Developed Countries

The energy sector is up marginally from its lows when compared with the overall market, an abysmal performance given the rally in crude oil and natural gas. Our strategy has been to keep only a market neutral weight on the overall sector this year via an overweight in oil & gas producers and underweight in refiners. While this has served our portfolio well, we are fine-tuning our intra-sector exposure. OPEC recently agreed to make a modest production curtailment. Whether members adhere to quotas and/or actually reduce output remains to be seen, but the more important point may be that the quest to drive down prices to cause financial pain for high cost producers appears to have come to an end. BCA's Energy Strategy Service believes that despite significant improvements in drilling efficiency and productivity during the downturn, current drilling levels are 30-40% lower than needed just to stem production declines. Re-inflating the rig count to an expansionary level will take time (~6 months), and then realized production will lag the rig count by 4-6 months. Renewed acceleration in drilling and completion activity will create inflationary pressures: pricing power will shift in favor of services firms relative to producers at a time when oil & gas extraction labor cost inflation has spiked to double-digit rates (third panel). If commodity prices are flat, it will be difficult for E&P firms to grow cash flow unless production is on the upswing. Take profits of 15% and downgrade the S&P oil & gas exploration & production index to neutral, funneling the proceeds into energy services firms, see the next Insight.

The mini-consolidation in equities reflects the ongoing tension between market-supportive liquidity and a sketchy corporate profit backdrop.

Global bond yields continue to grind higher, led by signs of improving growth, moderately higher inflation and central banks having difficulty staying credibly dovish. Maintain a below-benchmark duration stance.

When earnings growth negatively diverges from GDP growth, the gap rarely closes <i>via</i> a rebound in profit growth. The most notable feature of prior episodes is weak corporate pricing power and the current period is no different; an ongoing profit margin squeeze means earnings in the next few months risk being a disappointment.

As the U.S. median voter is shifting to the left, redistributive policy could come into play. A strong dollar helps to achieve this goal as it results in a bigger share of labor income in the economy. EM and commodity currencies could bear the brunt of the pain. Favor the euro on its crosses. Stay short CAD/NOK, but tighten stops.

Our <i>Fourth Quarter Strategy Outlook</i> presents the major investment themes and views we see playing out for the rest of the year and beyond.

Gold prices and gold-related equities have been caught in a sharp selloff. The motivation behind our early-August profit-taking stemmed from extremely overheated sentiment at a time when the yellow metal was vulnerable to an increasingly more hawkish Fed. Despite rumblings about asset purchase tapering at the ECB and Bank of Japan, we continue to see gold as an excellent long-term play given the likelihood of a prolonged period of depressed real interest rates. We are looking for an opportunity to return to an overweight position, but are reluctant to add just yet given that the Fed still seems intent on tightening policy, which could support U.S. dollar strength. In addition, neither technically overbought conditions nor extreme bullishness have been fully unwound. The bottom line is that near-term policy threats may keep gold and gold shares in consolidation mode for a while longer. Stay neutral, but be prepared to lift positions in the coming months.

Fixed income proxies have been pummeled recently, with the S&P utilities underperforming the S&P 500 by nearly 14% since the mid-year relative performance peak, on a mere 32bps jump in 10-year U.S. Treasury yields (UST). Since 2010 there have been three iterations of meaningful bond market selloffs, with yields rising by an average of 120bps (see table). Relative utilities returns in these iterations fell by an average of over 18% (top three panels). Utilities have already sold off by nearly 75% of the average bond yield selloff, even though long-term yields have barely budged. The implication is that a large yield back up has already been discounted and now is not the time to rush for the exits. In fact, our inclination is to look for buying opportunities, given that we do not envision much upside in government bond yields. Stay neutral, but look to buy when value improves. Table 1