Developed Countries

Highlights It was easy to upgrade equities to overweight at the beginning of the year, … : The fourth-quarter selloff had reduced the S&P 500’s forward four-quarter multiple to 13.6 at its trough, and we never shared the market’s fear that the Fed was one false move from triggering a recession. … but what should someone who sat out January’s and February’s moves do?: Is it worth buying stocks now, after they’ve risen 10% since our upgrade, and 18% since the Christmas Eve bottom? Wait, in our opinion, but it’s not an easy answer: We find it hard to believe that the S&P 500 is going to go straight back to its late-September highs, reversing the fourth-quarter swoon in a mirror-image first-quarter blast. Our best guess is that the bull market is not yet over, but we think its upside is limited: It’s hard to see a bear market materializing in the absence of a recession, and the Fed’s pause has likely pushed the next one out to the second half of 2020 at the earliest. The potential gains are not unlimited, however, and an inflation-wary Fed will eventually cut off the bull’s oxygen. Feature Take two dozen opinionated people with backgrounds in markets and economics and scatter them around a boardroom table. Introduce the day’s key global economic data releases, market activity, corporate news, and geopolitical developments as potential discussion topics. Have the moderator remain alert for points of contention and seek to intensify them at every opportunity. Add four or five months of the worst winter weather North America’s got to offer, this side of Winnipeg and International Falls, Minnesota, and stir. If only economists were more telegenic, or Canadians could credibly be as unpleasant as their neighbors to the south, that might be the elevator pitch for a can’t-miss reality show. Instead, it’s the recipe for BCA’s daily morning meetings, and not one of its hard-working participants is likely to be able to use it as a step on the path to celebrity riches. It is a path to getting better at analysis and reasoning, however, and an ideal forum for stress-testing economic or market hypotheses. It can also furnish research ideas, as it did for us last week. “Let’s say you have a client who missed the equity run-up in January and February. What would you recommend s/he do now?” one of our colleagues called out to us late in Tuesday’s session. Someone else jumped in before we could reply, the thread was lost, and the meeting broke up so everyone could get back to their own research priorities. Had we gotten to reply, we would have recommended that the client wait for a better entry point, and this week’s report is devoted to explaining why, in the simplest back-of-the-envelope terms. How Much Can S&P 500 Earnings Grow? When analyzing equities, we like to decompose them into their component parts: forward earnings and the multiple investors are willing to pay for them. In the hall of mirrors as described in Keynes’ newspaper-beauty-contest metaphor,1 what matters for our purposes in projecting S&P 500 earnings is less what will happen, or what our own earnings models might project will happen, than what the analyst consensus thinks will happen. The consensus estimate of calendar 2019 S&P 500 earnings per share (EPS) is currently $168.37, a modest 4% increase over calendar 2018 EPS. This is a conservative estimate, relative to history, given that S&P 500 operating EPS have grown at an average rate of 8% over the last 40 years (Chart 1). Chart 1Outside Of Recessions, Earnings Typically Grow It is also conservative given the pattern earnings estimates have followed across the five bull markets that have occurred in the 40 years since estimates began to be compiled. We have previously observed that equity bull markets tend to sprint to the finish line. On average, they begin by being blasted out of a cannon, sharply cool off in the second quintile, and build back up in the third and fourth quintiles, before retrenching ahead of a latter-stages surge (Chart 2). The earnings estimate pattern is jumpier. Forward estimates stumble out of the first-decile gate before rising at a double-digit rate over the rest of the first half, then slow sharply to the first decile’s pace in preparation for posting their most potent growth in the final decile (Chart 3). Disaggregating the individual bull markets’ performance shows that the overall last-decile performance is not the product of a couple of outlier readings. In all but the December ’87 – July ’90 bull market that ended with flatlining estimates, estimated forward four-quarter earnings growth in the final decile of the bull market comfortably exceeded mean growth across the full bull market (Chart 4). Chart 4Optimistic At The Very End Analysts’ 2019 estimates additionally look low because median corporate revenue growth ought to converge with nominal GDP growth over time. With 40 basis points of fiscal stimulus slated to be deployed in 2019, we expect the U.S. will have no trouble growing above its 2 – 2.25% trend. Assuming GDP growth at the top of that range, no change in profit margins, share buybacks to reduce outstanding share count by 2%, and 2% inflation, the S&P 500 should be able to grow EPS by 6.25%. The 2.25% difference between the consensus estimate and the back-of-the-envelope projection aligns with corporations’ desire to manage analyst expectations. If the S&P 500 can grow earnings at a rate of 6.25% this year, calendar 2019 EPS would come in at $172.13. The default estimate for the following year would be the mean of historical EPS gains, or about 9%. Applying a 2% lower-the-bar haircut, corporate management teams might guide to 7% growth in 2020. Grossing up our estimated calendar 2019 earnings by 7% yields projected calendar 2020 earnings of $184.17 (Table 1). Table 1Estimating Consensus Expectations For Calendar 2020 S&P 500 EPS What Multiple Might Investors Pay? Estimating a plausible forward multiple is more of a challenge than coming up with a reasonable consensus S&P 500 EPS estimate. Multiples, like all market prices, are dictated in large part by emotion, which often defies prediction. We can make some inferences from the 40-year history of forward multiples nonetheless. That history suggests that the current 16.5 multiple is elevated, but not worryingly so, as it is only a little more than half of a standard deviation above the mean (Chart 5). Chart 5Elevated, But Not Stretched Multiple movements have followed a pattern across the last five bull markets, but their moves are much more volatile than moves in forward estimates, which never decline in a bull market. Broadly, multiples explode higher at the start, plateau, and then retrace some of their initial gains (Chart 6). Their growth pattern inflects higher in the second half before peaking near the end of the bull market and rolling over into the finish. The broad pattern applies to all of the bull markets except the October ’02 – October ’07 bull, in which the multiple peaked in the third decile before sinking for much of the rest of the way. Chart 6Multiples Usually Follow A Well-Defined Pattern Aggregating the multiple moves by decile shows the pattern with more clarity (Chart 7). A burst of re-rating in the first decile signals the beginning of the bull market. The multiple goes on to retrench through the fourth decile and then expands at a double-digit annualized rate until it runs out of steam at the beginning of the final decile. The empirical takeaway is that investors shouldn’t look for much in the way of multiple expansion over the rest of the bull market, and we therefore apply a 16.5 multiple to our $184.17 estimate of forward four-quarter earnings a year from now, yielding an S&P 500 target of 3,040. Mapping A Course Using forward four-quarter earnings four quarters out to develop our price target shows that we do not expect the S&P 500 to surpass its late September highs anytime soon. We have marveled at the way the index has moved straight up since its Christmas Eve bottom, and have been waiting for it to reveal the top of a tradeable range. We thought 2,640, which had marked a triple-bottom in October and November’s turbulence, might present some resistance, and then perhaps 2,700, but the S&P went through both levels like a warm knife through butter (Chart 8). This week’s action suggests that 2,800 – which was a significant level throughout much of 2018 – just might mark the top for a little while. Chart 8Trying To Find The Top Of The Range Our recommendation to an investor who spent January and February underweight equities is therefore to wait. It’s also our recommendation to anyone seeking to add more exposure. As for investors seeking to reduce exposure, the action Friday as we were going to press seemed to suggest that the current levels around 2,800 are a good place to lighten up on equity holdings. If we’re wrong, an investor could buy out-of-the-money calls, which are not too onerously expensive now that the VIX is back below 15, though we almost always think the insurance offered by options is cost prohibitive for investors who are judged on a relative-return basis. Closing Thoughts We are devoted followers of long-term-oriented investors with long-term records of success who are willing to share aspects of their approach in print or in public appearances. We avidly read Warren Buffett’s annual letter to Berkshire Hathaway shareholders this week, and were delighted to discover a transcript of Charlie Munger’s Q-and-A session with shareholders at the privately-held Daily Journal Corporation’s annual meeting. Howard Marks has been a particular favorite of ours over the years, and this exercise provided confirmation of his view that bull markets end when conditions appear to be at their very best. In line with the Buffett view that investors should be fearful when others are greedy, Marks has argued that bull markets are done in by too much optimism. The tendency for earnings estimates to grow at their most rapid pace in the final stages of a bull market supports Marks’ position. It seems improbable on its face that corporate earnings would make their biggest move at the end of the cycle (Chart 3). The fact that the growth in actual operating earnings tends to peak well before the end of the business cycle (Chart 1) suggests that analysts – and the corporate management teams whose guidance provides the starting point for their earnings models – get lulled to complacency by the successes in the rear-view mirror. In that sense, it may be good for equities that expectations are so beaten down now. Perhaps this bull market will not end until managers, analysts and investors get at least a little bit euphoric.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 In his General Theory of Employment, Interest and Money, Keynes compared financial markets to a newspaper contest in which every contestant chooses the six most attractive people from a set of one hundred head shots. The winner is the contestant whose choices best align with the most attractive photos as selected by all of the entrants. Sophisticated contestants don’t bother with the faces they consider to be the most attractive, but with the faces that best align with conventional notions of attractiveness. “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects average opinion to be.”

Feature The GAA DM Equity Country Allocation model is updated as of February 28, 2019. The quant model increased allocations to Spain, Italy, Sweden and Germany at the expense of the U.S., the Netherlands and Switzerland. As such, now the model underweights the U.S., Japan, the U.K, France, Canada (downgraded from overweight) and Australia, while overweighting Germany, Spain, Italy, Switzerland and Sweden (upgraded from underweight), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark by 18 bps in February, with a 54 bps of outperformance from the Level 2 model offset by a 9 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 148 bps, with Level 2 outperforming by 267 bps and Level 1 outperforming by 29 bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2)​​​​​​​ Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.   GAA Equity Sector Selection Model We are happy to reintroduce the GAA Equity Sector Selection model after we suspended it as of October 2018 following the GICS adjustments to global sector composition. As noted in our September 2018 Special Alert and October 2018 Quarterly, the most notable changes occurred in the new Communication Services sector (previously known as Telecommunication Services) and the Information Technology sector, whereas the Consumer Discretionary sector had various yet insubstantial movements in and out of the sector. Having received historical performance of the revised data, we have retested and adjusted various inputs in the model to match the cyclicality of the revised sectors. We were able to backtest the model to only June 2008 as this was the starting point of the revised data. Given the nature of firms that are now included in the global Communication Services sector, we revised our classification of this sector from a defensive to a cyclical. Hence, it will be positively impacted by the model’s growth component. Furthermore, we have introduced Real Estate as its own sector (following its removal from Financials in August 2016). Additionally, we have neutralized the impact of the liquidity component on the Real Estate sector; in other terms, we found no evidence that the Fed cycle affects this sector in any of its four phases. We also revised the valuations component by shortening the confirming signal of our technical indicator from a 12-month to a 6-month moving average. To properly assess the model’s adjusted performance, we have reset the “since going live date” to begin in March 2019. However, the historical backtested performance of the model will still be shown in Chart 4. Additionally, we show the old model’s performance vs. its benchmark (Table 3). Chart 4Overall Model Performance Given the above, and following our Monthly Update that was released yesterday, the model corroborates our slightly cyclical stance by overweighting Industrials and Materials (Table 4). Additionally, the model’s biggest underweight shift from last month was on Consumer Staples as the momentum indicator significantly deteriorated. The model is overweight Utilities due to positive inputs from its momentum and liquidity components. Table 3Old Model’s Performance Table 4Current Model Allocations​​​​​​​ For more details on the model, please see the Special Report “Introducing The GAA Equity Sector Selection Model,” dated July 27, 2016, available at https://gaa.bcaresearch.com.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com   Amr Hanafy, Research Associate amrh@bcaresearch.com  

Feature Recommendations Two Key Questions For Asset Allocators Stocks have rallied this year – MSCI ACWI is up 17% from its late December low – despite the fact that economic growth outside the U.S. has continued to deteriorate. The PMI in Germany has fallen to 47.6, in Japan to 48.5, and the average in Emerging Markets to 49.5 (Chart 1). Chart 1PMIs Ex-U.S. Still Falling U.S. growth remains robust, though recent data have showed some signs of weakness. The Citigroup Economic Surprise Index has fallen sharply, capex indicators have slipped, and December retail sales were terrible (Chart 2). The New York Fed NowCast for Q1 is now pointing at only 1.2% real GDP growth. Most of the slippage, however, was caused by the six-week government shutdown, and should be reversed in Q2. And the retail sales number appears “rogue”, perhaps caused by irregular data-collection methods during the shutdown, since other retail data do not support it (Chart 2, panel 3). The tightening of financial conditions in the last months of 2018 – which has now partly reversed – may have added to the slowdown (Chart 3). BCA’s view is that U.S. GDP growth is likely to come in well above 2% in 2019, slower than last year’s 2.9% but still above trend. Chart 2Should We Worry About U.S. Growth Too? Chart 3Financial Conditions Now Easing Our recommendation, therefore, is to continue to overweight equities (particularly U.S. equities), which should be supported by decent earnings growth (our top-down model points to 12% EPS growth for the S&P500 this year, compared to a bottom-up consensus forecast of only 5%), reasonable valuations, and sentiment that appears still to be damaged by the Q4 sell-off (Chart 4). Chart 4Environment Still Positive For U.S. Equities Two key questions will determine which asset allocation will be optimal this year. First, how long will the Fed stay “patient” and keep rates on hold? The futures market has almost completely priced out the possibility of any rate hikes in 2019, and even assigns a 15% probability of a cut (Chart 5). We still see upside risk to inflation, with core PCE likely to print above the Fed’s target of 2% by mid-year, partly because of the year-on-year base effect (in January 2018, monthly inflation was especially high), but also because underlying inflation pressures remain (Chart 6). Chart 5Is The Fed Really Going To Cut Rates? Chart 6Inflation Pressures Haven't Gone Away The market has misunderstood two of the Fed’s recent messages. Its mooted plan to end balance-sheet reduction by year-end is not intended as part of monetary policy. It is simply that bank excess reserves will have reached USD1-1.2 trillion, the level required to operate monetary policy using current tools, rather than those used before 2007 when reserves were zero (Chart 7). Second, recent discussions about changing the Fed’s inflation target from 2% a year to a price-level target will probably become effective only when the effective lower bound is hit in the next recession and, anyway, no decision will be taken until mid-2020. Chart 7Excess Reserves Will Be At Equilibrium Soon The market has taken this talk as dovish. We read recent comments by Fed Chairman Jay Powell to mean that if, by June, the economy is robust, risk assets are still rebounding, and inflation is ticking up, the Fed will continue to hike, maybe two or three times by year-end. This implies long-term bond yields will rise too. Equities may wobble initially but, as long as the Fed is hiking because growth is solid and not because of an inflation scare, this should not undermine the 12-month case for equity outperformance. The second key question is whether China has now abandoned its focus on deleveraging and switched to a 2016-style liquidity-driven stimulus. Certainly, the January total social financing number pointed in that direction, with new credit creation of almost 5 trillion RMB ($750 billion) and the first signs of an easing of restrictions on shadow banking (Chart 8). But the jury is still out on whether this is the massive reflation the market has been waiting for. Premier Li Keqiang criticized the increase, saying, “the increase in total social financing appears rather large…it may also bring new potential risks”. A PBOC official commented that the big increase was “due to seasonal factors” and emphasized that China was not embarking on “flood irrigation-style” stimulus. The recent more positive noises on the U.S./China trade war may also alleviate the pressure on China to stimulate. Chart 8First Signs Of Chinese Reflation? If and when Chinese growth does rebound, this will have major implications for asset allocation. It would signal a bottoming of the global cycle, which would favor stocks in Emerging Markets, Europe and Japan. It would push up commodity prices, and imply a weaker dollar. For now, we are not positioning ourselves like this, since global growth remains weak. Nonetheless, the first signs of a bottoming are appearing with, for example, the diffusion index of the global Leading Economic Index (which often leads the LEI itself) turning up (Chart 9). We may shift in this direction mid-year, and are now making some minor changes to our recommendations (see below) to hedge against this risk. But for the moment we prefer U.S. equities, expect further USD appreciation, and remain cautious on EM. Chart 9Is The LEI Close To Bottoming? Equities: We prefer U.S. equities given their better growth, reasonable valuations, and depressed sentiment (despite their outperformance year-to-date). But we are watching for an opportunity to increase our weighting in Europe, where growth still looks poor but may rebound in H2 due to fiscal stimulus, improving wage growth, a dovish turn by the ECB, and an eventual recovery in exports to China (Chart 10). We still see problems in EM, since earnings growth expectations need to be revised down further and stock prices have risen prematurely on expectations of a Chinese recovery (Chart 11). But we reduce the size of our underweight bet, to hedge against Chinese credit growth continuing to accelerate. We are also raising our recommendation for the industrials sector (with its large weight in capital goods companies dependent on exports to China) to overweight for the same reason.  We fund this by cutting consumer staples to underweight. We also raise our weighting on the energy sector, given our positive view on oil prices (see below). This gives our sector weightings a slightly more cyclical tilt, in line with our macro view. Chart 10Some Good News In Europe Too Chart 11EM Has Further Downside Fixed Income: It has been a conundrum this year why equities have risen and credit spreads tightened significantly, but the 10-year Treasury yield remains stuck below 2.7%. One explanation is that inflation expectations have been dampened by the crude oil price and if, as we forecast, oil continues to recover, the inflation component of the yield will rise (Chart 12). U.S. yields have also been dragged down by weak growth in other developed markets, where bond yields have therefore fallen. The spread between U.S. and German and Japanese yields reached record high levels in late 2018 (Chart 13). The term premium also is deeply into negative territory because many investors remain highly bearish and have hedged this view by buying Treasuries. If our view of robust U.S. growth, rising inflation, and more Fed hikes is correct, we would see 10-year Treasury yields rising towards 3.5% over the next 12 months. Accordingly, we are underweight global government bonds. We raised credit to neutral last month, but continue to have some qualms about this asset class, and prefer equities as a way of taking exposure to further upside for risk assets. Besides high leverage among U.S. corporates, we are worried about the deterioration in the quality of the credit market, since duration has been extended, covenants weakened, and the average credit rating fallen (Chart 14). Chart 12Inflation Expectations Driven By Oil Chart 13U.S. Yields Pulled Down By Europe And Japan Chart 14Deterioration In Credit Market Fundamentals Currencies: We see some more upside in the U.S. dollar over the next few months, given U.S. growth and monetary policy relative to the euro area and Japan (Chart 15). This may reverse, however, if global cyclical growth rebounds in the second half. The dollar is particularly vulnerable if macro conditions change, since it looks around 10% overvalued relative to other major DM currencies, and speculative positions are predominantly long dollar (Chart 16). Chart 15Relative Rates Support USD Chart 16But Dollar Vulnerable To Macro Shifts Commodities: With demand likely to grow steadily this year, but supply under pressure because of production cuts by OPEC and Canada, lower U.S. shale oil output, and disruptions in Venezuela and elsewhere, our energy strategists see drawdowns in inventories throughout the year (Chart 17). They forecast Brent to average $75 a barrel during 2019 (compared to $66 now), with WTI $5 a barrel lower. Industrial commodities continue to be driven by China which means, given our view expressed above, that we may see further weakness short-term, with a possible rebound in H2 (Chart 18). Chart 17Oil Supply/Demand Is Tight Chart 18When Will Metal Prices Bottom?   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   GAA Asset Allocation  

Neutral There are high odds that the chip cycle will soon take a turn for the better. Global chip sales have been decelerating for 17 months and are now on the cusp of contraction (middle panel). Over the past two decades, steep contractions have been associated with recession. Given that BCA’s view does not call for recession this year, it is highly unlikely for global semi sales to suffer a major setback. While we do not rule out a brief and shallow dip below zero similar to the 2011/12 and 2015/16 parallels, leading indicators of global semi sales suggest that a trough is near. Namely, BCA’s Global Leading Economic Indicator (GLEI) diffusion index is in a V-shaped recovery signaling that global growth is close to a nadir (middle panel). Similarly the U.S. dollar is decelerating which is a boon to global growth and conducive to higher global chip sales (trade-weighted U.S. dollar shown inverted, bottom panel). Bottom Line: In Monday’s Weekly Report, we lifted the S&P semiconductors index to neutral and added it to our upgrade watch list; we are looking for an opportunity to boost to overweight on a pullback, stay tuned. Finally, from a risk management perspective we increased our trailing stop to 15% in our tactical overweight in the S&P semi equipment index, in order to protect gains. The ticker symbols for the stocks in the S&P semiconductors index are: BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO.