Developed Countries

Equities initially cheered the soft employment report, because it cooled prospects for imminent Fed interest rate hikes. However, whether equities can break out on the back of growth slippage depends on whether profits or liquidity will be the dominant market force and/or if the economy weakens by more than expected. In other words, is bad economic news actually good news for stocks, or is bad news bad? The tight correlation between the 2-year Treasury yield, an excellent tracker of Fed funds rate expectations, and equities suggests that higher share prices require better economic/profit growth rather than simply a less hawkish Fed. Moreover, history shows that P/E multiples get squeezed on a sustained basis once monetary conditions tighten courtesy of the Fed. The chart shows a cycle-on-cycle analysis of how the S&P 500 forward P/E has fared after the onset of Fed interest rate increases since the early-1980s. Without exception, forward multiples contract. Thus, a sustainable advance from current levels requires a new profit up-cycle. To forecast that a weaker U.S. dollar will revitalize rather than simply stabilize profits on a broad-basis, it is critical for the rest of the world to demonstrate an internal demand impulse. However, that remains elusive and we remain reluctant to forecast a sustained profit recovery, especially on a par with the massive rebound analysts currently expect. We retain a defensive portfolio bias.

At current levels, Treasury yields are consistent with our assessment of fair value. Further, the Fed's Labor Market Conditions Index does not suggest an imminent recession. Expect payrolls to stabilize above levels consistent with further progress on wage growth and inflation, allowing the Fed to hike rates later this year.

For now, maintain a benchmark duration stance leading into the June 23 U.K. Brexit vote, favoring Treasuries and (especially) Gilts over Bunds and JGBs.

Risk assets will take their cues more from the dollar than the Fed if the euro rises above its 16-month range against the dollar. Retain exposure to energy equities and gold.

This week's report discusses whether bad news is good news for stocks, or a potential restraint. Tumbling long-term yields argue for augmenting consumer discretionary sector weightings, <i>via</i> the movies & entertainment group.

The 1990s mid-cycle slowdown is an appropriate analogue to current market conditions. A lower dollar was the key ingredient the easing in monetary conditions that resolved this episode. This suggests that today, as the sole economic lever left, the greenback has further downside. Go short USD/SEK. Go long a basket of NOK, CAD, AUD and NZD against the USD.

The disappointing May payroll report does not foreshadow an imminent economic downturn. The Japanese government's decision to postpone next year's VAT increase and introduce fresh fiscal stimulus should help jumpstart growth. On the flipside, the Fed is likely to restart its hiking cycle in September and the Chinese government will crack down later this year on what it regards as excessive credit growth. More worryingly, the odds of Brexit have increased over the past few weeks. Go tactically short European stocks (in dollar terms).

The S&P technology sector has been drifting lower in relative performance terms, which is notable given that the broad market has made a charge toward the top end of its trading range. The lack of leadership from this traditionally high beta sector reflects ongoing deterioration in earnings drivers. The San Francisco Fed's Tech Pulse Index, a coincident indicator of tech sector activity including employment, output and shipments, has rolled over after a multiyear expansion. Additional downside is probable, given that tech new orders have slipped into the contraction zone on the back of the nascent retrenchment in corporate sector capital spending and relentless contraction in emerging market exports (bottom panel). Technical conditions are warning that the downturn in relative performance is the start of a sustained bear market. Our Technical Indicator has declined into the sell zone after diverging negatively from the share price ratio. Breadth is thin, as far less than half of the sub-industry groups are trading above their 40-week moving average, in relative terms, and/or with a positive 52-week rate of change. The bottom line is that an underweight stance is the best way to protect portfolios from looming underperformance.

Underweight Following up on yesterday's cautious Insight on the overall financials sector, the heavyweight bank sub-component looks precariously positioned. The latest FDIC Quarterly Banking Profile made for grim reading. Credit losses are on the rise and loan-loss provisions are following suit. Worrisomely, noncurrent C&I loans (the largest bank loan category) spiked to the highest level since 1987, on the back of souring energy-related loans. Historically, relative performance and the noncurrent C&I loan rate have been inversely correlated. The current message is to expect additional bank selling pressure as investors discount the profit drag from faltering credit (top panel). Moreover, the loan loss coverage ratio declined for the first time since 2012 (not shown), as provisions outpaced charge-offs, reinforcing that the credit quality cycle is deteriorating. Given that the labor market is showing signs of softness, non-performing loans are likely to accelerate in the coming quarters (middle panel). Meanwhile, both return on assets and on equity have crested for the cycle and nudged lower last quarter (bottom panel). Risks are skewed to the downside, and we continue to recommend underweight positions. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.

What is liquidity? How is it created and destroyed? And when does it trigger turning-points in financial markets?