Developed Countries
The shares of movie & entertainment firms have been under pressure in the last several weeks, despite what has generally been a positive Q3 earnings print, driven down by speculation the AT&T/Time Warner merger may be blocked by the Department of Justice. Rumors that Disney was interested in acquiring most of Fox were not enough to lift spirits in the beleaguered index. The more important driver is the secular decline in consumer spending on media, which seems likely to continue to weigh on the industry's top line. High operating leverage, which has been a boom to EPS growth in the past, is now swinging the other way, explaining the drop in earnings growth (second panel). The industry has rerated to the downside in 2017, implying that the weak profit outlook is mostly priced in to the index (bottom panel). As such, we continue to recommend a benchmark allocation in the S&P movies & entertainment index. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB.
Highlights The current mini-upswing in the global mini-cycle started in May and is likely to end around January. On a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. The contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Feature Key to the medium-term behaviour of markets is the existence of what we call 'mini-cycles' in global activity. The evolution of these perpetual mini-cycles explains much of what has happened, what is happening, and what will happen, to financial markets both in Europe and more broadly. Chart of the WeekExpect A Trend-Reversal In The Metals Market Mini-cycles are not a hypothesis. They are an indisputable empirical fact. Just look at the global bond yield (Chart I-2), metal price inflation (Chart I-3), global inflation (Chart I-4), and the bank credit impulse (Chart I-5 and Chart I-6). The regular mini-cycles shout out at you! Furthermore, given that these clearly observed mini-cycles show the same half-cycle length of about 8 months, Investment Reductionism strongly suggests that there is a common over-arching driver. Chart I-2The Global Bond Yield Exhibits Mini-Cycles Chart I-3Metal Price Inflation Exhibits Mini-Cycles Chart I-4Inflation Exhibits Mini-Cycles Chart I-5The Global Credit Impulse Exhibits Mini-Cycles Chart I-6Individual Credit Impulses Exhibit Mini-Cycles Explaining Mini-Cycles Previously,1 we explained that the distinct mini-cycles are interconnected parts of the same never-ending feedback loop. A lower bond yield accelerates bank credit flows... which boosts economic growth... which pushes up commodity inflation and overall inflation... causing the bond market to raise the bond yield, at which point the cycle reverses. And then the alternate cycles repeat ad perpetuam (see Box I-1). Box I-1The Mathematics Of Mini-Cycles One common question we get is: why focus on bank credit analysis and not on bond-intermediated credit analysis too? The simple answer is that bank credit expands the broad money supply whereas bond-intermediated credit usually does not. When a bank issues a new loan, fractional reserve banking allows it to create money 'out of thin air'. In contrast, when a company or government issues a new bond, no new money is created, unless the primary issue is financed by the central bank - which is generally forbidden. Usually, when a bond is issued, existing money just moves from one account - that of the bond buyer - to another account - that of the bond issuer. This means that bond-intermediated credit cannot increase demand by creating new money, but only by increasing the velocity of existing money. Whereas bank credit can increase demand by increasing both the amount of money and its velocity. Therefore, changes in bank credit are the much bigger driver of the mini-cycle in economic activity. If a bank issues 100 euros of credit today, then we know that this new money will be spent in the coming days and weeks - because nobody borrows money just to sit on it. If, in the previous period, the bank had issued 90 euros which was spent, it means that economic activity in the coming period will grow by 10 euros. But if the bank had previously issued 110 euros, it means that economic activity in the coming period will contract by 10 euros. In this way, the cycles in credit and activity are interconnected. Mini-upswings in the credit impulse mini-cycle tend to signal mini-upswings in commodity inflation (Chart I-7), overall inflation and bond yields. So if we can identify turning points in the credit impulse then we can correctly position the cyclical stance of our investment strategy. Chart I-7The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The problem is that the bank credit data is slow to come out. For example, although we are in the middle of November, the last bank credit data for the euro area refers to September. This means that if the mini-cycle is turning now, we might not find out until January. Nevertheless, we can still use the mini-cycle framework. We know that the current mini-upswing started in May and that mini-upswings have an average length of 8 months. Hence, we can infer that the mini-upswing is likely to end around January. That said, upswing lengths do have some degree of variation: the current upswing might be longer or shorter than the average. How to avoid being too early or too late? Combining Mini-Cycles With Fractal Analysis To optimise our proprietary mini-cycle framework, we propose combining it with our proprietary fractal analysis framework. As regular readers know, fractal analysis measures whether herding in a specific investment has become excessive, signalling the end of its price trend. The combined mini-cycle and fractal framework works best if we use a 130-day herding indicator (fractal dimension), as it broadly aligns with the mini half-cycle length. Excessive herding signals that an investment's trend is approaching exhaustion because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when the market is split between different herds - say, short-term momentum traders and long-term value investors. This is because the herds disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity. But liquidity starts to evaporate when too many value investors join the momentum herd. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders add fuel to the trend. The tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. Earlier this year, our combined frameworks signalled that the aggressive rise in bond yields was likely to reverse (Chart I-8). Therefore, on February 2 we correctly advised: "Lean against the rise in bond yields and bank equities." Chart I-8Excessive Herding In Bonds Always Signals A Trend Reversal Today, we see the same dynamic in parts of the commodity rally - and specifically the move in the LME Index (Chart of the Week). Hence, on a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. Could Italy Be A Good Surprise? Returning to the concept of the bank credit cycle, the evolution of longer-term impulses also explains the contrasting recent fortunes of Spain and Italy. In 2013, Spain recapitalized its banking system and ring-fenced bad assets within a 'bad bank'. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. As Spanish banks' aggressive deleveraging ended, the bank credit impulse rebounded very sharply and has remained positive for several years. This undoubtedly explains why Spanish real GDP has grown by 13% since mid-2013 (Chart I-9). In contrast, Italy's banking system remained dysfunctional - which meant that its own credit impulse stayed much more muted and barely positive over the past four years (Chart I-10). But now, the Italian banking system is slowly recuperating. Italian banks' equity capital is rising, their solvency is improving, and the share of non-performing loans has fallen sharply this year. Chart I-9Spain's Peak Credit Impulse##br## Is Probably Behind It Chart I-10Italy's Peak Credit Impulse##br## Is Likely Ahead Of It So the contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Credit Slumps While Animal Spirits Soar. Why?' March 30, 2017 available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week, leaving us with six 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-11 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Chart II-6Indicators To Watch - ##br##Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Chart II-8Indicators To Watch -##br## Interest Rate Expectations
U.S. home sales have been soaring, with new single-family homes reaching a 10-year high in September, driven by still-low financing costs and peaking consumer sentiment. This surging housing demand which includes temporary hurricane rebuilding related sales, has already shown up in earnings; HD reported a 7.9% same store sales increase in Q3 yesterday, a stunning number relative to the current malaise in the overall retail landscape. This elevated demand, coupled with the impact of countervailing duties on Canadian imports, has pushed lumber to the stratosphere. High lumber prices benefit home improvement retailers' top lines (third panel), but serve to crimp builders' margins. With a much better profit outlook and a still reasonable valuation (bottom panel), we think the best way to gain exposure to the healthy domestic housing market is via the S&P home improvement retail index, not the S&P homebuilders. Accordingly, we reiterate our respective overweight and neutral recommendations. The ticker symbols for the stocks in these indexes are: BLBG: S5HOMI - HD, LOW and BLBG: S5HOME - PHM, DHI, LEN.
Managed health care stocks have performed exceptionally well since our early-April 2016 overweight recommendation, besting the market by roughly 24%. This begs the question: Is the time ripe to lock in impressive profits and move to the sidelines or is there more upside left? Leading profit indicators suggest that more gains are in store for the relative share price ratio. After petering out in 2016, our managed care cost proxy has plummeted by over 350bps from the recent peak (shown inverted, second panel). Given that premiums are set on a trailing cost basis, profit margins should surprise to the upside. Further, drug price deflation should prove a boon to managed care providers' bottom lines and the pharmaceutical sector's pain this year will be the managed health care industry's gain (bottom panel). Bottom Line: Melting input costs should augment managed health care profits, supporting a durable valuation expansion phase. Stay overweight and see this week's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC.
Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve Chart 3Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 1Managements Focused On The Message##BR##Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.
Dear Client, Next week on November 20th instead of our regular weekly publication you will receive our flagship publication "The Bank Credit Analyst" with our annual investment outlook. Our regular publication service will resume on November 27th with our high-conviction trades for 2018. Kind Regards, Anastasios Avgeriou Highlights Portfolio Strategy Melting medical care input costs, sustainable enrollment gains and even modest tax relief would augment managed health care profits. Stay long health care insurers. Pharma and biotech stocks suffer from declining pricing power. Continue to avoid both. As a result, the S&P health care index remains in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities consolidated recent gains as earnings season drew to a close last week. Recent election results coupled with the revealing of the Senate tax bill raised fresh concerns, unwarranted according to our geopolitical strategists, about the likelihood of a bill passage. While such heightened fiscal policy uncertainty is disquieting, solid EPS growth on the back of synchronized global economic and capex growth should sustain the overshoot phase in stocks. Q3 EPS vaulted to a fresh all-time high (Chart 1) and, were it not for two financials sector sub-indexes - reinsurers and multi-line insurers that were severely hit by the one off hurricane catastrophes - financials EPS growth would have been nil from -7.3%, pushing the overall SPX EPS number to 9.2% from 8.1%. Chart 2 shows that the positive EPS surprise factor remained close to the recent average. Going into earnings season, Q3 EPS growth forecasts collapsed to 4.1%, but actual results ended up 400bps higher. Chart 1Earnings-Led Advance Continues Chart 2Surprise Factor In Line With Recent Average While EPS growth cannot stay in the high teens forever, settling down close to 10%/annum EPS growth rate is possible in the near run. The softness in the U.S. dollar along with the basic resource sector commodity-related comeback, synchronized global economic and capex growth and financials contributing more than sell side analysts expect to overall EPS, suggest that such profit growth is attainable in 2018. Tack on the possibility of fiscal easing and sustained lift in animal spirits (bottom panel, Chart 1), and the odds of low double-digit EPS growth increase further. Meanwhile on the monetary policy front, news of Powell's nomination to take the helm at the Fed barely budged the equity market, but some cracks are appearing in the bond market (Chart 3). Keep in mind that going back to Volcker's late-1970s nomination, Fed Chair transitions have been volatile. In fact, the market has tested the resolve of all four previous Fed leaders (Chart 4). As soon as Volcker come into power he had to deal with the early-1980s recession (and the LatAm crisis in 1982) that saw the market fall by 17% from peak to trough. When Greenspan was confirmed Chairman in August of 1987, two months into his tenure Black Monday happened and he had to step in and reiterate the Fed's function as a lender of last resort. In 2006 Bernanke took over from the Maestro, and a recession hit by the end of 2007 that morphed into the Great Recession. Finally in early-2014, Yellen become the Fed Chairwoman and in late-2015 a global manufacturing recession had taken hold resulting in a 14% drawdown in the SPX. Chart 3Watching The Bond Market Chart 4Testing Times Inevitably, the market will test the new Fed Chairman. This expansion has been long in the tooth and given BCA's 2019 recession view, this testing time is at least a year away. This week we reiterate our underweight stance in a defensive sector and highlight its key sub-components. Stick With Managed Health Care Exposure Following a two year hiatus, managed health care stocks broke out in 2017 and the juggernaut has now resumed (Chart 5). While the recent unsuccessful intra-industry M&A attempts (breakdown of both AET/HUM and ANTM/CI deals) were a mild setback, CVS's latest announcement, to take over AET and further vertically integrate, has brought euphoria back to this health care subgroup. We have added alpha to our portfolio as relative performance is up smartly, roughly 24% since our early-April 2016 overweight recommendation, begging the question: Is the time ripe to lock in impressive profits and move to the sidelines or is there more upside left? Leading profit indicators suggest that more gains are in store for the relative share price ratio. After petering out in 2016, our managed care cost proxy (comprising physician and hospital services and medical care commodity inflation) has plummeted by over 350bps from the recent peak (shown inverted, second panel, Chart 5). Given that premiums are set on a trailing cost basis, profit margins should surprise to the upside, i.e. the industry's medical loss ratio has room to fall. Not only is our medical care input cost proxy melting, but the latest employment cost index release revealed that managed health care wage inflation is also steadily decelerating (third & bottom panels, Chart 6). Taken together, these two cost categories are heralding a solid industry EPS growth backdrop in the coming months (total cost proxy shown inverted, second panel, Chart 6). Chart 5Melting Costs Are A Boon To Margins... Chart 6...And EPS Importantly, health care insurers are also set to benefit from the Trump administration's push toward lowering drug prices and the proliferation of generic drugs. While drug inflation is positive for the pharma/biotech space, it is an expense incurred by managed care providers and vice versa. The upshot is that the pharmaceutical sector's pain will be the managed health care industry's gain (bottom panel, Chart 5). On the legislative front, the failed attempts to repeal and replace the ACA is positive as the newly enrolled will likely remain insured and underpin recurring industry revenues. As long as costs stay in check, the implication is ongoing earnings improvement. Tack on any relief related to a tax bill passage (the managed care index has a 47% effective tax rate or 24% higher than the overall S&P health care sector, see Table 2) and the path of least resistance is higher for profits. Table 2Tax Relief Potential Despite all of these positives, relative valuation remains muted, hovering near the neutral zone. On a forward P/E basis the S&P managed care index is trading on a par with the S&P 500 (Chart 7). If our thesis of sustained earnings outperformance materializes in the coming quarters, then a valuation re-rating phase looms. In sum, melting input costs, sustainable enrollment gains and even modest tax relief would augment managed health care profits. This is a recipe for a durable valuation expansion phase. Bottom Line: While we are underweight the broad health care index, our sole overweight remains the S&P managed health care index. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Ailing Pharma We downgraded pharma to an underweight stance on July 31 on the back of weak pricing power fundamentals, soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics. The S&P pharmaceuticals index relative performance is down 5% since then as our bearish profit thesis is validated. Our dual synchronized global economic and capex growth themes bode ill for defensive pharmaceutical stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, middle panel, Chart 8). A depreciating currency is also synonymous with pharma profit ails (bottom panel, Chart 8). Historically, a soft U.S. dollar has been closely correlated with global growth, whereas greenback strength tends to slowdown the global economy. In that context, pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases. However, pharma exports are contracting at an accelerating pace (top panel, Chart 8) despite the U.S. dollar's year-to-date softness, warning that global pharma demand is sick. Importantly, the news on the pricing power front is disconcerting. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam. In the context of a bloated industry workforce, the profit margin outlook darkens significantly (Chart 9). If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Worrisomely, were pharma prices to continue to trail overall corporate sector price inflation, as we expect, then the de-rating phase in the S&P pharmaceuticals index has a long ways to go (bottom panel, Chart 9). Finally, even on the operating metric front, the news is mostly grim. Pharma industrial production is nil and our pharma productivity proxy remains muted, warning that profits will likely underwhelm. Industry retail sales growth is also flirting with the zero line and pharma inventories have resumed growing on a short-term rate of change basis across the supply channel. Pharma shipments offer the only ray of hope. But the recent acceleration in the latter may be the result of the hurricane-related catastrophes (Chart 10). Chart 8Counter Cyclical With##br## No Export Relief Chart 9Weak Pricing Power And Bloated##br## Cost Structure Weighs On Margins Chart 10Operating Metrics ##br##Are Also Feeble Netting it out, pharma profit growth is on track to continue to disappoint as the confluence of synchronized global growth, softening U.S. dollar, pricing power losses and deteriorating operating metrics are all profit headwinds. Bottom Line: We reiterate our late-July downgrade in the S&P pharma index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. A Few Words On Biotech Biotech stocks are another casualty of weakening pharmaceutical wholesale price inflation, and given that the industry's profits move neck-and-neck with their pharma siblings, revenue and EPS growth are bound to continue to surprise to the downside (Chart 11). We expect such profit woes will weigh on the S&P biotech index relative performance, and re-iterate our high-conviction underweight status. Chart 11Biotech Equities Hate Higher Rates Chart 12Technicals Say Sell Not only are biotech firms modestly concealed Big Pharma, i.e. they manufacture multi-billion dollar blockbuster drugs, and the Trump administration's scrutiny of drug price inflation is a profit negative, but also a rising interest rate backdrop is working against this health care sub-index. Historically, rising interest rates have been inversely correlated with biotech stocks. High flying valuations tend to gravitate back to earth when the Fed embarks on a tightening cycle. The opposite is also true. BCA's U.S. Bond Strategy view remains that in the coming 12 months interest rates will be higher, moving closer to the 3% mark on the 10-year Treasury yield front. If such a selloff materializes in the bond market, then investors will abandon biotech stocks in a heartbeat (Chart 11). Chart 13Heed The EPS Growth Model Signal Meanwhile, according to empirical evidence since the mid-1990s, relative momentum in biotech stocks is nearly perfectly inversely correlated with the global credit impulse (Chart 11). This negative correlation has become more pronounced in the past decade underscoring the non-discretionary/defensive nature of large biotech outfits. In other words biotech stocks behave like counter-cyclicals similar to their pharma brethren. Given BCA's view of a recession hitting some time in 2019, we recommend investors still avoid biotech stocks. Finally, technicals are also waving a red flag. Chart 12 shows that a head-and-shoulders formation has taken root and were the neckline to give way in the coming weeks, relative performance would suffer a substantial setback. Bottom Line: Biotech stocks remain a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY. Health Care Sector Implications What does all this mean for the broad S&P health care sector? Our relative profit growth model best encapsulates these forces and is signaling that profits will remain downbeat into 2018 (Chart 13). Managed health care stocks (overweight) comprise 13% of the index, while pharma (underweight) and biotech (underweight) market capitalization weights both add up to 54% of the total. As a result of our intra-sector positioning and given our neutral weightings in the remaining health care sub-indexes, we continue to recommend a below benchmark allocation in the S&P health care index. Bottom Line: Stay underweight the S&P health care sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
The S&P household products index story in 2014-15 was that a firm U.S. dollar had sapped top-line growth from the key export market and a turnaround in the former would provide a lift in the latter. While that thesis has proven correct (second panel) and consumer goods exports have substantially recovered, earnings growth remains flat and trails the broad market (third panel). In the most recent quarter, organic domestic growth concerns weighed on household products stocks. Further, hurricane-driven input price hikes have temporarily crimped margins. The result is that the S&P household products are at their cheapest level this decade (bottom panel). With compelling valuations and the makings of an export-led EPS recovery, we maintain our overweight recommendation. The ticker symbols for the stocks in this index are: PG, CL, KMB, CLX, CHD.