Financials

The exponential rise in banks' non-standard credit assets has occurred in spite of the government's efforts to contain and regulate it. The government does not have full control over shadow banking and non-large banks. These have become a large part of the credit system. Hence, the assumption that the central government in Beijing can sustain any rate of credit growth it desires is overly simplistic. Short small bank stocks in China.

At current levels, Treasury yields are consistent with our assessment of fair value. Further, the Fed's Labor Market Conditions Index does not suggest an imminent recession. Expect payrolls to stabilize above levels consistent with further progress on wage growth and inflation, allowing the Fed to hike rates later this year.

Risk assets will take their cues more from the dollar than the Fed if the euro rises above its 16-month range against the dollar. Retain exposure to energy equities and gold.

Underweight Following up on yesterday's cautious Insight on the overall financials sector, the heavyweight bank sub-component looks precariously positioned. The latest FDIC Quarterly Banking Profile made for grim reading. Credit losses are on the rise and loan-loss provisions are following suit. Worrisomely, noncurrent C&I loans (the largest bank loan category) spiked to the highest level since 1987, on the back of souring energy-related loans. Historically, relative performance and the noncurrent C&I loan rate have been inversely correlated. The current message is to expect additional bank selling pressure as investors discount the profit drag from faltering credit (top panel). Moreover, the loan loss coverage ratio declined for the first time since 2012 (not shown), as provisions outpaced charge-offs, reinforcing that the credit quality cycle is deteriorating. Given that the labor market is showing signs of softness, non-performing loans are likely to accelerate in the coming quarters (middle panel). Meanwhile, both return on assets and on equity have crested for the cycle and nudged lower last quarter (bottom panel). Risks are skewed to the downside, and we continue to recommend underweight positions. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. bca.uses_in_2016_06_09_001_c1 bca.uses_in_2016_06_09_001_c1

The brief bout of relative strength in financial stocks has proven fleeting, as rate hike expectations have been dashed by weakening U.S. employment. Whether the Fed hikes now or later, sluggish domestic growth is sustaining downward pressure on the terminal Fed funds rate, which limits how much interest rate relief investors can ultimately discount. Importantly, deflationary pressures undermining financial sector relative profit performance are a global phenomenon. Global financial stocks led U.S. financials lower at the peak in 2015, and continue to diverge negatively from domestic share prices. That is an ominous sign for a sector that has been struggling to generate positive productivity growth in recent quarters, as proxied by financial sector sales/employment. Now that leading indicators of credit quality and corporate loan demand are deteriorating, it will become even more challenging to generate above-market profit growth. We continue to recommend a below-benchmark financial sector allocation, with our sub-surface exposure focused on the defensive REIT and Insurance groups. Financials Make A U-Turn Financials Make A U-Turn

In this <i>Special Report</i>, we revisit our list of signpost economic indicators introduced two years ago to identify if the U.S. and Euro Area were falling into a "Secular Stagnation".

In March we recommended doubling down on our overweight S&P consumer finance index call, because company-specific factors had caused relative performance to undershoot the bulk of our macro indicators. Since then, the share price ratio has climbed, aided by the largest monthly gain in revolving consumer credit growth in well over a decade (second panel). However, the latest consumer confidence survey showed that consumer income expectations have receded, which may forewarn of a cooling in rapid debt growth. This bears close attention, as rising credit card receivables are a major profit lever. Still, consumers are in much better financial shape than the business sector, and banks remain willing to extend consumer credit, especially relative to corporate sector loans, underscoring that revolving credit growth should remain robust. Importantly, the narrowing Treasury yield curve is not having a negative impact on industry earnings, as the credit card interest rate spread is widening anew. Against a backdrop of attractive relative valuations, we continue to recommend an overweight position, as well as a long/short position vs. the S&P bank index. The ticker symbols for the stocks in this index are: BLBG: S5CFIN - AXP, COF, SYF, DFS, NAVI. bca.uses_in_2016_06_02_002_c1 bca.uses_in_2016_06_02_002_c1

While the financial sector relief bounce is likely to peter out as the Fed threatens to tighten monetary conditions during a profit recession, the more defensive REIT sub-component should continue to outperform. REITs are still not overvalued, despite the relentless decline in yields on competing assets. While Fed rate hikes could be construed as an impediment if they lift the cost of capital, REITs have not typically run into trouble until policy has tightened by enough to cause a trifecta of headwinds: a cresting in commercial real estate prices, a peak in occupancy rates and by extension, a downturn in the CPI for rental inflation. Once these factors turn bearish, upward pressure on cap rates materializes. None of these concerns currently exist. Keep in mind that with QE and NIRP, there is still a massive search for yield in global financial markets. Roughly $9T of global bonds trade at a negative yield, a massive increase from only two years ago, which should sustain the secular advance in REITs. Moreover, REITs are slated to become a new GICS1 sector on August 31, a new classification that has the potential to augment investor interest. Adding it up, the security, safety and yield appeal of REITs should remain intact regardless of the Fed's near-term zigs and zags, unlike the overall financials sector. Stay overweight and see yesterday's Weekly Report for more details. REITs Remain In A Structural Bull Market REITs Remain In A Structural Bull Market

The Turkish central bank has almost exhausted its foreign exchange reserve. It has been printing money to keep interest rates lower, and sustain the credit boom in the economy. Such policies are unsustainable and the currency will plunge anew. Currency depreciation will push up market-based interest rates. Stay short/underweight Turkish risk assets. A new trade: Short 2-year local currency government bonds.

Investors have embraced renewed Fed hawkishness as a vote of economic confidence and confirmation of analysts' rosy earnings forecasts, but the bounce in financials looks unsustainable, outside of REITs. Hang on to gold shares.