Equities
Financial stocks have risen in sympathy with the back up in global bond yields, but that likely represents position squaring more so than a sustained shift into the sector. Financial profits will continue to be challenged by a downturn in the credit cycle, both in terms of quality and loan creation, given the negative global credit impulse and flattening yield curve (shown inverted and advanced, bottom panel). Importantly, productivity is waning. Financial sector employment is probing new highs, reflecting a more onerous cost structure required to meet regulatory obligations. Employment is now growing faster than sales (third panel), a reliable indication of flagging productivity. The implication is that financial sector profits will continue to lag those of the broad market. We continue to view cheap financial sector valuations as a trap, and recommend below benchmark positions.
Highlights Chile's economy is headed for recession. Facing strong external and domestic headwinds, any policy stimulus will be too late to prevent the impending contraction in economic activity. Investors should receive 3-year interest swaps and stay short CLP / long USD. South Africa's cyclical and structural outlook remains bleak. Banks have been selling foreign assets and repatriating capital which has helped the rand to appreciate. However, as this capital repatriation tapers, the rand will enter a renewed bear market. Stay short the rand versus the U.S. dollar and long MXN / short ZAR. Feature Chile: Stimulus Will Arrive Too Late To Prevent Recession Chart I-1Chile: From Stagflation To Recession? The stagflationary environment in Chile over the past two years - a combination of sluggish growth and high inflation - will give way to outright recession (Chart I-1). As economic activity downshifts further, we are doubtful that policymakers will be able to push through stimulus measures in time, and of sufficient size, to stave off recession. On the fiscal front, the government is unlikely to preemptively engage in a significant spending push. The deceleration in economic activity will soon translate into lower fiscal revenue at a time when the fiscal deficit is already quite wide, at 2.8% of GDP. Furthermore, a renewed fall in copper prices (more on this below) means mining revenue will also be weaker than currently expected, inflicting substantial damage on the government's budget. Meanwhile, monetary policy is unlikely to become stimulative in the near term. Having concluded a two-year battle to tame sticky core inflation, the central bank is unlikely cut interest rates too fast. Besides, as the current term of Central Bank President Rodrigo Vergara ends in December, chances of a new rate cut cycle before he is replaced are low. On the whole, the lack of imminent policy stimulus means economic growth is set to fall much further. Investors can profit by receiving 3-year swap rates (Chart I-2). Although the central bank will be late to cut rates, long-term interest rates will fall because Chilean growth is facing strong headwinds on several fronts: Copper prices have failed to rally amid the reflation trade of the past nine months, and are set to drop to new lows as Chinese property construction and demand for industrial metals contracts anew (Chart I-3). As a result, copper exports will continue to act as a serious drag on Chilean growth (Chart I-4). Chart I-2Receive 3-Year Interest ##br##Rate Swaps In Chile Chart I-3China's Industrial Metals ##br##Demand To Contract Chart I-4Exports Will Remain ##br##A Drag On Growth Capital expenditures will contract, partially due to very downbeat business confidence owing to the uncertain political environment created by the government's reforms agenda since 2014 (Chart I-5, top panel). As discussed in detail in our December 2014 Special Report on Chile,1 from a big-picture perspective, these reforms have shifted the structure of the economy toward higher government expenditures at the expense of the private sector. This has severely eroded business confidence. In addition, the downturn in the housing market will gain momentum, further depressing activity (Chart I-5, bottom panel). Meanwhile, employment growth has been weak and income growth has been decelerating steadily - and we foresee further downside ahead (Chart I-6). Importantly, the economy's credit impulse is now turning negative (Chart I-7). Higher delinquencies in turn will force banks to curtail lending going forward. Chart I-5Chile: Capex To Remain Weak Chart I-6Chile: Labor Market Will Weaken Further Chart I-7Negative Credit Impulse##br## Will Weigh On Growth Finally, narrow (M1) money supply growth, a very good leading indicator for economic activity, is now decelerating sharply (Chart I-8). Consistently, our marginal propensity to consume proxy points to weak spending and lower consumer price inflation (Chart I-9). Chart I-8Chile: Narrow Money Growth, ##br##Economic Activity And Inflation Chart I-9Consumption Is Set ##br##To Decelerate Further The economy has developed considerable downward momentum. Any policy stimulus is likely to come too late to prevent the economy from falling into recession. Therefore, local interest rates in Chile are headed to new lows. An economic recession and lower copper prices are clearly bearish for the Chilean peso, and we maintain that its 8.5% rally this year versus the U.S. dollar will be followed by new lows (Chart I-10). Turning to equities, lower interest rates will help only marginally as equity valuations are not cheap (Chart I-11). Moreover, as Chilean banks account for 20% of the MSCI market cap and, while they are better run and more conservative than many others in the EM, they are not immune to a decelerating credit and business cycle. Besides, this bourse's Latin American consumer plays will also likely disappoint. As such, dedicated EM investors should stay neutral on Chilean stocks relative to the EM equity benchmark (Chart I-12). Chart I-10Chilean Peso Valuation Chart I-11Chilean Equities Are At Fair Value Chart I-12Chilean Equities: Stay ##br##Neutral Relative To EM Benchmark Lastly, as highlighted in our recent in-depth Special Report on EM corporate credit,2 credit investors should stay long Chilean and Russian corporate debt versus China. Chilean corporate credit will likely outperform Chinese corporate credit, as the latter is more frothy - overbought and expensive. Bottom Line: The Chilean economy is heading into recession, and policymakers will be late with stimulus to prevent it. Fixed-income investors should receive 3-year interest rate swaps. Dedicated EM equity investors should maintain a neutral stance on the Chilean bourse versus the EM equity benchmark. Stay short CLP / long USD. Santiago E. Gomez Associate Vice President santiago@bcaresearch.com South Africa: Flows Versus Fundamentals Chart II-1Improving Trade Has Helped The ZAR The South African rand has rallied since the start of the year on the back of an improving trade balance (Chart II-1) and strong capital inflows. However, it is facing a key technical resistance level, as are many other EM assets. We expect these resistance levels to hold for EM risk assets in general and the South African rand in particular. The underlying reasons behind our outlook center around our expectations of a stronger U.S. dollar, rising U.S. and G7 bond yields and a relapse in commodities prices. This is in addition to a lack of cyclical recovery and poor structural fundamentals in South Africa. A well-known explanation as to how South Africa has been able to finance its wide current account deficit is that there have been strong foreign portfolio inflows stemming from the global search for yield. What is less known is that South African banks have in the past year been selling foreign assets and repatriating capital back into South Africa (Chart II-2). Over the past 12 months, this repatriation of capital has amounted to US$ 6.5 billion, which effectively allowed the country to fund 50% of its current account deficit. While there is no doubt that this repatriation of capital has aided the rally in the rand and domestic bonds, it remains to be seen whether these flows will continue. Our suspicion is that with South African banks' holdings of foreign bonds dropping from US$ 18 billion in December 2015 to US$ 12 billion at the end of June 2016, and G7 bond yields rising, the speed of capital repatriation will likely slow. In the meantime, fundamentals in South Africa remain weak: The household sector, which accounts for 60% of GDP, has been sluggish. Private consumption growth has been anemic and credit growth to households has been falling rapidly (Chart II-3). Chart II-2South Africa: Banks Have Been ##br##Repatriating Capital Enormously Chart II-3South African ##br##Consumption Is Anemic The corporate sector is not painting a reassuring picture either. South African firms are not investing; real gross fixed capital formation is contracting (Chart II-4, top panel) and business confidence is at an all-time low (Chart II-4, bottom panel). The ongoing dynamic of persistently high wage growth - despite negative productivity growth - only reinforces the gloomy outlook as it creates downward pressure on corporate profit margins, or upward pressure on inflation (Chart II-5). Chart II-4Contracting Capex And ##br##Record-Low Business Confidence Chart II-5Toxic Structural Dynamics: Contracting ##br##Productivity And High Wage Growth Along with renewed weakness in the rand, higher wage growth will raise interest rate expectations. The fixed-income market is currently discounting no policy rate hikes during the next 12 months making it vulnerable to potential depreciation in the rand. In addition to a poor economic backdrop, uncertainty regarding economic policy is considerable. Chart II-6South Africa's Central ##br##Bank's Liquidity Injections First, fiscal policy will not be market friendly. The poor performance of the ANC in the last municipal elections shows the ANC is clearly losing support from the population. This will lead President Zuma and ANC to adopt even more populist policies. This is bearish for both the fiscal accounts and the structural growth outlook. As such, this will cap the upside in the rand and put a floor under domestic bond yields. Second, the central bank will not defend the exchange rate if the latter comes under selling pressure anew. In fact, monetary policy remains somewhat unorthodox. Specifically, the Reserve Bank of South Africa continues to inject liquidity into the system to cap interbank rates (Chart II-6). This will facilitate ZAR depreciation. Investment Conclusions Stay short the rand versus the U.S. dollar. Three weeks ago we also initiated a long MXN / short ZAR trade, and this trade remains intact as the MXN is oversold and the ZAR is overbought. Dedicated EM equity investors should maintain a neutral allocation to South African stocks. On the back of a fragile and deteriorating consumer sector, we recommend staying short general retailer stocks. Their share prices seem to be breaking down despite the rebound in the rand and a drop in domestic bond yields (Chart II-7). Policy uncertainty and pressure for populist policies is still an overarching issue for South Africa, especially compared to Russia. As such we suggest fixed income investors continue to underweight South African sovereign credit within the EM sovereign credit universe (Chart II-8), and maintain the relative trade of being long South African CDS / short Russian CDS. Chart II-7Stay Short South ##br##African General Retailers Chart II-8Stay Underweight South ##br##African Credit And Short Rand Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy & Geopolitical Strategy Special Report titled, "Chile: A New Economic Model?," dated December 3, 2014 available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "EM Corporate Health Is Flashing Red," dated September 14, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
A reduction in the rate of drug price increases, and in the case of generics, outright price cuts, is a blessing for the S&P managed care industry. Cost inflation had been perking up, but should ease in the coming quarters as drug expenses abate. Health insurance premiums are growing at a faster rate than overall inflation, while job growth remains decent, underscoring that top-line growth is still outpacing that of the overall corporate sector. If cost inflation eases while revenue climbs, the index should move to at least a market multiple from its current discounted valuation. Importantly, technical readings have improved. Cyclical momentum has begun to reaccelerate from neutral levels after unwinding overbought conditions, suggesting that a breakout to new relative performance highs is in the offing. Bottom Line: the pain in drug-related shares should provide a gain to health care insurers. Stay overweight.
A number of drug wholesalers have reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic drug pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has neither been confirmed by still strong retail drug store sales nor booming hospital employment. Nevertheless, in light of new information, which implies that company disclosed pricing pressure is worse than current government data show, we are downgrading our outlook for drug-related shares. However, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels, we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. In the meantime, the S&P pharma and biotech indexes are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit, see the next Insight.
Beyond early last century's military rearmament, the idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis. If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global (but especially U.S.) defense stocks as a structural play will pay handsome dividends. The early-1960s experience in U.S. aerospace & defense (A&D) stocks is the closest stock market parallel we found in our analysis (given data constraints). Then, relative performance was up over 100% in a span of four years, as U.S. A&D industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95%. A&D factories were humming, racing to fulfill orders as U.S. military expenditures boomed. That demand surge translated into a jump in sector sales and given the industry's high operating leverage, earnings and book values soared. The chart shows that from trough to peak, sector EPS rose by more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled. That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the BCA U.S. defense index (that is a pure play on global defense spending). Bottom Line: Stay overweight the BCA U.S. defense index (LMT, GD, RTN, NOC, LLL), and please see yesterday's Special Report for additional details.
GAA DM Equity Country Allocation Model The model significantly reduced the weight of France by six percentage points due to change in liquidity condition, the other downgrade, albeit much smaller, was the U.S. All other countries had been upgraded as a result, with Germany being the largest beneficiary. Japan and U.K. remain the two largest underweights (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed the MSCI World benchmark by 27 basis points (bps) in October, driven completely by the Level 2 model (as U.K and Australia underperformed the euro area). The Level 1 model was in line with the benchmark. Since going live, the overall model performed slightly better than its benchmark. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850 GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of October 31, 2016. The momentum component has shifted Financials from underweight to overweight. For mode details on the model, please see the Special Report "Introducing the GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Highlights A poor fundamental backdrop for high yield is being offset by easy monetary conditions. A prolonged shallow uptrend in corporate defaults - and therefore spreads - is most likely. The relative performance of equities versus corporate credit has not been distorted by monetary policy: the high-yield debt market will remain a reliable indicator for equity market vulnerability. A December rate hike will not be problematic for the residential real estate market. Plenty of pent-up demand for housing exists, and this will provide long-term support, so long as the labor market remains robust. Feature High-yield (HY) corporate bond spreads have dramatically narrowed throughout 2016 (Chart 1). This trend should not go unnoticed, since beyond being an important asset class in its own right, we have long viewed the high-yield debt market as an early warning system for equities. The current message suggests an all-clear for stocks. Chart 1Dramatic Spread Narrowing In 2016, But... We have had a cautious stance on U.S. high yield since August 2015, based on the view that corporate balance sheet health has deteriorated to the point where defaults would continue to rise on a cyclical basis. This week, we explore whether this remains the right strategy, and also whether junk bond spreads are still a relevant leading indicator for the equity market. Our answer to both questions is: Yes. In our view, the HY comeback can be explained by three main factors. First, the recovery in energy-related junk bonds has led the rally, as rising oil prices have helped diminish the default risks among U.S. shale issuers. Second, the 2015 spike in junk bond yields - mainly due to contagion from energy-sector bankruptcy fears - created tactical value in high-yield. Throughout most of 2016, we have seen an unwinding of these previously oversold positions. And third, the high-yield market benefits from an ongoing and intense search for yield in a world of unattractive higher-quality interest rates. Looking ahead, the first two forces are unlikely to play much of a role in the outcome for junk bonds. Oil prices are likely to trade in narrow range, allowing energy-related company fundamentals to stabilize. The rally in junk bonds over the past several months has removed any perceived value in this sector. Thus, it is only the search for yield/accommodative monetary policy that still supports a narrowing in spreads. Over time, we believe junk bond performance will once again be aligned with balance sheet fundamentals, i.e. high-yield spreads will gradually widen. A Review Of Our HY Indicators Our fixed income strategists have developed three key indicators to gauge major turning points in corporate spreads (Chart 2): Corporate Health Monitor (CHM): An aggregate indicator of non-financial corporate balance sheet health. The CHM deteriorated further in the second quarter, and has reached levels that historically tend to only be seen during recessions. Of the indicator's six components, most of the weakness has occurred in measures of corporate profitability (Chart 3). One caveat is that our measure of leverage in the CHM remains low, but this understates the risks because it measures total debt as a percent of market value of equity. Leverage looks decidedly worse if measured using net debt/book value. Chart 2Key Corporate Credit Indicators Chart 3Corporate Health Monitor Components C&I bank lending standards: A Fed survey that measures how easy/difficult it is for the corporate sector to access bank loans. According to this gauge, banks have already been tightening credit conditions for the past three quarters. Deviation in monetary conditions from equilibrium: We use our Monetary Conditions Index (MCI), which incorporates movements in both the dollar and interest rates. Due to a very accommodative Fed, monetary conditions remain very easy according to this measure. At present, two of these three indicators are sending negative signals for corporate spreads. Our corporate health monitor is decidedly bearish, as are lending standards. Indeed, focusing on corporate balance sheets and fundamental credit quality metrics would almost unanimously lead investors to recognize that the credit cycle is in its late stages and to expect spreads to move wider. After all, spreads have widened in every episode of deteriorating balance sheet health since the mid-1990s. Or to put it more simply, a default cycle - leading to spread widening - has occurred each time that year-on-year profit growth has gone negative since 1984 (Chart 4). Chart 4Profit Contraction Spells Trouble For Junk Bonds Our Bank Credit Analyst service came to the same conclusion earlier this year. In a Special Report, our colleagues analyzed financial ratios for 770 companies from across the industrial and quality spectrum. Their work uncovered that the corporate re-leveraging cycle is far more advanced than is widely believed and that key financial ratios and overall corporate health look only mildly better excluding the troubled energy and materials sectors. Of course, there is an important salve this cycle at work and it is captured in our third indicator - monetary policy. As shown in Chart 2, easy monetary conditions have never persisted for this long and low rates have driven a colossal search for yield, causing high-yield bonds to become ever more divorced from fundamentals. This divergence between corporate bond spreads and balance sheet fundamentals is likely to persist for as long as monetary conditions remain supportive. Adding it up, a poor fundamental backdrop for high-yield is being offset by easy monetary conditions. This combination argues for a cautious long-term bias toward lower-quality corporate credit because a prolonged shallow uptrend in corporate defaults (and spreads) is most likely. Nimble investors may look to tactically buy junk bonds when spreads overshoot our forecast of default losses, although such an opportunity is not present at the moment (Chart 5). The equity market is suffering from the same dynamic. Chart 5No Value Here Will Junk Bond Yields Still Warn Of Stock Bear Markets? Junk bond yields have long been one of our early warning indicators for equity bear markets. Since the 1980s, junk yields (shown inverted in Chart 6) have consistently broken out to new highs 3-6 months before stock bear markets take hold. This is because in a typical cycle, junk yields tend to respond more quickly to an erosion in corporate health fundamentals and/or a credit event. Chart 6Junk Bonds Provide Early Warning For Stocks Chart 7Typical Behavior Here But, as we note above, in the current cycle, the reaction to worsening corporate health fundamentals has been far more subdued than historical relationships would have predicted, due to the salve effect of easy monetary policy. If corporate bonds are in a "bubble", does it mean that the behavior of junk bond spreads will no longer be an early predictor of stocks returns? We believe corporate bonds will still be a useful timing tool for equities. If equities are experiencing the same divorcing from fundamentals, courtesy of central bank largesse, then it stands to reason that what pops the bond bubble will also burst the equity balloon. The search for yield has affected the behavior of investors, and therefore returns, in a fairly systematic way. Due to the current extended period of ultra-low interest rates and central bank asset purchases, government bond prices have been pushed sky high (yields have sunk to rock-bottom lows). As a shortage of government bonds has taken hold, investors have sought to invest in "Treasury-like" products, first seeking out the safest corporate bonds, but eventually reaching further out on the risk spectrum to include high-yield bonds and (dividend yielding) stocks. Indeed, asset prices of all stripes have been distorted by the search for yield, which has fueled a broad inflation in all asset classes. The behavior of stocks relative to corporate bonds is telling (Chart 7). Since 2010, and until very recently, stocks outperformed junk bonds on a total return basis. Junk bonds outperformed investment-grade bonds over roughly the same period (although junk underperformed investment-grade in most of 2015 due to the collapse in energy prices and related energy company defaults). This is exactly what has occurred during every recovery phase since the 1980s. Over the past forty years, investment-grade bonds tended to outperform junk bonds and equities during economic recessions. Junk bonds beat equities during the early phases of recovery (i.e. when economic growth turns positive) and for as long as companies continue to repair balance sheets. And equity returns trump both investment-grade and high-yield corporate bonds when our Corporate Health Monitor is deteriorating, i.e. in the latter half of the economic cycle, such as now. This suggests that the relative performance of equities versus corporate credit has not been distorted by monetary policy. One key takeaway is that, although very easy monetary conditions mean that corporate credit performance is becoming divorced from fundamentals, monetary policy has had a similar effect on equity prices (we have written at length in past reports about equity market performance diverging from profit indicators). As in past cycles, once the monetary cover fades, it is most likely that corporate credit markets will once again respond most quickly to balance sheet fundamentals. The bottom line is that we believe the high-yield debt market will remain a reliable indicator for equity market vulnerability. The current message is that a bear market in stocks will be averted, although as we have written in recent reports, earnings disappointments amid dollar strength represent a potential trigger for a near-term correction. Housing Outlook: Room To Expand Over the past quarter, residential real estate data has been slightly disappointing. September housing starts slipped to the bottom end of the range that has held this year and are only marginally above year-ago levels. House price inflation, as measured by the Case Shiller index, is negative on a 3-month basis. Despite this mild disappointment, we continue to believe the housing market is a relative bright light and will continue to be a significant positive contribution to GDP growth. Most indicators show that the housing market continues to recover along the typical path of the classic boom/bust real estate cycle (Chart 8). Chart 8Housing And Its History Chart 9First-Time Homebuyers Entering The Market Moreover, both supply and demand conditions are supportive of further construction activity and upward pressure on house prices over the next several quarters. On the demand side, household formation and a pick-up in interest from first-time buyers are the largest positives. Household formation: The number of households being formed is the most basic measure of marginal new demand for housing units. Household formation was suppressed during the Great Recession and early recovery years, because very poor job prospects and restricted access to credit sorely limited prospective new households from entering both the rental and ownership market. From 2007-2013, the annual household formation rate was 625,000, compared to over 1.1 million in the pre-crisis period.1 Now that the unemployment rate is at 5% and job security is improving, household formation rates are accelerating, particularly among young adults who have hitherto delayed moving out on their own. Monthly numbers are choppy, but household formation could easily run on average at 1.1 million per year for the next few years, simply to make up for muted rates post-housing crisis. First-time buyers: After years of putting off purchases, first-time buyers appear to be finally coming back to the housing market (Chart 9). According to the National Association of Realtors, the proportion of first-time homebuyers for existing home sales has reached its highest mark since July 2012 (34%). But there is still room for this share to improve, as prior to 2007, first-time homebuyers averaged about 40% of total purchases. Once again, persistent income gains and job security will be the driving factors behind first-time homebuyers' decisions. Could a Fed interest rate rise slow housing demand? We don't think so. Mortgage payments relative to income will remain well below their long-term average even if rates are increased by 200bps, an extreme case scenario. Even under this scenario, housing affordability would still be above average, conservatively assuming that income is held constant (Chart 10). Income and employment prospects will continue to trump mortgage rates for consumers making housing decisions; the current employment backdrop is positive for continued housing market activity. Chart 10December Rate Hike Won't Bother The Housing Market Chart 11Supply Is Tight From a supply perspective, conditions remain ripe for more robust construction activity. As Chart 11 shows, the supply of new homes remains low both in absolute, and in terms of months of supply. The bottom line is that we do not fear that a December rate hike will be particularly onerous for the residential real estate market. Plenty of pent-up demand for housing still exists, and this will provide long-term support, so long as the labor market remains robust, as we expect. The recent soft patch in housing will give way to stronger home building activity in the coming months, helping to boost real GDP growth in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 The State Of the Nation's Housing 2016, Joint Centre For Housing Studies of Harvard University http://jchs.harvard.edu/research/publications/state-nations-housing-2016
Recommended Allocation Central Banks Still In The Driving Seat Markets continue to obsess about every move from the three major DM central banks. With two of them (the Fed and the ECB) likely to withdraw accommodation cautiously over the coming 12 months, the upside for risk assets is limited. The Fed is signaling that it will probably hike in December and the futures market is pricing in a 70% probability of that happening (roughly the probability one month before the rate rise in December last year). Inflation expectations have picked up recently (Chart 1) and core PCE inflation ticked up to 1.7% in August, within "hailing distance", as Fed vice-chair Stanley Fischer put it, of the Fed's 2% target. There is a political angle, too: having forecast four rate rises for the year, the Fed would endanger its credibility (and risk an audit from Congress) if it failed to deliver even one. At the same time, with growth in the Eurozone running a little above trend, the ECB is likely to announce in December an extension to its asset purchase program beyond March 2017 but eventually at a slower pace (a "tapering"). Reflecting these factors, government bond yields have moved up in recent months (Chart 2), and the trade-weighted dollar has strengthened by 4% since mid-August. None of these moves are good for risk assets, which have consequently moved sideways since August. But neither do they presage a big selloff since central banks will err on the side of caution. Inflation in the U.S. is unlikely to jump: wage growth will be kept under control by a gradual rise in the participation rate, which will prevent unemployment falling much further (Chart 3). The Fed's leaders continue to sound dovish. Janet Yellen even raised the question in a recent speech of "whether it might be possible to reverse these adverse supply-side effects [from the 2007-9 Global Financial Crisis] by temporarily running a 'high-pressure economy'", though she emphasized this was a suggestion for further economic research not her view. More practically, the FOMC will have a more dovish tilt in 2017, as the three regional Fed presidents who voted for a hike in September rotate out. Chart 1Have Inflation Expectations Bottomed? Chart 2Bond Yields Moving Higher Chart 3Core Workers Reentering The Labor Force Meanwhile, economic data remain somewhat sluggish. The U.S. manufacturing and non-manufacturing ISMs both rebounded sharply in September, suggesting that the very weak August prints were, as we suggested, an anomaly. Q3 U.S. real GDP growth come in at 2.9%, but the New York Fed's NowCast points to a slowdown to 1.4% in Q4. The Citi Economic Surprise Index (Chart 4) has also turned down again recently, with notable weakness in consumer spending and housebuilding. We expect this sluggish pace to continue through 2017: consumption should hold up as wage rises come through, but it is hard to forecast a strong recovery in capex, given the low capacity utilization rate (Chart 5), even if investment in the mining and energy sectors bottoms out next year. Eurozone growth could stutter too. It is driven substantially by credit growth, but historically European banks have tended to curtail lending after their share prices have fallen, as has been the case recently (Chart 6). Chinese growth has stabilized (at least in the GDP data, which seems to come in regularly at 6.7%, bang in the middle of the government's target range), thanks to the government's reflation policy from earlier this year. While the Chinese authorities have now reined back a little on stimulus, given their worries about the run-up in house prices,1 they offer an option since they would undoubtedly reflate again should growth slow. Chart 4Data Surprising Negatively Again Chart 5Hard To See More CAPEX Indeed Chart 6Share Prices Influence Lending All this suggests that returns from investment assets will be low, but positive, over the coming 12 months. With economic growth anemic but stable, bond yields prone to drift up, and equities expensive (but not as expensive as bonds), we expect risk-adjusted returns from the major asset classes to be broadly similar. We continue to recommend therefore a neutral weighting between bonds and equities, and suggest that investors look to pick up extra return through tilts to investment-grade corporate credit, inflation-linked over nominal bonds, and alternative assets such as real estate and private equity. Equities: Our preference remains for U.S. equities over European ones in USD terms. The dollar is likely to strengthen further, and the worst is not over for Eurozone banks - the time to buy into them will be at the point of maximum pain, which may come if German or Italian banks have to be bailed out by their governments. We continue to recommend a small (currency-hedged) overweight on Japan. The Bank of Japan's new policy to cap 10-year government bond yields at 0% has worked so far: the yen has weakened to JPY 104 to the dollar and equities have risen moderately. We expect further fiscal or wage-control measures from the government to give inflation an extra push. We remain wary of EM equities: earnings growth is negative, loan growth has started to slow (with the credit impulse having a high correlation with earnings and economic growth), and there is still little sign of structural reform. Some sectors in EM - notably IT and Healthcare - are attractive, however. Fixed Income: U.S. Treasury bond yields are likely to rise further - our model suggests fair value is a little below 2% (Chart 7) - and so we remain underweight duration. A moderate pickup in inflation suggests that TIPs will outperform nominal bonds (as described in detail in our recent Special Report).2 We lowered our recommendation in high-yield corporate debt to neutral last month because, at 65 BPs, the default-adjusted spread no longer offers sufficient return to justify the risk. At the start of the year it was 400 BPs (Chart 8). We continue to like investment-grade debt, where the spread over government bonds is 120 BPs in the U.S. and 100 BPs in the Eurozone, higher than at any point in 2005-2006 during the last expansion. Chart 7Treasury Yields Could Rise Further Chart 8Junk No Longer Offers Enough Return Currencies: We expect the U.S. dollar to continue to appreciate given the differential in growth and monetary conditions between the U.S. and other developed economies. The dollar looks expensive, but is nowhere near the over-bought levels it got to at the peak of previous rallies in 1985 and 2002 (Chart 9). China seems likely to allow a further weakness of the RMB against the dollar, repegging it to a trade-weighted currency basket. This could push down other emerging market currencies too particularly if, like Brazil recently, they try to cut rates to boost growth. Chart 9USD Not As Overvalued As In The Past Commodities: Oil has probably overshot in the short-term on expectations that Saudi Arabia and Russia will cap, or even cut, production. We think this talk has been overhyped and that the OPEC meeting in November could prove a disappointment. Nonetheless, we still see the equilibrium level for crude over the next two years at USD 50 a barrel, the marginal cost for U.S. shale producers. Industrial commodities are likely to fall further (they peaked in June) if we are right that the dollar appreciates. We continue to like gold as an inflation hedge, but short-term are nervous because it, too, is negatively correlated with the dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see China Investment Strategy "Housing Tightening: Now And 2010" dated October 13, 2016, available at cis.bcaresearch.com 2 Please see Global Asset Allocation Special Report "TIPS For Inflation-Linked Bonds," dated October 28, 2016, available at gaa.bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)