Financials

It's hard to make a case for attractive returns from any asset class over the next year. We dial down risk a bit but ending our overweight on junk bonds. Investors should pick up yield where they can but without taking excessive risk.

Recently, the insurance group has enjoyed yet another mini relative performance burst of strength, supported by the modest uptick in bond yields. However, we doubt that a sustainable outperformance phase can ensue. Pricing power momentum has rolled over. Total home and auto sales growth has decelerated close to nil, suggesting a slowing in new written premiums. In the meantime, insurance companies have been bizarrely aggressive in terms of hiring. Insurance headcount has vaulted higher in the last several quarters. A more onerous cost structure is not compatible with headwinds to top-line growth. As a result, we doubt that excellent value will be realized. Downgrade to neutral and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ. bca.uses_in_2016_09_27_002_c1 bca.uses_in_2016_09_27_002_c1

Stocks are flirting with new highs, courtesy of a gradualist Fed and the reduced threat
of incremental near-term U.S. dollar strength.

Following a temporary reprieve, banks are about to run into a brick wall. The latest Bank For International Settlements (BIS) Quarterly Review[1] made for grim reading on the global loan growth front: the global credit impulse continues to nosedive reflecting capital constraints and deleveraging. Weak demand for and limited availability of credit is a serious constraint to banking sector profitability. The bottom panel of the chart shows that the BIS global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and the current message is bearish. Higher interest rates are unlikely to solve this problem, as appears to be the hope based on the short-term positive correlation between interest rates and bank stock relative performance. Bottom Line: Every bank rally has proved self-limiting year-to-date and at least a retest of the July relative performance lows is looming. Stay underweight the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, CMA, HBAN, ZION, RF, PBCT. Banks: Follow The Global Credit Impulse Banks: Follow The Global Credit Impulse [1] http://www.bis.org/publ/qtrpdf/r_qt1609.htm

An attractive cyclical pair trade opportunity is developing between the S&P telecom services and S&P financial sectors. Both are depressed from an historical standpoint, but will perform differently in the face of relentless global deflationary pressures. To a large extent, the fortunes of this position will depend on whether the global economy can finally break out of its see-saw pattern of low amplitude mini-cycles, all within the context of secular stagnation and a scarcity of final demand growth. When deflation is the dominant global force, corporate credit quality comes under pressure. Overall ratings migration is deteriorating, underscoring that non-performing loans will weigh on the financial sector's earnings. Notwithstanding the recent blip up in global yields from exceptionally low post-Brexit depths, the undercurrent of chronic excess global capacity and deleveraging will keep long-term yields under downward pressure, to the detriment of financials sector net interest margins. While both sectors are largely domestically-focused, telecom services should have the upper hand given the non-cyclical nature of their revenue stream. If the U.S. continues to import profit strains through U.S. dollar strength, the financials sector will be harder hit. We recommend using the recent pullback to initiate a long telecom services/short financials pair trade. Please see yesterday's Weekly for more details. bca.uses_in_2016_09_20_002_c1 bca.uses_in_2016_09_20_002_c1

Consumer products stocks are likely to move to an even larger valuation premium before the cyclical outperformance phase ends.

The secular bond bull market is over. Safety is in a bubble. The shift from monetary to fiscal easing is the most likely candidate to prick the bubble in safety.
In this piece we revise our yield portfolio to increase its resilience to interest rate shocks.

It is becoming increasingly likely that the U.K. will, after all, exit the EU. Feature The initial post-Brexit economic data have surprised to the upside as a result of the Bank of England's quick reflexes, the fall of the pound, and decline in real interest rates. Yet this does not reflect the real impact of Brexit - which, of course, has not happened yet and likely will not for the next 48 months. Despite the sanguine outcome thus far, we expect the economy to deteriorate going forward: The country's credit impulse, which leads GDP growth by about six months, suggests that a recession looms (Chart 1). Chart 1U.K. Economy Post Brexit Vote: Don't Get Complacent U.K. Economy Post Brexit Vote: Don't Get Complacent U.K. Economy Post Brexit Vote: Don't Get Complacent Leading indicators for housing prices in London and Britain are also diving. Business and consumer confidence have collapsed (Chart 2). The recent stall in global equities only makes matters worse, given the U.K.'s high exposure to financial markets (Chart 3). Chart 2First Feel For Brexit First Feel For Brexit First Feel For Brexit Chart 3Global Worries For Britain bca.gps_sr_2016_09_16_c3 bca.gps_sr_2016_09_16_c3 Most ominously, the decline in the GBP implies that net FDI has also already nosedived (we are still waiting for Q2 data), which would mean that the U.K. has become structurally less appealing to long-term investors (Chart 4). Will the costs of Brexit be enough for "Bregret" to set in? Given that the recession is expected to be mild, probably not. Generally, there are three signposts suggesting that Brexit is here to stay: Public opinion: Britons are not yet having second thoughts regarding the June 23 referendum. First, opinion polling shows Britons are not suffering "Bregret" but in fact support the referendum outcome by 46% to 42-3%, roughly the same as the Brexit camp's margin of victory on Britain's "independence day." Meanwhile, the Conservative Party's approval ratings have remained resilient at 37% (Chart 5). Prime Minister Theresa May is polling at a 50% support rate, signaling that an outright majority thinks she is cut out for the unenviable job of negotiating exit with the European Union and stabilizing the economy (Chart 6). Chart 4Will FDI Turn Away? Will FDI Turn Away? Will FDI Turn Away? Chart 5No Brexit Cost For The Tories bca.gps_sr_2016_09_16_c5 bca.gps_sr_2016_09_16_c5 Labour Pains: The Labour Party has suffered the brunt of the post-referendum backlash. In stark contrast with May's popularity, Labour leader Jeremy Corbyn is wallowing in unpopularity. He is fending off a leadership challenge by Owen Smith, whom the parliamentary side of the party prefers (as opposed to the grassroots, who still defend Corbyn). The leadership challenge should be determined at the Labour Party conference September 24-8. Corbyn is most likely to prevail since, according to polls of the party's internal electorate, 62% support him over Smith (Chart 7). A Corbyn win is bullish for Brexit given his unpopularity nationally, wavering support of EU membership, and general lack of support amongst fellow Labour MPs. Chart 6May-Corbyn Gap Suggests No Bregret BREXIT Update: Brexit Means Brexit, Until Brexit BREXIT Update: Brexit Means Brexit, Until Brexit Chart 7Under Corbyn, Labour May Split BREXIT Update: Brexit Means Brexit, Until Brexit BREXIT Update: Brexit Means Brexit, Until Brexit No U.K. Breakup: The Scottish quest for independence - a likely derivative of Brexit, at least eventually - has been waylaid by short-term concerns over economic and political stability. There will be no quick Scottish reaction to shock British voters about the consequences of the Brexit vote and give reason for pause (Chart 8). Chart 8Scotland Is Becoming Cautious bca.gps_sr_2016_09_16_c8 bca.gps_sr_2016_09_16_c8 The conclusion is inescapable: "Brexit means Brexit," as Prime Minister May has repeatedly maintained. While there is still a fair chance for an eventual second referendum on the terms of the EU-U.K. negotiations - or a 2020 general election that is, in effect, the same thing - the economic fallout will have to create a tangible shift in public opinion before a reversal of the referendum can be contemplated again. "Bregret" may yet happen, but it most likely will require a formal exit from the EU! At that point, it will be too late for policymakers to act on it and adjust the course. So what does this mean for the U.K.? Britain faces long-term opportunity costs from leaving the EU. As we have argued, departing the EU will not be devastating, but is clearly a suboptimal outcome. Freedom isn't free. Three long-term risks stand out: Financial sector: The conventional wisdom regarding the costs to the U.K. financial sector is probably correct. The Brexit referendum gave policymakers a mandate to negotiate access to the free market and limit the flow of EU migrants. It is highly unlikely that voters who favored Brexit care much about the wellbeing of the London financial elite. The U.K. political elites may want to abandon their base and make a deal that favors the financial industry, but we doubt that the EU member states have any intentions of being reasonable and compliant. As such, the EU will set up barriers to British services exports in general and financial system in particular. For example, now that the U.K. has decided to leave, the EU will have even less incentive to implement the 2006 EU's Services Directive, which has been a source of contention between London and Brussels for a decade. In addition, London will no longer have recourse to the EU judiciary in order to stymie protectionism emanating from the continent. In 2015, the U.K. took the ECB to court over its decision to require financial transactions in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that force the financial industry - at least that dedicated to transactions in euros - out of London. FDI: As the Bremain camp warned, the U.K. will likely cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign direct investment. Post-Brexit FDI statistics are not available, but the trend had already declined after the Great Recession and yet again after 2014 (see Chart 4). Chart 9Intra-EU Migration##br##Boosts Labor Force Growth BREXIT Update: Brexit Means Brexit, Until Brexit BREXIT Update: Brexit Means Brexit, Until Brexit Growth: If the U.K. successfully reduces the inflow of EU migrants, a key demand of the Brexiteers, then potential GDP growth will fall by about 25% (Chart 9). Despite the high cost, we do not see how Westminster can pull a bait-and-switch on the populace over this issue, one of the key demands of the Brexit voters. Ultimately the EU will not prevent the U.K. from blocking immigration. Dominant EU countries like Germany gain nothing from the flow of relatively productive and well-educated Eastern European migrants into the British labor force. On the contrary, they benefit from taking more of these migrants themselves. Therefore the EU can ultimately compromise on this critical issue - though it will exact a price. By demanding both market access and restricted flows of people, the U.K. will exhaust most of its capital in the exit negotiations. The EU will dictate the rest of the terms. The U.K. will likely emerge in a tolerable situation, but it will have to adopt, without shaping, all EU regulations, thus negating almost entirely the argument that Brexit would restore sovereignty (Diagram 1). The result will be little alleviation of burdensome regulation, but higher EU protectionism toward U.K. service exports. Diagram 1Brexit And Sovereignty: It's Complicated BREXIT Update: Brexit Means Brexit, Until Brexit BREXIT Update: Brexit Means Brexit, Until Brexit Bottom Line: It is becoming increasingly clear that Brexit will mean Brexit. However, the initial positive economic surprises are not telling the entire story. The U.K. will have no trouble surviving outside the EU but will face economic headwinds as the long-term detriment becomes palpable. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Managing Editor marko@bcaresearch.com

A common perception is that the euro has been a failure for Italy. We challenge this perception and explain why it is so important for investors, whether it is wrong or right.

The latest FDIC Quarterly Banking Profile showed that bank earnings' improvement remains lackluster. What caught our attention from the release was the persistent widening in the C&I non-current loan rate, coupled with rising C&I charge-offs. C&I loans now comprise the largest category of bank credit and the recent credit quality deterioration is unnerving, despite the low starting point (C&I non-current rate shown inverted, top panel). There are high odds that the credit cycle has turned for the worse given deteriorating corporate balance sheets. Moreover, the latest reading from the labor market conditions index - the Fed's preferred labor market indicator - is signaling that total non-performing loans will soon hook back up (middle panel). This message is also corroborated by the quickly flattening yield curve, which has historically been an excellent leading indicator of the credit cycle (yield curve shown inverted, third panel). Bottom line: Shy away from the banking sector. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, CMA, HBAN, ZION, RF, PBCT. bca.uses_in_2016_09_08_002_c1 bca.uses_in_2016_09_08_002_c1