Developed Countries
Neutral Despite rising rates, homebuilders remain highly optimistic about the prospects for the domestic housing market, with the homebuilder survey persistently pushing near decade-highs (second panel). The message from Q2 earnings calls echoed this positivity, with the public homebuilders indicating demand was resilient even in a rising price environment. Still, the niche S&P homebuilding index has been moving sideways since our late-May upgrade to neutral. The cue from lumber prices is equally mixed; while the fall from the stratospheric levels of late-2017 is certainly a boon to profits, such a fall may be indicative of declining demand (third panel). At the same time, the tight labor market has seen wages in construction accelerating at the fastest rate since the rebound coming out of the financial crisis (bottom panel). The margin implication is thus unclear; we remain comfortable on the fence and reiterate our benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.
Highlights Chart 1Wage Growth Playing Catch-Up To Curve Last Friday's employment report confirmed that the U.S. economy remained on a solid footing through August, even as leading indicators outside of the U.S. have weakened. Our back-of-the-envelope GDP tracking estimate - the year-over-year growth in aggregate weekly hours worked (2.14%) plus average quarterly productivity growth since 2012 (0.86%, annualized) - points to U.S. growth of approximately 3%. But strong GDP growth is old news for markets. Rather, it was the 0.4% month-over-month increase in average hourly earnings that caused bond yields to jump last Friday. Rising wage growth is usually a bear-flattener, consistent with both higher yields and a flatter curve (Chart 1). But in recent years the yield curve has flattened considerably while wage growth has lagged. The curve's front-running suggests that continued gains in wage growth will keep the Fed on its current tightening path, but may not translate into much curve flattening. Investors should maintain below-benchmark duration, but look for attractively valued curve steepeners. We also recommend only a neutral allocation to spread product to hedge the risk from weakening global growth. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 43 basis points in August, dragging year-to-date excess returns down to -93 bps. The index option-adjusted spread widened 5 bps on the month, and currently sits at 113 bps. Despite recent spread widening, corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa-rated credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much less support for corporate bond returns going forward. These are the two main reasons we downgraded our cyclical corporate bond exposure to neutral in June.1 On a positive note, gross leverage for the non-financial corporate sector likely declined for the third consecutive quarter in Q2 (panel 4), but we remain pessimistic that such declines will continue in the back-half of the year. As we noted in a recent report, weaker foreign economic growth and the resultant dollar strength will eventually weigh on corporate revenues.2 Accelerating wage growth will also hurt profits if it is not completely passed through to higher prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to +220 bps. The average index option-adjusted spread widened 2 bps on the month, and currently sits at 336 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 226 bps, slightly below the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months, we should expect excess high-yield returns of 226 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.15% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critical to track real-time indicators of the default rate such as job cut announcements, which have increased since mid-2017 (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in August, dragging year-to-date excess returns down to -18 bps. The conventional 30-year zero-volatility MBS spread widened 5 bps on the month, driven by a 3 bps increase in the compensation for prepayment risk (option cost) and a 2 bps widening of the option-adjusted spread. The excess return Bond Map shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map does not account for the macro environment, which remains very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage lending standards.4 Refi activity is tepid, and continued Fed rate hikes will ensure that it stays that way (Chart 4). Meanwhile, lending standards have been slowly easing since 2014 (bottom panel), but the Fed's most recent Senior Loan Officer Survey reports that standards remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further easing is likely going forward. The amount of MBS running off the Fed's balance sheet has failed to exceed its cap in recent months, meaning that the Fed has not needed to enter the market to purchase MBS. This will probably continue to be the case going forward, due to both limited run-off and increases in the monthly cap. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -10 bps. Sovereign debt underperformed the Treasury benchmark by 48 bps on the month, dragging year-to-date excess returns down to -83 bps. Foreign Agencies underperformed by 14 bps on the month, dragging year-to-date excess returns down to -36 bps. Local Authorities underperformed by 20 bps on the month, dragging year-to-date excess returns down to +41 bps. Supranationals performed in line with Treasuries in August, keeping year-to-date excess returns at +12 bps. Domestic Agency bonds outperformed by 5 bps, bringing year-to-date excess returns up to +4 bps. Despite poor returns relative to Treasuries, Sovereign debt managed to outperform similarly-rated U.S. corporate debt in recent months. The outperformance is particularly puzzling given the unattractive relative valuation and the strengthening U.S. dollar (Chart 5). We reiterate our underweight allocation to Sovereign debt. The excess return Bond Map shows that both Local Authorities and Foreign Agencies offer exceptional risk/reward trade-offs compared to other U.S. bond sectors. We remain overweight both sectors. The excess return Bond Map also shows that while Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 70 basis points in August, dragging year-to-date excess returns down to +116 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 3% in August, and currently sits at 85% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. In a recent report we demonstrated that while M/T yield ratios are low, municipal bonds offer attractive yields compared to corporate bonds.5 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.29% versus a yield of 3.35% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 32% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. What's more, municipal bonds are also more insulated from the risk of weak foreign growth than the U.S. corporate sector, and recent enacted revenue increases at the state level should lead to lower net borrowing in the coming quarters (bottom panel). All in all, attractive relative yields and lower risk make municipal bonds preferable to corporates in the current environment. Remain overweight. Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve has flattened since the end of July, with yields at the short-end of the curve slightly higher and yields at the long-end slightly lower. The 2/10 Treasury slope currently sits at 23 bps and the 5/30 slope is currently 29 bps. The yield curve is already quite flat, consistent with a late-cycle economy. However, the economic data do not yet synch up with the curve's assessment. Chart 1 shows that wage growth is lagging the yield curve, while another yield curve indicator - nominal GDP growth less the fed funds rate - is moving in the opposite direction (Chart 7). We are likely to see both accelerating wage growth and decelerating nominal GDP growth during the next few quarters, but such outcomes are to a large extent in the price. In other words, the pace of curve flattening is likely to moderate in the coming months. With that in mind, we maintain our position long the 7-year bullet versus a duration-matched 1/20 barbell. That position is priced for 20 bps of 1/20 flattening during the next six months (Table 5). Table 4Butterfly Strategy Valuation (As Of August 3, 2018) Table 5Discounted Slope Change During Next 6 Months (BPs) Curve flatteners look more attractive at the long-end of curve. For example, the 5/30 barbell over 10-year bullet is priced for no change in 5/30 slope during the next six months. We also continue to hold this position to take advantage of the attractive value, and as a partial hedge to our position in the 1/7/20. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in August, dragging year-to-date excess returns down to +122 bps. The 10-year TIPS breakeven inflation rate declined 4 bps on the month and currently sits at 2.10%. The 5-year/5-year forward TIPS breakeven inflation rate declined 6 bps on the month and currently sits at 2.22%. Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. TIPS breakevens have remained relatively firm in recent weeks even as commodity prices have declined sharply (Chart 8). This suggests that breakevens are increasingly taking cues from the U.S. inflation data, and might now be less sensitive to the global growth outlook. Core inflation should remain close to the Fed's 2% target going forward. This will gradually wring deflationary expectations out of the market, allowing long-dated TIPS breakevens to reach our 2.3% to 2.5% target range. While the macro back-drop remains highly inflationary - pipeline inflation measures are elevated (panel 4) and the labor market is tight - we noted in a recent report that the rate of increase in year-over-year core inflation will probably moderate in the months ahead, due to base effects that have become less supportive.6 ABS: Neutral CHart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to 18 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 1 basis point on the month and now stands at 37 bps, 10 bps above its pre-crisis low. The excess return Bond Map shows that consumer ABS offer attractive return potential compared to other high-rated spread products - such as Agency CMBS and Domestic Agencies - but also carry a greater risk of losses. Further, credit quality trends have been slowly moving against the sector and we think caution is warranted. The consumer credit delinquency rate bottomed in 2015, albeit from a very low level, and it should continue to head higher based on the trend in household interest coverage (Chart 9). Average consumer credit bank lending standards have also been tightening for nine consecutive quarters (bottom panel). The New York Fed's Household Debt and Credit report showed that consumer credit growth increased at an annualized rate of 4.6% in the second quarter, compared to 3.3% in Q1. However, the prospects for further acceleration in consumer credit are probably limited. A rising delinquency rate and tightening lending standards will both weigh on future credit growth (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 28 basis points in August, bringing year-to-date excess returns up to +126 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month and currently sits at 68 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.7 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. At present, both lending standards and demand for nonresidential real estate loans are close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in August, bringing year-to-date excess returns up to +41 bps. The index option-adjusted spread was flat on the month and currently sits at 45 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of September 7, 2018) Chart 12Total Return Bond Map (As Of September 7, 2018) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)
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
The S&P communications equipment index received a substantial leg up in the past month as the quarterly results issued by index giant Cisco proved more resilient than anticipated and growth surpassed analyst expectations. However, on the earnings call management noted that pricing power continued to erode in the quarter and margins were under pressure from rising input costs. This is corroborated by the macro data we track which shows that communications equipment pricing power remains stubbornly in decline; the recent collapse in Asian currencies points to more of the same. Further, the industry wage bill is rapidly moving in the opposite direction of pricing power, pointing to a margin squeeze. Tack on valuations that have fully recovered and the message comes through clearly: stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, JNPR, FFIV.
Overweight It has been in vogue to be bearish on industrials this year as they are relatively easy targets for investors fearful of a blowback over trade rhetoric. We think a negative positioning is not constructive. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (second panel). Domestic ex-tech output is firing on all cylinders (third panel), which has helped to drive firming pricing power (bottom panel). Tack on the reacceleration in our U.S. capital expenditure indicator - 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. While we caution a rising U.S. dollar presents a risk to our sanguine view on industrials, a sturdily supportive macro view puts the chips squarely in the overweight column. Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technical suggest that the path of least resistance is higher for the S&P industrials sector. Please see this week's Weekly Report for more details.
Highlights Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. Feature How long and how deep will the selloff in emerging markets (EM) be? There are many factors that investors should be watching to gauge potential for further downside in the EM universe, and to exercise judgement about a bottom. These include the business cycle trajectory, policy actions and shifts, market technicals, liquidity, valuations and other fundamental variables. Not all of preconditions typically need to be satisfied before a major bottom emerges. What's more, not all bottoms are identical and contingent on the same factors. Hence, there is no magical formula for calling a bottom or top in any financial market. Today we revisit some of the variables that, in our opinion, are worth monitoring in terms of gauging a bottom. To begin, we address a currently popular narrative within the investment industry, which contends the following: EM woes are primarily being driven by Federal Reserve tightening. According to this view, when the Fed halts its tightening campaign, the skies will clear for EM risk assets. By and large, we disagree with this narrative. EM And The Fed: Let's Get Things Straight Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary drivers of EM economies are domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed (Chart 1). On this chart, we shaded the periods in which EM stocks rallied, despite a rising fed funds rate. Chart 1EM Equity Prices And Fed Funds Rate: Mixed Correlation There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits, pegged exchange rates, and so on. Importantly, EM stocks and currencies did well during other periods of a rising fed funds rate: in 1983-1984, 1988-1989, 1999-2000 and 2017, as illustrated by the shaded periods in Chart 1. Hence, statistically there is no case that EMs plunge when the Fed is tightening policy. Why did the behavior of EM risk assets during various Fed tightening episodes differ? The key was EM fundamentals at the time: When fundamentals were healthy, EM managed to rally, despite Fed tightening; when fundamentals were flawed, EM markets relapsed regardless of the Fed's policy stance. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Notably, U.S. and EU growth were booming and U.S. bond yields were dropping in 1997-'98. Specifically, U.S. and EU import volumes were growing at double-digit rates but this did not preclude EM crises, including in export-dependent Asian economies such as Korea, Malaysia and Thailand (Chart 2). It is critical to emphasize that China was not an economic superpower in the late 1990s. EM economic dependence on the U.S. and European economies was much greater than it is today. Yet neither booming demand in the U.S. and EU nor falling U.S. government bond yields prevented the Asian/EM crises from rolling across the globe in 1997-'98 (Chart 3A). Moreover, the S&P 500 was in a bull market in the second half of 1990s, as it is today (Chart 3B), but it did not help EM either. Chart 2Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Chart 3AAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Chart 3BAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Hence, we can safely conclude that the EM fallout in 1997-'98 was due to EM domestic fundamentals - not developed market dynamics in general and Fed tightening in particular. An essential question is: Why are EM risk assets currently plunging while U.S. stocks and credit markets are holding up just fine? The U.S. economy is much more exposed to rising U.S. borrowing costs than EM. Despite this, the American economy, U.S. share prices and corporate bonds have been performing very well. In our view, this also stipulates that the core root for the current EM bear market is EM fundamentals. As we have repeatedly noted in various reports,1 EM fundamentals have been very frail, and the end of easy Fed monetary policy has not helped. The Fed's tightening can be regarded as the trigger - not the cause - of the EM bear market. The cause is weak EM fundamentals, such as credit excesses, low return on capital, weakening productivity growth and, in some cases, inflation and dependence on external funding. Importantly, the dependence of EM countries on the Chinese economy is presently greater than their dependence on the U.S. as shown in Table 1. Further, mainland growth is decelerating. Adding it all up, it is not surprising to us that EM financial markets are in turmoil. Table 1Many Emerging Economies Sell More##br## To China Than to The U.S. Our bearish view on EM has not been based on a negative view on U.S./EU growth. On the contrary, we have been bearish on EM/China and positive on domestic demand in the U.S. and the EU. Early this year, we promoted the theme of tectonic macro shifts,2 arguing that China/EM growth would slump and the U.S. economy would accelerate - and that such dynamics would propel the U.S. dollar higher. In turn, a firm dollar would inflict substantial pain on EM. Bottom Line: Rising U.S. interest rates, in and of itself, is neither a necessary nor a sufficient condition for EM to sell off. Consequently, the Fed adopting an easier policy stance or lower U.S. Treasury yields may not, in and of themselves, create sufficient conditions for a reversal in EM financial markets, unless they coincide with a turnaround in other variables that matter for EM. What Matters For EM? As of now, we do not think sufficient conditions exist for a bottom in EM financial markets because of several pertinent factors: The most important factor for EM assets in the medium term is the direction of the business cycle in EM in general, and in China in particular. The EM business cycle is still decelerating, as evidenced by falling manufacturing PMI indexes in EM ex-China and China (Chart 4). Consistently, corporate earnings growth is decelerating for EM non-financial companies and Chinese non-financial A-share corporates (Chart 5). The rationale for our focus on non-financial corporate earnings is that non-performing loans are usually not recognized and provisioned for by banks in a timely way to reflect their true profitability. Typically, banks' earnings cycle lags the real economy. When the real economy is slowing, banks' profits typically deteriorate with a time lag. Chart 4Manufacturing Is Slowing In China And EM Ex-China Chart 5EM/China Corporate Profit Growth Is Decelerating Corporate profits in China and in EM have not yet contracted, but our view is that there will be a meaningful profit contraction in this downturn. As and when corporate earnings shrink, share prices will sell off. In brief, we are not out of the woods yet. In China, the industrial part of the economy continues to weaken, as evidenced by the slump in the total freight index and electricity consumption by manufacturing and resource sectors (Chart 6). So far, the cumulative impact of policy easing in China has not been sufficient to reverse its business cycle. As we discussed in our prior report,3 money/credit impulses lead China's industrial sector by nine months or so. Even if the government's recent stimulus initiatives cause money/credit impulses to improve materially today (which we still doubt), the impact on growth will be felt only next year. While financial markets are forward-looking, they are unlikely to bottom a full six months before the bottom in the real economy. Hence, we are currently in the window where China plays in financial markets remain at risk. Global trade is also weakening, as evidenced by falling semiconductor prices (Chart 7) and industrial metals. Similarly, the container freight index at Chinese ports is sluggish, and broader Asian export volumes are slowing (Chart 8). Chart 6Signs Of Industrial Slowdown In China Chart 7Semiconductor Prices Are Plunging Chart 8Asian Export To Slow Further Regarding liquidity, there are various definitions and ways to measure liquidity. One measure of EM liquidity is EM local interest rates. Chart 9A and 9B shows that interbank rates in various EM countries are rising due to the ongoing currency weakness. EM benchmark local currency bond yields are also under upward pressure (Chart 10, top panel). These are all signs of tightening liquidity. The ramifications of higher interest rates will be a slowdown in money and credit, and consequently a slump in domestic demand. Chart 9AEM: Interbank Rates##br## Are Rising Chart 9BEM: Interbank Rates##br## Are Rising Chart 10EM: Local Currency Bonds Yields##br## And Narrow Money Growth Chart 10 illustrates that local bond yields negatively correlate with narrow money growth in EM ex-China, Korea, Taiwan and India. These four markets are not included in the EM GBI local bond index; to maintain consistency, we have removed them from the money supply aggregate. EM sovereign and corporate bond yields continue to rise. As we have shown numerous times in previous reports, EM share prices do not bottom until EM corporate and sovereign bond yields roll over on a sustainable basis. Finally, we discussed EM equity and currency valuations in our August 23 report. We maintain that aggregate EM equity and currency valuations are not yet cheap enough to warrant bottom-fishing. Bottom Line: The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. 6 September 2018 The list of our trades and country allocation is always presented at the end of each report (please see page 10-11). Specifically, we continue shorting BRL, CLP, ZAR, IDR and MYR versus the U.S. dollar. Within the equity space, our overweights are Taiwan, Korea, Thailand, Chile, India, Mexico and central Europe; and underweights are Brazil, Peru, Malaysia, Indonesia, and South Africa. Among local currency bonds we are overweight Russia, Korea, Mexico, Thailand, and central Europe and underweight Brazil, South Africa, Turkey, Malaysia, and Indonesia. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," July 19, 2018. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Two Tectonic Macro Shifts," January 31, 2018. 3 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Do Note Catch A Falling Knife," August 23, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights German real estate and real estate equities remain a worthwhile multi-year position, especially in relative terms. The dominant stocks are Vonovia, Deutsche Wohnen, LEG, and GSW. Swedish real estate and real estate equities are likely to face harder times. The dominant stocks are Lundbergforetagen, Castellum, Fastighets, and Fabege. The structural pair-trade is long German real estate equities, short Swedish real estate equities. Italian real estate offers distressed opportunities. The long-term equity play is Covivio. We remain reluctant to own U.K. residential real estate or real estate equities. Chart of the WeekExtremes In European Real Estate Feature Nowadays, the best way to play the relative performance of an individual economy is through real estate. Indeed, European real estate offers compelling structural opportunities for investors who want to go long, and for investors who want to go short. By contrast, the opportunities to play intra-European economic divergences through other asset-classes have become limited. Nineteen European countries share one currency and one policy interest rate; and the mega-cap companies that drive the major equity indexes are multinationals exposed to the global economy. Meaning that a stock market's relative performance is no longer defined by its home economy; it is now defined instead by its dominant sectors and stocks.1 This leaves real estate as the purest play on the domestic economy. The evidence comes from the huge divergences in real estate market performances across Europe through the past two decades (Chart I-2-Chart I-4). While house prices in Sweden and Norway have more than trebled in real terms, house prices in Germany and Italy are at the same real level today as in 1995 (Chart of the Week). Chart I-2Winners And Losers In##br## European Real Estate Chart I-3Winners And Losers In##br## European Real Estate Chart I-4Winners And Losers In##br## European Real Estate How can German real estate be such a massive structural underperformer when the German economy has been one of Europe's star performers? The answer is that house prices take their cue from wages. German wages were suppressed for more than a decade, from which they are now playing a long catch up. A Tale Of Two Real Estate Markets: Germany And Sweden The two long-term drivers of house prices, assuming no supply bottlenecks, are: Real wages. The availability and price of bank credit. Real rents should trend higher to reflect the increasing quality of accommodation. For example, kitchens and bathrooms, heating and cooling systems and home security should all get better. In essence, the quality of accommodation benefits from productivity improvements. Of course, such improvements require investment expenditure. But a real estate investor requires a return on this investment. Therefore, rents - even after expenses - should increase in real terms. Given that house prices must maintain some long-term connection with rents, house prices should also trend higher in real terms, reflecting the improvements in home quality. But if real wages are not rising, it is impossible for tenants to absorb higher real rents, and so real rents and house prices stagnate. This describes the situation in Germany through 1995-2010 when labour market reforms resulted in real wages going nowhere, despite major gains in workers' real productivity (Chart I-5). Furthermore, as nominal adjustments to rents occur infrequently, German real rents and house prices actually fell through this extended period (Chart I-6). Chart I-5Through 1995-2010 German##br## Real Wages Stagnated... Chart I-6...So German Real Rents And ##br##House Prices Declined Since 2010, the dynamic has reversed. Needing to catch up with the economic fundamentals, German real wages, real rents and house prices have all rebounded very strongly. Nevertheless, based on the long-term connection with real productivity gains, German real rents and house prices have considerable further catch up potential. Just fifty miles across the Baltic Sea, the opposite is true. In Sweden - and Norway - house prices appear to have run well ahead of the economic fundamentals. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that the flood of bank credit has been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated bank credit fuelled bubbles... albeit in Sweden and Norway. Real estate equities are just a leveraged play on rents - and thereby real estate capital values - because the companies take on debt to finance their property portfolios. This means that in the short term, they are (inversely) sensitive to bond yields, but in the long term the main driver is rental growth. Hence, in the German real estate market's post-2011 rebound, German real estate equities - now dominated by Vonovia, Deutsche Wohnen, LEG, and GSW - have trebled (Chart I-7), and the market relative trade is up a very pleasing 75 percent since we initiated it. Any rise in bond yields would be a short term drag, but given that real rents and house prices have further catch-up potential, the sector remains a worthwhile multi-year position, especially in relative terms. Chart I-7German Real Estate Equities ##br##Have Trebled Since 2012 Interestingly, Swedish real estate equities have also trebled in the post-2011 period (Chart I-8). But in Sweden's case, house prices are extended relative to the economic fundamentals. Swedish real estate equities - now dominated by Lundbergforetagen, Castellum, Fastighets, and Fabege - are likely to face harder times. Chart I-8Swedish Real Estate Equities ##br##Have Also Trebled Since 2012 Hence, the structural pair-trade is long German real estate equities, short Swedish real estate equities. Italian Real Estate Offers Distressed Opportunities Turning to Italian real estate, it has exhibited the mirror-image pattern of Germany. From the late nineties to 2008, Italian house prices almost doubled in real terms - only then to enter a ten year bear market. In recent years, Italian real wages have been growing again, raising the question: what is holding back Italian house prices? The answer is a banking system that will not lend, making it difficult for anybody to finance a house purchase (Chart I-9). Chart I-9Italian Banks Haven't Been Lending... This lack of bank financing means that the natural flow of real estate that has to find a new owner is not receiving any bids. The upshot is that a long-term investor who can access financing can pick up property at highly distressed valuations, often at a fraction of the market price a few years ago. Some investors cannot remove a nagging fear about an 'Italexit' from the monetary union and the deep crisis that would follow. It is precisely because of the deep crisis that would ensue from a euro breakup that its likelihood remains low - though admittedly not zero. But even in that extreme eventuality, as long as Italy did not become an outlaw state in which property rights were dismantled, a long-term investor might still fare well. Because he would own a real asset bought at a very distressed price. Within the stock market, the real estate equity sector in Italy - just as in Germany and Sweden - has been a leveraged play on the house price cycle (Chart I-10). But there are two caveats: the sector is tiny with one dominant company, Beni Stabili; and Beni Stabili has just been taken over by the French property company Covivio. Still, now that Covivio owns a large portfolio of Italian real estate assets, it would be the appropriate equity to play this multi-year theme. And the bonus is that it offers a dividend yield of 5 percent. Chart I-10...Creating Distressed Opportunities In Italian Real Estate U.K. Real Estate Faces Headwinds Finally, the recent pressure on U.K. house prices is likely to persist (Chart I-11) - with the housing market facing at least one of three potential headwinds: Chart I-11U.K. Real Estate Faces Headwinds A disorderly Brexit, though not our central case, would pose a huge risk for the U.K. economy. On the other hand, an orderly and smooth transition to Brexit would liberate the Bank of England to hike interest rates further in 2019. Bear in mind that in the U.K., wage pressures and CPI inflation are not dissimilar to those in the U.S., where the Federal Reserve has already hiked the policy rate seven times. So it is largely the uncertainties surrounding Brexit that are staying the BoE's hands. The precarious path to leaving the EU on March 29 2019 is littered with landmines for Theresa May. Any of these landmines could trigger a snap General Election, a Jeremy Corbyn led Labour government, and the spectre of a high-end 'land value' tax. Hence, we remain reluctant to own U.K. residential real estate or real estate equities. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For the compelling evidence, please see Charts 1-6 in the European Investment Strategy Weekly Report 'The Eight Components Of Equity Market Allocation' July 26 2018 available at eis.bcaresearch.com. Fractal Trading Model* The 30% outperformance of India versus China during the recent EM shock is technically stretched, hitting a fractal dimension that signals a potential reversal, assuming no further deterioration in news flow. On this technical basis, the countertrend trade would be long China/short India with a profit target of 9% and symmetrical stop-loss. In other trades, long platinum/short nickel reached the end of its 65 day holding period very comfortably in profit. However, short consumer services versus consumer goods hit its stop-loss. This leaves five open trades. 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. Chart I-12 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed 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