Developed Countries

The secular stagnation narrative is gaining traction amongst the FOMC. Expect further downward revisions to longer run FOMC interest rates forecasts, toward levels already discounted in the Treasury curve.

The financials sector led the recent pullback in the broad market. Rather than view this as a buying opportunity, it is symptomatic of the relentless plunge in global bond yields and an increasing scarcity of financial sector pricing power. For instance, the asset management & custody bank (AMCB) index will struggle to overcome profit margin pressure. Punitively low running yields represent a major challenge for the AMCB industry. Anything that can be capitalized has been re-rated. High valuations mean that prospective long-term equity returns are slim. Against this backdrop, management expense ratios look high in both the equity and bond universes. Fees have already been under structural pressure due to the shift into passive equity products (bottom panel), and outperformance of bonds, which garner even lower margins than equity products. Index funds generate much lower fees than actively managed pools of capital. If bonds continue to outperform stocks as global economic sentiment sours, then performance chasing investors are likely to continue putting more capital into lower margin bond products relative to equity funds. In other words, as the equity risk premium climbs, AMCB profit potential will decline. Stay underweight.

For the broad market, capital appreciation potential will be levered to profit trends rather than liquidity/multiple expansion at the current stage of the cycle. The fuel to drive up global aggregate demand remains absent. According to BIS data, global credit growth is contracting. That is significant, because credit greases the wheels of the global economy. The message is that it is too soon to expect profit relief from overseas. Corporate profit margins are already narrowing, but bottom up forecasts discount an aggressive move out to new highs in the coming quarters (middle panel). The growth backdrop is not conducive to such a development. The yield curve, which is an excellent business cycle indicator and a leading signal for profit margins, continues to narrow relentlessly. Fewer than 50% of the non-financial and non-utility industry groups are currently expanding profit margins. Yet 8 out of 10 sectors are expected to grow margins, according to analyst earnings estimates. Specifically, cyclical sectors such as industrials, materials, energy and technology are slated to show broad-based improvement in profitability. That would not be farfetched if the world were on the cusp of a V-shaped, post-recession type of acceleration and the U.S. dollar were set to weaken significantly. However, deleveraging and the global credit contraction warn that global growth is not about to rebound. As such, we remain skeptical that the macro backdrop will validate upbeat analyst forecasts, rendering deep cyclical sectors vulnerable to underperformance.

We prefer to fade the recent fall in yields by moving to neutral on U.K. Gilts and underweight Australia, while maintaining a benchmark overall stance on portfolio duration.

The sinking global credit impulse warns that reflation has not overwhelmed deflationary forces. Financials will continue to suffer, while utilities and retail drug stores will benefit.

The Fed has reason to delay the next rate hike until at least September, even if volatility subsides after the June 23 Brexit vote.

Special Report

This fact sheet outlines what you need to know ahead of the U.K.'s referendum on EU membership. The "Leave" camp has taken the lead, and while the polls likely overstate its position, the status quo faces serious risks.

Gold stocks have regained traction after a brief interlude in the bull market, and the path forward remains bullishly skewed. The Fed took a slightly dovish turn at this week's FOMC meeting, reinforcing that they remain in reactive mode, thereby sustaining rising policy uncertainty (second panel). Given our bias to expect economic disappointment, the odds are good that policy will need to remain accommodative, with real interest rates staying in negative territory for a prolonged period. That is a plus for a zero yielding asset such as gold. With world economic expectations continuing to grind lower (shown inverted, top panel), the appeal of owning gold stocks as a portfolio hedge remains attractive, particularly given that sentiment towards the yellow metal is far below prior extremes. Stay overweight.

The Brexit vote is a coin toss. We introduce a simple model to estimate the effect of a "stay" or a "leave" vote on various currencies and assets. A "leave" vote could cause GBP/USD to fall to 1.32 or less, creating a tactical buying opportunity. Extreme GBP implied volatility suggests that selling vol is attractive. The Fed decreased its rate projections.

The "reflation trade" is breaking down. Brexit risk is partly at fault; the bigger issue is the lack of a global "spender of last resort." Globally, savings must equal investment. The problem is that desired savings are rising and desired investment is falling. Policy is increasingly reflecting this reality: Fiscal austerity is yielding to stimulus, the obsession with fighting inflation replaced with talk of helicopter money/other radical solutions. Bond yields are likely to stay depressed for the next two years, but could then begin to rise much more than current market expectations. We are closing our short EUR/JPY trade.