Estados Unidos
Highlights Unsurprisingly, OPEC 2.0's leadership agreed on the need to extend the coalition's 1.8mm b/d production-cutting agreement to end-March 2018. Leaders of the coalition - the energy ministers of the Kingdom of Saudi Arabia (KSA) and Russia - will recommend as much when the coalition meets next week in Vienna. Meanwhile, sequential production in U.S. shales during the first four months of the year is up just under 100k b/d, based on the EIA's latest estimates. This was led by surging Permian production. We expect shale-oil production growth to continue, and are revising our year-end 2017 light-tight-oil (LTO) production estimate for the four main shale-oil plays to 5.66mm b/d, up from our earlier assessment of 5.39mm b/d. We also are lifting our year-end 2018 estimate of shale production to 6.64mm b/d. This means December-to-December LTO production will increase ~ 1mm b/d by Dec/17 and by another ~1mm b/d by Dec/18. Energy: Overweight. As of last Thursday's close, we are long Dec/17 Brent $65/bbl calls vs. $45/bbl puts at -$1.16/bbl, and long Dec/17 vs. Dec/18 Brent at -$0.21/bbl. These positions were up 16.4% and 242.9%, respectively. Base Metals: Neutral. The physical deficit in zinc appears to be widening slightly, based on supply-demand estimates from the International Zinc Study Group. Usage totaled 2.282mm MT in Jan-Feb 2017 vs. refined production of 2.28mm MT. For 2016, usage was 13.89mm MT vs. supply of 12.67mm MT. Precious Metals: Neutral. Metal refiner Johnson Matthey expects a 790k oz. palladium deficit this year, up from a little over 160k oz. last year. Separately, the World Platinum Investment Council expects platinum supply to fall 2% this year to 7.33mm oz. Ags/Softs: Underweight. The USDA reported corn planting stood at 71% for the week ended May 14, vs. an average of 70% over the 2012 - 16 period. We remain bearish. Feature The determination of the leaders of OPEC 2.0 to clear the storage overhang could not have been made more clear, following comments earlier this week from KSA's and Russia's energy ministers the coalition's 1.8mm b/d production-cutting agreement would be extended to end-March 2018. This is three months beyond earlier speculation the deal would be extended to year-end 2017. Chart of the WeekBalances Chart Still, when dealing with a political organization of any sort - and OPEC 2.0 is nothing if not a political entity - our bias is to assume less-than-complete compliance with production cuts, and an earlier return to pre-agreement production levels than proffered by the leadership of the coalition. Hence, in our updated balances model (Chart of the Week), in addition to assuming higher U.S. production out of the shales, we have Russian production returning to a level just below 11.30mm b/d by October 2017, up roughly 150k b/d from the 11.15mm b/d we assume they'll be producing until the end of September. We also assume Iraq's production will move up to 4.45mm b/d (up 50k b/d) beginning in January, and that Iran will be steadily, yet slowly, increasing production by 5-10k b/d per month beginning this month. The only assumption we're making for staunch compliance to the OPEC 2.0 accord after our assumed extension to year-end 2017 at next week's Vienna meeting is that KSA and its GCC allies - Kuwait, Qatar, and the UAE - will continue to abide by their voluntary production cuts. This group has maintained solidarity on past production-management deals, we expect them to do so again in this round. Of course, the other members of the coalition could vote against this proposal next week, and instead decide to end the production deal in June under its original conditions. Or, they could agree to extend the deal, but only until year-end 2017. Regardless of whichever policy decisions are agreed to during next week's meeting, come November, when OPEC meets again, they might tweak/change those agreements to reflect their updated outlook at that time. Given this uncertainty, we believe the assumptions we've made are realistic, but we will be monitoring conditions closely so that we can modify our view quickly. Shale Coming On Strong Part of OPEC 2.0's desire to extend its deal likely is the improvement in the performance of shale-oil producers in the U.S. In its latest Drilling Productivity Report (DPR), the EIA noted that sequential production in the first four months of the year has risen ~ 100k b/d per month in the U.S. shales. This surge was led by higher Permian production, which accounted for ~ three-quarters of the increased output (Chart 2). Interestingly, rig-weighted production per rig dropped for the first time in April 2017, but it still is high at 732 b/d, down from 735 b/d in March. We will be watching this closely to see if it is the beginning of a trend of stagnating productivity amid a rapid expansion of industry activity. The resurgence in the shales can be seen in the year-on-year (yoy) growth in total production in the seven basins the EIA tracks, which broke back above 5.0mm b/d in February and crossed into positive yoy growth in March (Chart 3). Net, we expect 2017 global supply to average 97.65mm b/d, for an increase 610k b/d this year, and for demand to average 98.3mm b/d, for an increase of 1.5mm b/d. EM demand, which we proxy using non-OECD consumption, accounts for 1.27mm b/d of this year's global demand growth, and continues to lead overall growth in oil demand (Chart 4, panel 2). Of this, China and India account for 350k and 210k b/d, respectively, of the growth in EM demand. Chart 2Permian Basin Leads##br##U.S. Shale's Resurgence Chart 3Year-On-Year LTO Production##br##Breaks Out In 1Q17 Chart 4EM Growth Continues##br##To Lead Global Demand China, India Lead EM Oil Consumption Non-OECD countries represent more than 50% of global oil consumption. Indeed, within the ~1.6mm b/d global oil demand growth we expect for 2017 and again in 2018, slightly more than 87% of it comes from EM economies. Table 1 below shows the average yoy growth by year for different regions - DM and EM - and countries from 2011 to 2018. Over this period, almost all of the world's oil-demand growth comes from non-OECD countries. From 2011-2018, the average p.a. demand growth for non-OECD countries is 2.79%, while for OECD countries it is only 0.12%. Table 1EM Leads Oil-Demand Growth Looking more closely at the composition of the EM economies, we see that, on average, between 2010 and 2018 Chinese oil consumption accounts for 24% of non-OECD demand, while the Indian oil consumption represents 8.3%, for a combined total of 32.37% of non-OECD average consumption. These two countries alone contributed on average to around 50% of the world oil consumption growth from 2010 to 2018. China has been the fastest-growing oil market in the world since the early 2000s. However, since 2015, when it emerged as an important growth market on the world stage, India's consumption has been increasing at a faster pace than China's. One of the reasons for this likely is the desire of the Chinese government to resume its pivot to a more service-oriented economy, which is less commodity-intensive than the export-oriented economy dominated by heavy industry. India, meanwhile, is looking to increase its manufacturing output, lifting it from the low-teens to 25% of GDP by 2022 under Prime Minister Narendra Modi's "Make in India" campaign. This change in the composition of global oil-demand growth is reducing demand for residual fuel oil and distillates. Indeed, IEA data continues to show a steady decline in yoy consumption for these two types of fuel in China, with residual fuel oil consumption down 26.5% yoy in 2016, and gasoil and diesel (distillates) consumption down close to 3% yoy. By contrast, gasoline consumption, is up more than 8% yoy along with jet fuel and kerosene. LPG demand (propane and butane, along with other light ends) and ethane demand (a petrochemical feedstock) is surging, up 24% in 2016, according to the IEA. In relative terms, China will remain the main driver of global oil consumption. At ~ 12.5mm b/d, China's oil demand is close to three times as high than India's. However, India likely will surpass China in terms of its contribution to global oil demand growth in coming years. A combination of structural and policy-driven factors points toward a possible sustainable growth path for Indian oil consumption for the coming years (oil consumption per capita is increasing, as is vehicle usage, particularly motorcycles (Chart 5); and, the government's desire to increase the share of the manufacturing to 25% of GDP by 2022 will boost oil demand growth as well). Chart 5India Passenger Car Sales Are Soaring Recent studies assessing the "take-off" of an economy look at its per capita oil consumption in transportation, in particular, given that this sector accounts for more than half of the world's oil consumption (63% according to IEA Energy Statistics 2014). The theory boils down to the following: As income grows, a larger share of the population becomes vehicle owners. This is referred to as the "motorization" of an economy. In India, the transportation sector represents around 40% of total oil consumption.1 According to Sen and Sen (2016), the level of vehicle-ownership per capita is still low in India compared to other economies that have experienced similar take-offs. The government's targeted increase in manufacturing as a share of GDP to 25% under the "Make In India" program (from a current level of ~ 15%) would, according to the Sen and Sen (2016) formulation, lead to an increase in oil consumption. The "Make in India" campaign was launched in 2014 by Prime Minister Narendra Modi and aims to transform the country's manufacturing sector into a powerhouse for growth and employment. Other key objectives of this campaign include a target of 12-14% annual growth in the manufacturing sector, and the creation of 100 million new jobs by 2020 in the sector.2 In 2017Q1, India's liquid fuels consumption declined by 3% yoy. This decline was, for the most part, caused by the government's "demonetization" program, which was designed to streamline the economy and reduce rampant black-market transactions. The government chose to invalidate the 500- and the 1,000-rupee banknotes, the most-used currency denominations in the economy (around 86% of the total value of currency in circulation). This represented a huge shock to the average citizen, since it limited the purchasing power of a large part of the consumer economy for an extended period of time and impacted India's overall economic activity. Recent data show Indian oil and liquids consumption up 3% in April (yoy), and its money supply is almost back to its pre-demonetization levels, according to the EIA. This suggests economic activity and liquid-fuel consumption will get back to their previous levels. Bottom Line: We believe OPEC 2.0's deal will be extended at next week's Vienna meeting to March 2018. However, after September, we are expecting compliance to fall off meaningfully, leaving KSA and its allies as the only producers adhering to their voluntary cuts past year-end 2017. Even so, we expect the storage overhang to be worked off - mostly this year - but also into next. Even though U.S. shale production is surprising on the upside, the commitment of a majority of OPEC 2.0 to production cutbacks at least through September of this year will force the storage overhang to draw down by year end. KSA and its core allies will maintain production discipline to March 2018, which will keep storage from refilling too quickly during the seasonally weak consumption period in the first quarter next year. We continue to expect oil forward curves to backwardate by December 2017, and remain long Dec/17 Brent vs. short Dec/18 Brent. In addition, we remain long Dec/17 Brent $65/bbl calls vs. short Dec/17 Brent $45/bbl puts, expecting prices to rally toward $60/bbl by the time Brent delivers in December. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com 1 Sen, Amrita; Anupama Sen (2016), "India's Oil Demand: On the Verge of 'Take-Off'?". Oxford Institute for Energy Studies. 2 Some of the recent policies to enhance the manufacturing growth include: Government subsidies of up to 25% for specific manufacturing sub-sectors; area-based incentives to increase the manufacturing development in key regions; allowances for companies that invest a predetermined amount in new plant and machinery; deductions for additional wages paid to new regular employees; deductions for R&D expenditures; and other incentives aimed at promoting the manufacturing sector and improving the India's ease of doing business to attract foreign direct investments. Please see http://www.makeinindia.com/article/-/v/direct-foreign-investment-towards-india-s-growth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016
Highlights Fed: The Fed is likely to lift rates in June, which could roil markets if economic data do not improve between now and then. Municipal Bonds: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Economy & Inflation: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Feature How stubborn are Fed policymakers? This is an important question for markets at the moment. The Fed has clearly articulated that its base case economic outlook will result in two more rate hikes before the end of 2017, and even traditionally dovish Chicago Fed President Charles Evans said he "could be fine with two more rate hikes this year."1 Meanwhile, broad indexes of financial conditions suggest that markets can absorb another rate increase (Chart 1). Everything appears to be set up for the FOMC to lift rates by another 25 basis points when it meets next month, and this remains our expectation. The only problem is that the flow of economic data has turned decisively negative (Chart 2). Most recently, core CPI disappointed expectations by increasing only 0.1% in April, causing the year-over-year growth rate to fall to 1.9%. It was only three months ago that core CPI was growing 2.3% year-over-year. True to form, President Evans also noted last week that "downside risks [to inflation] still predominate". Chart 1Green Light From Financial Conditions Chart 2Red Light From Data Surprises The risk from a market point of view is that the Fed holds true to its promise and lifts rates in June, despite the fact that recent data have disappointed and inflation remains well below target. In that scenario, it is possible that markets come to the conclusion that the Fed is running an overly tight policy, resulting in a bear-flattening of the yield curve and a near-term sell-off in spread product. Chart 3Stay Positioned For Higher Yields As we have highlighted numerous times in the context of our Fed Policy Loop,2 with inflation below target, the Fed will be quick to adopt a more dovish stance when faced with a sharp tightening of financial conditions. This will put a floor under risk assets. Further, as was discussed in last week's report,3 negative data surprises are not likely to persist for much longer. But until that turnaround occurs, there is a heightened risk of a near-term widening in credit spreads if the Fed sticks to its guns. Ultimately, the Fed will continue to support credit spreads, and we remain overweight spread product on a 6-12 month investment horizon. Our 6-12 month outlook for Treasury yields is also unchanged, even though recent yield movements reflect the "hawkish Fed" scenario described above. The nominal 10-year yield has risen in recent weeks, driven entirely by real yields that have moved higher alongside increasingly hawkish rate hike expectations (Chart 3). The compensation for inflation protection has actually declined, in reaction to disappointing inflation data and perceptions of a more hawkish Fed. Even in the event that financial conditions tighten and the Fed is forced to adopt a more dovish policy stance, we would expect the decline in real yields to be offset by an increase in the cost of inflation compensation, which still has considerable upside (see section titled "The Consumer Is Strong, But Where's The Inflation?" below). We therefore continue to recommend a below-benchmark duration stance. Finally, futures market positioning is now solidly net long, suggesting that yields are biased higher during the next three months (Chart 3, bottom panel). Bottom Line: Risk assets could sell off in the near-term if economic data do not turn around and the Fed proceeds with a June hike. However, Fed policy will ultimately encourage tighter credit spreads and a higher cost of inflation compensation on a 6-12 month horizon. Remain at below-benchmark duration and overweight spread product. Municipal Bonds: Not Just About Taxes The uncertain outlook for fiscal policy is the immediate concern in municipal bond markets. While we expect some sort of tax bill will make its way through Congress before the end of the year, as of now, we don't have much clarity on what that bill will include. Lower corporate and individual tax rates seem likely, and the administration has also expressed a desire to curb deductions. Unfortunately, for now that's about all we can say for certain. Lower tax rates would be negative from the perspective of municipal bond investors, but fewer deductions would increase demand for munis, assuming the municipal bond tax exemption is not scrapped altogether. We haven't even mentioned the potential replacement of Obamacare and a possible federal infrastructure bill! For now, the muni market seems content to shrug off this uncertainty. Muni / Treasury (M/T) yield ratios are approaching their post-crisis lows across the entire curve (Chart 4), though longer maturity yield ratios remain elevated compared to pre-crisis levels (Chart 5). We recently recommended that investors favor long over short maturities on the Aaa muni curve.4 Chart 4Yield Ratios At Post-Crisis Lows Chart 5More Value In Long Maturities As for tax reform, although nothing is known for certain, we do expect that the administration's desire for increased infrastructure investment will keep the muni tax exemption in place. We also anticipate lower corporate and individual tax rates. How much of an impact will lower tax rates have on M/T yield ratios? Even that is hard to pin down, although we note that historically there has only been a loose relationship between yield ratios and the top marginal income tax rate (Chart 6). Chart 6The Municipal Treasury Yield Ratio & Tax Rates Further, elevated yield ratios since the financial crisis are much more driven by concerns about credit quality than changes in tax policy. With the potential for municipal bankruptcy more present than ever in investors' minds, as long as the muni tax exemption is not repealed, we think that trends in state & local government balance sheet health will continue to drive yield ratios. On that latter point, there is growing reason for optimism. Revenue Growth Ready To Rebound Periods of rising state & local government net savings have historically coincided with tightening M/T yield ratios, and vice-versa. Net savings increases when revenue growth exceeds expenditure growth. However, expenditure growth has been outpacing revenue growth since early 2015 and net savings have declined as a result (Chart 7). Unsurprisingly, state & local governments have reduced their pace of hiring in an effort to protect budgets (Chart 7, panel 3). Ratings downgrades have also spiked, but the message from our Municipal Health Monitor is that they will soon subside (Chart 7, bottom panel).5 We concur, and in fact believe that state & local government revenue growth has reached an inflection point and is poised to head higher. Breaking out the different sources of state & local government revenue we see that the recent deceleration has been concentrated in income tax and sales tax revenues (Chart 8). Property tax growth has been steady, if unspectacular. Transfers from the federal government have also decelerated since early 2015, but have been flat recently. Transfer revenue is at risk of falling if the federal government is able to pass a healthcare bill that includes the block-granting of Medicaid payments. But there is still a long road ahead before any proposed healthcare bill becomes law, and a lot can change in the interim. Chart 7A Setback In State & Local Savings Chart 8State & Local Revenue By Source What seems clear at the moment is that personal income growth is heading higher and consumer spending is firm (please see the following section of this report, titled "The Consumer Is Strong, But Where's The Inflation?", for a discussion of the outlook for income and consumer spending growth). Both suggest that income and sales tax revenue growth have bottomed for the time being. Chart 9State & Local Revenue By State Using data from the Rockefeller Institute, we can also examine state & local government revenue by state. Then, if we split out the nine states that are most heavily dependent on the energy and mining sectors,6 we observe that commodity-dependent states have dragged overall state & local government revenue growth lower since commodity prices collapsed in mid-2014 (Chart 9). Further, we see that revenue growth in commodity-dependent states is heavily influenced by nonresidential investment in the energy and mining sectors (Chart 9, bottom panel). Now that commodity prices have recovered from the 2014 bust and energy sector investment is coming back on line, we would expect state & local revenue growth to follow with a lag. Investment Implications Although we expect state & local government revenue growth to accelerate from here, yield ratios already reflect quite a lot of good news. Also, heightened policy uncertainty means there is an increased risk that yield ratios will widen sharply in the coming months. For now, we recommend only a neutral allocation to Municipal bonds within U.S. fixed income portfolios. However, an interesting opportunity could lie in focusing municipal bond exposure on those aforementioned commodity-dependent states, where revenues are likely to grow more quickly as energy capex rebounds, and whose bonds might still trade at a discount because of lower current revenues. Looking at Charts 10 & 11, we notice that the General Obligation (GO) bonds of energy-dependent Texas offer a yield advantage of 15 bps versus the overall Aaa muni curve at the 10-year maturity point. This is close to the same yield advantage offered by Massachusetts GO bonds, even though Massachusetts is rated Aa1 and Texas carries a Aaa rating. Other Aaa-rated states (Virginia, Georgia, Maryland, North Carolina, South Carolina and Tennessee) trade at much lower yields. Not only that, but Texas has also seen the strongest population growth during the past 12 months of all the states in our sample (Chart 11), and employment growth in Texas should continue to rebound alongside rising oil prices (Chart 12). Our Commodity & Energy Strategy service maintains a $60/bbl year-end oil price target.7 Chart 10Grab The Premium In Texas GOs Part I Chart 11Grab The Premium In Texas GOs Part II Chart 12Texas Bouncing Back Bottom Line: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Commodity-dependent states should benefit disproportionately. Texas GOs in particular look attractive on a risk/reward basis. The Consumer Is Strong, But Where's The Inflation? Consumer Spending Chart 13Consumer Spending Looks Solid The post-election surge in consumer confidence does not look as though it's about to reverse. At least not according to the University of Michigan Consumer Sentiment Survey, which was released last week. The expectations component of that survey, which closely tracks real consumer spending (Chart 13), rose from 87 in April to 88.1 in May, suggesting that weak first quarter consumer spending will prove to be nothing more than a blip. We like to think about consumer spending as a combination of income growth and the savings rate. On income growth, survey measures are also pointing to an imminent acceleration (Chart 13, panel 2). Meanwhile, the savings rate will likely remain elevated compared to pre-crisis levels, but is unlikely to move meaningfully higher from here. In our February 21 report,8 we noted that while tightening bank lending standards correlated with a higher savings rate prior to the financial crisis, that relationship has since completely broken down (Chart 13, panel 3). Since the housing bust, the supply of credit is no longer the chief constraint on consumer borrowing. Households are now much more concerned with maintaining the health of their own balance sheets. For this reason, we do not view the recent tightening of consumer lending standards as a meaningful impediment to consumer spending. Similarly, we do not think the recent decline in demand for consumer credit (according to the Fed's Senior Loan Officer Survey) will soon translate into much weaker consumer spending. In prior cycles, we see that loan demand tended to fall several years prior to the next recession, while the savings rate did not spike until the recession actually hit (Chart 13, bottom panel). Inflation & TIPS As was mentioned above, the Consumer Price Index for April was also released last week. Not only was the core CPI print disappointing, but the decline was broad based across the four major components of core CPI: shelter, core goods, core services excluding shelter, and medical care (Chart 14). The tick lower in shelter inflation is not surprising, and in fact should continue now that rental vacancies have put in a bottom. We would also expect core goods inflation to stay low, given that the U.S. dollar remains in a bull market. More worrisome is the large drop in core services inflation excluding shelter (Chart 14, panel 3). This component of core inflation correlates most closely with wage growth, and we would expect this component to drive core inflation higher as the labor market tightens and wage growth accelerates. It is worth noting that while wage growth has also weakened during the past few months, leading wage growth indicators are still trending up (Chart 15). Pipeline measures of inflationary pressures, such as the core Producer Price Index and the Supplier Deliveries and Prices Paid components of the ISM Manufacturing index, are the other bright spots in the inflation outlook (Chart 16). While the 10-year TIPS breakeven rate has fallen all the way to 1.85% from its post-election high of 2.08%, these pipeline measures suggest the decline will prove fleeting. Chart 14Core CPI By Major Component Chart 15Wage Growth Will Recover Chart 16Pipeline Measures Still Positive We continue to expect that the 10-year TIPS breakeven inflation rate will reach 2.4% to 2.5% by the time that core PCE inflation returns to the Fed's 2% target, sometime near the end of this year. Bottom Line: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.bloomberg.com/news/articles/2017-05-12/evans-says-risks-to-fed-inflation-outlook-still-on-the-downside 2 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "Past Peak Pessimism", dated May 9, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 5 For further details on our Municipal Health Monitor, please see: U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 6 These states are: Alaska, Louisiana, Montana, New Mexico, North Dakota, Oklahoma, Texas, West Virginia and Wyoming. 7 Please see Commodity & Energy Strategy Weekly Report, "Oil: Be Long, Or Be Wrong", dated May 11, 2017, available at ces.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
We used this year’s underperformance in the financial sector to boost positions to overweight two weeks ago. Similarly, we recommend buying capital markets equities on price weakness. This sub-index thrives when investor risk appetites are healthy and the business sector is moving from retrenchment to expansion mode, and vice versa. The outlook for increased capital formation has improved considerably. The corporate sector financing gap is beginning to widen anew, reflecting the surge in business and consumer confidence since the pro-business U.S. Administration took power. The widening financing gap is particularly notable because it is occurring alongside improving profit growth. In other words, the wider financing gap reflects accelerating capex, not weak corporate cash flows. This is confirmed by BCA’s Capital Spending Indicator. BCA’s loan growth model also signals that demand for external capital should accelerate. With M&A activity starting to reaccelerate, capital markets return on equity is poised to climb further. We recommend shifting to a high-conviction overweight position. Please see yesterday’s Weekly Report for more details. The ticker symbols for the stocks in this index are BLBG: S5INBK - GS, MS, SCHW, RJF, ETFC.
Media shares have been under pressure of late, as a flare up in cord cutting worries and related concerns about TV ad spending. While these structural headwinds will likely remain intact for the foreseeable future, cheap valuations amidst positive cyclical signs suggest that a contrarily positive stance will be rewarded. In aggregate, demand for media services is brisk. Consumer outlays on media have soared to a two decade high, hitting a double digit annual growth rate. S&P media sales are tightly correlated with media spending (second panel). Importantly, buoyant demand is boosting industry productivity gains (third panel). Importantly, our Ad Spending Indicator, which incorporates key indicators of media demand, consumption and overall corporate profits, has hooked up, signaling that signaling that the path of least resistance for earnings estimates is up (bottom panel). Consequently, we recommend sticking with an overweight bias, please see yesterday’s Weekly Report for more details and analysis of the two major media sub-groups, movies & entertainment and cable & satellite. The ticker symbols for the stocks in these two indexes are BLBG: DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively.
Highlights The risk asset friendly outcomes in the French and South Korean elections are the latest examples of fading geopolitical risk, and we expect that to continue over the remainder of 2017. Although it has been well over a year since the last 10% pullback, the U.S. equity market is not "due" for a correction. For many investors, the drop in commodity prices has replaced geopolitics as the most likely cause of the next equity market correction. What is Dr. Copper's diagnosis? We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a correction. Many investors cite the monthly report on average hourly earnings as evidence that the Fed has it wrong on the economy and the labor market. We disagree. Feature U.S. stock prices remain within striking distance of their all-time highs and many investors continue to worry about the next correction. The risk asset friendly outcomes in the French and South Korean elections are the latest examples of fading geopolitical risk, and we expect that to continue over the remainder of 2017. The market has all but ignored the recent political turmoil in Washington. For many investors, the drop in commodity prices has replaced geopolitics as the most likely cause of the next equity market correction, while others note that it's been more than 15 months since the last 10%+ correction and that we are "due" for one. But is Dr. Copper still a reliable indicator of equity market tops? And if a correction is at hand, which assets would hold up best on the way down? We also review yet another disconnect between the Fed and the market: average hourly earnings. Geopolitical Risk Continues To Fade As A Market Concern Emmanuel Macron's victory was a resounding one as French voters rejected Le Pen's anti-Europe message in last week's election. Removing the possibility of a French President that is dedicated to exiting the eurozone is obviously positive for European stocks and investor risk appetite the world over. Next up are the two rounds of legislative elections in June. Polls are sparse, but they support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. A Macron presidency supported by Les Republicains in the National Assembly would be a bullish outcome for investors, according to our geopolitical strategists. On the international stage - where the president has few constraints - France will be led by a committed Europhile willing to push Germany towards a more proactive policy. On the domestic stage - where the National Assembly dominates - Macron's cautiously pro-growth agenda will be pushed further to the right by Les Republicains. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. The presidential election result in South Korea last week was exactly what the market expected, and should help to reduce tensions on the Korean peninsula. For now, the situation in Washington around President Trump's firing of FBI Director Comey has not had a major impact on markets. If the Democrats win the House of Representatives in 2018, our geopolitical team believes that impeachment proceedings will begin against Trump. On one hand, this means that polarization in the U.S. is about to reach record-high levels. On the other, it should motivate the GOP to get tax reform done before it is too late. Bottom Line: Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus, but that is a risk for 2018. We expect market-friendly policies emerging from Washington this year, although the Comey affair highlights that the road will be anything but smooth. Corrections And Pullbacks In Context Geopolitical risk appear to have faded for now, but with U.S. equities at or close to all-time highs, talk of a correction is hard to avoid. We continue to favor stocks over bonds this year and suggest that any sell-off in equities will be bought not sold. A hard landing in China, major disappointment on the Trump legislative agenda, a prolonged spell of weakness in the U.S. economic data1, and an overly aggressive Fed in 2017 may all serve as catalysts for a pullback. Above average PE ratios and measures of market volatility that are at cycle lows have only added to the chorus of those saying we are "due" for a correction. History suggests otherwise. From the end of WWII through 2009, the S&P 500 has experienced, on average, two 10% corrections and 10 corrections of 5% of more during equity bull markets. Since the start of the current bull market in March 2009 we've had 22 pullbacks of 5% or more and six corrections of more than 10% (using market closing prices) Table 1. This suggests that the market has seen its fair share of pullbacks and corrections since 2009, and isn't really "due". Chart 1 takes a different approach, but reaches the same conclusion. At 15 months (325 days) since the end of the last 10% correction, the current bull market is right of the middle of the pack of all bull markets since 1932. Table 1Six S&P 500 Corrections Of 10% Or More Since March 2009: We're Not "Due" Chart 1Current Equity Bull Market Is Not Long In The Tooth Our view remains that any pullback in U.S. equities will be bought, not sold, and we favor stocks over bonds in 2017. There are few notable imbalances in the U.S. or global economies and we see an acceleration in both over the remainder of 2017. The Fed will raise rates gradually this year, and there is general agreement between the Fed and the market on the pace of hikes at least for 2017. The Fed and the market remain far apart on hikes in 2018. Our view of the economy and labor market suggests that the market will ultimately move toward the Fed's view. The U.S. corporate earnings outlook remains solid, after a very good Q1 earnings season and favorable guidance for Q2 2017 and beyond. Bottom Line: Equity pullbacks - even during bull markets - are normal and healthy. We do not believe that the market is especially "overdue" for a pullback, but when the inevitable pullback or correction occurs, we expect that investors will take the opportunity to add to equity positions and not turn the pullback into a bear market. Dr. Copper? Chart 2Metals Prices Are Rolling Over...##BR##But Is It A Signal? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 20% on a year-ago basis, but has fallen by 8% since February (Chart 2). From their respective peaks earlier this year, zinc and copper are down about 10%, nickel has dropped by 22% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Some of our global leading economic indicators have edged lower this year, as we have discussed in recent Weekly Reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart 3). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over (annual growth is shown on a 12-month moving-average basis in Chart 4 because of the extreme volatility in the series). Both the PMI and housing starts are correlated with commodity prices. Chart 3China is The Main Story##BR##For Base Metals Demand Chart 4Direct Fiscal Spending And Infrastructure##BR##Have Picked Up Recently The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: Chart 5Dr. Copper Is Not Signaling##BR##A Slowdown in Global Growth There is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Moreover, both direct fiscal spending and infrastructure investment have picked up noticeably in recent months (Chart 4). Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. This all adds up to a fairly benign outlook for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. We intend to update our view on oil prices in the May 22, 2017 edition of this report. Bottom Line: From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Chart 5 highlights that the LMEX base metals index has a high positive correlation with the U.S. stock-to-bond total return ratio on a daily change basis. However, in terms of trends and turning points, base metals are far from a reliable indicator for the stock-to-bond ratio. Where To Hide In A Stock Market Correction Over the past several years, BCA's U.S. Investment Strategy service has periodically recommended that investors add a variety of investments as portfolio "insurance" to help guard against the possibility of a material correction in equities. More recently, we have highlighted two specific forms of insurance: our yield and protector portfolios. We last discussed the protector portfolio in the October 17, 2016 and November 7, 2016 Weekly Reports2, and in today's report we revisit the issue by comparing both portfolios to a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. Charts 6, 7, and 8 show a breakdown of the relative performance of S&P 500 defensives along with our yield and protector portfolios. Panels 2 and 3 of Charts 6, 7 and 8 present the rolling 1-year beta and alpha of each strategy vs. the S&P 500. Here, we present alpha as the difference between the actual year-over-year excess return of the portfolio (vs. short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is sometimes referred to as "Jensen's alpha". Chart 6A Modestly Low-Beta Option Chart 7A Lower Beta Than Defensives Chart 8A Negative Beta, And Positive Alpha There are several noteworthy observations from the charts: Based on the historical beta of the three portfolios vs. the S&P 500, defensive stocks are the most correlated with the overall equity market. Our protector portfolio has a negative correlation to the broad market, and our yield portfolio is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 2); with our protector portfolio composed entirely of non-equity assets. Table 2A Breakdown Of Three##BR##Portfolio Insurance Options After accounting for their lower beta, all three portfolios have tended to outperform the S&P in risk-adjusted terms since the onset of the global economic recovery. But this outperformance has been more significant for our yield and protector portfolios: the top panel of Charts 7 and 8 highlight that both portfolios have generated essentially the same return as equities have since the end of the recession (since the relative profile has been flat), despite exhibiting considerably less volatility than stocks. All three portfolios have experienced a relative decline vs. the S&P 500 since the election, but this has largely occurred due to passive rather than active underperformance. In other words, they have underperformed due to a failure to keep up with the S&P 500 rather than because of losses in absolute terms. There are two important conclusions from Charts 6, 7 and 8 for U.S. multi-asset investors. First, the lower beta of our yield and protector portfolios compared with S&P defensives means that the former represent a better insurance bet against a sell-off in the equity market than the latter. Second, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets over the past few years, which is likely to persist over the coming 6-12 months. But investors should also recognize that this preference could eventually be subject to a reversal if the long-term economic outlook significantly improves, an event that could be catalyzed either by organic economic developments or policy decisions by the Trump administration. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. But our analysis suggests that clients who anticipate the need for portfolio insurance over the coming year should favor our yield and protector portfolios over a defensive sector allocation within an equity portfolio, and we are likely to recommend an allocation to these portfolios for all clients were we to see any material progression towards the sell-off triggers that we identified earlier in the report. Bottom Line: Investors seeking some protection against a potential equity market sell-off should favor our yield and protector portfolios over defensive sector positioning. We do not currently recommend these portfolios for all clients, but we are likely to do so if our key sell-off trigger "red lines" are breached. What's Up With Wage Growth? On the surface, the April jobs report-released in early May seemed to send mixed signals to investors and the Fed about the health of the labor market3. Our view remains that the economy is growing fast enough to tighten the labor market, push up wages and ultimately inflation, which will lead the Fed to raise rates twice more in 2017. But even though the economy is very close to full employment and the output gap has nearly closed, patience is required. Although it's a close call, the next hike is likely to come next month. Markets remain somewhat skeptical of this view, and have only priced in 39 bps of tightening by the end of the year, and have not yet fully priced in a June rate hike. The lack of wage growth (up just 2.5% year-over-year in April according to average hourly earnings (AHE)) remains a key source of the market's skepticism about the pace and timing of Fed rate hikes. Many investors cite the monthly report on average hourly earnings as evidence that the Fed has it wrong on the economy and the labor market. Does the Fed see something the market does not? Or is it the other way around? Markets tend to focus on data that are timely. That requirement certainly fits the AHE. The monthly wage measure is the most timely data point on labor compensation. While timeliness is an important factor when assessing the health of the labor market, it is also critically important to watch what the Fed watches. Investors should note that the AHE data is only one of at least four measures of labor compensation the Fed mentions in its Semi Annual Monetary Report to Congress. Since Fed Chair Yellen took office in 2014, the Fed has specifically referenced (and charted together) three measures of labor compensation in the report: Average hourly earnings Employment Cost Index and Compensation per Hour in the nonfarm business sector, and Chart 9The Fed Tracks All Four Of##BR##These Compensation Measures The Atlanta Fed's Wage Tracker was mentioned in the June 2016 Monetary Policy Report, and the Fed added it to the chart of the other three metrics in the most recent report, released in February 2017. As Chart 9 shows, all have moved higher in recent years, although it is clear that AHE has lagged the others. Given the attention it receives in the financial news media on and just after "Employment Friday" each month, it may surprise investors to learn that neither AHE nor wages were directly mentioned in any of the FOMC statements since Yellen took charge. However, wage growth (or lack thereof) has been a topic of discussion at all but a few of the 13 post FOMC press conferences Yellen has held. When asked about wages, she is careful to note that the Fed watches a wide range of indicators of labor compensation, but has lamented the lack of progress on wages. In her most recent press conference, Yellen noted that "I would describe some measures of wage growth as having moved up some. Some measures haven't moved up, but there's some evidence that wage growth is gradually moving up, which is also suggestive of a strengthening labor market." Average hourly earnings are routinely mentioned in the FOMC minutes, but only alongside mentions of the other metrics noted above. On balance, average hourly earnings are viewed by the Fed - and therefore should be viewed by the market - as one of several indicators of the health of the labor market, but not the only indicator. Chart 10 shows that only a third of industries have seen an acceleration in wage increases over the past year, which supports the market's view that the economy is not growing quickly enough to push up wages and inflation. A recent report by the Kansas City Fed4 takes a different view. Using a bottom-up approach, the author points out that only a few industries (mostly in the goods producing sector of the economy) have accounted for much of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail trade, professional and business services and leisure and hospitality - all service sector industries - have been the laggards. The study done by the economists at the Kansas City Fed shows that although earnings growth has lagged in those more service-oriented industries since 2015, hours worked have seen faster growth than in the mainly goods producing sector (chart not shown). This suggests to the author - and we concur - that labor demand has been strong in the past few years in areas that have not seen much wage growth. As the labor market continues to tighten, wages in these industries may accelerate, but patience may be required. Chart 11 shows that it takes two to three years after a bottom in the output gap for a decisive turn higher in ECI or AHE. While this cycle has seen a more shallow recovery - especially in AHE - both have moved higher since the output gap bottomed out in 2009/2010. Chart 10Only 33% Of Industries Have Seen##BR##Wage Acceleration Over The Past 12 Months Chart 11Measures Of Labor Compensation Move##BR##Higher After Output Gap Bottoms Out Bottom Line: Investors are always wise to watch what the Fed watches. The evolution of wage growth will be critical to FOMC policymakers, because a clear acceleration will confirm that the economy is truly at full employment and, thus, at risk of overheating. We do not expect a surge in wages, but a steady upward trend will keep the Fed on a gradual tightening path. 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 Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Growth, Inflation And The Fed", dated May 8, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Reports "Portfolio Insurance: What, How, When?", dated October 17, 2016 and "Policy, Polls, Probability", dated November 7, 2016, both available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "Growth, Inflation And The Fed" dated May 8, 2017, available at usis.bcaresearch.com. 4 See "Wage Leaders and Laggards; Decomposing the Growth in Average Hourly Earnings" The Macro Bulletin, February 15, 2017; Federal Reserve Bank of Kansas City.
Highlights Portfolio Strategy Upgrade capital markets stocks to overweight and put them on the high-conviction list. Capital formation is poised to accelerate in the second half of the year. Our Indicators suggest that demand for media services will continue to improve. Stay overweight both the movies and entertainment and cable and satellite indexes. Recent Changes S&P Investment Banking & Brokerage - Upgrade to overweight and add to the high-conviction overweight list. S&P Consumer Finance - Remove from the high-conviction overweight list. Table 1Sector Performance Returns (%) Feature The S&P 500 continues to churn near its highs. Following a robust earnings season, the onus is now on the economy to provide confidence that the corporate profit recovery will prove durable, thereby justifying thinning equity risk premia. While slumping commodity prices suggest that global end-demand has downshifted a notch, the former boost real purchasing power and provide a reflationary support for stocks, particularly since resource-dependent sectors do not have a market leadership role. In fact, financial conditions remain sufficiently accommodative to expect a growth reacceleration in the back half of the year. It is notable that the recent selloff in the Treasury market has been driven by the real component, while inflation expectations have moved sideways. As a result, there is little pressure on the Fed to normalize at a faster pace than currently discounted in the forward curve. Thus, we expect the window for additional equity price appreciation to remain open this summer, unless growth reaccelerates sufficiently to stir inflation fears. Nevertheless, selectivity will become even more critical. Cross asset correlations have collapsed. Diminishing global macro tail risks have reduced the dominance of the beta-oriented "risk on/risk off" trade as a source of return. Empirical evidence suggests that asset correlations and the broad equity market are inversely correlated. This message is corroborated by falling correlations between regional stock market returns. Receding equity index correlations have been associated with positive S&P 500 returns (middle panel, Chart 1). This inverse correlation is also mirrored in the CBOE's implied correlation index, which tracks the correlation of the S&P 500 stocks with one another: tumbling correlations imply solid overall equity returns (top panel, Chart 1). These relationships are intuitive. Diminished macro tail risks bring earnings fundamentals to the forefront as the key driver of returns, and reward differentiation and discrimination in sector/region/asset class selection. While an eerie calm has dominated markets of late, as our Asset Class Volatility Indicator has collapsed to a multi-decade low (bottom panel, Chart 1), a more bullish explanation is that all-time highs in equities are synonymous with all-time lows in the VIX. This can be viewed as a contrary warning sign, but history shows that the VIX can stay depressed for a prolonged period. Our Equity Market Internal Dynamics Indicator (EMIDI), first introduced in late-March, has tentatively troughed, suggesting that sub-surface dynamics are becoming more supportive of the broad market (Chart 2). The EMIDI, which comprises relative bank, relative transport, small/large and industrials/utilities share prices, has been coincident to the leading market indicator, especially since the GFC. Chart 1Tumbling Correlations = Rising Stock Returns Chart 2Sub-Surface Dynamics Have Turned The Corner In that light, this week we are further augmenting our cyclical portfolio exposure by lifting another interest rate-sensitive group to overweight and are also updating the early cyclical media index and its major components. Capital Markets Stocks Have Rally Potential Two weeks ago, we recommended using this year's financial sector underperformance to boost allocations to overweight. This week we are further augmenting our exposure by upgrading the S&P investment banks & brokerage index to above benchmark. While the equity bull market is in the later innings, our view is that the overshoot will be extended for a while longer as a consequence of the overall sales and profit recovery and low probability that monetary conditions will tighten meaningfully in the near run. If this plays out, there is an opportunity for capital markets stocks to recover from their recent consolidation. This sub-index thrives when investor risk appetites are healthy and the business sector is moving from retrenchment to expansion mode, and vice versa. The outlook for increased capital formation has improved considerably. The corporate sector financing gap is beginning to widen anew (Chart 3), reflecting the surge in business and consumer confidence since the pro-business U.S. Administration took power. The widening financing gap is particularly notable because it is occurring alongside improving profit growth. In other words, the wider financing gap reflects accelerating capex demand, not weak corporate cash flows. This is confirmed by BCA's Capital Spending Indicator, which signals an increase in business investment ahead. Consequently, corporate sector demand for external capital should accelerate. The latter is the lifeblood of capital markets profitability. The nascent recovery in total bank credit growth after a period of malaise reinforces that working capital requirements are on the upswing (Chart 3).1 As businesses shift from maintenance capital spending to a more expansionist mindset, and companies reach further for growth to justify high stock valuations, capital markets activity could accelerate in the second half of the year. After all, investor confidence is high. Corporate bond spreads have tightened and corporate bond issuance is soaring. The Equity Risk Premium is steadily narrowing (shown inverted, second panel, Chart 4), reducing the cost of equity capital. New stock issuance is following on the heels of corporate bond issuance. Stocks are outperforming bonds by a comfortable margin and total mutual fund assets have grown sharply (Chart 3). The upshot is that access to corporate sector capital should stay healthy. As flows into equities advance, it will fuel a reacceleration in M&A activity (Chart 5). Chart 3Capital Markets Activity Is... Chart 4...Firing On All Cylinders Chart 5ROE On The Upswing Capital markets return on equity (ROE) is highly levered to business and investor risk appetite. Fees earned on M&A activity heavily influence overall profitability. As such, it is normal for ROE to expand when M&A activity picks up, and shrink when financial conditions tighten and takeovers dry up. Currently, M&A transactions represent an historically elevated share of GDP, but that is not a barrier to an increased rate of takeover activity. Companies are no longer using their balance sheets to repurchase their own shares en masse. Instead, there is an incentive to pursue business combinations as the global economy reaccelerates, underscoring that capital allocation should shift in favor of capital markets firms. Indeed, Chart 5 shows that ROE also follows the trend in our global leading economic indicator, and the current message is bullish. Even capital markets companies themselves confirm that their pipelines are full. Hiring activity remains robust. Pro-cyclical firm headcount rises quickly alongside revenue opportunities, and is just as quick to shrink when the outlook darkens. Ergo, we interpret headcount growth as a net positive. While trading activity is always a wildcard, and could be a source of weakness if bond market, and generalized asset class, volatility stays muted, the upbeat outlook for fee generation from increased capital formation provides us with confidence to use share price weakness as an opportunity to build a bigger position. Bottom Line: Lift the S&P investment banking & brokerage index to overweight, adding to our recent decision to upgrade the overall financials sector to above-benchmark. The ticker symbols for the stocks in this index are BLBG: S5INBK - GS, MS, SCHW, RJF, ETFC. Media Stocks: Temporary Pressure Media stocks have come under pressure recently, giving back all of this year's relative gains. Investor worries have centered around two thorny issues: cord-cutting and ad spending. Cord-cutting is not new, but weak overall Q1 TV subscriber numbers have refocused investors' attention on the secular challenges ahead. In addition, a number of companies noted softening ad spending on Q1 conference calls. According to media executives, this slowdown is not isolated to the automotive segment. Is it time to pull the plug or is a worst case scenario already priced into the group? We side with the latter. In aggregate, demand for media services is brisk. Consumer outlays on media have soared to a two decade high, hitting a double digit annual growth rate. S&P media sales are tightly correlated with media spending (second panel, Chart 6). Despite coming off the boil recently after hitting unusually high growth rates, media pricing power also remains in expansionary territory. Importantly, buoyant demand is boosting industry productivity gains. The third panel of Chart 6 shows that our media productivity proxy has reaccelerated. Meanwhile, an improving economic backdrop also bodes well for media earnings prospects. The ISM services new orders sub component has been an excellent leading indicator of relative profit growth expectations and the current message is positive (middle panel, Chart 7). If the overall economy bounces smartly from the weak Q1 print, as we expect, then an earnings-led recovery should sustain the valuation re-rating phase (bottom panel, Chart 7). Chart 6Buoyant Media Demand Chart 7Valuation Re-Rating Looms Our Ad Spending Indictor (ASI) incorporates all of these key media profit drivers, including consumption and overall corporate profits. The ASI has recently hooked up, signaling that earnings estimates should continue to rise (bottom panel, Chart 8). Nevertheless, sub-media group returns have been bifurcated, with the S&P movies and entertainment index exerting downward pressure on the overall sector of late. Relative performance has mostly treaded water since our upgrade last summer, but hit a soft patch after recent quarterly results. Before rushing to make a bearish judgment, it is notable that the relative forward P/E remains close to an undervalued extreme, signaling that it will be increasingly difficult to disappoint. Historically cheap valuations exist despite depressed expectations, which should serve to artificially inflate valuations: both top and bottom line are expected to lag the broad market, representing a very low hurdle (Chart 9). Chart 8Rosier EPS Prospects Lie Ahead Chart 9Unloved And Undervalued Beyond the positive consumer spending backdrop (Chart 10), we are inclined to stick with overweight positions in this sub-component for four major reasons. First, merger and acquisition activity should reduce capacity, and by extension, support pricing power, especially if the AT&T/Time Warner deal clears the regulatory hurdle. There is scope for additional M&A that could further reduce shares outstanding (Chart 11). Chart 10Improving Demand... Chart 11...And M&A Activity Are An EPS Tonic Second, content providers are adapting to the competitive threat. New online-only offerings and slimmer/nimbler packages should stem the drag from the likes of Netflix and other streaming services. Consumer spending on electronics continues to surge, suggesting that content providers have ample opportunity to fill increasing demand. Third, there is no substitute for live TV. News and live sports are two sticky offerings that will continue to be cash cows for the industry and drive select subscriber growth. Fourth, media giants have stepped up focus on other segments with higher growth potential, such as studios and franchises highlighting increasingly diversified revenue streams. Moreover, CEOs have been aligning cost structures to the new realities of cord-cutting, exercising strict cost control. Companies have also been careful with capex allocation decisions. All of this suggests that any shakeout in this media subgroup is a good entry point for building new positions with a compelling valuation starting point. Unlike the S&P movies and entertainment index, the S&P cable and satellite group has been relentlessly grinding higher, underpinning the broad media index. The multiyear share price advance has been cash flow driven. As a consequence, cable stocks still trade at a 25% discount to the broad market on a price/cash flow basis and the relative multiple is hovering near the historical mean (third panel, Chart 12). Cable and satellite sales growth has surged to healthy low double-digit growth rates after a one year lull. Encouragingly, soaring pricing power signals that recent revenue momentum is sustainable (second panel, Chart 12). As mentioned above, consumer outlays on cable services have had a V-shaped recovery, underscoring that the latest upleg in selling prices is demand driven (bottom panel, Chart 12). It is remarkable that the industry has consistently raised selling prices at a faster pace than overall inflation for decades (Chart 13). This impressive track record reflects cable operators' ability to continually evolve offerings and provide attractive content, even in the face of cord-cutting. Chart 12Cash Flow Driven Outperformance Chart 13The Cable Signal Is As Strong As Ever Meanwhile, content inflation rates have remained within the range of the past few years, underscoring that threats to robust profit margins are limited (bottom panel, Chart 13). More recently, news that Comcast and Charter will come together and cooperate on a wireless offering adds another layer of defense in effectively combating cord-cutting. How? By increasing the bundle offering beyond cable and internet services, cable providers are positioned to attract new clients by offering a one stop shop triple-play solution. A move into wireless service offerings would also assist in retaining existing customers. In sum, most of our indicators suggest that the demand outlook for media services continues to improve. Our Ad Spending Indicator is climbing, underscoring that fears of a deep and widespread slump are overblown. Bottom Line: The media index remains an overweight and we continue to recommend an above benchmark exposure both in the S&P movies and entertainment and S&P cable and satellite sub-groups. The ticker symbols for the stocks in these two indexes are BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively. 1 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds," dated April 11, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Telecom services shares have been crushed this year, down by over 10% in absolute terms and 17% relative to the broad market. The collapse in relative performance has been entirely earnings driven. While every sector's EPS and sales-per-share metrics grew year-over-year in Q1, telecom services was the sole GICS1 sector that contracted on both fronts. That abysmal showing is a consequence of the aggressive price war that has engulfed the industry. Telecom carriers are at each other's throats, protecting their customer base. To make matters worse, competition appears to have intensified: wireless telecom selling prices have collapsed on a 3-, 6- and 12-month rate of change basis (bottom panel). Worrisomely, recent news from the cable industry that Comcast and Charter would come together and offer wireless services signals that intra- and inter-industry price competition to preserve customers and to win new ones over will remain intact. Under such a backdrop, it is still prudent to avoid telecom services stocks.
Highlights The U.S. unemployment rate stands 0.1 points below the FOMC's year-end projection and 0.4 points below its estimate of NAIRU. If the unemployment rate keeps falling, it will have nowhere to go but up - and the U.S. has never been able to avoid a recession whenever the unemployment rate has risen by more than one-third of a percentage point. So far the FOMC has failed in its efforts to tighten monetary policy. U.S. financial conditions have actually eased sharply since the Fed resumed hiking rates in December. The Fed will turn more hawkish over the coming months. Stay short the January 2018 fed funds futures contract and position for a stronger dollar. What happens in the euro area has become increasingly irrelevant for what happens to EUR/USD. Even if the ECB raises rates somewhat more rapidly than expected, this will be largely counterbalanced by hawkish actions by the Fed. Investors should stay cyclically overweight global equities, but be prepared to pare back exposure next summer. Feature Beware Of Full Employment Chart 1Recoveries Usually Lose Steam##br## WhenThe Unemployment Rate Falls Below NAIRU After eclipsing 10% in 2009, the U.S. unemployment rate fell to 4.4% in April, 0.1 points below the median end-2017 dot in the Fed's Summary of Economic Projections, and 0.4 points below the FOMC's estimate of NAIRU.1 The fact that most Americans who want to work are able to find jobs is obviously a good thing. However, today's increasingly tight labor market does have a dark side: As Chart 1 illustrates, recoveries have tended to run out of steam whenever the unemployment rate has fallen below its full employment level. Two points about the unemployment rate are worth keeping in mind: The unemployment rate has rarely been stable over time; usually, it is either rising or falling. The former tends to occur very quickly, while the latter is more drawn out. The unemployment rate displays momentum over short horizons, but is "mean-reverting" over the long haul (Chart 2).2 Since there is a limit to how low the unemployment rate can go, periods when it is below its full employment level typically do not last long. This is confirmed by Chart 3, which shows that there is a clear positive correlation between the degree of labor market slack and the onset of the next recession: High slack means that a recession is usually far away, whereas low slack means that a downturn is approaching. And it doesn't take much of an increase in the unemployment rate to sow the seeds for another recession - the U.S. has never escaped a recession in the postwar period whenever the three-month moving average of the unemployment rate has risen by a mere one-third of a percentage point (Chart 4). Chart 2The Unemployment Rate Is Mean-Reverting Over The Long Haul, But Displays Momentum In The Short Term Chart 3The Degree Of Labor Market Slack And The Onset Of The Next Recession: A Clear Positive Correlation Chart 4What Goes Down Must Come Up? Rising unemployment tends to generate all sorts of vicious cycles. When someone loses their job, they spend less. The resulting decline in aggregate demand forces firms to lay off workers, leading to even less spending throughout the economy. A weaker economy also makes it more difficult for borrowers to pay back loans, causing them to pare back spending. Falling asset prices only serve to exacerbate this problem. Threading The Needle Today's low unemployment rate puts the Federal Reserve in a bind. On the one hand, if the Fed raises rates too quickly, this could precipitate exactly the sort of downturn that it is trying to avoid. On the other hand, if the Fed fails to raise rates quickly enough, this could cause the economy to overheat. This, in turn, may force the Fed to raise rates aggressively - something that would destabilize both the economy and financial markets. The hope is that the Fed succeeds in threading the needle to ensure that the economy achieves a soft landing. There are some reasons to be optimistic about such an outcome, but also several reasons to be pessimistic. On the optimistic side, inflation expectations remain well anchored. This means that an overheated economy is unlikely to produce a powerful price-cost spiral such as the one that broke out in the 1970s. This limits the risk that the Fed will be forced to raise rates dramatically. The real economy is also not suffering from the sort of clear-cut imbalances that plagued the late innings of the last two business cycles - a massive capex overhang in the late 1990s, and an even larger housing overhang in the years leading up to the Global Financial Crisis. Private debt levels have also fallen as a share of GDP for most of the recovery, unlike in past cycles (Chart 5). On the pessimistic side, uncertainty about the level of the neutral rate - the interest rate consistent with full employment and stable inflation - will make it difficult for the Fed to calibrate monetary policy in a way that ensures a soft landing. It typically takes 12-to-18 months for changes in monetary conditions to fully make their way through the economy. Thus, if the Fed does end up either too far behind or too far ahead of the curve in normalizing monetary policy, it may not realize this until it's too late. Structurally slower potential GDP growth could also complicate matters. The Congressional Budget Office estimates that real potential GDP growth will average only 1.8% over the next 10 years, compared to 3.1% between 1980 and 2007 (Chart 6). Today's equity valuations are arguably pricing in faster GDP growth. Should growth settle below 2% - a rate that has often been associated with stall speed - risk assets could suffer, complicating the Fed's efforts in achieving a soft landing. Chart 5The Economy Is Not Showing ##br##Clear-Cut Signs Of Imbalances Chart 6Potential GDP Growth Is Not ##br##What It Used To Be The Fed's Choice Given the choice between erring on the side of raising rates too slowly or too quickly, the Fed has opted for the former. This is a quantitative statement, not a qualitative one. Chart 7 shows that U.S. financial conditions have eased considerably since the Fed resumed raising rates last December, thanks to a weaker dollar, tighter credit spreads, and a soaring stock market. If the whole point of hiking rates is to tighten financial conditions, then the Fed has not done enough. Worries that the headline unemployment rate may understate the true amount of labor market slack partly explain the Fed's angst in raising rates as quickly as it has in past cycles. While the headline rate has fallen back to its 2007 low, the broader U-6 unemployment rate - which incorporates people who are out of the labor market but claim to want a job, as well as those who are working part-time for economic reasons - is still 0.7 points above it. Likewise, the employment-to-population ratio for prime-age workers (ages 25-to-54) is 1.7 points below its pre-recession levels. The "quits rate" - a good measure of labor market confidence - also remains a notch below its pre-recession peak. Perhaps most glaringly, the median duration of unemployment has only fallen back to 10.2 weeks, which is still close to the high of the previous cycle (Chart 8). Chart 7Financial Conditions Have Been Easing Chart 8Headline Unemployment Rate ##br##Back To 2007 Levels, But Other ##br##Measures Still Point To Slack Each of these factoids has a counterargument: The elevated share of involuntary part-time workers may be partly due to the effects of Obamacare, which has made it burdensome for companies to add full-time workers to the payrolls;3 the low quits rate and the high median length of unemployment may reflect the aging of the population as well as lower gross job creation (Chart 9); and automation, globalization, and low-skilled immigration may have depressed real wages for less-educated workers, causing them to abandon the labor market (Chart 10). Nevertheless, with core inflation still below the Fed's 2% target, it is not hard to see why the Fed has elected to take a "go slow" approach so far. Chart 9The Labor Market Has Become Less Dynamic Chart 10Less-Educated Men Are Fleeing The Labor Market The Hawks Spread Their Wings That may be changing, however. The growth in nominal unit labor costs has already surpassed 2% and is close to the peaks reached in 2000 and 2007 (Chart 11). Most other measures of wage growth remain in a clear uptrend (Chart 12). If GDP growth accelerates over the remainder of the year, as we expect, the Fed will pursue a more aggressive tightening path than what the market is currently discounting. Chart 11Unit Labor Cost Inflation Close To Past Peaks Chart 12Most Measures Of Wage Growth Are In An Uptrend Recent communications from the Fed have revealed an increasingly hawkish bias. The latest Fed statement downplayed the slowdown in Q1 as "transitory." This follows Chair Yellen's comment that "waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession."4 Investment Conclusions Higher U.S. rate expectations should give the dollar a boost (Chart 13). We do not agree with the often-heard argument that the actions of foreign central banks will materially weaken the dollar. Consider the case of the ECB. There has been much speculation that the ECB will phase out some of its emergency measures. That may well happen, but even if it does, a full-fledged hiking cycle is nowhere on the horizon. According to a recent ECB study, the rate of labor underutilization still stands at 18% in the euro area, 3.5 points higher than in 2008 (Chart 14).5 Stripping out Germany, the rate of underutilization would be seven points higher (Chart 15). It is still too early for Mario Draghi to begin removing monetary accommodation in a concerted manner. Chart 13Higher U.S. Rate Expectations ##br##Should Give The Dollar A Boost Chart 14Labor Market Slack In The Euro Area Remains High... Chart 15...Especially Outside Of Germany Moreover, anything the ECB does which inadvertently leads to a stronger euro will likely be matched by offsetting hawkish actions by the Fed. Remember that the Fed needs to tighten financial conditions in order to prevent the unemployment rate from falling so much that it has nowhere to go but back up. A weaker dollar runs contrary to that strategy. The argument above can be applied more broadly. The euro rallied in the lead-up to the French election on the now-realized hope that Emmanuel Macron would prevail. Put aside the fact that Macron's platform calls for cutting the budget deficit from 3.2% of GDP this year to 1% of GDP in 2022 - something which, all things equal, would lead to less monetary tightening and a correspondingly weaker euro. Even if Macron's victory somehow did manage to allow the ECB to raise rates earlier than it would have otherwise, it is hard to believe that this would not influence the pace of Fed rate hikes. U.S. financial conditions could tighten through some combination of higher rates and/or a stronger dollar. The only way the Fed could engineer a tightening in financial conditions while the trade-weighted dollar still weakened would be to jack up interest rates by an inordinate amount. However, this outcome would require that other central banks raise rates even more. That's not going to happen. Stay short EUR/USD. We think the euro will reach parity against the dollar later this year. Where does this leave equities? So long as global growth remains solid and corporate earnings are in an uptrend, the path of least resistance for stocks is up. However, the risk is that the Fed overplays its hand and ultimately tightens monetary policy too much. This could lead to a broad-based global slowdown towards the end of 2018. Investors should stay cyclically overweight global equities, but be prepared to pare back exposure next summer. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is the unemployment rate consistent with stable inflation. 2 An Ordinary Least Squares (OLS) regression using monthly data between 1960 and 2017 shows that the change in the unemployment rate over the coming three months is positively associated with a change in the unemployment rate over the prior three months, and negatively associated with the level of the unemployment gap. 3 See, for example: Marcus Dillender, Carolyn Heinrich, and Susan Houseman, "Effects of the Affordable Care Act on Part-Time Employment: Early Evidence," Upjohn Institute Working Paper, 2016. 4 Janet Yellen, "Semiannual Monetary Policy Report To The Congress," February 14, 2017. 5 Please see ECB, "Focus: Assessing Labour Market Slack," Economic Bulletin Issue 3, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlight Once-ebullient oil markets are overwrought. Fears that an economic slowdown in China will spill over into EM - the engine of global commodity demand growth - along with a very weak 1Q17 U.S. GDP performance, will keep oil markets focused on downside risks to prices. On the supply side, high-frequency inventory data from the U.S. suggests visible OECD stocks remain high, seemingly impervious to OPEC 2.0's best efforts to drain them. Steadily rising U.S. shale output also weighs on prices. Markets appear to be looking right through the choreographed comments on production cuts from leaders of OPEC 2.0, which suggest these cuts will definitely be extended to year-end 2017, and possibly into 2018. We doubt the demand picture is anywhere close to a fundamental downshift, expecting, instead, continued robust demand. We also expect the extension of OPEC 2.0's production cutbacks to year-end 2017 to significantly drain storage, even as shale output continues to grow. If anything, recent market action has presented an opportunity re-establish length, and to position for backwardation toward year-end. Energy: Overweight. The stop-loss on our Dec/17 Brent $45/bbl puts vs. $65/bbl calls was elected May 4/17, leaving us with a loss of $1.54/bbl (-327.7%). We are reinstating the position as of tonight's close, anticipating Brent will reach $60/bbl by year-end. We also stopped out of our Dec/17 Brent long vs. Dec/18 Brent short on May 4/17, with a $0.50/bbl loss (-263.2%). We will re-establish this position as well basis tonight's close. Base Metals: Neutral. LME and COMEX stock builds are keeping copper under pressure, offsetting possible renewed labor unrest. This is keeping us neutral. Precious Metals: Neutral. We were made long spot gold at $1230.25/oz basis last Thursday's close as a hedge against inflation risk, and a possible equities correction. Ags/Softs: Underweight. USDA data indicate a favorable start to the grain planting season. We remain bearish. Feature Softer Chinese PMIs spooked commodity markets, coming as they did on the heels of a very visible and much-reported weakening of base metals and iron ore prices emanating from Chinese markets (Chart of the Week).1 Financial markets fear weaker Chinese growth could presage weaker EM growth, which is the engine of commodity growth generally.2 With U.S. GDP coming in weak as well - registering a paltry growth of 0.7% in 1Q17 - markets started re-calibrating oil demand estimates for this year in light of still-high inventory levels. Adding to the market's agita, visible oil inventories in the OECD remain stubbornly high, thwarting OPEC 2.0's best efforts to drain them via their closely followed production cuts. By Wednesday of this week, this potent combination shaved some 9.6% off 1Q17 average prices, taking international benchmarks Brent and WTI below $50/bbl. Dubai prices have largely been spared similar carnage, as Gulf OPEC states continue to reduce supplies of heavier sour crude availabilities (Chart 2). Chart of the WeekChina PMIs Weaken As Monetary##BR##Conditions Tighten Slightly Chart 2Oil Prices##BR##In Retreat OPEC 2.0 Responds To Weaker Prices OPEC 2.0 - our moniker for the producer group comprised of OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia - was not oblivious to these concerns. Indeed, earlier this week KSA Oil Minister Khalid al-Falih said the group would "do whatever it takes" to drain stocks and normalize global inventories (Chart 3). The OPEC 2.0 leadership is well aware that failure to do so would again expose these petro-states to the risk of a price collapse, as, absent production discipline, oil inventories once again would fill. This would force prices through producers' cash costs until enough production was knocked off-line to drain the storage overhang.3 Comments by leaders of OPEC 2.0 regarding the extension of its 1.8mm b/d production cuts this year and into next year are consistent with a strategy we laid out earlier, part of which includes the use of forward guidance to convince markets the supply side will tighten in the future.4 The other critical part of the strategy is for OPEC 2.0 to keep the front of the Brent curve at or below $60/bbl, using their own production, spare capacity and storage, and guiding to higher supply in the future, which would keep markets backwardated in 2018 once visible storage returns to five-year average levels. A persistent and deep backwardation - on the order of 10% p.a. - would, based on our modelling, slow the return of rigs to U.S. shale fields. In addition, the combination of a front-end forward curve capped at $60/bbl and persistent backwardation would keep depletion rates elevated, as cash-strapped producers - e.g., non-Gulf OPEC producers with high fiscal breakeven oil prices - are forced to forego maintenance capex. Taken together, this would give OPEC 2.0 a stronger hand in guiding prices - provided the coalition can hold together and maintain production discipline. We continue to expect an extension of the 1.8mm b/d OPEC 2.0 cuts will backwardate markets once inventories normalize later this year, even with strong growth from U.S. shales.5 Indeed, we expect this combination of fundamentals will clear the storage overhang by end-2017, and produce draws of more than 1mm b/d on average from April - December (Chart 4). Chart 3OPEC 2.0 Leaders KSA,##BR##Russia: "Whatever It Takes" Chart 4Steady Demand,##BR##Extended Cuts Will Drain Inventories Wobbly Oil Demand Is Transitory The 1Q17 demand-side scares emanating from China and the U.S. are transitory. Chart 5Fiscal And Infrastructure Spending##BR##Picked Up This Year In China Following their return from the mainland, our colleagues on BCA's China Investment Strategy desk note that monetary conditions still are fairly stimulative, and are unlikely to cause the economy to roll over.6 Most of the deterioration in economic growth results from a slowing in the depreciation of China's trade-weighted RMB, following a years-long appreciation from 2012 to 2015, which did dampen growth. In addition, while fiscal stimulus was reduced at the end of 2016, the government "quickly reversed course" as direct spending and investment in infrastructure picked up substantially (Chart 5). Our China Investment Strategy colleagues note China's fiscal spending is pro-cyclical - it increases as the economy improves and tax revenues increase. The government shows no sign of wanting to wind this down: "China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant." The impact of Chinese demand on global oil demand is increasing, based on econometric work we've recently completed. From 2000 to end-April 2017, a 1% increase in Chinese oil demand has translated into a 0.64% ncrease in Brent prompt prices. During this period, the impact of non-OECD demand ex China was more than two times that of China's - a 1% increase there could be expected to lead to a 1.3% increase in Brent prices. China's impact on Brent prices in the post-GFC world more than doubled, while the impact of non-OECD demand ex-China increased marginally. Since the Global Financial Crisis, a 1% increase in China's oil consumption has produced a 1.4% increase in Brent prices, while a similar increase in EM ex-China has translated into a 1.8% increase in Brent prices.7 Turning to the U.S., we believe, along with the Fed, the weak patch in GDP in 1Q17 is transitory. Following the report on the quarter's weak 0.7% GDP growth, the U.S. Bureau of Labor Statistics surprised markets with a reading of 4.4% unemployment (U3 measure), and an equally impressive U6 measure of 8.6%, which takes it almost to pre-GFC levels. We expect robust U.S. labor-market conditions will keep demand for refined products in the U.S. robust, which will support oil prices there going forward. Globally, the U.S. EIA expects oil consumption will grow 1.6mm b/d this year - unchanged from last year. This is above our 1.4mm b/d estimate for the year. If the EIA's demand estimate is accurate, we can expect a sharper draw (+200k b/d) in global inventories than the average 860k b/d we currently are projecting, all else equal (Chart 4). This would lead to a sharper and earlier backwardation in prices that we currently expect. We will be re-estimating our balances model next week. Investment Implications We continue to expect the global storage overhang to clear by year-end, given the extension of OPEC 2.0's production cuts to at least year-end 2017. Wobbly demand is a transitory phenomenon, and we expect a recovery in the balance of the year. Given our expectation, we are re-establishing our long year-end Brent exposure, and are going short a $45/bbl Dec/17 Brent put vs. long a $65/bbl Dec/17 Brent call at tonight's close. We had a -$1.00/bbl stop-loss on this position, which was elected May 4/17 and resulted in a 1.54/bbl loss (-327.7%). We stopped out of our long Brent front-to-back position - long Dec/17 Brent vs. short Dec/18 Brent - in anticipation of backwardation. We also will be looking to re-establishing this position at tonight's closing levels, and for a good entry point to re-establish the same position in WTI. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Iron-ore (62% Fe) prices are down 33.5% after peaking this year at close to $91/MT in March. The LMEX base metals index is down 7.7% from its 2017 peak in February. Regular readers of Commodity & Energy Strategy will recall we've been bearish iron ore and steel for months, and have remained neutral base metals. Please see "China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals," and "Copper's Price Supports Are Fading," in the January 19, and March 23, 2017, issues of Commodity & Energy Strategy. They are available at ces.bcaresearch.com. 2 In the May 5, 2017, issue of BCA Research's Foreign Exchange Strategy, our colleague Mathieu Savary notes, "The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing." Please see "The Achilles Heel of Commodity Currencies" in the May 5 FES, available at fes.bcaresearch.com. 3 Please see "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," published by BCA Research's Commodity & Energy Strategy April 20, 2017, for a further discussion of the logic behind these cuts. 4 This aligns with a strategy we laid out last month, which uses forward guidance to convince markets to anticipate tighter supply further out the curve. By leading markets to anticipate lower crude oil availabilities in the future - while storage is drawing - OPEC 2.0 is setting the stage for forward curves to remain backwardated. Please see "The Game's Afoot In Oil, But Which One?" published April 6, 2017, in BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 5 "Backwardation" refers to a futures forward-price curve in which contracts for prompt delivery are higher than prices for deferred delivery. This indicates merchants and refiners are willing to pay more for a commodity delivered close in time versus in the future. It is the opposite of a "contango" curve, in which deferred prices exceed prompt prices. 6 Please see "Has China's Cyclical Recovery Peaked?" in BCA Research's China Investment Strategy Weekly Report published May 5, 2017. It is available at cis.bcaresearch.com. 7 These coefficients are all significant at less than 0.01. R2 coefficients of determination for these cointegrating regressions, which include the USD broad trade-weighted index (TWIB) all exceed 0.90, indicating that the USD TWIB and Brent prices share a common long-term trend, and that FX effects remain important in assessing oil prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016