Best Current Activity Indicator Is The Relative Performance Of Economically Sensitive Equity Sectors Chart I-6The Best Current Activity Indicator Is The Relative Performance Of Economically Sensitive Equity Sectors …But Can The Acceleration In Economic Activity Continue? To be crystal clear, let’s repeat the crucial point. Economically sensitive investments do not move on the level of GDP growth; economically sensitive investments move on the real-time change in GDP growth. The simple reason is that profits growth is highly leveraged to economic growth. Hence when GDP growth picks up, the embedded ‘g’ used to calculate the present value of the investment rises very sharply, which means that today’s price also rises very sharply; and vice versa when GDP growth declines. But once GDP growth stabilizes, even at a high level, there is no further meaningful change in ‘g’, or in the price. For any remaining sceptics, Chart I-7 shows that for many years, the big moves in the Euro Stoxx 50 have resulted from the changes in euro area GDP growth.   Chart I-7The Euro Stoxx 50 Moves On Changes In GDP Growth   It follows that what investors really need is not a current activity indicator, but a future activity indicator (FAI). If investors could reliably predict the change in economic activity, then they could also reliably allocate between economically sensitive and defensive investments, as well as to the equity market as a whole.   We have found that a future activity indicator for Europe would contain three components: The domestic 6-month credit impulse. The international 6-month credit impulse, and specifically the 6-month credit impulse in China given the large volume of European exports that head to the largest emerging economy. The crude oil price 6-month impulse, where a price decline constitutes a positive impulse given Europe’s dependence on energy imports. Chart I-8The Drivers Of Europe's Future Activity Indicator Are Losing Momentum Today, we find that the 6-month credit impulse both in the euro area and in China have lost momentum; meanwhile, given the rebound in the oil price, the crude oil price 6-month impulse has clearly faded (Chart I-8). Hence, our future activity indicator suggests that in the second half of this year, euro area GDP growth is unlikely to accelerate much from the current 1.5-2 percent clip.  For investors, this means that this year’s absolute double-digit returns have most likely already been made during the early-2019 star alignment of near-perfect conditions. And the remainder of the year is likely to be much tougher going for all the major asset-classes.  Still, there are always double-digit returns to be found somewhere in the investment landscape. In the second half of the year, the big story will be sector rotation. For example, in recent reports, we highlighted that healthcare is likely to flip from underperformer to outperformer versus technology. Given their sector skews, it follows that European equities are likely to outperform Chinese equities. Fractal Trading System* This week’s recommended trade is based on an oddity. While the majority of stock markets have suffered corrections, New Zealand’s NZX 50 has escaped relatively unscathed so far, making it vulnerable to a corrective underperformance one way or another. Hence, short the NZX 50 versus the FTSE100, and set the profit target and stop-loss at 2 percent. In other trades, short China versus Japan quickly achieved its profit target. Long Nikkei 225 versus Hang Seng was also closed in profit at the end of the 65 day maximum holding period. Against these two profitable trades, long SEK/NOK was closed at its stop-loss. This leaves the Fractal Trading System with four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The precise mix of the portfolio is 29% MSCI World $, 29% German 30-year bund, 29% U.S. 30-year T-bond, 13% WTI. Please see a replay of the webcast ‘From Sweet Spot to Weak Spot’ available at eis.bcaresearch.com. 2  Quarter-on-quarter real GDP growth at annualized rates. 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