Commodities & Energy Sector

The global search for yield, not an improvement in EM fundamentals, has been driving the EM rally. EM/China growth conditions have stabilized but not recovered. Barring a full-fledged cyclical profit upsurge in EM EPS, EM stocks are not cheap at all. EM/China final demand for commodities will disappoint and will likely produce a major reversal in EM risk assets.

U.S. inflationary forces remain tame, forcing the Fed to maintain an easy bias. Yet, the global economy is improving. This confluence could weigh on the dollar and boost commodity currencies. The NZD has more upside, but it will lag petro currencies. The BoJ will act, but timing is uncertain. Keep a negative bias toward the yen. CAD/NOK has more downside.

The deepening interconnectedness of the "global eco-system" brought front-and-center by NY Fed President Dudley will keep inflation at the consumer level synchronized in the world's largest economies. The importance of global variables in the evolution of local inflation rates will remain elevated.

A bearish outlook for refiners is becoming a more mainstream thesis, but there likely is one more meaningful relative performance downleg before it will be time to book profits. Refined product consumption has been solid for much of the past year. As a result, refiners have operated at full tilt in order to produce enough gasoline to meet demand. However, overproduction has occurred, compounded by accelerating refinery production outside the U.S. Increased import competition is a serious threat. Saudi Arabia, China and India have all ramped up refined product output this year on the back of cheaper OPEC oil supplies; consequently, exports are flooding the global market, depressing relative demand for U.S. oil product exports, which are falling steadily. Consequently, U.S. refiners will need to both cut refinery production and selling prices in order to rebalance the market. That is a toxic combination for any low margin, high volume cyclical industry. Against a structural backdrop of rising global refining capacity, rich valuations need to be reset. Stay underweight The ticker symbols for the stocks in this index are: BLBG: S5OILR-MPC, PSX, TSO, VLO.

A two-speed economy requires selective portfolio construction, favoring consumer-oriented and mainly non-cyclical industries. Put communications equipment on the high-conviction overweight list, and stay clear of refiners.

With the Fed more sensitive to how its policy affects the global economy, and <i>vice versa</i>, we believe monetary policy will remain accommodative to encourage U.S. and EM growth.

The Chinese manufacturing sector has remained under downward pressure, but the stress level has alleviated compared to a few months ago. The Chinese labor market will likely continue to deteriorate, which will force policymakers to stay accommodative. Despite the recent rally, Chinese investable stocks remain exceptionally cheap.

We are recommending profit taking in gold shares after a dramatic surge since our overweight call earlier this year. The long-term outlook for gold remains appealing, given the need for low or even negative real interest rates for a prolonged period in order to restore global growth to trend or above-trend levels. Nevertheless, on an intermediate-term basis, we are concerned that a rise in the U.S. dollar could cap the upside in bullion and related-share prices. Evidence of speculative zeal is mounting. ETF gold holdings have skyrocketed since late-2015, reflecting massive inflows into related funds. Net speculative positions have surged as a percent of open interest (third panel), underscoring that momentum and performance-chasing have turbo-charged the yellow metal's advance. Sentiment toward gold has also spiked. Importantly, relative stock price performance has become extremely overbought. The 52-week rate of change has soared to its highest level in decades. While that upsurge partially reflects a lasting cyclical and structural trend change, an intermediate-term digestion phase is inevitable to relieve overbought conditions in the coming months, with a stronger currency the most likely catalyst. Take profits of 45% and downshift to neutral.

It is dangerous to equate recent equity strength with economic vitality, as history shows that liquidity-fueled equity advances favor non-cyclicals over deep cyclicals. Take profits in gold, buy rails and sell industrial machinery.

The U.S. and the global economies are improving. A synchronized upswing normally trumps the Fed in determining the path for the dollar. U.S. inflation expectations are likely to rise relative to the rest of the world, weighing on the dollar. The risks for EUR/USD have risen. We are hedging our long EUR/USD position by shorting the euro on some crosses. Buy CHF/JPY.