Equities

We took profits in the S&P software index and downgraded to neutral in January, because the boost to corporate software investment to offset flagging productivity growth looked to have been fully discounted. After a six month consolidation, relative performance has jumped back to this year's highs, but the conditions to sustain a breakout are absent. Software demand is more levered to business investment than consumer spending. In the macro environment we envision, consumption will continue to outpace investment. The rise in the personal savings rate means that there is pent-up consumer spending to be realized as wage inflation recovers. On the flipside, stretched corporate balance sheets and a dearth of sales growth pose significant restrictions to capital spending budgets. Ominously, software sales are already contracting relative to total S&P 500 sales. The software industry's contribution to GDP growth invariably becomes negative, i.e. a drag, when overall capital spending retrenches, as is currently the case. Sales contraction, and profit margin erosion, is not conducive to premium valuations. Cut to underweight and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG-S5SOFT: ADBE, ADSK, CA, CTXS, EA, INTU, MSFT, ORCL, RHT, CRM, SYMC, ATVI.

The equity rally has been in a holding pattern, with some tactical fraying around the edges.

In August, the model outperformed the S&P 500 and global equities in both USD and local-currency terms. For September, the model increased its allocation to cash and trimmed its exposure to equities.

The post-Brexit rebound has pushed stocks into overbought territory. U.S. equities, in particular, look increasingly priced for perfection. Higher U.S. rate expectations will push up the dollar, further curbing S&P 500 profit growth. Share buyback activity and dividend growth are slowing, while U.S. election risks are likely to rise. Go short the NASDAQ 100 futures as a tactical hedge.

Gold stocks have been pummeled since we recommended booking profits on our overweight position on August 1. While the cyclical backdrop of policy and political uncertainty, rampant debt growth and negative interest rates are bullish for the yellow metal, tactical froth remains to be wrung out. The chart shows that flows into gold ETFs have been very aggressive this year, and speculative positions are running hot. Meanwhile, the relative gold share price ratio had reached extraordinarily overbought levels, and overheated conditions have barely been dented by the recent pullback. With the Fed talking tougher, the risk is that any premature tightening in financial conditions through a stronger U.S. dollar will continue to weigh on gold shares. We recommend staying on the sidelines for a while longer and will look to reestablish overweight positions once tactical downside risk has been expunged.

Steel share prices celebrated the introduction of punitive import tariffs earlier this year, but that impact may already be wearing off. The latest data show that U.S. steel imports, while still well below the 2015 peak, have hooked back up, and are rising as a share of domestic production. China's steel prices have plunged, and are well below U.S. prices, a trend that may continue given that Chinese steel production has reaccelerated. Consequently, Chinese steel exports are likely to rise anew, especially given that floor space started is moving laterally and infrastructure spending growth is cooling rapidly (shown inverted, second panel). Less domestic consumption implies increased pressure to export. While U.S. producers may stay somewhat insulated given trade barriers, it will be difficult for U.S. steel prices to rise if prices in the rest of the world are deflating. Balance sheets remain stretched, as measured by historically high net debt/EBITDA ratios, underscoring that risk premiums will increase if low steel prices pressure cash flow. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S15STEL-NUE, STLD, RS, X, WOR, ATI, CMC, CRS, AKS, HAYN, SXC, TMST, ZEUS.

The excitement surrounding steel stocks earlier this year on the back of the liquidity-driven bounce in commodity prices, whiffs of stabilization in Chinese economic growth and new steel import duties is diminishing. We used the rally to reduce positions back to underweight several months ago, as valuations overshot on the back of short covering. We remain concerned that relative performance downside risks have not abated after failing at a key trend line. New orders for steel products continue to contract, signaling that underlying steel commodity prices are at risk of sinking anew. Importantly, new vehicle sales have leveled off, and total construction spending growth has downshifted to almost nil. The implication is that steel demand is likely to stay sluggish in the coming quarters. To make matters worse, China appears likely to ramp up export activity, please see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S15STEL-NUE, STLD, RS, X, WOR, ATI, CMC, CRS, AKS, HAYN, SXC, TMST, ZEUS.

Investors are being forced into riskier asset classes by the TINA effect, but the gaping macro disequilibria makes it difficult for investors to see how we move back to equilibrium in a benign way. Monetary policy on its own is limited in its ability to soften the adjustment, but the good news is that the political pendulum is swinging toward fiscal stimulus.

Special Report

Mental Accounting Bias creates an irrational attraction to yield, while The Halo Effect incentivizes companies to generate yield. Neither phenomenon is sustainable. We identify three sectors to avoid, and two to own.

Our primary argument for continued EM/China growth disappointments is that their credit growth is set to decelerate further and credit impulses will remain negative, depressing economic growth. Rising LIBOR could lead to a stronger U.S. dollar versus EM currencies. In Venezuela, the economic and financial situation will continue deteriorating hindering any further rally in its sovereign and corporate credit.