Economy
U.S. dollar softness may be sparking a subtle shift in sub-surface dynamics, to the benefit of select deep cyclical industries. Switch from rails into electrical equipment, and take profits in data processing.
Somewhat like 1998, the dilemma for the Fed is that the labor market is approaching full employment and may justify eventual interest rate hikes.
Plunging commodities have been driven by increased supply and falling investor demand, not a major downshift in physical demand. Stay neutral global equities. The earnings outlook remains uninspiring, but bottoming oil prices and continued monetary stimulus support valuations. The selloff in global bank shares reflects NIRP-related "income statement worries", not "balance sheet concerns" linked to deteriorating credit quality. Downgrade Treasury notes to neutral. The rally in bonds has brought 10-year yields near our long-standing, out-of-consensus target of 1.5%.
Central bankers fail to grasp that in a non-linear world, it can be futile and dangerous to set an over-precise target for inflation. Today, European banks are the victims of such misguided linear-thinking.
Global trade is plummeting as commodity prices remain depressed and emerging markets unravel. Even if oil were not plumbing new lows, we would remain bearish on EM economies, where poor governance and low efficiency suggest that more crises will rear their heads. Above all, we are watching China for policy clarity. After seizing 14% of global exports in recent years, it is now exporting surplus goods into an already deflationary world. Protectionism - not a coordinated response among leading countries - is the likely result. In essence, we reiterate our theme that globalization has peaked. Along the way, we call attention to five geopolitical "Black Swans" that <i>no one</i> is talking about.
This week we are publishing a new thematic chartpack <i>The BCA China Industry Watch</i> in an effort to monitor the growth profiles, balance sheet strength and stock market performances of major Chinese industrial sectors.
Despite its substantial decline, the 10-year Treasury yield still appears reasonably valued relative to our base case scenario of a flat or slightly weaker U.S. dollar. In this <i>Special Report</i> we outline our Treasury valuation framework, in which the dollar plays a key role.
With global bond yields converging toward the lower levels of the NIRP countries, it still makes sense to favor markets with higher nominal and real yields and steeper curves, like U.S. Treasuries (especially U.S. TIPS) and U.K. Gilts.
Economic disappointment represents a serious obstacle for stocks. Stay with non-cyclical plays, including telecom services and health care. Upgrade the managed care group, and stay clear of banks, regardless of cheap valuations.
Stay cautious. The Fed is only beginning to acknowledge what markets already realize. Eventually, they will back off, which reduces the odds of a further sustained equity decline. So far, however, the central bank is lagging deflationary forces acting on the U.S. economy, markets and profits. The weak ISM surveys are consistent with this. The risk is that employment follows suit.