Corporate Profits
Highlights Duration: The housing market is the key channel through which monetary policy impacts the economy. As such, it is unlikely that Treasury yields will peak until housing shows meaningful weakness. While residential investment has decelerated in recent quarters, we expect this weakness will prove temporary and that Treasury yields have further cyclical upside. Maintain below-benchmark portfolio duration. Yield Curve: The Fed will maintain its 25 bps per quarter rate hike pace for the time being, but could be forced to pause next year if weak foreign growth migrates to the U.S. via a stronger dollar. We recommend hedging this risk via a long position in the 7-year bullet versus a short position in the 1/20 barbell. Corporate Health: Strong profit growth - both organic and as a result of corporate tax cuts - has led to a significant improvement in corporate balance sheet health during the past few quarters. This improvement will not persist for much longer. We recommend only a neutral allocation to corporate bonds, both investment grade and junk. Feature This time last week the 10-year Treasury yield was bumping up against 3% and money markets were on the cusp of discounting an extra rate hike between now and the end of 2019. Both resistance levels broke during the past seven days. The 10-year yield is now 3.07% and the January 2020 fed funds futures contract is fully priced for four rate hikes (Chart 1). Chart 1Past Resistance Levels With the 10-year yield back above 3%, many investors are once again speculating about where it will ultimately peak for the cycle. Any answer to this question relies on an assumption about the neutral fed funds rate, the level of interest rates above which monetary policy turns restrictive and acts to slow economic growth and inflation. In past reports we have suggested several measures investors can track to help decide whether interest rates are close to breaking above neutral.1 In this week's report we focus on one particularly important indicator - the housing market. In his essential 2007 paper "Housing Is The Business Cycle", Edward Leamer notes that of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.2 Given that recessions are also typically preceded by tightening monetary policy, it is not a stretch to connect the two. In fact, there is good reason to believe that housing is the main channel through which monetary policy impacts the economy. Since leverage is employed in the acquisition of new homes, interest rates impact the cost of homeownership more directly than other assets. A similar claim could be made about leveraged investment from the corporate sector, but business investment is also beholden to swings in expected future demand. Households can easily postpone the acquisition of a new home if the interest rate environment makes it uneconomical, businesses need to act when the market demands it. But most importantly, Leamer's paper demonstrates that, unlike residential investment, weaker business investment does not consistently provide advance warning of recession. The State Of U.S. Housing Turning to the data, we see that Leamer's claim is validated by the top panel of Chart 2. Residential investment tends to decline in the year preceding a U.S. recession. Housing starts and new home sales display a similar pattern (Chart 2, panels 2 & 3). Chart 2The Housing Market Predicts Recessions What's worrying is that residential investment has barely grown at all during the past year (Chart 2, bottom panel). If this weakness continues it would signal that interest rates are too high for the housing market, and that we are likely very close to the cyclical peak in bond yields. However, we doubt the current weakness will persist. For one, the recent decline in construction activity has been concentrated in the multi-family sector while single-family construction continues to expand at a steady rate (Chart 3). This could simply reflect a shift in demand away from multi-family toward single-family, reversing the trend witnessed between 2010 and 2012. It's possible that some households who were forced into the rental market in the aftermath of the Great Recession now find themselves able to switch back. But even if we focus on the multi-family sector exclusively, there is little reason to believe that construction will see significantly more downside. The rental vacancy rate remains very low, and the National Multi Housing Council's Survey of Apartment Market Conditions suggests that there is no strong upward or downward pressure on the vacancy rate at the moment (Chart 3, bottom 2 panels). The fact that single-family housing starts have not declined casts some doubt on the notion that higher mortgage rates are to blame for the deceleration in residential investment. This is further borne out by the fact that, while higher mortgage rates have certainly increased the cost of homeownership, mortgage payments as a percent of median income are not stretched compared to history (Chart 4). The demand back-drop for housing also remains robust, with household formation in a clear uptrend (Chart 4, panel 2) and homebuilders as optimistic as ever about future sales activity (Chart 4, bottom panel). Chart 3A Temporary Weakness In Residential Investment Chart 4Higher Mortgage Rates Are Not The Culprit We conclude that interest rates are still too low to meaningfully impact the housing market. Residential investment will re-accelerate in the coming quarters and Treasury yields have plenty of room to rise before reaching their cyclical peak. Bottom Line: The housing market is the key channel through which monetary policy impacts the economy. As such, it is unlikely that Treasury yields will peak until housing shows meaningful weakness. While residential investment has decelerated in recent quarters, we expect this weakness will prove temporary and that Treasury yields have further cyclical upside. Maintain below-benchmark portfolio duration. Hedging Weak Foreign Growth With Steepeners The resilience of the U.S. housing market makes it likely that interest rates will continue to rise for quite some time. However, this does not preclude weak foreign growth - and the resultant dollar strength - from forcing the Fed to slow its 25 basis point per quarter rate hike pace at some point during the next 6-12 months. In fact, we have flagged in recent reports that, since 1993, every time the Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed (Chart 5).3 Unless foreign growth suddenly recovers, it is quite likely that dollar strength will drag the U.S. LEI lower in the first half of next year. At that point, the Fed may be forced to pause its rate hike cycle in order to take some shine off the dollar, allowing the recovery to continue. Chart 5Weak Global Growth Could Bring Down The U.S. Drops in the U.S. LEI to below zero almost always coincide with a recommendation for easier monetary policy from our Fed Monitor (Chart 5, bottom panel). Although one notable exception did occur in 2005. An examination of the three components of our Fed Monitor reveals that a falling LEI caused the economic growth component of our monitor to decline in 2005 (Chart 6). However, this was offset by an elevated inflation component and extremely easy financial conditions (Chart 6, bottom 2 panels). Chart 6The Three Components Of Our Fed Monitor As in 2005, inflation pressures are once again elevated and financial conditions remain accommodative. It follows that it could take a significant deterioration in economic growth before the Fed is forced to pause its 25 bps per quarter rate hike cycle, one that is not yet evident in the data. Nevertheless, we cannot ignore the risk that weak foreign growth will infiltrate the U.S. via a stronger dollar, forcing the Fed to pause. With only two 25 basis point rate hikes currently discounted for 2019, some pause is already in the price. This makes us reluctant to advocate shifting away from below-benchmark portfolio duration. We think a better way to hedge the risk of a Fed pause is through yield curve steepeners. Since short-dated yields are more heavily influenced by the expected near-term pace of rate hikes than long-dated yields, any Fed pause will cause the yield curve to steepen. Steepeners are also very attractively priced at the moment, meaning that they should even perform well in a mild curve flattening environment.4 Our preferred method for implementing a curve steepener is to go long a bullet maturity near the middle of the curve and short a duration-matched barbell consisting of the very short and very long ends of the curve.5 With that in mind, we can determine the best yield curve trade to implement by answering the following two questions: Which bullet over barbell combination offers the most attractive value? Which bullet over barbell combination is most likely to outperform in the "Fed pause" scenario we are trying to hedge? In response to the first question, we consider the 2-year, 3-year, 5-year and 7-year bullet maturities all relative to a duration-matched 1/20 barbell. All of those butterfly spreads offer approximately the same yield pick-up (Chart 7). They also all offer approximately the same yield pick-up relative to our fair value models, which are based on regressions of the butterfly spread versus the 1/20 slope of the curve (Chart 8).6 To answer the second question, we try to identify which of the 2-year, 3-year, 5-year or 7-year yields is likely to decline the most in response to the market pricing-in a pause in Fed rate hikes. To do this we look at the historical correlations between different yield curve slopes and our 12-month Fed Funds Discounter - the change in the fed funds rate that is priced into the market for the next 12 months. The correlations are displayed in Chart 9, and they show that monthly changes in the 7/10 slope are almost always negatively correlated with monthly changes in the 12-month discounter. In other words, when the discounter falls, the 7-year yield falls by more than the 10-year yield. Chart 7Different Bullets, Similar Yield Pick-Up I Chart 8Different Bullets, Similar Yield Pick-Up II Chart 9Hedging The "Fed Pause" Scenario Monthly changes in the 5/7 slope are also usually negatively correlated with changes in the discounter, though the correlation has been closer to zero in recent years. This makes it difficult to say with certainty whether the 5-year or 7-year yield would fall by more in response to a decline in the discounter. Chart 9 also shows that changes in both the 2/3 and 3/5 slopes are positively correlated with changes in the 12-month discounter. This means that when the discounter falls, the 3-year yield falls by more than the 2-year yield and the 5-year yield falls by more than the 3-year yield. In general, we can safely conclude that the 5-year and 7-year bullets are better hedges against a Fed pause than the 2-year or 3-year bullets. The 7-year in particular appears to be a safe bet. Given that the differences in valuation between the different options are miniscule, we are inclined to maintain our current yield curve position: long the 7-year bullet and short the 1/20 barbell. This week we also close our recommendation to favor the 5/30 barbell over the 10-year bullet for a small loss of 2 bps. This trade was designed to hedge the risk of Fed overtightening leading to an inverted yield curve. This trade would underperform in the event of a Fed pause, which we now view as the greater risk. Bottom Line: The Fed will maintain its 25 bps per quarter rate hike pace for the time being, but could be forced to pause next year if weak foreign growth migrates to the U.S. via a stronger dollar. We recommend hedging this risk via a long position in the 7-year bullet versus a short position in the 1/20 barbell. Corporate Balance Sheet Reprieve Last week's release of the second quarter U.S. Financial Accounts (formerly Flow of Funds) allows us to update our indicators of nonfinancial corporate balance sheet health. Overall, there has been a significant improvement in our Corporate Health Monitor (CHM) since the end of 2016. It has fallen from deep in "deteriorating health" territory to close to the "improving health" zone (Chart 10). By far, the biggest driver of the CHM's improvement has been the sharp increase in after-tax cash flows (Chart 10, panel 2). This is partly due to the recent corporate tax cuts, but also reflects a significant rebound in pre-tax cash flows (Chart 10, bottom panel). Despite the rebound in profits, we remain cautious on the outlook for corporate balance sheets going forward. First, our bottom-up samples of firms included in the investment grade and high-yield Bloomberg Barclays bond indexes both show that the median firm's net debt-to-EBITDA has improved in recent quarters, but remains elevated compared to history (Chart 11). Chart 10After-Tax Cash Flows Drive CHM Improvement Chart 11Debt Levels Still High Second, we see increasing headwinds to profit growth going forward. The positive impact from tax cuts is set to wane, while the stronger dollar and faster wage growth will both weigh on pre-tax profits during the next year.7 It is important to note that it will not take much deceleration in pre-tax profits for corporate balance sheets to worsen. Our measure of gross leverage - total debt over pre-tax profits - has only managed to flatten-off during the past few quarters, even as profit growth has surged. This means that the rapid gains in profits have only managed to keep pace with the rate of debt growth. Even a small deceleration in profits will cause leverage to rise, and rising leverage tends to occur alongside an increasing default rate (Chart 12). Chart 12Gross Leverage And Corporate Defaults Bottom Line: Strong profit growth - both organic and as a result of corporate tax cuts - has led to a significant improvement in corporate balance sheet health during the past few quarters. This improvement will not persist for much longer. We recommend only a neutral allocation to corporate bonds, both investment grade and junk. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 2http://www.nber.org/papers/w13428 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Playing Catch-Up", dated September 11, 2018, available at usbs.bcaresesarch.com 5 For further details on why we prefer this trade construction, please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 We calculate the butterfly spread as: the bullet yield minus the yield of the duration-matched barbell. 7 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy Stick with a neutral weighting in the tech sector as rising interest rates, higher inflation and a firming greenback offset improving industry operating metrics on the back of the virtuous capex upcycle. Chip and chip equipment stocks will remain under pressure as global semi sales are under attack and leading indicators of semi demand suggest that more pain lies ahead at a time when chip selling prices are steeply decelerating. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities regained their footing last week and remain perched near all-time highs. Investors are largely ignoring the trade-related uncertainty and are instead focusing on the upbeat economic backdrop. Both soft and hard data continue to send an unambiguously healthy signal for the U.S. economy, a potent tonic for corporate profitability. Chart 1EPS Will Do All The Heavy Lifting While a lot of parallels have been drawn between today and the late-1990s, our sense is that the current financial market and economic outlooks resemble more the mid-2000s. Chart 1 shows that, between 2004 and the stock market peak in late-October 2007, forward profit growth estimates peaked at over 20%/annum and the forward multiple drifted steadily lower. Nevertheless, stocks remained well bid and rose alongside forward EPS (top and third panels, Chart 1). In other words, despite decelerating forward profit growth estimates and a contracting forward multiple, expanding forward EPS did the heavy lifting, explaining all of the advance in the SPX. The similarities to today are eerie: while profit growth peaked in Q1/2018, 10% EPS growth is elevated for the tenth year of an expansion, and the forward multiple is coming in (Chart 1). On the policy front, the Bush tax cuts hit in the mid-2000s with the elimination of the double taxation of dividends and a drop in personal income tax rates, along with a one-time cash repatriation of corporate profits stashed abroad. With regard to the economic backdrop, capex was roaring and nominal GDP was firing on all cylinders as a housing bubble was getting inflated. The GDP deflator also hit a high mark. The ISM manufacturing survey eclipsed 61 in 2004 and non-farm payrolls were expanding smartly (Chart 2). But despite all that apparent overheating especially in the housing market, the real fed funds rate was near zero in 2004 (top panel, Chart 3). Finally, a number of financial market metrics were also similar to today. Oil prices were on their way to triple digits, high yield spreads were below 400bps and the VIX probed, at the time, all-time lows (Chart 3). However, one key difference between the mid-2000s and today is the strengthening U.S. dollar. The firming greenback remains a key risk to our positive equity market view (bottom panel, Chart 3), as it will eventually infiltrate EPS. Netting it all out, if history at least rhymes, an earnings-led advance in the SPX is the most likely outcome. Our sanguine cyclical (9-12 month) equity market view remains predicated on a 10%/annum increase in EPS and a sideways-to-lower move in the forward multiple. Meanwhile, wage inflation is slowly starting to rear its ugly head. In fact, we are surprised by the fits and starts in average hourly earnings growth. At this stage of the cycle, wage growth should start galloping higher as executives aggressively bid up the price of labor in order to fill job openings and bring expansion plans to fruition. A simple wage growth indicator comprising resource utilization and the unemployment gap suggests that wage inflation will really kick into higher gear in the coming 12 months (shown as a Z-score, Chart 4). Chart 2Eerie... Chart 3...Parallels With 2004 Chart 4Mind The Return Of Inflation Two weeks ago we highlighted that the S&P 500's profit margins are benefiting from lower corporate taxes and muted wage growth, a goldilocks backdrop. Despite evidence of a pending inflationary impulse, as long as businesses are successful in passing rising input costs down the supply chain and onto the consumer, then margins and EPS will continue to expand. Nevertheless, deconstructing the SPX's all-time high profit margins is in order. Chart 5 & Chart 6 show the 11 GICS1 sector profit margin time series using Standard & Poor's data, and Chart 7 is a snapshot of Q2/2018 profit margins for the 11 sectors and the broad market. Chart 5Sectorial Profit ... Chart 6...Margin Breakdown Chart 7Tech Is A Clear Outlier Five sectors (tech, industrials, materials, consumer discretionary and utilities) are enjoying record-high profit margins, and four (financials, consumer staples, telecom services and real estate) are on the verge of joining that club. This leaves two sectors with declining margin profiles: health care and energy. While most sectors are +/- five percentage points away from the S&P 500, the tech sector sports profit margins at twice the level of the SPX or eleven percentage points higher and is the clear outlier (Chart 7). The implication is that the broad market's EPS fortunes are closely tied to the high-flying tech sector that commands a 26% market cap weight. Thus, this week we are compelled to highlight the deep cyclical tech sector, and two of its hyper-sensitive and foreign exposed subcomponents. Tech On Steroids In late-August we published a chart on tech margins (which we are reprinting today) showing the upward force they have exerted on the broad equity market for the better part of the past decade (top panel, Chart 8). Naturally, stratospheric profits must underpin these parabolic margins. The middle panel of Chart 8 highlights that since 2006 tech EPS have almost quadrupled, pulling SPX profits higher. As a reminder, the S&P tech sector commands a 24% profit weight in the S&P 500, the highest since the history of this data series and almost double the weight during the previous cycle's peak (bottom panel, Chart 8). The implication is that in order for the broad market to suffer a severe blow, tech has to take a hit, and vice versa. Chart 8Secular Tech EPS Growth Has Boosted Margins Chart 9EPS Growth Model Flashing Green On the EPS front, our profit growth model has recently ticked higher from an already extended level, signaling that the profit outlook remains bright (Chart 9). The virtuous capex upcycle - BCA's key theme for the year - remains the key driver behind our EPS model. Chart 10 shows that the tech sector continues to make inroads in the overall capex pie, according to financial statement-reported data, and has now doubled its share since the GFC trough to roughly 12%. National accounts corroborate this data and underscore that pent up demand is getting unleashed, following a near 15-year hibernation period (bottom panel, Chart 10). The news on the operating front is equally encouraging. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity1 - is reaccelerating. Tech new orders-to-inventories are also picking up steam and suggest that sell side analysts have set the relative EPS bar too low (Chart 11). Finally, the latest PCE report revealed that consumer outlays on tech goods are also gaining momentum, even relative to overall consumer spending. While this upbeat backdrop would point to an above benchmark tech allocation, three risks keep us at bay. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind, especially for 2019 when the delayed negative FX translation effects will most likely emerge (third panel, Chart 12). Chart 10Capex On The Upswing... Chart 11...Underpinning Tech Operating Metrics... Chart 12...But Three Risks Keep Us At Bay Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Tech business models are built to withstand deflation and thrive in a disinflationary environment. Thus, when inflation re-emerges, tech stocks suffer (CPI and 10-year UST yield shown inverted, top two panels, Chart 12). Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM in general and tech-laden Korean and Taiwanese economic data in particular would retrench further (bottom panel, Chart 12). Bottom Line: We prefer to remain on the sidelines in the S&P information technology sector and sustain a barbell portfolio within the sector. As a reminder we continue to express our bullishness via two high-conviction overweight defensive tech sub-sectors, S&P software and S&P tech hardware, storage & peripherals (THSP), and our bearishness via avoiding their early cyclical peers, S&P semis and S&P semi equipment. Avoid Chip Stocks At All Costs While we are neutral the broad tech sector and prefer secular growth defensive tech sub-sectors, we continue to recommend shying away from chip and chip equipment stocks. Chart 13 shows the extreme sensitivity to changes in final demand of chip related stocks versus their defensive tech peers. In more detail, software and THSP indexes are in a secular advance with regard to EPS outperformance, whereas semis and semi equipment profits are hyper-cyclical with mean-reverting relative profit profiles. Granted, the commoditization of semiconductors explains this close correlation with the business cycle. But, as we highlighted last November when we put the semi equipment index on the high-conviction underweight list, extrapolating EPS growth euphoria far into the future was fraught with danger.2 In fact, late-November 2017 marked the peak in semi equipment performance versus the overall IT sector, confirming the early cyclical nature of chip stocks (Chart 14). Chart 13Bifurcated EPS Chart 14Good Times... Three factors have weighed heavily on this industry's growth prospects and there is no light at the end of the tunnel yet. Bitcoin's (and other cryptocurrencies) collapse is dealing a blow, at the margin, to demand for semi equipment (top panel, Chart 15). Taiwan's financials statement-reported data on IT capex and national data on overall Taiwanese capital outlays corroborates this downbeat demand backdrop (Chart 16). Finally, the drubbing in EM currencies is sapping purchasing power from the consumer and also warns that things will get worse for U.S. semi equipment stocks before they get better (bottom panel, Chart 15). Chart 15...Do Not Last Forever Chart 16Semi-Heavy Taiwan Emits A Grim Signal The outlook for their brethren, semi producers, is equally downtrodden. Global semi sales have crested and leading indicators of future semi revenue growth are sending a warning signal. Chinese imports of electronics have come to an abrupt halt, and the U.S. dollar's appreciation is also waving a red flag (second & bottom panels, Chart 17). BCA's calculated global leading economic indicator excluding the U.S. and BCA's calculated global ZEW Indicator of Economic Sentiment excluding the U.S. both herald a steep deceleration in global semi sales (Chart 17). On the pricing power front, using Asian DRAM prices as an industry pricing power gauge, DRAM momentum is on a trajectory to contract some time in Q1/2019. The implication is that semi earnings will surprise to the downside. Still expanding global chip inventories are not providing an offset and also confirm that semi EPS optimism is unwarranted (middle & bottom panels, Chart 18). Finally, another source of demand for chip stocks has reversed, as industry M&A activity has plummeted toward decade lows. Not only is this negative for pricing power, but inflated premia are also now working in reverse especially given this year's QCOM/NXPI and AVGO/QCOM flops (top panel, Chart 18). Our Chip Stock Timing Model (CSTM) does an excellent job encapsulating all these moving parts and is currently in the sell zone (bottom panel, Chart 19). Chart 17Global Semi Sales Trouble... Chart 18...Abound Chart 19Chip Stock Timing Model Says Sell Bottom Line: Continue to avoid the S&P semis and S&P semi equipment indexes. The ticker symbols for the stocks in these indexes are: BLBG: S5SECO - INTC, NVDA, QCOM, TXN, AVGO, MU, ADI, AMD, MCHP, XLNX, SWKS, QRVO, and BLBG: S5SEEQ - AMAT, LRCX, KLAC, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 2 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Last week's View Meeting underlined the point that BCA's take on the macro backdrop hasn't changed. Decelerating global growth and the potential for a nasty EM debt episode still argue for slightly cautious asset allocation. Global desynchronization is in full swing, with the U.S. leading the other major DM economies by a wide margin. The growth disparity will be dollar-positive while it lasts, but the deteriorating U.S. budget position will weigh on the dollar in the long run. S&P 500 performance across the earnings cycle reveals that decelerating earnings growth is not a problem for stocks as long as earnings are still growing year-on-year. Acceleration beats deceleration, but peaking earnings growth is not a signal to trim equity exposures. The U.S. is not impervious to a meaningful EM credit event, but its direct exposures are very limited. Post-crisis banking regulations have meaningfully reduced the banking system's vulnerabilities and make it very unlikely that another LTCM-like event might occur. Feature BCA researchers convened last week for our monthly View Meeting with the explicit goal of taking stock of our strategy teams' macro views. The nine-year-plus U.S. expansion is well advanced, and we are carefully monitoring the business cycle, the credit cycle, and the policy cycle for early warning of inflections in the rates, credit, and equity markets. In addition to the regular cyclical movements, we also have to gauge the impact of the ongoing reversal of extraordinary monetary accommodation and a raft of geopolitical issues. The investment outcome of the many crosscurrents continues to be subject to spirited debate, but the warily constructive house view, in place since mid-June, was not challenged. Decelerating global growth was a key driver of our June downgrade to neutral on equities. The U.S. economy may be surging as two years of fiscal stimulus makes its presence felt, but the other major developed-world economies are softening, and the emerging-market bloc faces considerable pressure. Although the S&P 500 has since made new highs (Chart 1, top panel), the MSCI All-Country World Index ("ACWI") has gone nowhere (Chart 1, second panel). Within the ACWI, DM equities (Chart 1, third panel), have handily outperformed struggling EM equities (Chart 1, bottom panel). We continue to expect more of the same. Tax cuts will keep corporate profits growing at better than 20% for the rest of the year, and federal spending will boost the U.S. economy through the end of 2019. The pickup in aggregate demand will strain dwindling spare capacity, feeding inflation pressures, and keeping the Fed from easing up on its rate-hiking campaign. A resolute Fed will ratchet up the pressure on EM borrowers, while increasing trade barriers pose a headwind for the many DM and EM economies that are more open than the U.S. Chinese policymakers could provide some respite to the global economy, but our China and EM strategists aren't counting on it. Easing monetary and/or fiscal policy would run counter to the Party's ongoing deleveraging and anti-corruption campaigns (Chart 2). Though China's rulers have demonstrated a tendency to overreact when acting to offset adverse economic events, our in-house experts think conditions will have to get a good bit worse to provoke meaningful stimulus of any sort. The strike price on a Chinese policy put may be considerably out of the money. Chart 1So Far, So Good Chart 2Will They Swim Against The Tide? Bottom Line: Overindebtedness, rising trade barriers, and a U.S. economy with the potential to overheat will keep the pressure on the EM bloc and cast a shadow over global growth. The Chinese policy cavalry may not feel any particular urgency to ride to the rescue. Leading The Pack There was no dispute about the U.S. growth outlook, absolute or relative. The U.S. economy is flying high, and will continue to outdistance its DM peers for the rest of this year and next. S&P 500 EPS growth will maintain its better than 20% pace in the third and fourth quarters. Next year's 10% consensus may be ambitious, given that this year's dollar appreciation probably hasn't shown up in earnings data, but corporate management teams have not yet expressed much in the way of dollar concerns. Decoupling cannot go on forever in the 21st-century global economy, but the comparatively closed U.S. economy has room to run in the near term. Last week's August ISM Manufacturing survey reached a 14-year high while the global PMI continued to hook lower (Chart 3). The gap between the U.S. LEI index and the global ex-U.S. LEI index has been widening for over a year (Chart 4), and would seem to herald additional dollar strength (Chart 4, bottom panel). Our corporate earnings models see U.S. EPS growth widening its lead on Europe and Japan over the rest of the year (Chart 5). Chart 3You Go Your Way And I'll Go Mine Chart 4Dollar Strength... Chart 5...Hasn't Gotten In Earnings' Way Yet Bottom Line: The U.S. is outgrowing its developed market peers, and there is nothing on the immediate horizon that suggests a reversal is in store. Superior corporate earnings growth and dollar strength should allow U.S. equities to outperform their major DM peers on a common-currency basis well into 2019. The Change, Or The Change Of The Change? Deceleration has been at the heart of BCA's managing editors' concerns, and there is an intuitive appeal to the idea that equity markets prize the change of the change (the second derivative) over the first-order move itself. It has the potential to clash, however, with the empirical fact that stocks typically rise unless earnings are contracting. To determine the degree to which decelerating earnings growth has historically presented a challenge to the S&P 500, we posit a four-phase earnings cycle based on the interaction between earnings-estimate growth and acceleration (Diagram 1), as follows: Diagram 1The Earnings Cycle Phase I begins when the worst part of the cycle has ended. Earnings estimates are contracting on a year-over-year basis, but at a slowing rate. Because earnings typically grow, and the bounce off the bottom is typically swift, this phase has occurred just 8% of the time. In Phase II, year-over-year earnings are growing at an accelerating rate. In Phase III, year-over-year earnings are still growing, but at a slowing rate. Phase II and Phase III are the de facto default phases, each accounting for 39% of all observations. In Phase IV, year-over-year earnings are contracting at an accelerating rate. Phase IV is more common than Phase I because the decline to the bottom tends to unfold more slowly than the bounce off of it, but it still occurs just 14% of the time. Table 1 shows annualized S&P 500 price returns for each phase of the cycle and then groups the phases by acceleration/deceleration and expansion/contraction. Stocks perform better when the rate of earnings growth is accelerating than they do when it's decelerating, but they also perform better when earnings are growing on a year-over-year basis than they do when they're declining. Stocks perform terribly when earnings are falling year-on-year at an increasing rate (Phase IV), and do great when the pace at which they're falling slows (Phase I), but those occurrences are few and far between. Earnings grow four-fifths of the time, and when they do, the differences between accelerating and decelerating growth aren't all that big a deal (Chart 6). Table 1Acceleration Is Better, But Deceleration Isn't All Bad... Chart 6...As It's Not A Problem As Long As Earnings Still Grow Bottom Line: Deceleration in the rate of earnings growth is not a signal to abandon stocks as long as earnings are still growing year-on-year. Investors have fared well for 40 years when earnings estimates expand, regardless of whether the rate of expansion is accelerating. 2018 Is Not 1997-98 In the wake of August's wobbles, several clients have been eager to explore various EM economies' vulnerabilities1 in more detail. We have fielded several questions relating to U.S. banks' EM exposures and how they compare to their exposures to the Asian Tigers on the cusp of the Asian Crisis. Per data from the Bank for International Settlements and the FDIC, U.S. claims on Thailand, Indonesia, the Philippines, Singapore, Malaysia, South Korea and Taiwan amounted to about 14% of all U.S. bank credit at the end of 1996. That exposure is very similar to the U.S. banking system's current exposure to Argentina, Turkey, Brazil, Colombia, Mexico, Chile, South Africa, and Indonesia. Direct exposure to fragile EM economies did not drive the S&P 500's 19% decline across July and August of 1998, however, nor did it inspire a consortium of fourteen major global financial institutions to come together to attempt to ring-fence the U.S. banking system. Those outcomes can be laid to the brokers' and investment banks' indirect exposure to the massively leveraged investment portfolio of the Long-Term Capital Management hedge fund (LTCM). To gauge the system's fragility back then, we perform a simple comparison of LTCM's debt to the publicly traded U.S. investment banks' total equity. In our back-of-the-envelope analysis (Table 2), we assume that the four investment banks, which contributed a quarter of the funds to rescue LTCM, had provided at least a quarter of LTCM's financing.2 Per our assumptions, LTCM claims accounted for 82% of the four banks' total equity. Losses given default would not have been anywhere near 100%, but a disorderly exit from LTCM's positions would surely have forced several of LTCM's creditors to conduct urgent capital raisings of their own. Fortunately for investors, today's banking system is nowhere near as vulnerable. Investment bank leverage ratios of 30 or more, commonplace in the late '90s, are a practical impossibility today. While lenders are no less likely to chase business late in the cycle today, post-crisis regulation makes it far more difficult to indulge their folly. Today's investment banks operate with a third of the leverage of 20 years ago (Table 3). The odds that another overextended investor, or group of investors, could imperil the U.S. banking system are much longer today than they were then. It's considerably harder to come by leverage via the regulated banking system, and leverage is the essential contagion ingredient. Table 2Enormous Leverage Made The Banking System Unstable In The Summer Of 1998 ... Table 3... But It's Not A Problem Anymore Bottom Line: Basel III, Dodd-Frank and the Volcker Rule save lenders from their own worst impulses. The odds of another LTCM crisis are far slimmer than they were in the late '90s. Investment Implications We continue to have a constructive view of the business, market and policy cycles in the U.S., but there's more to the global investing backdrop than just the U.S. Global investors should overweight U.S. equities versus equities in the rest of the world and U.S. investors should be sure to be at least equal weight equities, but the environment is sufficiently risky to inspire caution. We join our colleagues in continuing to recommend a benchmark equity allocation, while underweighting bonds and overweighting cash. August's employment report supports our economic and investment takes. The labor market remains tight, with the broader U-6 definition of unemployment (including involuntary part-time and discouraged workers) making a second straight 17-year low (Chart 7, top panel), and average hourly earnings extending their slow march higher (Chart 7, bottom panel). With the three-month moving average of payrolls (185,000) expanding at a rate well above the 110,000-per-month pace required to absorb new entrants to the labor market, qualified candidates are going to become even more difficult to find. The upshot is that the Fed remains firmly on a path to hike rates more than the market consensus currently expects. Despite the potential for a near-term flight-to-safety bid for Treasury bonds, we are sticking with our below-benchmark duration call. Chart 7As Slack Is Absorbed, Wages Will Rise Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 20, 2018 U.S. Investment Strategy Weekly Report, "Rude Health," available at usis.bcaresearch.com. 2 Lehman did not contribute to the bailout, but it is highly improbable that it had not lent to LTCM.
Highlights The U.S. has outperformed most major stock markets over the past few years largely because U.S. earnings have increased more rapidly than earnings abroad. U.S. companies will continue to deliver superior earnings growth during the remainder of this year. However, profit growth is likely to slow in 2019 owing to a larger wage bill, a stronger dollar, and a sluggish global economy. The efficacy of buybacks in boosting earnings-per-share is waning due to soaring valuations and rising interest rates. For the time being, asset allocators should maintain a neutral weighting to global equities, while favoring developed market stocks over emerging markets and overweighting defensive sectors relative to cyclical ones. Within the developed market equity space, the U.S. will outperform over the coming months in dollar terms, but will trade broadly in line with Europe and Japan in local-currency terms. Longer term, odds are high that earnings growth in the rest of the world will catch up with that of the U.S. Feature There Is No Mystery As To Why U.S. Stocks Have Outperformed The stock market is influenced by many variables, but in the end, the one that matters most is earnings. The U.S. has outperformed most major stock markets during the past few years largely because U.S. earnings have increased more rapidly than earnings abroad. Stronger earnings growth, in turn, has caused investors to assign a higher earnings multiple to the U.S. in comparison to other regions. This has given U.S. stocks a further lift (Chart 1). Differences in sector weights have helped flatter overall U.S. earnings to some extent. Globally, earnings in the tech and health care sectors have grown much more quickly than earnings in the financials and materials sectors (Chart 2). The former sectors have large weights in U.S. indices, while the latter are overrepresented in overseas indices (Table 1). Still, our analysis suggests that most of the outperformance of U.S. firms can be explained by their superior earnings growth within sectors (Chart 3). Chart 1U.S. Stocks Have Outperformed ##br##Thanks To Faster Earnings Growth Chart 2Global Earnings Sector Breakdown Table 1Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials ##br##And Materials Are Overrepresented In Markets Outside The U.S. Chart 3AU.S. Earnings Have Risen Faster ##br##Within Each Equity Sector (I) Chart 3BU.S. Earnings Have Risen Faster ##br##Within Each Equity Sector (II) We do not expect U.S. corporate earnings growth to slow sharply this year. In fact, our margin proxy points to a slight increase in profit margins in the second half of the year (Chart 4). Nevertheless, there are four reasons why U.S. earnings growth will decelerate in 2019 and beyond: Wage growth is likely to pick up. Chart 5 shows that there is an almost perfect correlation between profit margins and the ratio of selling prices-to-unit labor costs. A variety of surveys suggest that U.S. firms are struggling to find qualified workers (Chart 6). This is confirmed both by the most recent Fed Beige Book and by firms' Q2 earnings conference calls. A stronger dollar will eat into earnings. A reasonable rule of thumb is that every 5% appreciation in the broad trade-weighted dollar reduces S&P 500 earnings by 1% over the course of the ensuing 12-to-18 months. The broad trade-weighted dollar has risen 6.2% so far this year and we expect further strength in the months ahead. Global growth will weaken further. The U.S. is increasingly running out of spare capacity, which is limiting domestic growth prospects. Emerging markets are struggling, with the crises in Turkey and Argentina likely to spread to bigger players such as Brazil and South Africa. A major Chinese stimulus package would help reboot global growth, but concerns about high debt levels, overcapacity, and an overheated housing market will limit the response. The policy environment will become more challenging. Corporate tax cuts helped boost earnings earlier this year. However, the regulatory landscape is likely to turn less benign over the next few years. The tech sector is facing increased scrutiny.1 New EU privacy rules came into effect in May, which will limit the ability of internet companies to harvest personal data. The Trump Administration is also increasingly targeting social media companies for allegedly suppressing conservative voices. In addition, our geopolitical strategists expect U.S.-China trade tensions to remain elevated, with the U.S. likely to impose tariffs on an additional $200 billion worth of Chinese imports. Meanwhile, a trade deal with Canada is no slam dunk. President Trump has even reiterated that he would be willing to exit the World Trade Organization. Chart 4Margins Could Rise A Bit More ##br##In The Near Term Chart 5Higher Wage Growth Will Undermine Profit Margins Chart 6U.S. Firms Are Having Difficulty ##br##Finding Qualified Workers Diminishing Returns From Buybacks U.S. companies are on track to spend a record amount of money buying back shares in 2018, with tech companies accounting for about 40% of all shares repurchased. While this may seem very bullish for stocks, one should keep in mind that the prior peak in share buybacks occurred in 2007. Companies are not particularly adept at timing the stock market, even when it is their own shares they are purchasing. Moreover, U.S. stock market capitalization has doubled since 2007. As a share of market cap, today's pace of buybacks is high, but not exceptionally so (Chart 7). To state the obvious, the more expensive stocks get, the more money it takes to purchase the same number of shares. U.S. equity valuations are quite stretched by historic standards (Chart 8). On a price-to-sales basis, U.S. stocks are now as expensive as they were in 2000. Our estimate of the U.S. equity risk premium - calculated as the difference between the cyclically-adjusted earnings yield and the average expected short-term real interest rate over the next decade - is well below its historic average (Chart 9). Chart 7Buybacks As A Share Of Market Cap: Fairly Muted Chart 8U.S. Equities Are Trading At Lofty Valuations Chart 9The U.S. Equity Risk Premium Is Well Below Its Historic Average It is also important to remember that share repurchases will only boost EPS if the interest rate that companies receive on their cash balances is below their earnings yield. To see this, consider a simple example where the earnings yield and the interest rate are the same. Specifically, suppose that a company has a market cap of $1 billion, $20 million in earnings, and earns 2% on its cash holdings. If the company buys back $100 million in shares, its share count will decline by 10%, but the interest payments that it receives will fall by $2 million, pushing profits down by 10% from $20 million to $18 million. The net result is no change in EPS. As U.S. interest rates continue to increase, companies will see ever-smaller benefits to their bottom lines from share buybacks. Where's The Earnings Growth Going To Come From? The foregoing discussion raises another point, which is that buybacks, by their very nature, leave companies with less cash to invest in future growth. This issue is quite relevant for the current environment. Analysts today expect the average S&P 500 company to grow earnings at an annual rate of 16.6% over the next 3-to-5 years (Chart 10). This is wildly optimistic. It is six points higher than the long-term earnings growth rate they expected just three years ago. Indeed, it is only topped by the euphoric projection of 18.7% reached in 2000 - just before the stock market came crashing down. Apparently, on Wall Street, companies can have their cake and eat it too. Chart 10Analyst Expectations Are Too Optimistic Creative Accounting? Earnings are earnings, correct? Actually, no. What constitutes earnings has changed over the years. Up until the 1990s, companies generally reported GAAP earnings - earnings based on Generally Accepted Accounting Principles. Over the past two decades, however, companies have moved towards reporting so-called "pro forma" or "operating" earnings. Unlike GAAP earnings, there is no codified set of rules governing the definition of operating earnings. Conceptually, companies are supposed to exclude both one-off losses and gains when calculating operating earnings in order to give shareholders a better sense of the underlying trend in profits. In practice, they tend to exclude the former much more often than the latter. This problem has gotten worse over time, so much so that an apples-to-apples comparison now requires that we reduce earnings today by about 15% in order to compare them with earnings in the early 1980s (Chart 11). More ominously, it is possible that even GAAP earnings are currently overstated. Chart 12 shows that EBITDA profit margins, which are generally more difficult to fudge, have fallen over the past decade, while operating margins have risen. Economy-wide profit margins, as measured in the national accounts, have also increased much more slowly than S&P 500 operating margins (Chart 13). Chart 11A Bull Market In Creative Accounting? Chart 12S&P 500 Operating Margins Have Risen Much More Than EBITDA Margins Chart 13Profit Margins, As Measured In The National Accounts, Have Fallen Relative To S&P 500 Margins This raises the risk that we will see more earning restatements - or at the very least, earnings disappointments - in the years ahead as companies run out of magic asterisks to pull out of their bag of accounting tricks. Investment Conclusions Corporate earnings are highly correlated with the state of the business cycle (Chart 14). We do not expect the U.S. to enter a recession at least until 2020. Thus, it is doubtful that U.S. earnings will suffer a sharp decline before then. Nevertheless, as this report argues, earnings growth is likely to decelerate early next year. Investors have a lot riding on the assumption that earnings growth will hold up. U.S. households owned nearly $30 trillion of equities in Q1 of 2018, or 25% of total household assets, the highest level since 2000 (Chart 15). The monthly asset allocation survey published by the Association of Individual Investors (AAII) shows that stocks comprised 68.5% of investors' portfolios in August (Chart 16). While this is below the peak of 77% reached in March 2000, it is still more than seven points above the post-1987 average of 61%, putting it in the 84th percentile of the historic distribution. Chart 14Earnings Are Highly Correlated ##br##With The Business Cycle Chart 15Households Are Loaded Up On Stocks Which... Chart 16...Comprise A Big Chunk Of Their Portfolios If earnings growth slows significantly, investors could end up deciding to cut their exposure to the stock market. Since for every buyer there must be a seller, the only way for investors to collectively reduce the value of their equity holdings is if share prices decline. U.S. equities account for 55% of global stock market capitalization (Chart 17). Thus, if U.S. earnings begin to stagnate, this will limit the upside for global equity indices. Chart 17U.S. Equities Account For More Than Half Of Global Stock Market Capitalization Chart 18Earnings In Other Regions Will Eventually Catch Up With The U.S. Does this mean that investors should look for greener pastures abroad? Not yet. We expect the dollar to strengthen and global growth to slow further over the coming months. This will put downward pressure on cyclical stocks, which are overrepresented in foreign indices. For the time being, asset allocators should maintain a neutral weighting to global equities, favoring developed market stocks over emerging markets. Within the DM space, the U.S. will outperform in dollar terms, but will trade broadly in line with Europe and Japan in local-currency terms. Longer term, we are more sanguine about the prospects for non-U.S. stocks. The outperformance of U.S. equities over the past decade follows a decade of underperformance. In fact, EPS in Europe and emerging markets actually grew more rapidly between 1990 and 2007 than in the United States (Chart 18). Historically, the relative growth of earnings across different regions follows multi-year cycles, and there is no reason to think that this will change. As such, it is likely that earnings growth in the rest of the world will begin to outstrip the U.S. once the problems plaguing emerging markets have been flushed out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see U.S. Equity Strategy, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Portfolio Strategy Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. A looming positive global growth impulse, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuations all suggest that now is not the time to throw in the towel on the S&P construction machinery & heavy truck (CMHT) index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Chart 1All-time Highs Everywhere The SPX catapulted to fresh all-time highs last week following an eight month hiatus, as a de-escalation in the global trade war gained further traction. Chart 1 shows that this is a broad based equity market advance as a slew of major equity market indexes have simultaneously vaulted to new highs. Even the high-yield corporate bond market confirms this breakout with the total return index also vaulting to new all-time highs (not shown). Any further moderation in trade rhetoric from the U.S. administration could serve as a catalyst for additional gains in the SPX, and trade-affected sectors would likely lead the charge, especially post the mid-term elections.1 While the U.S./China trade spat will prove the ultimate equity market litmus test, the longevity and magnitude of the profit upcycle remain the key equity market advance pillars. On that front, a deeper dive into profit margins is in order. The S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018. Nevertheless, it is important to remember that this year's strong profits are not the result of any massaging from CEOs/CFOs of the share count. In other words, profit margins (earnings per share / sales per share) are not impacted by changes in the number of shares outstanding, unlike simple EPS growth. Chart 2 shows that SPX margins recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's mid-2007 peak. While we are not fans of excluding sectors from our analysis, the sheer size and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years as tech giants are flexing their oligopolistic/monopolistic muscle. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing most of the heavy lifting given the high profit and market cap weight in the SPX. Keep in mind that the commodity complex in general and energy in particular are also adding to the recent margin euphoria. The late-2015/early-2016 global manufacturing recession-induced collapse in margins is now re-normalizing across basic resources, with margins in the S&P energy sector increasing by 11 percentage points since the Q2 2016 trough (Chart 2). Beyond the sector-related margin implications, from a macro point of view, U.S. stock market-reported employment has also been a significant contributor to the phenomenal profit margin expansion phase. Typically, stock market constituents reported job count growth peaks right before the NBER designated recession commences, on average at over an 8% year-over-year growth rate. The current labor market, while vibrant, has been trailing previous cycles by a wide margin. The most recent year-over-year growth rate clocked in at 3.5% (second panel, Chart 3). Chart 2Tech Margins Leading##br## The Pack Chart 3Smaller Than Usual Labor Footprint##br## Is A Boon For Margins National accounts data also corroborate this enticing profit margin backdrop. Average hourly earnings (AHE) have crested north of 4% in the past three cyclical peaks. Currently AHE are 130bps below that level (top panel, Chart 3). The implication is that as long as top line growth remains solid and corporate pricing power stays upbeat, profit margins will continue to underpin profits. Unlike the tech sector's excessive contribution to the SPX profit margin, the opposite rings true with regard to analysts' forward profit projections. Both on a 12-month and 5-year forward basis the S&P tech sector is trailing the SPX (Chart 4). Importantly, the latter has been at the center of a healthy debate within BCA, and decomposing this seemingly high number is instructive. A 16% long-term EPS growth rate is a tall order. However, sell-side analysts never get the shorter-term, let alone longer-term, forecasts correct. In hindsight, analysts' 5-year forward EPS growth forecasts back in 2016 sunk to an all-time low, even lower than the depths of the Great Recession (top panel, Chart 4). Currently, all we are experiencing is a move from one extreme to the other, and while we are clearly in overshoot territory, it is impossible to predict where this number will peak. Decomposing the broad market's projected long-term EPS growth rate is revealing. First, we note that the tech sector is projected to grow at half the rate predicted during the tech bubble. Second, four sectors comprise the outliers (i.e. forecast to surpass the 16% SPX growth rate) and such a breakneck pace will surely fail to materialize. Another common characteristic these four sectors share is that they all surpassed their tech bubble peak rates, something that the broad market has yet to achieve. Thus, consumer discretionary, financials, industrials and especially energy are in uncharted territory (Chart 5). On the opposite end of the spectrum, Chart 6 highlights the sectors that have yet to overtake their respective peaks and are sporting long-term EPS growth rates below the broad market. Chart 4Putting Tech Long-term Profit##br## Growth Rate In Context Chart 5Decomposing... Chart 6...Long-Term EPS Growth Netting it all out, we continue to have a sanguine cyclical (9-12 month horizon) SPX view, and our price target for 2019 remains 10% higher, assuming the multiple moves sideways leaving the onus on EPS to do all the heavy lifting.2 The week we are highlighting a deep cyclical sector that can benefit from a further de-escalation of the trade war and update one of its key subcomponents that remains a high-conviction overweight. Are Industrials Running On Empty? Last week, in a Special Report on President Trump's trade rhetoric impact on equity markets, we showed that trade policy uncertainty has risen to the highest level with the exception of the 1994 Clinton-era trade spat with the Japanese.3 While U.S. stocks have come out on top versus their global peers, within the U.S. equity market industrials have borne the brunt of the President's trade wrath (Chart 7). Chart 7Trade Uncertainty Weighing On Industrials In more detail, since peaking on January 26th, 2018, two stocks explain over 62% of the S&P industrials sector's fall: GE and MMM, two industrial conglomerates highly exposed to global trade. However, transports in general and rails in particular have been rising smartly almost entirely offsetting the industrial conglomerates' weakness. As a reminder, we are overweight the rails and air freight & logistics, underweight the airlines, neutral on industrial conglomerates and remain comfortable with that intra-sector positioning. Importantly, green shoots are emerging, warning that it does not pay to become bearish on this deep cyclical sector. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (Chart 8). Domestic ex-tech output is firing on all cylinders (Chart 8), a message reviving core capital goods orders corroborate (Chart 9). All of this has resulted in firming pricing power. Tack on the reacceleration in our U.S. capital expenditure indicator (second panel, Chart 8) - capex upcycle remains a key BCA theme for the remainder of 2018 - and industrials sector stars are aligned. The upshot is that depressed relative profit growth will easily surprise to the upside (bottom panel, Chart 8). Chart 8Green Shoots... Chart 9...Appearing Not only are there U.S. macro tailwinds, but also a global growth recovery is in the offing that will herald a snapback in relative share prices. The global manufacturing PMI remains squarely above the 50 boom/bust line (fourth panel, Chart 9), and there are early signs of a budding recovery in China. The Li-Keqiang index is ticking higher, Chinese monetary conditions have eased significantly via a depreciating currency and a drop in interest rates, excavator sales continue to expand at a healthy clip, industrial profits are reaccelerating and even Chinese share prices have likely troughed. Expanding Chinese wholesale selling prices also suggest that a reflationary impulse is looming (bottom panel, Chart 9). Were trade tensions to further de-escalate, especially post the midterm elections that could serve as a powerful tonic for relative share prices. Our Industrials EPS growth model does an excellent job in capturing all these forces and is currently signaling that profits will continue to grow into 2019 (Chart 10). Valuations have returned to the neutral zone, but technicals have plunged to one standard deviation below the mean, a level that has historically been associated with playable rallies (bottom panel, Chart 10). One key risk to our optimistic take on the S&P industrials sector is the U.S. dollar. Chart 11 highlights that capital goods revenues, exports and multiples are in jeopardy if the greenback continues to appreciate. Add to that a full blown trade war between the U.S. and China - which is dollar positive - and industrials stocks would suffer another blow. Chart 10Great Entry Point Chart 11Further U.S. Dollar Appreciation Is A Risk Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. What To Do With Construction Machinery? Early in the year, following our risk management implementation of a 10% stop on our high conviction call list, we got stopped out with a 10% gain from the high-conviction overweight call in the S&P CMHT index. We were subsequently compelled to reinstitute this high-conviction call as all of the fundamental drivers remained in place. However, our timing was not perfect, and given that bellwether Caterpillar has a near 60% foreign sourced revenue exposure, this industrial subsector also bore the brunt of the President's hawkish trade rhetoric. The key question currently is: does it still make sense to be overweight this highly cyclical industrials sub group? The short answer is yes. First, while global growth has decelerated, global trade is still expanding and the signal from the Baltic Dry Index is that the risk of an abrupt halt in global trade similar to the late-2015/early-2016 episode is small (second panel, Chart 12). In addition, the global capex upcycle remains in place and is one of BCA's two themes we continue to explore for the rest of the year. The upshot is that it still pays to remain invested in the S&P CMHT index. Demand for machinery remains upbeat across the globe. Both our global exports and orders proxies for machinery continue to grow, underscoring that a profit-led recovery in construction machinery stocks is looming (third & fourth panels, Chart 12). Second, while China is the administration's primary trade target, easy monetary conditions there will provide much needed breathing room for the Chinese economy. Already, Chinese housing construction data and the rebounding Li-Keqiang Index are pointing to a brighter backdrop for relative share prices (top two panels, Chart 13). Moreover, Chinese excavator sales are advancing at a brisk year-over-year rate, highlighting that construction machinery end-demand remains solid. Chart 12Global Growth & CAPEX Are Tailwinds... Chart 13...And So Is The Troughing Chinese Economy Third, the key energy end-market shows no signs of deceleration. The steeply recovering global oil rig count on the back of a $78 Brent crude oil price suggests that demand for oil & gas field machinery remains on the recovery path and is a harbinger of a rising relative share price ratio (Chart 14). Fourth, industry operating metrics are overheating and signal that profits will continue to surprise to the upside. Rising capex budgets have reduced industry slack (second & third panels, Chart 15). As a result, machinery selling prices have soared to the highest level since the Great Recession (bottom panel, Chart 15) and will underpin industry profits. Chart 14Energy End-market To The Rescue? Chart 15Vibrant Operating Metrics Finally, relative valuations have plunged to near one standard deviation below the average and so have relative technicals. While both can sink further, we would be taking a punt here (Chart 16). Despite our optimistic view on the S&P CMHT index's profit prospects, the appreciating U.S. dollar and recent cresting in the CRB raw industrials index represent key downside risks to our overweight call. This commodity price index is a crucial input to our machinery EPS growth model that has petered out, but at a high level. Any further steep appreciation in the greenback will likely deal a blow to the commodity complex and jeopardize the virtuous machinery profit upcycle (Chart 17). Chart 16Compelling Valuations And Washed Out Technicals Chart 17Risk To Monitor: Commodity Price Relapse Adding it up, a looming global growth pick up, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuation and technical conditions all suggest that now is not the time to throw in the towel in the S&P CMHT index. Bottom Line: Were we not overweight already we would not hesitate to initiate a new above benchmark position in the S&P CMHT index. We reiterate our high-conviction overweight status. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target" dated April 30, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades
Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. John Canally, Chief U.S. Investment Strategist Highlights Late in the business cycle, investors should remain overweight risk assets generally, as long as margins are still rising. A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector. The bar remains high for Q2 2018 EPS, but investors are already focused on 2019 and the impact of trade policy on corporate results. Economic surprise is rolling over as inflation surprise climbs. Feature U.S. equities prices rose last week as U.S.-China tariffs kicked in. The U.S. dollar and 10-year Treasury yields dipped, while oil and gold held steady to start the first quarter. Despite the relative calm, investors remain concerned about the impact of trade policy and rising labor and raw materials costs on corporate margins. BCA expects S&P 500 margins to peak later this year. In the next section of this report, we examine the performance of a broad range of asset classes after the economy reaches full employment. Higher labor and input costs, along with the impact of global trade disputes, will be key topics of discussion as the Q2 earnings seasons kicks off this week. We provide a preview later in this report. Market participants are also worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. We explore those concerns in the second section below. Although the June jobs report (see below) was mixed relative to consensus expectations, the Citigroup Economic Surprise Index (CESI) is poised to turn negative. In the final section of this week's report, we discuss how investors should positions as CESI troughs and how to prepare for the inevitable bounce higher. The rise in the U.S. unemployment rate to 4% in June is not the start of a new trend. The labor market continues to tighten and the FOMC is noticing (Chart 1, panels 1 and 2). Chart 1Don't Be Fooled By The Uptick##BR##In The U.S. Unemployment Rate The June Establishment Survey revealed a 213k rise in payrolls, along with upward revisions to the previous two months. The three-month average, at 211k, remains well above the underlying trend in labor force growth. In contrast, the Household Survey showed a more modest 102k increase in jobs in the month. Moreover, the number of people entering the workforce surged by 601k, which caused the unemployment rate to rise from 3.8% to 4%. We doubt this signals a trend change in the unemployment rate. The Household Survey is quite volatile relative to the Establishment Survey, suggesting that employment gains in the former are likely to catch up next month. The surge in the labor force in June could reflect the possibility that the tight labor market is finally drawing people into the workforce who were not previously looking for work. The participation rate rose by 0.2 percentage points to 62.9% (panel 4). However, this rate bounces around from month-to-month and is still in its post-2015 range. Moreover, the typical wave of college and high school students entering the workforce at this time of the year may have distorted the labor force figures due to seasonal adjustment problems. The real story is that the underlying labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. Average hourly earnings edged up by 0.2% m/m in June. The y/y rate held at 2.7% in the month, but the trend in wage growth remains up (panel 3). Moreover, the June non-manufacturing ISM report highlighted that economic momentum remains very strong, and the respondents' comments noted widespread building cost pressures related to labor shortages, rising commodity prices and a shortage of transportation capacity. China: It's Not 2015...Yet Investor concerns escalated last week over emerging markets and specifically China. Market participants are worried that the weakness in Chinese equities and the decline in the CNY are signaling a repeat of late 2015-early 2016. BCA's Foreign Exchange Strategy's view1 is that Beijing is letting the CNY depreciate at a faster pace against the U.S. dollar for two reasons. First, it is a means to reflate the economy because the proposed U.S. tariffs on Chinese goods would inflict a non-negligible blow to China that would need to be softened if it materializes. Secondly, letting the yuan depreciate sends a message to the U.S.: China can weaponize its currency if necessary. Meanwhile, our China Investment Strategy service remains cautious on Chinese equities, but notes that the recent selloff in domestic stocks may be overdone (we remain neutral on the investable market).2 Chart 2China's Borrowing Costs Have Climbed... A 2015-style deceleration in the Chinese economy cannot be ruled out if it suffers a serious shock to its external sector, which would be very problematic for financial markets given our view that China has a higher pain threshold for stimulus than in the past. But tight monetary policy was a key driver of China's 2015 slowdown, and while monetary conditions have tightened since late-2016, they remain easier than what prevailed four years ago (Chart 2). There are key differences between 2015 and today from a U.S./global perspective as well. In late 2015, the dollar had moved up by 27% from its mid-2014 low, business capital spending was in freefall, credit spreads widened and oil dropped by over 50% year-over year. None of those conditions are currently in place. The key difference between 2015 and today is that three years ago there was no threat of a trade war with China, or the widespread imposition of protectionist measures more generally. Late Cycle Asset Return Performance Some of our economic and policy analysis over the past year has focused on previous late-cycle periods, especially those that occurred at the end of long expansions such as the 1980s, 1990s and the 2000s.3 Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment - NAIRU). This week we look at asset class returns during late-cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart 3). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM or a peak in the S&P 500 index itself. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table 1 (and Appendix) presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the next recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in margins to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart 3Profit Margins Peak Late##BR##In The Late Cycle Period Table 1Historical Returns; Average Of##BR##Late 1990s And Mid-2000s We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cycles the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a 6-12 month horizon. Similar to Treasuries, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasuries after margins peaked and into the recession. High-yield (HY) bonds followed a similar pattern, but suffered negative returns in absolute terms after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but after margins peaked relative performance was mixed. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value before and after margins peaked, but tended to outperform in the recessions. Dividend aristocrat returns performed well relative to the overall equity market after margins peaked and into the recession on average, but the performance is not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge funds are supposed to be able to perform well in any environment, but returns have been a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns are attractive across all periods and cycles, except for Timberland during recessions where the return performance was mixed. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The return analysis underscores that investing late in an economic cycle is risky because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears promising. Based on this approach, investors should remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investor should scale back in most of these areas as soon as margins peak, although they can hold onto Farmland, Timberland, structured products, real estate (including REITs) for a while after margins peak because it may not be as important to exit these areas before the next recession begins. For fixed income, investor should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. S&P 500 margins are still rising at the moment which, on its own, suggests that investors should be fully-exposed to all risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market (e.g. trade war, economic China slowdown, and EM economic and financial vulnerabilities). We are not yet ready to go underweight on risk assets, but the risk/reward balance at the moment suggests that risk tolerance should be no more than benchmark. Still Going Strong The consensus predicts a 21% year-over-year increase in the S&P 500's EPS in Q2 2018 versus Q2 2017, and 22% in calendar year 2018. Expectations are high; at the start of 2018, analysts projected 11% growth in Q2 and 12% in 2018. Energy, materials, technology and financials will lead the way in Q2 earnings growth, while real estate and utilities will struggle. Excluding the energy sector, the consensus expects a robust 18% increase in profits. The stout profit environment for Q2 2018 and the year ahead reflects sharply higher oil prices compared with Q2 2017, and the impact of last year's Tax Cut and Jobs Act on share buybacks and management confidence. However, global growth, which was a tailwind for S&P 500 results in 2017 and early 2018, has stalled. Moreover, rising costs for raw materials and labor will erode margins, but not until later this year. S&P 500 revenues are forecast to rise by 8% in Q2 2018 versus Q2 2017, matching the Q1 2018 year-over-year increase. The consensus expects a year-over-year gain in Q2 sales in all 11 sectors. Trade policy will continue to be at the forefront as managements discuss Q2 outcomes and provide guidance for 2H 2018 and beyond. In addition, capacity constraints, labor shortages and rising input costs will be key topics. Elevated corporate debt levels4 and climbing interest rates also will be debated as CEOs and CFOs provide guidance to Wall Street for Q3 2018 and beyond. Their counsel is more vital than the actual Q2 results. The markets probably have already priced in a robust 2018 earnings profile linked to the Tax Cut and Jobs Act, and are looking ahead to 2019 and 2020 (Chart 4). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 22% increase expected this year. Chart 4High Bar For 2018... But Focus Will Quickly Turn To 2019 At 9%, the consensus estimate for S&P 500 EPS growth in 2020 is too high (Chart 4). BCA's view5 is that the next recession in the U.S. will commence in 2020. Since 1980, S&P 500 profits have dwindled by 28%, on average, in the first year of a recession. Chart 5 (panel 1) shows that elevated readings on the ISM manufacturing index still provide a very favorable backdrop for S&P 500 profit growth in 2018. However, the top panel also illustrates that the index rarely stays above 60 (it was 60.2 in June), especially late in the business cycle. The ISM is a good proxy for S&P 500 forward earnings (panel 2) and sales (panel 3). The implication is that while the near-term environment for S&P 500 earnings and sales is solid, there is not much more upside. Chart 5Domestic Backdrop For S&P Profits In ''18 Still Looks Solid... Global growth is peaking despite the rosy domestic economic environment. At close to 3%, the consensus view of U.S. GDP growth in 2018 is still accelerating thanks to pro-cyclical fiscal, monetary and legislative policies in the U.S.6 However, in early April, analysts estimates for 2019 GDP growth in the U.S. reached a zenith at 2.5% and have since rolled over (Chart 6). The FOMC projects real GDP growth at 2.8% in 2018 and 2.4% in 2019.7 Meanwhile, global GDP growth estimates for 2018 began flattening near 3.5% in early April 2018, about a month after President Trump announced the first round of tariffs. Estimates for 2019 economic growth peaked in mid-May, near 3.25% (Chart 6). Chart 6Consensus GDP Estimates For U.S., World Are Rolling Over BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. The trade-weighted dollar is up by 2.5% year-to-date, and by 7% from its recent (February 2018) trough. Nonetheless, the dollar is down by 2% year-over-year and should not have a major impact on Q2 results. Furthermore, based on the minimal references to a robust dollar (only eight in the past eight Beige Books), the dollar probably will not be an issue for corporate profits in Q2 2018 (Chart 7). The handful of recent references is in sharp contrast with a surge in comments during 2015 and early 2016. The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The implication is that a robust dollar may get a few mentions during the earnings season, but those mentions will be drowned out by concerns over global trade. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically-focused corporations versus globally-oriented ones. Economic growth trends, discussed above, also play a role. Chart 8 shows that sales of domestically-oriented firms in the U.S. are still in a clear uptrend (panel 2). However, revenues of U.S. companies with a global focus stalled in recent quarters, even before the first round of tariffs were announced (panel 4). Margins at domestically-focused firms are still accelerating (panel 1), while margins at global businesses are topping out, albeit at a higher level than domestic ones. Moreover, since the start of 2017, the weaker dollar has allowed profit and sales gains of global corporations to rebound and outpace those companies with only domestic concerns. BCA expects that margins for S&P 500 companies will peak later this year. Investors are skeptical that S&P 500 margins can advance in Q2 2018 for the eighth consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate and raw materials costs escalate. Bottom Line: BCA expects that the earnings backdrop will support equity prices in 2018 (Chart 9). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on the upcoming 2019 and 2020 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 9). In late June,8 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Chart 7The Dollar Should Not Be##BR##A Big Concern In Q2 Earnings Season Chart 8Global Sales,##BR##Margins Stalled... Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Look Out Below Citi's Economic Surprise Index (CESI) is poised to turn negative (Chart 10) after hitting a four-year high in late 2017. Since then, a harsh winter and early spring in the U.S., coupled with elevated expectations following the introduction of the tax bill, saw most economic data fall short of expectations. Moreover, a slowdown in global growth and uncertainty around U.S. and global trade policy negatively affected U.S. economic data in the spring and early summer months. Chart 10Citi Economic Surprise Poised To Turn Negative In our late March 2018 report,9 we noted that there have been six other episodes since 2011 when the CESI behaved similarly. These phases lasted an average of 96 days; the median number of days from peak to trough was 66 days. Moreover, in our March 2018 report we stated that a trough in CESI may be a month or two away, but there are no signs that has occurred. Table 2 illustrates the performance of key U.S. dollar-based investments, commodities and the dollar itself as the CESI moves from zero to its ultimate trough. We identified eight periods since 2010 when the CESI moved lower from zero. Table 2U.S. Stocks, Credit And Commodities As Economic Surprise Turns Negative On average, these episodes lasted 43 days, with the longest (81 days) in early 2015 and the shortest (13 days) in January-February 2013. During these phases, U.S. equities posted minimal gains and underperformed Treasuries (Chart 11). Moreover, investment-grade and high-yield credit tracked Treasuries, and there was little difference between the performance of small cap and large cap equities. Gold and oil struggled, while the dollar barely budged. Chart 11U.S. Financial Assets, Commodities And The Dollar As Economic Surprise Troughs While the CESI is rolling over, the Citigroup Inflation Surprise index is on the upswing (Chart 12). We identified seven stages when the CESI rolled over while the Citi Inflation Surprise Index: 2003-2004, 2007-2008, 2009, 2011, 2012-13, 2014 and this year. The late 2007 period is most similar to today; the other five episodes occurred either during early cycle (2003-2004, 2009 and 2011) or mid-cycle (2012-13 and 2014). In late 2007, the U.S. economy was in the late stages of an expansion, the unemployment rate was below full employment and the Fed was raising rates. The stock-to-bond ratio fell, credit underperformed Treasuries and gold and oil rose. Furthermore, small caps outperformed large caps, and the dollar fell (Chart 13). Chart 12Episodes Of Rising Inflation Surprise##BR##When Economic Surprise Is Falling Chart 13U.S. Financial Assets,##BR##Commodities And The Dollar As... Our work10 shows that these periods were associated with higher wage and compensation metrics, and higher realized core inflation. Moreover, these phases tended to occur when the economy was at full employment and the Fed funds rate was above neutral. The implication is that inflation indices are poised to move higher in the coming year, and prompt the Fed to continue to boost rates gradually at first, but then more aggressively starting in mid-2019. Bottom Line: The disappointing run of economic data is not over. Treasury bond yields will likely dip as the CESI troughs. However, the weakness in the economic data does not signal recession. We expect that the Inflation Surprise Index will continue to grind higher, while unemployment dips further into excess demand territory and oil prices rise. After the CESI forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb.11 Fed policymakers have signaled that they will not mind an overshoot of their 2% inflation target. However, because core PCE inflation is already at the Fed's target, the central bank will be slower to defend the stock market in the event of a swoon. 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 Appendix 1 Please see BCA Research's Foreign Exchange Strategy Weekly Report "What Is Good For China Doesn't Always Help The World", published June 29, 2018. Available at fes.bcaresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report "Standing On One Leg", published July 5, 2018. Available at cis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Weekly Report "Till Debt Do Us Part", published May 8, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Third Quarter 2018: The Beginning Of The End", published June 29, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Line Up," published March 12, 2018. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180613.pdf 8 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways," published June 25, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Waiting", published March 26, 2018. Available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report "Wait A Minute", published May 28, 2018. Available at usis.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Solid Start," published January 8, 2018 and "The Revenge Of Animal Spirits," published October 30, 2017. Both available at usis.bcaresearch.com.
Highlights Portfolio Strategy A near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to lift the S&P homebuilding index to neutral. Troughing health care outlays versus overall PCE, minor cracks in small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest that managed health care relative share prices are as good as they get. Recent Changes Book profits of 24% and augment the S&P Homebuilding Index to a benchmark allocation. Downgrade the S&P Managed Health Care Index to neutral, locking in profits of 28%. Take the S&P Telecom Services Index off the high-conviction underweight list for a gain of 10% (please see the Insight Report on May 24, 2018). Table 1 Feature Stocks held on to their early-May gains and are on track to end the month with handsome returns. While the SPX is not out of the woods yet, still shaking off the early-February tremor, our cyclically upbeat view remains intact. Recent data suggest that earnings will remain healthy, and we expect this will propel the S&P 500 to a fresh all-time high in the back half of the year. It's true that elevated corporate debt levels are a cause for concern, as we detailed in a recent Special Report titled 'Til Debt Do Us Part', and this week we highlight that the Bank for International Settlements (BIS) private non-financial business sector debt-to-GDP ratio confirms the Fed data we presented in that report (Chart 1). Similarly, BIS's debt service ratio1 for non-financial corporates also confirms the Datastream Worldscope stock market data of a deteriorating interest coverage ratio (EBIT/interest expense) for non-financial equities (Chart 1). While we are closely monitoring unfolding debt dynamics, high debt levels are probably a longer-term problem (beyond the next 9-12 months) for the U.S. equity market. Higher interest rates are required in order for a debt crisis to unravel. With that in mind we were pleasantly surprised to notice that net bond ratings migration is moving in the right direction i.e. upgrades are outpacing downgrades. This is impressive as the V-shaped recovery following the late-2015/early-2016 manufacturing recession is already reflected in the data and the most recent uptick likely represents a fresh/different mini credit cycle (downgrades minus upgrades as a percent of total shown inverted, bottom panel, Chart 2). Chart 1Saddled With Debt... Chart 2...But Ratings Migration Moving In The Right Direction Either bond rating agencies are lowering their standards or euphoric rating agencies just reflect the recent fiscal policy easing, extremely low starting point of interest rates and an overall recovery in animal spirits. We side with the latter, and the implication is that SPX momentum will reaccelerate in the coming months, if history at least rhymes (bottom panel, Chart 2). Other indicators we monitor corroborate the positive equity backdrop suggested by the ratings migration data. For example, tracking tax revenue provides an excellent near real-time gauge on corporate sector cash flows. Federal income tax receipts have spiked into double-digit territory. Even state and local government tax coffers are surging, although this dataset is quarterly and trails the monthly released Federal series by four months. Government tax receipt growth has either led or coincided with previous major and sustainable overall profit recoveries (Chart 3). This suggests that S&P 500 second quarter earnings growth will surprise to the upside, despite an already high bar, in-line with our still expanding EPS growth model; the ISM, interest rates, the U.S. dollar and house prices comprise our four factor model (Chart 4). Nevertheless, the latest bout of EM currency weakness spreading beyond the 'fragile five' is a risk to our sanguine EPS growth view, especially in the back half of the year and into 2019. In other words, if this episode mostly resembles the 2013 'taper tantrum' induced devaluations then most of the damage is already done (Chart 5). However, if all of a sudden China falls off a cliff and is forced to devalue à la 2015 then all bets are off and a 'risk off' phase will ensue leading to a spike in the U.S. dollar. Chart 3Money Flowing Into Government Coffers Takes##br## A Real Time Pulse Of Corporate Profits Chart 4Q2 Profits Will Likely ##br##Surprise To The Upside... Chart 5...But A U.S. Dollar##br## Spike Is A Risk As a reminder, the greenback is a key input to our EPS growth regression model and any sustained gains will eventually weigh on SPX profits. This is clearly a risk, but our sense is that there are more parallels with 2013 than with 2015 and one big difference is the bond market's response. The third panel of Chart 5 shows that spreads have not blown out to an alarming level, at least not yet, and signal that a generalized emerging market currency crisis will be averted. Finally, another big difference with the 2015 episode is that the commodity complex is not reeling (bottom panel, Chart 5). This week we are acting on two alerts, one downgrade and one upgrade, and crystalizing outsized gains in a defensive subsector and also taking profits in a niche early cyclical sub-index. Enough Is Enough, Upgrade Homebuilders To Neutral We put the niche S&P homebuilding index on upgrade watch in late-March,2 and today we recommend pulling the trigger and monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather 2. Housing fundamentals remain robust 3. Compelling valuations reflect most, if not all, of the bad news In March we posited that "any rise above 3.05% on the 10-year Treasury yield in a short timeframe would likely prove restrictive for the U.S. economy".3 Fast forward to today and BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased on the back of largely discounted Fed rate hikes, extended net short positioning and the recent moderation in economic data. This backdrop should, at the margin, give some breathing room to this interest rate-sensitive index. True, refinancing mortgage application activity has nearly ground to a halt, but the MBA's mortgage purchase index continues to climb to fresh cycle highs defying rising 30-year fixed mortgage rates (top panel, Chart 6). The MBA weekly survey is nearly exhaustive as it "covers over 75 percent of all U.S. retail residential mortgage applications".4 Importantly, examining the relative volume of purchase activity is instructive. Currently, purchase applications comprise over 2/3 of total applications. There is a positive correlation between interest rates and the purchase share of overall mortgage activity as the middle panel of Chart 6 clearly depicts. This is because refinancing takes the back seat as mortgage rates rise, whereas first time home buyers are less sensitive to the level of interest rates. Wage growth and job security are most important when undertaking the first mortgage. Put differently, a pick up in economic growth that is synonymous with higher interest rates entices rather than dissuades would-be first time home buyers. The U.S. economy is currently at full employment, underscoring that the unemployment rate should move inversely with the purchase share of mortgage activity. Indeed, empirical evidence confirms this negative correlation (bottom panel, Chart 6). Similarly, the firming economic backdrop should also lead to a renormalization of the residential housing market. Household formation is still running at a higher clip than housing starts, signaling that there is little slack in the residential housing market (middle panel, Chart 7). Homebuilder confidence is as good as it gets and home prices are expanding at a healthy pace (bottom panel, Chart 7). Chart 6Housing Fundamentals... Chart 7...Remain On A Solid Footing Importantly, new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (third panel, Chart 8). The tightness in the new home market is also evident in the relative sales backdrop: new home sales are outshining existing home sales which is conducive to a further increase in relative top line growth and thus relative share prices (top and second panels, Chart 8). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel, Chart 8). We deem that most of the bad news is likely reflected in cheap valuations and the message is that it no longer pays to be bearish the niche S&P homebuilding index. Nevertheless, we refrain from swinging all the way to an above benchmark allocation as spiking building material costs are starting to bite, according to the latest NAHB sentiment survey (middle panel, Chart 9). Moreover, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel, Chart 9). Were lumber prices to give way either courtesy of a rising U.S. dollar and/or a positive resolution in the NAFTA negotiations we would not hesitate to boost this index to an overweight stance. Chart 8Firming Top And Bottom Line Growth Prospects Chart 9Surging Building Supply Costs Are A Big Risk Netting it all out, a near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to move to a neutral stance in the S&P homebuilding index. Bottom Line: We are acting on our upgrade alert and booking gains of 24% in the S&P homebuilding index and lifting exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Managed Health Care: Don't Overstay Your Welcome Relative share price gains for the S&P managed health care index are nearly exhausted. We are acting on our late-March downgrade alert and taking profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. Long-term trends in HMOs move in distinct cycles tied with overall health care spending. When overall health care outlays begin to accelerate relative to total consumption the pressure increases on payers of medical services (i.e. health insurance) relative to the providers of those services. The opposite is also true (relative health care outlays shown inverted, Chart 10). Chart 10Rising Relative Health Care##br## Outlays Weigh On HMOs If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place. Industry top-line growth is also fraying around the edges. The second panel of Chart 11 shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. Despite an overall stable and growing employment backdrop, this letdown is disconcerting as roughly 65% of all net new job gains occur in the SME space.5 The implication is that enrollment may also be nearing a peak. Meanwhile, on the input cost front, a softer than expected blow to drug pricing practices revealed in the President's recent speech was music to the ears of Big Pharma executives, but cacophony to HMO CEOs. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net negative for managed health care profits. Historically, our medical care cost proxy has been inversely correlated with industry operating margins and the current message is that the mini margin expansion phase may be short-circuited (middle panel, Chart 12). Tack on a tick up in HMO labor costs and profits will likely underwhelm analysts' optimistic forecasts: the sell-side expects S&P managed health care index profits to outperform the SPX by 330bps in the coming twelve months (bottom panel, Chart 12). We deem it a tall order. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of this health care sub-group (top panel, Chart 13). Importantly, all this euphoria is likely reflected in relative valuations with the relative forward P/E trading one standard deviation above the historical mean (middle panel, Chart 13). Chart 11Early Signs Of... Chart 12...Margin Pressures Chart 13M&A Frenzy Fully Priced Into Expensive Valuations In sum, we do not want to overstay our welcome in the HMO space that has added considerable alpha to our portfolio since our overweight inception in April 2016. Troughing health care outlays versus overall PCE, minor cracks in the small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest relative share prices are as good as they get. Bottom Line: Downgrade the S&P managed health care index to neutral for a gain of 28% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 "The DSR reflects the share of income used to service debt, given interest rates, principal repayments and loan maturities," https://www.bis.org/statistics/dsr.htm. 2 Please see BCA U.S. Equity Strategy Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 https://www.mba.org/2018-press-releases/may/mortgage-rates-increase-applications-decrease-in-latest-mba-weekly-survey 5 https://www.stlouisfed.org/publications/regional-economist/april-2011/are-small-businesses-the-biggest-producers-of-jobs Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps