Consumer Discretionary
Last Wednesday’s Hilton Worldwide Holdings earnings call was littered with cautious commentary during the Q&A section of the call. Specifically, Hilton mentioned that global uncertainty, whether it is Brexit, Trade Wars, the U.S. elections, or the…
Underweight This Wednesday’s Hilton Worldwide Holdings earnings call was littered with cautious commentary during the Q&A section of the call. Specifically, Hilton mentioned that all around global uncertainty be it Brexit, Trade Wars, and other geopolitical events such as U.S. elections and impeachment process, are weighing on travel intensions. The above factors affect both leisure and business travel. Keep in mind that the ISM non-manufacturing survey has taken a beating of late (bottom panel) and revpar is also showing signs of distress (not shown). Nosediving small businesses’ capex intentions are also highlighting that CEOs remain cautious and are likely to become even more prudent with expense management. Historically, slowing capex has been a good predictor of personal income growth, which is also set to slow down (middle panel) subtracting from overall travel budgets. Finally, the U.S. consumer is sending a similar message as sentiment remains below the cyclical peak. Bottom Line: We reiterate our underweight call on the S&P hotels, resorts & cruise lines index. This position is currently up 18% since inception. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, RCL, CCL, NCLH.
We are downgrading the niche S&P homebuilding index to underweight, as most positive profit drivers are already reflected in relative share prices. Specifically, the drop in interest rates has been more than accounted for by homebuilders. Since…
Underweight In yesterday’s Weekly Report1 we recommended downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. The drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders and is no longer a positive catalyst. For instance, the mortgage application purchase index (MAPI) initially benefited from the plunge in interest rates, but the recent 30bps rise in the 10-year Treasury signals that the MAPI has tentatively crested (second panel). Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel). Bottom Line: Downgrade the S&P homebuilding index to underweight. For additional details on the rationale behind this move please refer to the most recent Weekly Report.1 The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. 1 Please See U.S. Equity Strategy, "Is This It?," dated October 21, 2019.
Highlights Portfolio Strategy Soft housing demand, the trough in interest rates, new home price deflation and weak industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. Firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Recent Changes Downgrade the S&P homebuilding index to underweight, today. Table 1 Feature Equities made a run for fresh all-time highs last week, continuing to cheer the trade war “phase one” deal and breathing a big sigh of relief on better-than-expected bank earnings. We doubt a real deal will materialize which would include Intellectual Property and the tech sector. Instead all we got was a trade truce, at best. Larry Kudlow’s recent football analogy is worth repeating: “It's like being on the seven-yard line at a football game…And as a long suffering New York Giants fan, they could be on the seven and they never get the ball to the end zone…When you get down to the last 10 percent, seven-yard line, it's tough". As a reminder, steep tariffs remain in place and there are high odds that the damage already done to global trade is severe enough that it will be months before the emergence of any green shoots. Meanwhile, following up on our “chart of the year candidate” we published two weeks ago, we drilled deeper and discovered two additional economically sensitive indexes that have consistently peaked prior to the SPX in the past three cycles (Chart 1). They now comprise the U.S. Equity Strategy’s Equity Leading Indicator – an equally weighted composite of the S&P Banks index, the Russell 2000 index and the Value Line Geometric index – which signals that the easy money has already been made this cycle in the SPX (Chart 2). Chart 1Three Bulletproof Signals... Chart 2...Combined Into One Leading Equity Indicator Importantly, absent profit growth, it remains extremely difficult for equities to embark on a sustainable fresh leg up by solely relying on multiple expansion. Chart 3 shows our updated Corporate Pricing Power Indicator (CPPI) and it continues to deflate. In fact the steep fall in our CPPI more than offsets the fall in wage growth warning that the margin contraction in the S&P 500 has staying power1 (bottom panel, Chart 3). Drilling beneath the surface, our CPPI is waving a red flag. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Only 42% of the industries we cover are lifting selling prices by more than 1%, and 33% are outright deflating. Worrisomely, only 26% of sectors are raising prices at a faster clip than overall inflation. With regard to pricing power trends, two thirds of the industries we cover are either flat or in a downtrend (Table 2). Chart 3Nil Corporate Pricing Power Table 2Industry Group Pricing Power Gold has jumped to the top of our table galloping at a 26%/annum rate (keep in mind it was deflating in our early July update), and only three additional commodity-related industries made it to the top twenty (Table 2). The disappearance of the commodity complex from the top ranks is consistent with global PPI ills and U.S. dollar strength. This week we update two groups, one early and one deep cyclical. Interestingly, defensive sectors have a healthy showing in the top ten spots with five entries. On the flip side, commodities in general and energy-related industries in particular occupy the bottom of the ranks as WTI crude oil is steeply deflating from the October 2018 peak. Adding it up, corporate sector selling price inflation is sinking in line with depressed inflation expectations. As we posited in our recent profit margin Special Report, profit margins have already peaked for the cycle. We reiterate our cautious overall equity market view on a cyclical 9-to-12 month time horizon. This week we update two groups, one early and one deep cyclical. Cracking Homebuilding Foundations We recommend downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Since the Great Recession, homebuilders have been in clearly defined mini up-and-down cycles, and there are high odds we will soon enter a down oscillation (bottom panel, Chart 4). Interest rates bottomed in early September and there is little additional push they can exert to relative share prices (10-year Treasury yield shown inverted, top panel, Chart 4). Chart 4Relative Gains Are Exhausted Worrisomely, consumers’ expectations to purchase a new home nosedived last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 5). Chart 5Cracks Forming Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled recently. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 6). While the mortgage application purchase index (MAPI) has been rising on the back of the plunge in interest rates, the 30bps rise in the 10-year Treasury yield since September 1 signals that the MAPI has tentatively crested (second panel, Chart 7). Chart 6Contracting Sales Chart 7Margin Trouble Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels, Chart 7). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel, Chart 7). Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. On the operating front, the labor market is also emitting a distress signal. Job openings in the construction industry are sinking like a stone and residential construction employment growth is flirting with the contraction zone. Historically, the ebbs and flows in construction jobs have moved in lockstep with relative share price performance and the current message is to expect a drawdown in the latter (Chart 8). Most of the indicators we track underscore a challenging homebuilding backdrop in the coming months. However, there is a key risk to our view: interest rates. Were the 30-year fixed mortgage rate to fall further from current levels, it would entice first time home buyers and cushion the blow to homebuilding demand (mortgage rates shown inverted, top panel, Chart 9). Similarly, bankers are willing extenders of mortgage credit and are reporting rising demand for residential real estate loans as a lagged consequence of falling rates. But, our sense is that the easy gains are exhausted and a reversal is in the offing in most of these measures (Chart 9). Chart 8Heed The Labor Market's Message Chart 9Potentially Lower Rates Are A Key Risk Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. Bottom Line: Downgrade the S&P homebuilding index to underweight, today. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Stick With Refiners While our bullish take on refiners got to a slippery start, it has recovered all the losses and this position is now in the black. Factors are falling into place for additional gains in the coming months and we recommend investors stick with this overweight recommendation in pure-play downstream stocks. Encouragingly, refining stocks have been trouncing the overall energy index of late and have resumed their multi-year relative uptrend (top panel, Chart 10). With regard to the export relief valve, U.S. net exports of refined products are on a secular uptrend and surprisingly unaffected by the greenback’s moves (bottom panel, Chart 10). Tack on the soon to be adopted International Maritime Organization (IMO) Sulfur 2020 regulations in maritime transportation fuel, and U.S. refiners that produce lower-sulfur fuel oil are well positioned to outearn the SPX. Chart 10Resumed Uptrend Domestic refined product consumption remains upbeat and should serve as a catalyst to unlock excellent value in this niche energy subgroup (middle panel, Chart 11). In fact, gasoline consumption is expanding anew on the back of rising vehicle miles travelled (bottom panel, Chart 11). Chart 11Solid Demand... Refining product supply dynamics are also moving in the right direction. Gasoline inventories are getting whittled down and should boost beaten down refining relative profit expectations (inventories shown inverted, bottom panel, Chart 12). Importantly, this firming demand/supply backdrop has been a boon to refining margins and should continue to underpin relative share price momentum (middle panel, Chart 12). In terms of what is baked in the cake for this industry, the expected profit growth bar is extremely low and falling and relative value has been fully restored. First in terms of relative valuations, the relative trailing price-to-sales ratio has corrected 35% from the mid-2018 peak (middle panel, Chart 11). On a forward PE ratio basis refiners are extremely appealing compared with the SPX following a near halving in the relative forward PE in the past fifteen months (second panel, Chart 13). Chart 12...Supply Backdrop Is Boosting Crack Spreads Chart 13Profit Hurdle Is Uncharacteristically Low Second, relative EPS growth has sunk below the zero line both twelve months and five years forward. Such pessimism is overdone and we would lean against sell-side bearishness (bottom panel, Chart 13). Even the refining industry’s net earnings revisions ratio has collapsed, which is contrarily positive (third panel, Chart 13). Adding it all up, firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Bottom Line: Stay overweight the S&P oil & gas refining & marking index. The ticker symbols for the stocks in this index are: BLBG – S5OILR – MPC, VLO, PSX, HFC. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Special Report, “Peak Margins” dated October 7, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights New structural recommendation: long GBP/USD. The substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. The most powerful equity play on a fading Brexit discount would be the U.K. homebuilders. Specifically, Persimmon still has a further 25 percent of upside. Take profits in long Euro Stoxx 50 versus Shanghai Composite. Within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Stay overweight banks versus industrials. Stay overweight the Euro Stoxx 50 versus the Nikkei 225. Fractal trade: long NZD/JPY. Feature Chart of the WeekThe Pound Has Substantial Upside If The Brexit Discount Fades Carnival Says The Pound Is Cheap Carnival, the world’s largest cruise liner company, lists its shares on both the London and New York stock exchanges. But there is an apparent riddle: in London the shares trade on a forward PE of 8.8, while in New York they trade on 9.4. How can Carnival trade at different valuations on the two sides of the Atlantic when the market should instantly arbitrage the difference away? The answer to the riddle is that the London listing is quoted in pounds, the New York listing is quoted in dollars, while Carnival’s sales and profits are denominated in a mix of international currencies. Neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. Carnival is trading on a higher valuation in New York versus London because the market is expecting its mixed currency earnings to appreciate more in dollar terms than in pound terms. Put another way, the valuation differential is expecting the pound to appreciate versus the dollar to a ‘fair value’ of around $1.40 (Chart I-2). Likewise, BHP Billiton shares are trading on a higher valuation in their Sydney listing compared to their London listing. This valuation differential is expecting the pound to appreciate versus the Australian dollar to around A$2.00 (Chart I-3). Chart I-2Carnival Says The Pound Is Cheap Chart I-3BHP Billiton Says The Pound Is Cheap In other words, the market believes that neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. We tend to agree. The Wrong Way To Pick Stock Markets… And The Right Way Before continuing with the pound’s prospects, let’s wander into the wider investment landscape. One important lesson from dual-listed companies like Carnival and BHP Billiton is that a multinational’s valuation will appear attractive in a market where the currency is structurally cheap.1 This lesson has deep ramifications. Today, multinationals dominate all the major stock markets, meaning that the entire stock market will appear cheap if its currency is cheap. The stock market will also appear cheap if it is skewed towards lower-valued sectors. But sectors trade on a low valuation for a reason – poor long-term growth prospects. Through the past decade, Japanese banks seemed a relative bargain, trading on a forward PE of less than half of that on personal products companies (Chart I-4). Yet Japanese banks were not a relative bargain. Quite the contrary. Through the past decade Japanese personal products have outperformed the banks by 500 percent! (Chart I-5) Chart I-4Japanese Banks Seemed A Relative Bargain... Chart I-5...But Japanese Banks Were Not A Relative Bargain Hence, beware of picking stock markets on the basis of observations such as ‘European stocks are cheaper than U.S. stocks’. Given that a stock market valuation is the result of its currency valuation and its sector composition, assessing relative value across major stock markets is extremely difficult, if not impossible. To repeat, Carnival appears to be trading at a valuation discount in London versus New York, but the cheapness is illusory. Here’s the right way to pick major stock markets. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In this regard, large underweight sector skews also matter. For example, China and EM have a near-zero exposure to healthcare equities, so their performances tend to correlate negatively with that of the global healthcare sector – albeit the causality could run in either direction. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In early May, we noticed that the extreme outperformance of technology versus healthcare was at a critical technical point at which there was a high probability of a trend reversal. This high conviction sector view implied overweight Europe versus China, as well as overweight Switzerland and underweight Netherlands within Europe (Chart I-6 and Chart I-7). Chart I-6When Tech Underperforms Healthcare, China Underperforms Switzerland Chart I-7When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland Given that this sector trend reversal has played out exactly as anticipated, it is time to bank the profits: Close long Euro Stoxx 50 versus Shanghai Composite. And within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Right now, it is appropriate to overweight banks versus industrials. It is the pace of the bond yield’s decline that has weighed on bank performance this year. But if the sharpest decline in bond yields is behind us, as seems likely, then banks should fare better versus other cyclicals (Chart I-8). Chart I-8If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials Once again, this sector view carries an equity market implication: stay overweight the Euro Stoxx 50 versus the Nikkei 225 (Chart I-9). Chart I-9Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen The Pound Is A Long-Term Buy Back to the pound. The message from the dual listings of Carnival and BHP Billiton is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40 (Chart of the Week and Chart I-10). Chart I-10The Pound Has Substantial Upside If The Brexit Discount Fades In the Brexit psychodrama, we do not claim to know exactly how the next few days or weeks will play out. In the short term, Brexit is a classic non-linear system, and non-linear systems are inherently unpredictable. However, in the longer term we expect the Brexit discount to fade in any sort of transitioned resolution that allows the U.K. to adapt to a new trading relationship with the world, or alternatively to stay in a relationship broadly similar to the current one. Whatever the eventual endpoint is, the key requirement to remove the Brexit discount is to avoid a cliff-edge. We expect the Brexit discount to fade in any sort of transitioned resolution. The stumbling block to a resolution is that the three key actors – the EU, the U.K. government, and the U.K. parliament – have conflicting red lines, so the Brexit ‘Venn diagram’ has had no overlap. The EU will not countenance a customs border that divides Ireland; the current U.K. government wants a Free Trade Agreement, which implies casting away Northern Ireland into the EU customs union; and the current U.K. parliament – unless its intentions suddenly change – wants the whole of the U.K., including Northern Ireland, to remain in the EU customs union. Given that the EU will not budge its red line, the only way to a lasting resolution is for the government and parliament red lines to realign, This could happen via parliament being willing to sacrifice Northern Ireland, via a second referendum, or via a general election in which the government’s intentions and/or the composition of parliament changed. Given a long enough investment horizon – 2 years or more – it is likely that the government and parliament will realign their red lines to a Free Trade Agreement or to a customs union, one way or another. On this basis, the substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. Accordingly, today we are initiating a new structural recommendation: long GBP/USD. For equity investors, the most powerful play on a fading Brexit discount would be the U.K. homebuilders (Chart I-11). Specifically, if the pound reached $1.40, Persimmon still has a further 25 percent of upside. Chart I-11U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades Fractal Trading System* Based on its collapsed fractal structure, we anticipate a countertrend rally in NZD/JPY within the next 130 days. Accordingly, go long NZD/JPY setting a profit target of 3 percent and a symmetrical stop-loss. Chart I-12 For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 There are also several companies with dual listings in the U.K. and the euro area. Unfortunately, these valuation differentials have been temporarily distorted by the risk of a no-deal Brexit, in which EU27 investors may have been forbidden from trading in the U.K. listed shares. Fractal Trading System Cyclical Recommendations Structural Recommendations Fractal Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights MARKET FORECASTS Investment Strategy: Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. We think both preconditions will be realized. Until then, risk assets could come under pressure. Global Asset Allocation: Investors should overweight stocks relative to bonds over a 12-month horizon, but maintain higher-than-normal cash positions in the near term as a hedge against downside risks. Equities: EM and European stocks will outperform once global growth bottoms out. Cyclical sectors, including financials, will also start to outperform defensives when the growth cycle turns. Bonds: Central banks will remain dovish, but yields will nevertheless rise modestly on the back of stronger global growth. Favor high-yield corporate credit over government bonds. Currencies: As a countercyclical currency, the U.S. dollar should peak later this year. Commodities: Oil and industrial metals prices will move higher. Gold prices have entered a holding pattern, but should shine again late next year or in 2021 when inflation finally breaks out. Feature Dear Client, In lieu of this report, I hosted a webcast on Monday, October 7th at 10:00 AM EDT, where I discussed the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist I. Global Macro Outlook A Testing Phase For The Global Economy The global economy has reached a critical juncture. Growth has been slowing since early 2018, reaching what many would regard as “stall speed.” This is the point where economic weakness begins to feed on itself, potentially triggering a recession. Will the growth slowdown worsen? Our guess is that it won’t. Global financial conditions have eased significantly over the past four months, thanks in part to the dovish pivot by most central banks. Looser financial conditions usually bode well for global growth (Chart 1). Our global leading indicator has hooked up, mainly due to a marginal improvement in emerging markets’ data (Chart 2). Chart 1Easier Financial Conditions Will Boost Global Growth Chart 2Global LEI Has Moved Off Its Lows An important question is whether the weakness in the manufacturing sector will spread to the much larger services sector. There is some evidence that this is happening, with yesterday’s weaker-than-expected ISM non-manufacturing release being the latest example. Nevertheless, the deceleration in service sector activity has been limited so far (Chart 3). Even in Germany, with its large manufacturing base, the service sector PMI remains in expansionary territory. This is a key difference with the 2001/02 and 2008/09 periods, when service sector activity collapsed in lockstep with manufacturing activity. Chart 3AThe Service Sector Has Softened Less Than Manufacturing (I) Chart 3BThe Service Sector Has Softened Less Than Manufacturing (II) The Drive-By Slowdown If one were to ask most investors the reasons behind the manufacturing slowdown, they would probably cite the trade war or the Chinese deleveraging campaign. These are both valid reasons, but there is a less well-known culprit: autos. According to WardsAuto, global auto sales fell by over 5% in the first half of the year, by far the biggest decline since the Great Recession (Chart 4). Production dropped by even more. Chart 4Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Chart 5U.S. Auto Demand Is Recovering The weakness in the global auto sector reflects a variety of factors. New stringent emission requirements, expiring tax breaks, lagged effects from tighter auto loan lending standards, and trade tensions have all played a role. In addition, the decline in gasoline prices in 2015/16 probably brought forward some automobile purchases. This suggests that the 2015/16 global manufacturing downturn may have helped sow the seeds for the current one. The fact that automobile output is falling faster than sales is encouraging because it means that excess inventories are being worked off. U.S. auto loan lending standards have started to normalize, with banks reporting stronger demand for auto loans in the latest Senior Loan Officer Survey (Chart 5). In China, auto sales have troughed after having declined by as much as 14% earlier this year (Chart 6). The Chinese automobile ownership rate is a fifth of what it is in the U.S., a quarter of what it is in Japan, and a third of what it is in Korea (Chart 7). Given the low starting point, Chinese auto sales are likely to resume their secular uptrend. Chart 6Auto Sector In China Is Finding A Floor Chart 7China: Structural Outlook For Autos Is Bright The Trade War: Tracking Towards A Détente? Chart 8A Fairly Regular Three-Year Manufacturing Cycle Manufacturing cycles typically last about three years – 18 months of slowing growth followed by 18 months of rising growth (Chart 8). To the extent that the global manufacturing PMI peaked in the first half of 2018, we should be nearing the end of the current downturn. Of course, much depends on policy developments. As we go to press, high-level negotiations between the U.S. and China have resumed. While it is impossible to predict the outcome of these talks, it does appear that both sides have an incentive to de-escalate the trade conflict. President Trump gets much better marks from voters on his management of the economy than on anything else, including his handling of trade negotiations with China (Chart 9). A protracted trade war would hurt U.S. growth, while weakening the stock market. Both would undermine Trump’s re-election prospects. Chart 9Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 10Who Will Win The 2020 Democratic Nomination? China also wants to bolster growth. As difficult as it has been for the Chinese leadership to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would especially be the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more pliant to deal with on trade matters. Does the Chinese government really want to negotiate over environmental standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 10)? The Democrats’ initiative to impeach President Trump make a trade resolution somewhat more likely. First, it brings attention to Joe Biden’s (and his son’s) own dubious dealings in Ukraine, thus delivering a blow to China’s preferred U.S. presidential candidate. Second, it makes Trump more inclined to want to put the China spat behind him in order to focus his energies on domestic matters. More Chinese Stimulus? Strategically, China has a strong incentive to stimulate its economy in order to prop up growth and gain greater leverage in the trade negotiations. The Chinese credit impulse bottomed in late 2018. The impulse leads Chinese nominal manufacturing output and most other activity indicators by about nine months (Chart 11). So far, the magnitude of China’s credit/fiscal easing has come nowhere close to matching the stimulus that was unleashed on the economy both in 2015/16 and 2008/09. This is partly because the authorities are more worried about excessive debt levels today than they were back then, but it is also because the economy is in better shape. The shock from the trade war has not been nearly as bad as the Great Recession – recall that Chinese exports to the U.S. are only 2.7% of GDP in value-added terms. Unlike in 2015/16, when China lost over $1 trillion in external reserves, capital outflows have remained muted this time around (Chart 12). Chart 11Chinese Stimulus Should Boost Global Growth Chart 12China: No Major Capital Outflows Better-than-expected Chinese PMI data released earlier this week offers a glimmer of hope. Nevertheless, in light of the disappointing August activity numbers, China is likely to increase the pace of stimulus in the coming months. The authorities have already reduced bank reserve requirements. We expect them to cut policy rates further in the coming months. They will also front-load local government bond issuance, which should help boost infrastructure spending. European Growth Should Improve A pickup in global growth will help Europe later this year. Germany, with its trade-dependent economy, will benefit the most. Chart 13Spreads Have Come In Across Southern Europe Chart 14Faster Money Growth Bodes Well For GDP Growth In The Euro Area Falling sovereign spreads should also support Southern Europe (Chart 13). The Italian 10-year spread with German bunds has narrowed by almost a full percentage point since mid-August, taking the Italian 10-year yield down to 0.83%. Greek 10-year bonds are now yielding less than U.S. Treasurys (the Greek manufacturing PMI is currently the strongest in the world). With the ECB back in the market buying sovereign and corporate debt, borrowing rates should remain low. Euro area money growth, which leads GDP growth, has already picked up (Chart 14). Bank lending to the private sector should continue to accelerate. A modest serving of fiscal stimulus will also help. The European Commission estimates that the fiscal thrust in the euro area will increase by 0.5% of GDP in 2019 (Chart 15). Assuming, conservatively, a fiscal multiplier of one, this would boost euro area growth by half a percentage point. Owing to lags between changes in fiscal policy and their impact on the real economy, most of the gains to GDP growth will occur over the remainder of this year and in 2020. Chart 15Euro Area Fiscal Stimulus Will Also Boost Growth Chart 17Brexit Angst: A Case Of Bremorse Chart 16U.K.: Brexit Uncertainty Is Weighing On Growth In the U.K., Brexit uncertainty continues to weigh on growth. U.K. business investment has been especially hard hit (Chart 16). Prime Minister Boris Johnson remains insistent that he will take the U.K. out of the EU with or without a deal at the end of October. We would downplay his bluster. The Supreme Court has already denied his attempt to shutter parliament. The public is having second thoughts about the desirability of Brexit (Chart 17). While we do not have a strong view on the exact plot twists in the Brexit saga, we maintain that the odds of a no-deal Brexit are low. This is good news for U.K. growth and the pound. Japan: Own Goal Recent Japanese data releases have not been encouraging: Machine tool orders declined by 37% year-over-year in August. Exports contracted by over 8%, with imports recording a drop of 12%. The September PMI print exposed further deterioration in manufacturing, with the index falling to 48.9 from 49.3 in August. In addition, industrial production contracted by more than expected in August, falling by 1% month-over-month, and close to 5% year-over-year. The ongoing uncertainty surrounding the U.S.-China trade negotiations, as well as Japan’s own tensions with neighboring South Korea, have also weighed on the Japanese economy. Japanese industrial activity will improve later this year as global growth rebounds. But the government has not helped growth prospects by raising the consumption tax on October 1st. While various offsets will blunt the full effect of the tax hike, it still amounts to unwarranted tightening in fiscal policy. Nominal GDP has barely increased since the early 1990s. What Japan needs are policies that boost nominal income. Such reflationary policies may be the only way to stabilize debt-to-GDP without pushing the economy back into a deflationary spiral.1 The U.S.: Hanging Tough Chart 18U.S. Has A Smaller Share Of Manufacturing Than Most Other Developed Economies The U.S. economy has fared relatively well during the latest global economic downturn, partly because manufacturing represents a smaller share of GDP than in most other economies (Chart 18). According to the Atlanta Fed GDPNow model, real GDP is on track to rise at a trend-like pace of 1.8% in the third quarter (Chart 19). Personal consumption is set to increase by 2.5%, after having grown by 4.6% in the second quarter. Consumer spending should stay robust, supported by rising wage growth. The personal savings rate also remains elevated, which should help cushion households from any adverse shocks (Chart 20). Chart 19U.S. Growth Has Softened, But Is Still Close To Trend Residential investment finally looks as though it is turning the corner. Housing starts, building permits, and home sales have all picked up. Given the tight relationship between mortgage rates and homebuilding, construction activity should accelerate over the next few quarters (Chart 21). Low inventory and vacancy rates, rising household formation, and reasonable affordability all bode well for the housing market (Chart 22). Chart 20The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Chart 21U.S. Housing Will Rebound Chart 22U.S. Housing: On A Solid Foundation Chart 23U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels In contrast to residential investment, business capex continues to be weighed down by the manufacturing recession, a strong dollar, and trade policy uncertainty. Core durable goods orders declined in August. Capex intention surveys have also weakened, although they remain well above recessionary levels (Chart 23). The ISM manufacturing index hit its lowest level since July 2009 in September. The internals of the report were not quite as bad as the headline. The new orders-to-inventories component, which leads the ISM by two months, moved back into positive territory. The weak ISM print also stands in contrast to the more upbeat Markit U.S. manufacturing PMI, which rose to its highest level since April. Statistically, the Markit PMI does a better job of tracking official measures of U.S. manufacturing output, factory orders, and employment than the ISM. Taking everything together, the U.S. economy is likely to see modestly stronger growth later this year, as the global manufacturing recession comes to an end, while strong consumer spending and an improving housing market bolster domestic demand. II. Financial Markets Global Asset Allocation Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. As such, investors should maintain larger-than-normal cash positions for the time being to guard against downside risks. Chart 24Stocks Will Outperform Bonds If Growth Recovers Fortunately, any pullback in risk asset prices is likely to be temporary. If trade tensions subside and global growth rebounds later this year, as we expect, stocks and spread product should handily outperform government bonds over a 12-month horizon (Chart 24). Admittedly, there are plenty of things that could upend this sanguine 12-month recommendation: Global growth could continue to deteriorate; the trade war could intensify; supply-side shocks could cause oil prices to spike up again; the U.K. could end up leaving the EU in a “hard Brexit” scenario; and last but not least, Elizabeth Warren or some other far-left candidate could end up becoming the next U.S. president. The key question for investors today is whether these risks have been fully discounted in financial markets. We think they have. Chart 25 shows our estimates for the global equity risk premium (ERP), calculated as the difference between the earnings yield and the real bond yield. Our calculations suggest that stocks still look quite cheap compared to bonds. Chart 25AEquity Risk Premia Remain Quite High (I) Chart 25BEquity Risk Premia Remain Quite High (II) One might protest that the ERP is high only because today’s ultra-low bond yields are reflecting very poor growth prospects. There is some truth to that claim, but not as much as one might think. While trend GDP growth has fallen in the U.S. over the past decade, bond yields have declined by even more. The gap between U.S. potential nominal GDP growth, as estimated by the Congressional Budget Office, and the 10-year Treasury yield is close to two percentage points, the highest since 1979 (Chart 26). Chart 26Bond Yields Have Fallen More Than Trend Nominal GDP Growth At the global level, trend GDP growth has barely changed since 1980, largely because faster-growing emerging markets now make up a larger share of the global economy (Chart 27). For large multinational companies, global growth, rather than domestic growth, is the more relevant measure of economic momentum. Gauging Future Equity Returns A high ERP simply says that equities are attractive relative to bonds. To gauge the prospective return to stocks in absolute terms, one should look at the absolute level of valuations. Chart 27The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM Chart 28S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector As we argued in a recent report entitled “TINA To The Rescue?,”2 the earnings yield can be used as a proxy for the expected real total return on equities. Empirically, the evidence seems to bear this out: Since 1950, the earnings yield on U.S. equities has averaged 6.7%, compared to a real total return of 7.2%. Today, the trailing and forward PE ratio for U.S. stocks stand at 21.1 and 17.4, respectively. Using a simple average of the two as a guide for future returns, U.S. stocks should deliver a long-term real total return of 5.2%. While this is below its historic average, it is still a fairly decent return. One might complain that this calculation overstates prospective equity returns because the U.S. earnings yield is temporarily inflated by abnormally high profit margins. The problem with this argument is that virtually all of the increase in S&P 500 margins has occurred in just one sector: technology. Outside of the tech sector, S&P 500 margins are not far from their historic average (Chart 28). If high IT margins reflect structural changes in the global economy – such as the emergence of “winner take all” companies that benefit from powerful network effects and monopolistic pricing power – they could remain elevated for the foreseeable future. Regional And Sector Equity Allocation The earnings yield is roughly two percentage points higher outside the U.S., suggesting that non-U.S. stocks will best their U.S. peers over the long haul. In the developed market space, Germany, Spain, and the U.K. appear especially cheap. In the EM realm, China, Korea, and Russia stand out as being very attractively priced (Chart 29). At the sector level, cyclical stocks look more appealing than defensives (Chart 30). Chart 29U.S. Stocks Appear Expensive Compared To Their Peers Chart 31Economic Growth Drives Stocks Over A 12-Month Horizon Chart 30Cyclical Stocks Are More Attractive Than Defensives Chart 32EM And Euro Area Equities Usually Outperform When Global Growth Improves Valuations are useful mainly as a guide to long-term returns. Over a horizon of say, 12 months, cyclical factors – i.e., what happens to growth, interest rates, and exchange rates – matter more (Chart 31). Fortunately, our cyclical views generally line up with our valuation assessment. Stronger global growth, a weaker dollar, and rising commodity prices should benefit cyclical stocks relative to defensives. To the extent that EM and European stock markets have more of a cyclical sector skew than U.S. stocks, the former should end up outperforming (Chart 32). We would put financials on our list of sectors to upgrade by year end once global growth begins to reaccelerate. Falling bond yields have hurt bank profits (Chart 33). The drag on net interest margins should recede as yields start rising. European banks, which currently trade at only 7.6 times forward earnings, 0.6 times book value, and sport a hefty dividend yield of 6.3%, could fare particularly well (Chart 34). Chart 33AHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Chart 33BHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) As Chart 35 illustrates, a bet on financials is similar to a bet on value stocks. Growth has trounced value over the past 12 years, but a bit of respite for value is in order over the next 12-to-18 months. Chart 34European Banks Are Attractive Chart 35Is Value Turning The Corner? Fixed Income Chart 36AYields Should Rise On Stronger Growth (I) Dovish central banks and, for the time being, still-subdued inflation will help keep government bond yields in check over the next 12 months. Nevertheless, yields will still rise from currently depressed levels on the back of stronger global growth (Chart 36). Chart 36BYields Should Rise On Stronger Growth (II) Bond yields tend to rise or fall depending on whether central banks adjust rates by more or less than is anticipated (Chart 37). Investors currently expect the Fed to cut rates by another 80 basis points over the next 12 months. While we think the Fed will bring down rates by 25 basis points on October 30th, we do not anticipate any further cuts beyond then. The cumulative 75 basis points in cuts during this easing cycle will be equivalent to the amount of easing delivered during the two mid-cycle slowdowns in the 1990s (1995/96 and 1998). All told, the U.S. 10-year Treasury yield is likely to move back into the low 2% range by the middle of 2020. Chart 37AStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Chart 36BStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Chart 38U.S. Government Bond Yields Are More Procyclical Than Yields Abroad Unlike U.S. equities, which tend to have a low beta compared to stocks abroad, U.S. bonds possess a high beta. This means that U.S. Treasury yields usually rise more than yields abroad when global bond yields, in aggregate, are increasing, and fall more than yields abroad when global bond yields are decreasing (Chart 38). Moreover, U.S. Treasurys currently yield less than other bond markets once currency-hedging costs are taken into account (Table 1). If U.S. yields were to rise more than those abroad over the next 12-to-18 months, this would further detract from Treasury returns. As a result, investors should underweight Treasurys within a global government bond portfolio. Stronger global growth should keep corporate credit spreads at bay. Lending standards for U.S. commercial and industrial loans have moved back into easing territory, which is usually bullish for corporate credit (Chart 39). According to our U.S. bond strategists, high-yield corporate spreads, and to a lesser extent, Baa-rated investment-grade spreads, are still wider than is justified by the economic fundamentals (Chart 40).3 Better-rated investment-grade bonds, in contrast, offer less relative value. Table 1Bond Markets Across The Developed World Chart 39Easier Lending Standards Bode Well For Corporate Credit Chart 40U.S. Corporates: Focus On Baa And High-Yield Credit Looking beyond the next 18 months, there is a high probability that inflation will start to move materially higher. The unemployment rate across the G7 has fallen to a multi-decade low (Chart 41). The share of developed economies that have reached full employment has hit a new cycle high (Chart 42). For all the talk about how the Phillips curve is dead, wage growth has remained tightly correlated with labor market slack (Chart 43). Chart 41Unemployment Rates Keep Trending Lower Chart 42Developed Markets: Full Employment Reaching New Cycle Highs Chart 43The Phillips Curve Is Alive And Well As wages continue to rise, prices will start to move up, potentially setting off a wage-price spiral. The Fed, and eventually other central banks, will have to start raising rates at that point. Once interest rates move into restrictive territory, equities will fall and credit spreads will widen. A global recession could ensue in 2022. Currencies And Commodities Chart 44The Dollar Is A Countercyclical Currency The U.S. dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 44). We do not have a strong near-term view on the direction of the dollar at the moment, but expect the greenback to begin to weaken by year end as global growth starts to rebound. EUR/USD should increase to around 1.13 by mid-2020. GBP/USD will rise to 1.29. USD/CNY will move back to 7. USD/JPY is likely to be flat, reflecting the yen’s defensive nature and the drag on Japanese growth from the consumption tax hike. The trade-weighted dollar will continue to depreciate until late-2021, after which time a more aggressive Fed and a slowdown in global growth will cause the dollar to rally anew. During the period in which the dollar is weakening, commodity prices will move higher (Chart 45). Chart 45Dollar Weakness Is A Boon For Commodities BCA’s commodity strategists are particularly bullish on oil over a 12-month horizon (Chart 46). They see Brent crude prices rising to $70/bbl by the end of this year and averaging $74/bbl in 2020 based on the expectation that stronger global growth and production discipline will drive down oil inventory levels. OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is currently below its historic average (Chart 47). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 48). Chart 46Supply Deficit To Continue Chart 47Limited Availability Of Spare Capacity To Offset Outages Chart 48Key Strategic Petroleum Reserves Higher oil prices should benefit currencies such as the Canadian dollar, Norwegian krone, Russian ruble and Colombian peso. Finally, a few words on gold. We closed our long gold trade on August 29th for a 20-week gain of 20.5%. We still see gold as an excellent long-term hedge against higher inflation. In the near term, however, rising bond yields may take the wind out of gold’s sails, even if a weaker dollar does help bullion at the margin. We will reinitiate our long gold position towards the end of next year or in 2021 once inflation begins to break out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “Are High Debt Levels Deflationary Or Inflationary?” dated February 15, 2019. 2Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 3Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed,” dated September 17, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights European and global growth will rebound in the fourth quarter but the rebound will lack longevity. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. Equities: a tug of war between growth and valuation will leave the broad equity market index in a sideways channel. But with the higher yield, prefer equities over bonds. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225. Feature Comfort and discomfort are not absolute, they are relative. Put your hand in cold water, and whether it feels comfortable or uncomfortable depends on where your hand has come from. If your hand has come from room temperature, the cold water will feel uncomfortable. But if your hand has come from an ice bucket, the cold water will feel like bliss! The same principle applies to how we, and the financial markets, perceive short-term economic growth. After a strong expansion, a pedestrian growth rate of 1 percent feels uncomfortable. But after an economic contraction, 1 percent growth feels very pleasant. This leads to two important points: In the short term, the market is less concerned about the rate of growth per se, it is more concerned about whether the rate of growth is accelerating or decelerating. When it comes to the short term drivers of growth – bond yields, credit, and the oil price – we must focus not on their changes, we must focus on their impulses, meaning the changes in their changes. This is because it is the impulses of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth, often with a useful lead time of a few months. The Chart of the Week combined with Chart I-1-Chart I-4 should leave you in no doubt. In the euro area, United States, and China, the domestic bond yield 6-month impulses have led their domestic 6-month credit impulses with near-perfect precision. Chart of the WeekCredit Growth To Rebound In The Fourth Quarter, Then Fade Chart I-2The Euro Area Bond Yield Impulse Leads Its Credit Impulse Chart I-3The U.S. Bond Yield Impulse Leads Its Credit Impulse Chart I-4The China Bond Yield Impulse Leads Its Credit Impulse Based on this near-perfect precision, the credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. But expect much less of a rebound, if any, in China. While bond yields have collapsed in the euro area and the U.S., resulting in tailwind credit impulses, they have moved much less in China. Indeed, China’s bond yield 6-month impulse has been moving deeper into headwind territory in the past few months (Chart I-5). Chart I-5Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China It follows that a credit growth rebound in the fourth quarter will be sourced in Europe and the U.S. rather than in China. From a tactical perspective, this will favour non-China cyclical plays over China plays. But moving into the early part of 2020, expect the credit impulses to fade across all the major economies – unless bond yields now fall very sharply everywhere. Investing On Impulse Many people still find it confusing that it is the impulses – and not the changes – of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth. To resolve this confusion, let’s clarify the point. The credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. A bond yield decline will trigger new borrowing. For example, a given decline in the U.S. bond yield, say 0.5 percent, will trigger a given increase in the number of mortgage applications (Chart I-6). New borrowing will add to demand, meaning it will generate growth. But in the following period, a further bond yield decline of 0.5 percent will generate the same further new borrowing and growth rate. The crucial point is that, if the decline in the bond yield is the same, growth will not accelerate. Chart I-6A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. Conversely and counterintuitively, growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. Don’t Blame Autos For A German Recession Chart I-7German Car Production Rebounded In The Third Quarter If the German economy contracts in the third quarter and thereby enters a technical recession, the knee-jerk response will be to blame the troubles in the auto industry. But the evidence does not support this story. German new car production rebounded in the third quarter (Chart I-7). Begging the question: if not autos, what is the true culprit for the deceleration? The likely answer is that Germany recently suffered a severe headwind from the oil price impulse. Germany has one of the world’s highest volumes of road traffic per unit of GDP, second only to the U.S. (Table I-1). A possible explanation for Germany’s high traffic intensity is that, just like the U.S., Germany is a decentralised economy with multiple ‘hubs and spokes’ requiring a lot of criss-crossing of traffic. But unlike the U.S., German transport is highly dependent on oil imports, which tend to be non-substitutable and highly inelastic to price. As the value of German oil imports rise in lockstep with the oil price, Germany’s net exports decline, weighing on growth. Table I-1Germany Has A Very High Road Traffic Intensity The upshot is that the oil price impulse has a major bearing on Germany’s short term growth accelerations and decelerations. The six month period ending around June 2019 constituted a severe headwind impulse. This is because a 30 percent increase in the oil price in that period followed a 40 percent decline in the previous six month period, equating to a headwind impulse of 70 percent.1 Germany has one of the world’s highest volumes of road traffic per unit of GDP. Allowing for typical lags of a few months, this severe headwind impulse was a major contributor to Germany’s recent deceleration. Oscillations in the oil price’s 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with a spooky accuracy (Chart I-8). The good news is that the oil price’s severe headwind impulse has eased – allowing a rebound in German economic growth during the fourth quarter. Chart I-8The Oil Price Impulse Explains Oscillations In German Growth Nevertheless, a putative rebound could be nullified by a wildcard: the ‘geopolitical risk impulse’. To be clear this is not an impulse in the technical sense, but it is a similar concept: are the number of potential tail-events increasing or decreasing? For the fourth quarter, our subjective answer is they are decreasing. In Europe, the formation of a new coalition government in Italy has removed Italian politics as a possible tail-event for the time being. Meanwhile, we assume that the Benn-Burt law in the U.K. has been drafted well enough to eliminate a potential no-deal Brexit on October 31. Elsewhere, the U.S/China trade war and Middle East tensions are most likely to be in stasis through the fourth quarter. How To Position For The Fourth Quarter After a disappointing third quarter for global and European growth, we expect a rebound in the fourth quarter. But at the moment, we do not have any conviction that the rebound’s momentum will take it deeply into 2020. Position for the fourth quarter as follows: Expect a rebound in the fourth quarter. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. With a Brexit denouement, the pound could be the biggest mover and our inkling is to the upside. But we await more clarity before pulling the trigger. Equities: a tug of war between growth and valuation will leave the broad equity market index in the sideways range in which it has existed over the past two years (Chart I-9). But with a higher yield than bonds, equities are the preferred asset-class in the ugly contest. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225 (Chart I-10). Chart I-9Global Equities Have Gone Nowhere For Two Years Chart I-10Stay Overweight Europe ##br##Versus China Fractal Trading System* The recent surge in the nickel price is due to scares about supply disruption, specifically an Indonesian export ban. However, the extent of the rally appears technically stretched. We would express this as a pair-trade versus gold: long gold / short nickel. Chart I-11Nickel VS. Gold Set a profit target of 11 percent with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. 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