Developed Countries

Highlights Portfolio Strategy The drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound, warranting an above benchmark allocation. An oil price rebound on the back of a more balanced supply/demand backdrop, a continuation in the global capex energy upcycle and compelling relative valuations all suggest that the path of least resistance is higher for oil majors. Recent Changes Boost the S&P Semiconductor Equipment index to overweight today, on a tactical three-to-six month time horizon. Table 1 Feature Equities attempted to stage a recovery last week and are in a triple bottom technical formation, still consolidating the October tremor. The Fed meeting later this week will likely prove a catalyst on the monetary policy front, especially if the closely watched FOMC median dots decrease for 2019 as the bond market has been expecting. As we mentioned in our 2019 High-Conviction calls Report two weeks ago,1 the Fed will dominate markets next year and any dovish change in interest rate expectations will breathe a sigh of relief into the SPX. Given the heightened volatility and violent recent equity market oscillations, it is important to separate the noise from the actual signal. While distinguishing between the two is hard at times, we are relying on a few key indicators to aid us in this process. First, our S&P 500 EPS growth model is still expanding near the 10% mark for next year as clearly 25% EPS growth is not sustainable. While the risk is that this growth rate decelerates further, as long as EPS do not contract next year, stock prices should recover (Chart 1). From a macro perspective, at this stage of the cycle with nominal GDP growth between 4-5%, organic EPS growth should at least mimic nominal output growth. Tack on a 2% buyback yield or artificial EPS growth and attaining a 7% EPS growth rate is likely next year. Second, while the 5/2 and 5/3 yield curve slopes have inverted and we heed these signals, the 10/2 and the Fed’s spread (2-year yield minus the fed funds rate) have yet to invert. Historically, the most significant yield curve signals for the equity market are when simultaneously all the different yield curve slopes are inverted. While everyone is infatuated with the yield curve inversion implications of recession, we are laser focused on the interplay between the yield curve and stock market peaks. Importantly, typically the 10/2 yield curve inversion occurs before stock market peaks. Going back to the mid-1960s there has been only one time when the stock market peaked prior to the yield curve inversion, in 1973: the SPX crested on January 11 and the yield curve inverted on January 16 (due to lack of data we use the effective fed funds rate instead of the 2-year yield prior to 1976). In all the other iterations, the yield curve inverts prior to the stock market top. Even in 1998 the yield curve inverted in late-May and the SPX peaked in mid-July before suffering a 20% drawdown. Similarly, on February 2, 2000 the yield curve inverted and on March 24, 2000 the SPX topped out for the cycle. Chart 3… And Then The SPX Peaks In other words, the yield curve inversion is a leading indicator and once the curve inverts, it signals that the stock market highpoint will follow soon thereafter (Charts 2 & 3). The broad market tops on average 248 days (median 77 days) following the yield curve inversion (Table 2), though the large variability in each iteration limits the usefulness of this average as an accurate predictor. Nevertheless, the implication remains that the SPX has yet to peak for the cycle. Table 2Yield Curve Inversions And S&P 500 Peaks Third, a slew of economically sensitive indicators have troughed. Sweden’s PMI and Swedish stock market relative performance have been in a V-shaped recovery. As we highlighted earlier this week,2 Sweden is a small open economy and it is likely sniffing out an improvement in global export volume growth and a likely de-escalation in the U.S./China trade tussle. EM FX, the CRB raw industrials commodities index, the Baltic Dry Index and semi equipment stocks (see more details in the next section) all suggest that the worst is over, and global trade will likely resume its advance in the coming months (Chart 4). Chart 4Hyper-sensitive Indicators Sniffing Out A Trough? Finally, inflation is coming off the boil and will likely decelerate in the months ahead courtesy of the fall in WTI crude oil prices. Were oil to move sideways from here, headline inflation would decelerate further, likely overwhelming core CPI (Chart 5). This is significant, as it could serve as a monetary policy catalyst. Put differently, decelerating inflation may cause the Fed to reconsider the pace of its interest rate hikes. A pause in the tightening cycle in March 2019 would be a welcome development for stocks, especially if the fed funds rate is nearing the terminal rate as we recently highlighted in our trough-to-peak fed funds rate tightening cycle analysis.3 Chart 5Inflation Will Decelerate Adding it all up, our still expanding SPX EPS growth model, a lack of a 10/2 yield curve inversion, a trough in a number of economically sensitive indicators and the potential for a temporary Fed hike pause in March next year, all signal that the equity bull market is not over and fresh all-time highs are looming in 2019. This week we are upgrading, on a tactical basis, a bombed out tech subgroup, and updating our view on a deep cyclical index. Semi Equipment: Enough Is Enough We are lifting exposure in the niche S&P semi equipment index from underweight to a modest overweight. Putting this in perspective, this small index comprises only 1.5% of the tech universe and commands a mere 0.3% weight in the S&P 500. There are high odds that most of the carnage in semi equipment stocks is already reflected in the violent swing of the sell side community from extreme bullishness up until August of this year to the current extreme bearishness. As a reminder, the S&P semi equipment index was part of U.S. Equity Strategy’s high-conviction underweight call revealed in November 27, 2017 when the sell-side could not have enough of semi equipment stocks as analysts were also mesmerized last winter by the near $20,000/bitcoin related mania.4 This timing coincided with the peak in performance of this hypersensitive early-cyclical tech index (Chart 6). Chart 6Extreme Bearishness... To get a sense of how far the pendulum has swung on the bearish camp, we note the following: The relative 12-month forward EPS growth has deflated from positive 60% to negative 20% (Chart 6). The index’s forward P/E is trading at a 40% discount to the SPX, relative 5-year EPS growth estimates are near previous troughs and even compared to the overall tech sector; semi equipment long-term EPS growth is now forecast to trail their tech brethren (Chart 7). Even forward sales growth has collapsed, falling to a multi-year low. Analysts now expect an outright contraction in revenues to the tune of 4% or 10 percentage points below the S&P 500 (Chart 6). Net EPS revisions have also been sinking like a stone, approaching the 2012 nadir (Chart 6). Technical conditions are oversold with cyclical momentum as bad as it gets (Chart 7).  Chart 7...Reigns Beyond this overly pessimistic backdrop, there are some macro indicators that, were they to sustain their recent budding recoveries, would serve to catalyze the chip equipment group. First, trade policy uncertainty has dealt a blow to this tech subindex (trade policy uncertainty shown inverted, top panel, Chart 8). Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Table 3 highlights the excessive sensitivity these stocks have to the U.S. dollar. In fact, the correlation with J.P. Morgan’s EM FX index is an almost perfect one (Chart 8). If President Trump is serious about striking a deal with China, then this group would enjoy a relief rally. Chart 8Potential Positive Catalysts Table 3U.S. Semi Equipment Geographical Sales Breakdown Second, emerging market manufacturing PMIs are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (Chart 9). Chart 9EM Green Shoots? Third, while global semi sales will continue to decelerate for the next three-to-six months, the semi market is functioning as if the inventory liquidation cycle is in the later innings, with our industry pricing power proxy plummeting 180 percentage points from peak-to-the-recent trough, just below the contraction zone (Chart 10). Chart 10Inventory Liquidation Is In Late Stages Finally, any bounce in cryptocurrencies may also serve as a positive catalyst for additional demand for the semi equipment companies that enjoy monopolies in their respective manufacturing niches (Chart 10). In sum, the drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound. Bottom Line: Lift the S&P semi equipment index from underweight to overweight today, as a tactical move for the next three-to-six months. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX and KLAC. Oil Majors Are Holding Firm In early-February we upgraded the heavyweight integrated oil & gas energy subindex to an above benchmark allocation. Our thesis centered on a capex upcycle recovery and firming oil price backdrop that would unlock excellent value in this key energy subgroup. Since then, the relative share price ratio has moved laterally. Interestingly, this defensive energy subindex neither kept up with the steep oil price advance until the end of September, nor with the recent drubbing in crude oil prices (Chart 11). Put differently, oil majors never discounted sustainably higher oil prices, and are also refraining from extrapolating recent oil prices weakness far into the future. Chart 11Defensive Oil Equities While the Trump Administration’s flip-flop on the Iranian sanctions has injected extreme volatility into oil prices, some semblance of normality has returned to the crude oil markets as last week OPEC and Russia agreed to a production cut in order to help balance the market. Another key factor that has contributed to the recent fall in oil prices at the margin has been U.S. shale oil supplies. Roughly 30% per annum growth in U.S. crude oil production is unsustainable and, were production to remain near all-time highs and move sideways in 2019, then the growth rate would fall back to the zero line. Such a paring back in the growth rate, along with OPEC/Russia discipline, would likely balance the oil market and pave the way for an oil price recovery (oil production shown inverted, Chart 12).   Chart 12U.S. Supply Response Is Looming Given that BCA’s Commodity & Energy Strategy service continues to forecast higher oil prices into 2019, the S&P integrated oil & gas index should stage a sustainable rebound next year. While the recent swift drop in oil prices is jeopardizing the still recovering capital expenditure cycle, we doubt $50/bbl oil would make current projects uneconomical and result in mothballing or outright canceling of ongoing oil exploration projects (Chart 13). Granted, a big assumption is that oil prices at least hold near the current level and do not suffer a relapse to the early-2016 lows. Historically, rising oil exploration outlays and integrated oil & gas share prices move in lock step and the current message is to expect a rebound in the latter (Chart 14). Chart 13Low Odds Of A Total... Chart 14...Capex Collapse Finally, sell-side analysts are throwing in the towel. Net earnings revisions have taken a beating of late, which is positive from a contrary point of view (second panel, Chart 15). Relative valuations are extremely compelling on a number of metrics including relative price-to-book, price-to-sales and relative forward price-to-earnings (third panel, Chart 15). Tack on a near 200bps positive delta in the dividend yield versus the broad market and yield hungry investors will also seek the relative safety of this defensive energy subindex (bottom panel, Chart 15). Chart 15Integrated Stocks Are On Sale Netting it all out, an oil price rebound on the back of a more balanced supply/demand backdrop, a continuation in the global capex energy upcycle and compelling relative valuations all suggest that the path of least resistance is higher for oil majors. Bottom Line: Stay overweight the heavyweight S&P integrated oil & gas energy subindex. The ticker symbols for the stocks in this index are: BLBG: S5IOIL – XOM, CVX and OXY. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Sector Insights, “Can Sweden Lead The SPX?” dated December 12, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “2018 High-Conviction Calls,” dated November 27, 2017, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Differences of opinion are what make a market, and we’ve got a big one when it comes to the Fed: The money market says the fed funds rate goes no higher than 2.75%; BCA says 3.5% by the end of 2019, and possibly 4% sometime in 2020. We are confident in our assessment of the economy’s underlying strength, … : Fiscal stimulus will keep the economy growing above trend in 2019, and the unemployment rate will almost certainly continue to grind lower. ... even if many commentators are accentuating the negative: The experts quoted in Barron’s found abundant fault with the November employment situation report, and the yield curve is out-trending all of the Kardashians combined. Amidst all the uncertainty, we’re sticking with an investment strategy that is more cautious than our outlook: The monetary backdrop is still too accommodative to spell the end of the equity bull market, but we are waiting for a better entry point to put our cash overweight to work. Feature Dear Client, This is our last report of 2018. Our regular publishing schedule will resume on Monday, January 7th. We wish you a happy, healthy and prosperous new year. Best regards, Doug Peta, Senior Vice President U.S. Investment Strategy   We have often remarked how we feel that we are watching a different game than the money market when it comes to the gap in our respective terminal fed funds rate expectations. Both we and the market expect a 25-basis-point (“bps”) hike to 2.5% at the conclusion of the FOMC’s two-day meeting on Wednesday, but from there our paths diverge sharply. The market grudgingly allows that one more hike, to 2.75%, is possible, though it is by no means certain. It sees about a 60% chance that the Fed will make that additional rate hike toward the end of 2019, but then proceeds to price that hike out by the end of 2020 (Chart 1). Chart 1Mind The Gap The terminal rate’s ultimate destination, and the path it follows along the way, is not just an academic matter. Once the fed funds rate crosses above the equilibrium fed funds rate (r-star, in economics-speak), monetary policy will become restrictive for the first time since the crisis began to break. We expect the shift to a restrictive policy setting will herald the end of the expansion. Most importantly for investors, it will mark the point when asset allocation should become considerably more defensive. Getting the Fed right, then, is of the utmost importance, and we need to get to the bottom of our differences with the market. We suspect they come down to disparate assessments of the state of the economy and the state of policy. The money market seems to believe that the economy is weaker than we perceive, and that the fed funds rate is currently much closer to equilibrium than we realize. In both cases, we are vulnerable if it is later in the cycle than we think, because we are not positioned for an imminent inflection. Is The Business Cycle Closer To Ending Than We Think? Real GDP growth will slow in 2019, just as one would expect when 60 bps of fiscal thrust is taken away from an economy that was already operating at its full 2-2.25% capacity (Chart 2). Per the IMF’s fiscal estimates, 2020 shapes up as the real challenge for the economy, especially once the Fed crosses the equilibrium-rate Rubicon. In October and November, however, financial markets acted as if they feared the beginning of the recession was considerably nearer (Chart 3). Our clients’ concerns seemed to coalesce around the implications of a slowdown in housing. Chart 2Lessened Thrust, Lessened Growth   Chart 3Growth Scare We do not worry about residential investment pulling down the economy,1 but we do pay close attention to nonfarm payrolls. Employment may be a coincident indicator, but it is powerfully self-reinforcing, and the sub-NAIRU2 unemployment rate looms large in the Fed’s policy calculus. Payrolls growth is robust, and our model projects that it will continue to be over the near term (Chart 4, top panel), as all of its components are in fine fettle, especially initial jobless claims (Chart 4, second panel), and small businesses’ hiring intentions (Chart 4, bottom panel). Chart 4Payrolls Should Keep Growing, ... As we have noted before, it only takes about 110,000 net new jobs every month to keep unemployment at a steady state. Even if our model turns out to be overly optimistic, the unemployment rate appears to be several months away from bottoming, unless the participation rate rises enough to materially increase the size of the labor force. Demographics argue against that, as the baby boomers, ages 54 to 72, exit the work world in a nearly interminable conga line. The participation rate has done well to stabilize in the face of the boomer headwind (Chart 5), but there’s a limit to how much more it can close the gap when businesses are already lamenting the difficulty of finding qualified workers (Chart 6). Chart 5... But The Part Rate Probably Won't   Chart 6Good Help Is Hard To Find A robust labor market suggests that households in the aggregate will have the means to support consumption. Now that payrolls have expanded for a record 98 straight months, the lowest-income households are finally in line to capture some of the benefits. Those households have the highest marginal propensity to consume, which may provide spending with an additional fillip. With the savings rate now back to its late-‘90s levels, better-heeled households are also in a position to do their part to keep consumption humming (Chart 7). Chart 7Plenty Of Dry Powder For Spending The near-term consumption outlook is additionally supported by the expectations component of the Conference Board’s consumer confidence survey, which has been a reliable coincident indicator throughout its entire history (Chart 8). The unusual divergence between the two series suggests that consumers may have more of an appetite to spend than they’ve demonstrated so far. Employment gains and real consumption also have a well-established history of traveling together (Chart 9). Chart 8Consumers' Optimism Points To More Spending ...\   Chart 9... And So Do Solid Employment Gains Bottom Line: We find it hard to believe the economy is set to weaken in a worrisome way when the labor market still has plenty of momentum, and consumption is well supported on multiple fronts. Is The Fed Funds Rate Cycle Further Along Than We Realize? The Real Economy Our equilibrium fed funds rate model continues to suggest that the target fed funds rate is well below its equilibrium level and will not exceed it until late next year.3 Equilibrium is only a concept, however, so we actively seek out objective data that may confirm or disprove our assessment. Our approach is to trust our modeled estimate of a concept, but verify it with as much real-time evidence as we can muster. Based on the current level of activity, housing seems to be the only major segment that is experiencing some indigestion from higher rates. Corporate investment may not have lived up to the most optimistic post-tax-cut estimates, but there is no evidence that corporations are holding back because of higher rates. A back-of-the-envelope proxy, calculating the difference between the S&P 500’s return on capital and the after-tax interest rate on BBB-rated corporate bonds, suggests that prospective returns to borrowing are near their best level in 30 years, even with the reduction in the debt tax shield4 (Chart 10). Through December 14th, the Atlanta Fed’s GDPNow model was projecting an increase of 3.8% in fourth-quarter final domestic demand, forcefully pushing back against the notion that r-star is at hand. Chart 10Higher Rates Aren't Biting Yet The ongoing application of fiscal thrust to an economy already operating at capacity argues for a higher equilibrium rate than would otherwise apply. The equilibrium rate is also higher because the unemployment rate is well below NAIRU (4.5%, per the dots), suggesting that the Fed will have to push harder against the economy than it otherwise would to keep it from overheating. Tepid post-crisis investment, mixed with unnecessary fiscal stimulus, and combined with a red-hot labor market, is a recipe for inflation pressures that can only be neutralized by a higher r-star. Financial Conditions As last week’s Google Trends chart of yield-curve searches made clear, investors have developed something of an obsession with an inverted yield curve. The yield curve’s ability to flag overly tight monetary policy in real time has made it a reliable leading indicator of recessions, and it is a key input into our simple recession indicator. The curve has flattened over the last five-plus weeks as the 10-year Treasury yield has melted, stoking recession fears. Before they get too worked up, however, investors should bear in mind that the depressed term premium has the potential to distort its signal in this cycle. The term premium is the yield differential between a Treasury note or bond, and a strip of T-bills, laddered to match the note or bond’s maturity. In line with its name, the term premium is typically positive, as investors have typically demanded compensation for bearing the increased interest-rate volatility embedded in longer-maturity instruments. That volatility may well have been restrained by the Fed’s large-scale asset purchase program, along with long yields themselves, though the entire matter of QE’s impact is subject to spirited debate. Whatever the mechanism, the term premium is considerably lower than it has been across the five decades that the yield curve has had a nearly perfect record of calling recessions (Chart 11). If the term premium were in line with its historical mean value, the yield curve would be nowhere near inverting. We continue to trust in the yield curve’s propensity to sense danger, but concede that the anomalously low term premium may render it somewhat less timely now. Given the preponderance of evidence to the contrary, we are not concerned that it is signaling that r-star is materially closer than our equilibrium fed funds rate model estimates. Chart 11The Bar For Inversion Is A Lot Lower In This Cycle QE raises one more issue for our equilibrium fed funds rate model, which does not account for any tightening of monetary conditions occasioned by the unwinding of the Fed’s balance sheet. We assume that such tightening occurs only at the margin, but it could delay our recognition that policy has shifted from accommodative to restrictive. Attempting to isolate the impact of balance sheet reduction on monetary conditions would be more trouble than it’s worth, however, and we simply assume that it will cause the confidence interval around our equilibrium estimate to widen a little. Bottom Line: Our equilibrium fed funds rate model projects that policy is not nearing restrictive territory, and our interpretation of the whole of the real-time data supports that view. We think that the Fed is still several hikes away from reaching r-star. Investment Implications As we noted in last week’s 2019 outlook, the view that the economy is strong enough to overheat undergirds all of our recommendations. The potential for overheating is what will impel the Fed to hike aggressively through 2019 and possibly beyond. Investors should therefore underweight Treasuries in balanced portfolios, while maintaining below-benchmark duration. The idea that the economy will gather more momentum on its way to overheating keeps us constructive on equities. We do not believe the bull market is over, and are therefore keeping an eye out for an opportunity to overweight the S&P 500 before it makes new highs. We are confident that the unemployment rate will continue to decline, but must concede that the key outcome for Fed policy – higher wages – has been slow to materialize. Several investors have become impatient with waiting for the Phillips Curve to assert itself, and we cannot blame them. Shorn of its fancy trappings, though, the Phillips Curve is just a supply-and-demand story, and we have always found it hard to argue against supply-and-demand stories’ plain logic. The action in the 10-year Treasury nonetheless has us reviewing our call closely in search of anything that we may be missing. It appears that the decline in yields is better explained by the unwinding of lopsided positioning and sentiment (Chart 12), than by anything connected to economic growth. We are acutely conscious of how a worsening of U.S.-China trade tensions could impair global growth and subvert our constructive take on risk assets. U.S. equities may shine on a relative basis in the worst-case scenario, but absolute losses would be assured. We remain in wait-and-see mode, open to deploying our cash overweight if the opportunity presents itself, but happy to have it for ballast and insurance in the meantime. Chart 12Stretched Rubber Bands Snap Back   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Reports, “Housing: Past, Present And (Near) Future,” and “Housing Seminar,” published November 19 and December 3, 2018, respectively, at usis.bcaresearch.com. 2 NAIRU, the non-accelerating-inflation rate of unemployment (also known as the natural rate of unemployment), is the unemployment rate that can be sustained over time without causing the economy to overheat. 3 Our model estimates that equilibrium fed funds is currently around 3%, will be around 3.25% by the middle of 2019, and will settle near 3⅜% at year end. 4 Before the 2017 tax reform act, corporations faced a top marginal rate of 35%, and could deduct interest expense without limit. After-tax interest expense for large corporations amounted to (1-.35), or 65% of the pre-tax expense. Now that the top marginal rate is 21%, after-tax interest expense is (1-.21), or 79% of pre-tax expense.

Special Report

Dear Client, I have been on the road visiting clients in St. Louis, Minneapolis, and Chicago this week. Instead of our regular Weekly Report, we are sending you a Special Report on European bank stocks written by my colleague Xiaoli Tang from our Global Asset Allocation service. In advance of the holiday season, we will be publishing next week’s report summarizing our key views for 2019 on Tuesday morning. Best regards, Peter Berezin, Chief Global Strategist   Highlights Euro area bank profits are driven more by economic growth than monetary factors. This growth link explains the close correlation between the relative performance of banks within the euro area and the relative performance between euro area and U.S. equities. It also highlights the importance of euro area banks to global asset allocators. Euro area banks now have attractive valuations, which are offset however by a lackluster profit outlook. Long-term investors should avoid banks in the region. Investors with a more tactical mandate and much nimbler style could use our valuation indicators to “time” their entry and exit into banks as a short-term trade. Feature Banks in the euro area have underperformed the region’s broader market by about 50% since March 2009, when global equities reached their financial crisis lows. In the same period, the overall euro area equity index also underperformed U.S. equities by about 50% in common-currency terms. In fact, the relative performance of euro area banks to the euro area broad market has been joined at the hip with the relative performance of euro area equities vs. U.S. equities over the past decade (Chart 1, panel 1). Getting the bank view right in the euro area is therefore an important input into our country allocation decision between U.S. and euro area equities. Chart 1Is It Time To Buy Euro Area Banks? With a more than 50% discount to the broad market in terms of price-to-book (P/B), banks are now looking very cheap. However, banks in the euro area have always traded at a discount to the broader market on an absolute basis. Currently the relative P/B reading of 0.45 is only slightly lower than the 3-year average of 0.47 – still higher than the lower band of the valuation range (Chart 1, panel 2). The relative dividend yield also gives similar information (Chart 1, panel 3). Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected. In order to support sustainable outperformance, however, banks need to have sustained profitability. In this Special Report, we delve into the fundamental factors that affect a bank’s profit outlook such as capital position, loan growth and non-performing loan situation to determine if banks in the euro area are cheap for a reason, or are about to embark on a period of sustainable outperformance. What Drives Bank Share Performance? According to research published in BCA’s Global Asset Allocation Special Report on July 27, 2017,1 it is clear that return on equity (ROE) has historically been closely correlated with the performance of bank shares, especially on a relative-to-the-broad-market basis (Chart 2, panel 1). Chart 2Euro Area Bank Performance Drivers The recovery of ROE has so far been tepid. This is largely a result of deleveraging in the banking system and very low asset utilization, because both return on assets and net profit margins have recovered strongly (Chart 2, panels 2 and 3). Since the Global Financial Crisis (GFC), euro area banks have steadily reduced leverage to a multi-decade low, while asset utilization has been in a downtrend since the 1990s – even though this ratio seems to have been stabilizing over the past few years. Profit margins reached a historical high of 12.7% in Q4/2006, then collapsed during the GFC and reached a low of 0.34% in Q3/2009. The subsequent rebound in profit margins was short-circuited by the euro debt crisis, causing net profit margins to plummet into negative territory, reaching a historical low of -7.6% in Q3/2012. They have recovered strongly since, reaching 9.8% in Q3/2018, not far from the 2006 peak margin level. As such, banks have to increase their leverage and asset utilization in order to generate higher ROE. This also means they need to increase their asset base and take on more risk. Do banks in the euro area have the ability to do so? Capital Adequacy Vs. Deleveraging The capital adequacy ratio (CAR), the ratio of a bank’s regulatory capital to its risk-weighted assets, measures a bank’s ability to absorb shocks. As shown in Chart 3, banks in all countries have steadily increased this ratio since the GFC. Banks in Ireland, the Netherlands and Finland have the highest CAR values, but they have all come down from their respective peak levels. On the other hand, Spanish, Italian and Portuguese banks have the lowest CAR readings, though they are still improving. French banks stand out because their capital adequacy ratio has been in a steady uptrend with the least volatility. Chart 3Improving Capital Position, But... Looking at CAR alone, however, could be misleading when trying to gauge a bank’s capital situation. In fact, the generally rising capital adequacy ratio has mainly been achieved through the reduction of risk-weighted assets in all countries except France (Chart 4). Chart 4...With Massive Leverage French banks’ risk-weighted assets have been more or less stable since 2006, with a small decline into 2015 and a gradual increase since. Belgian banks have also experienced similar asset growth as French banks over the past few years, though that is after massive deleveraging occurred between 2007 and 2014 (Chart 4, panel 1). Both Spanish and Italian banks tried to grow assets in 2014 after several years of deleveraging, but the attempt was short-lived as both resumed asset reduction, starting in 2015 (Chart 4, panel 2). Dutch banks seem to have stabilized their asset base since 2014, while Irish banks, which cut half their asset base between 2010 and 2014, have continued to deleverage, albeit at a much slower pace (Chart 4, panel 3). The deleveraging process in Portuguese and Finish banks has been ongoing since 2010, and it seems that the painful deleveraging process may have come to a stage of stabilization (Chart 4, panel 4). In terms of regulatory capital, the numerator of the capital adequacy ratio, French banks again stand out with a steadily increasing regulatory capital base, while Dutch banks have also grown their regulatory capital base at a similar pace. The regulatory capital bases in Spanish, Italian and Belgian banks, however, have been oscillating over the past decade, while Portuguese and Irish banks’ regulatory capitals have declined significantly (Chart 5). Chart 5Regulatory Capital Growth: No Synchronization Another indicator of bank resilience, the ratio of non-performing-loans (NPLs) net of provision relative to capital, measures if a bank can write off all of its bad loans and remain solvent. How do all the banks measure up in this aspect? Even though banks in all countries now have good readings (less than 100%), both Italy and Portugal were under severe stress until only a few years ago. Despite significant improvement since, banks in these two countries still have high levels of bad loans relative to capital compared to banks in other countries in the region (Chart 6). Chart 6Bad Loans Are Well Provisioned Loan Quality Vs. Quantity The ratio of NPLs-to-gross loans provides potentially useful insights into the quality of assets. NPL ratios in France, Germany, Belgium, Austria, and Finland are all less than 5%, while those in Italy, Portugal and Ireland are higher than 10%, and Spain is in between (Chart 7). Since the peak around 2015, the NPL ratios in all countries other than Finland have come down. Compared to levels before 2006, however, bad loan ratios are still high. Chart 7NPL Ratio In addition, despite the improvement in asset quality, banks have not aggressively grown their loan books. Only banks in France and Finland have been consistently lending to their respective private sectors – along with German banks, albeit at a lesser pace. Lending to the private sector in Spain, Portugal and Ireland has in fact contracted by 40%-50% since 2008, while loan growth from banks in Italy, Austria and the Netherlands has basically been flat since the GFC, as shown in Chart 8. Chart 8Bank Loans To Private Sector Exposure To Emerging Markets Banks in the euro area are known to have a strong presence in the emerging markets. As shown in panel 1 of Chart 9, Spanish banks have more than doubled their lending to emerging markets (EM) since 2006; even after a reduction over the past two years, loans to EM still account for over 16% of total lending. This stands in stark contrast to their domestic lending, which has contracted sharply since peaking in early 2009 (Chart 8, panel 3). Portuguese banks share similar patterns to Spanish banks in terms of loan growth to EM and domestically, however, their absolute amounts have been much smaller (Chart 8, panel 3 and Chart 9, panel 2). Dutch banks shrank their loan books to EM right after the GFC but have been gradually building them back up since 2011, while Austrian banks have been steadily reducing the pace of their lending to EM (Chart 9, panels 3 and 4). Chart 9Bank Exposure To EM After the turbulence earlier this year in Turkey and Argentina, BCA’s Global Investment Strategy and Foreign Exchange Strategy services identified six countries (Argentina, Turkey, Colombia, Brazil, Mexico, and Chile) as the most vulnerable to catching the “Turkish Flu,” based on the following factors: current account balance, net international investment position, external debt, external debt-service obligation, external funding requirements, private-sector savings/investment, private-sector debt, government budget balance, government debt, foreign ownership of local-currency bonds, and inflation2 (Table 1). The vulnerability of Latin America highlights the poor performance of Spanish banks, given their heavy exposure to the region. For example, Banco Santander, the largest Spanish bank and also the largest component in the euro area bank index, has aggressively expanded into Latin America to beef up asset utilization and return on assets. However, loan quality from Latin America has been much lower, as evidenced by the much-higher percentage of bad loan provisions from the region compared to its share of loans. Currently, loans to Latin America account for about 18% of total lending, yet bad loan provisions account for about 42% of total provisions (Chart 10). Chart 10Banco Santander: More Like An EM Bank Exposure To Italian Government Debt The fiscal budget saga in Italy has been a negative factor impacting euro area assets, especially Italian banks. Italian banks have been large buyers of Italian government debt securities, reaching over 400 billion euros at the peak and accounting for about a quarter of total debt securities. Following the European Central Bank’s quantitative easing program (QE) that started in March 2015, Italian banks’ share of government debt holdings subsequently dropped to about 18% by the end of 2017. In 2018, however, Italian banks purchased more government bonds to a level of 393.8 billion euros as of September 2018, or about 20% of the overall debt securities outstanding – only a tad lower than the peak level before the QE program (Chart 11). Chart 11Italian Debt By Type Of Investor Now the ECB’s QE program is expected to come to an end soon. With government debt securities holdings accounting for 24% of tier 1 capital in Italian banks, (Chart 12), investors should pay close attention to the “Doom Loop,” i.e. when weakening government bonds threaten to topple the banks that own those bonds, the banks are forced to unload the bond holdings, which in turn pushes the government into additional fiscal stress. Chart 12The Doom Loop Moreover, Italian banks are not the only banks in the euro area which are exposed to Italian government debt. According to the European Banking Authority’s 2017 Transparency Exercise, French and Spanish banks held 44 billion euros and 29 billion euros of Italian debt, respectively. For example, the largest French bank, BNP Paribas (BNP), which is the second-largest component by market cap in the euro area bank index, has gradually added more Italian government debt securities since 2015 (when the ECB started buying Italian bonds) following a large reduction in 2011 (Chart 13). Investment Implications The euro area banks and diversified financial sector indices are currently mostly dominated by Spain (30%), France (25%) and Italy (15%), which all have grown at the expense of the German banks over the past two decades (Chart 14). Chart 14Euro Area Bank Index: High Concentration From a fundamental perspective, only French banks have both good-quality assets with decent and steady loan growth; the largest weight – Spanish banks – has experienced negative loan growth domestically while expanding aggressively to emerging markets up until 2017. Some may argue that exposure to Italian debt and emerging markets may have already been fully priced in, given the massive underperformance of the banks. This may well be true, and there could be a short-term bounce in bank stocks, given the attractive valuation metrics. For long-term investors, however, such a bounce may not be captured easily. We suggest long-term investors stay away from euro area banks, in line with our regional equity view of favoring the U.S. over the euro area. Why? Because cheap valuations are offset by lackluster profit outlook at a time when growth is slowing and monetary policy is becoming less accommodative (Charts 15A and 15B). Relative earnings growth for both banks and diversified financials are closely tied to the euro area PMI, the leading indicator for economic growth (Charts 15A and 15B, panel 2). This growth link explains why the banks’ relative performance in the euro area has such a close correlation with the performance of euro area equities relative to their U.S. peers. Chart 15APoor Profit Outlook For Banks Chart 15BPoor Profit Outlook For Diversified Financials For investors with a more tactical mandate and much nimbler style, however, Chart 1 could be used as a guide to “time” an entry and exit to the industry: go overweight when the relative price-to-book reaches the lower band and relative dividend yield reaches the upper band, and vice versa.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1 Euro Area Bank Indexes Different index providers have different classifications and compositions for banks, based on their different respective index methodologies.3, 4 GAA uses the MSCI All Country Equity index as its global equity benchmark. As such, whenever possible, we use the MSCI indexes in our research work. When data is not available from MSCI, however, we also use the Datastream Thomson Reuters (Datastream) index. In this Special Report, we have combined the MSCI “Bank Index” and “Diversified Financials Index” into one Aggregate Bank Index for one reason: MSCI reclassified Deutsche Bank as a “diversified financial” from a “bank” in 2003. Appendix Table 1 and Appendix Table 2 show the comparisons between the Datastream Bank Index and the MSCI Aggregate Bank Index. Even though Datastream includes 16 countries and MSCI includes only eight countries, both indexes are quite concentrated in Spain, France, Italy and the Netherlands. These four countries account for 77.4% of the Datastream Bank Index with 34 stocks, while they account for 78.8% of the MSCI aggregate bank index with 19 stocks. What’s more, the top five stocks are the same in both indexes, but they account for half of the MSCI Aggregate Bank Index and only 42% of the Datastream Bank Index.   Consequently, while the two indexes are quite similar, users should be aware of the differences. For example, since March 2009, the MSCI Aggregate Bank index has underperformed the broader index by 48%, but Datastream banks have underperformed the broad index by 55%, as shown in Appendix Chart 1. Footnotes   1 Please see Global Asset Allocation Special Report, “What Drives Bank Share Performance?” dated July 27, 2017 available at gaa.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, “Hot Dollar, Cold Turkey,” dated August 17, 2018, available at gis.bcaresearch.com. 3 Please see https://www.msci.com/eqb/methodology/meth_docs/MSCI_GIMIMethodology_Nov2018.pdf 4 Please see http://www.datastream.jp/wp/wp-content/uploads/2017/02/DatastreamGlobalEquityIndicesUGissue05.pdf