Financials

The previous Insight showed that REITs in other parts of the world are outperforming smartly, but lagging in the U.S. We expect a re-convergence. Already a yawning gap has opened between REITs and Treasury yields (shown inverted). That is not sustainable, especially in view of positive underlying cash flow fundamentals. Our proxy for the REIT occupancy rate is still trending higher (third panel), supporting good growth in REIT pricing power proxies. Importantly, pipeline supply pressures look set to ease, based on the downturn in multifamily home construction. All of this points to decent cash flow growth prospects. Against a backdrop of still attractive value in a world starved for yield, we continue to recommend an overweight portfolio position in the defensive S&P REIT index. (Part II)...But REITs Are Oddly Out Of Favor In The U.S. (Part II)...But REITs Are Oddly Out Of Favor In The U.S.

Credit growth acceleration in China is a bearish development in the long run. Potential non-performing loans at Chinese banks could wipe out 40-55% of their equity capital. "Muddling through" for China, from its own internal standpoint, is possible. However, Chinese stocks and China-related equities worldwide will remain in a bear market. From the perspective of the rest of the world, China is now in recession.

Capital markets stocks have been crushed this year. Over the last few decades, capital market bear phases have ended with a forceful policy response that restores economic growth by rekindling the credit cycle. Fed rate cuts have usually started that process. This cycle, the Fed is still intent on tightening even as evidence of growth softness mounts. Thus, it is difficult to envision the start of a cycle that encourages increased capital formation, which is needed to avert a sustained capital markets profit downturn. Our concern is that the U.S. corporate sector has spent beyond its means long enough to erode balance sheet flexibility, which warns of high odds of a forced retrenchment. Access to capital is restricted to those who don't need it. Once our Corporate Health Monitor moves into deteriorating health territory, M&A activity usually begins to dry up (second panel). M&A has been running red-hot in the past few years, as the lack of organic global growth has forced companies to pursue acquisitions. If this source of investment banking income diminishes, then capital market companies will have a large profit hole to fill. If valuations could not expand with an easy Fed, an M&A boom and rampant stock and bond issuance, what will happen now these conditions are reversing? Stay with a high-conviction underweight. The ticker symbols for the stocks in this index are: GS, BLK, BK, MS, SCHW, STT, TROW, AMP, BEN, NTRS, IVZ, AMG, ETFC, LM. bca.uses_in_2016_02_23_002_c1 bca.uses_in_2016_02_23_002_c1

Lean against rally attempts until leading profit indicators improve. The conditions for a tradable oilfield services rebound remain elusive. Capital markets may bounce, but we would sell on strength.

The previous Insight showed that the financial sector is likely to experience a reprieve from intense selling pressure if the U.S. dollar weakens by enough to halt the slide in inflation expectations. However, before extrapolating any short-term recovery, it is important to keep the cyclical picture within the proper context. The sector has not hit previous valuation troughs. The yield curve is narrowing steadily, and could continue to flatten if domestic economic conditions erode further. Valuations tend to move positively with the yield curve. Moreover, the corporate debt binge of the last few years is ending. Our Corporate Health Monitor warns that balance sheets no longer have the flexibility to pursue aggressive growth, either through M&A or increased leverage. Weakening C&I loan demand warns that credit creation will slow. Against this backdrop, financial sector profitability will be constrained. Consequently, we recommend only a market weighting, with an emphasis on the more defensive components, including REITs, insurance and consumer finance. bca.uses_in_2016_02_19_002_c1 bca.uses_in_2016_02_19_002_c1

Financials have been tightly correlated with global growth expectations in recent years, given the high risk of deflation this cycle. The sector has been rattled by intensifying global growth shocks emanating from China and Emerging Markets and the spillover onto global economies. This process has culminated in a spike in banking sector fears around the world. However, the S&P financials sector has the capacity to enjoy a meaningful recovery from the drubbing it has taken year-to-date, provided the meltdown in inflation expectations takes a breather on the back of hopes for a less stringent Fed. If the U.S. dollar weakens by enough to reduce EM financial strains and reduce deflationary backlash onto the U.S. corporate sector, credit fears could subside, at least temporarily. Is it worth buying into a sunnier view? Please see the next Insight. bca.uses_in_2016_02_19_001_c1 bca.uses_in_2016_02_19_001_c1

Indonesia has been fighting the Impossible Trinity, a battle that cannot be won. The central bank will continue printing rupiahs and the currency will depreciate further. Eventually rupiah depreciation will push up interbank rates, and Indonesia's credit cycle and economic growth will stumble. Continue shorting the rupiah, underweighting Indonesian stocks and sovereign credit, and shorting long-term (5-year) local government bonds.

Greater safety for European taxpayers and bank depositors necessarily means more risk for bank equity and bond investors. We provide some detail, and also initiate two new short-term positions.

Value in the U.S. Treasury market is rapidly deteriorating, and the 10-year Treasury yield is now consistent with our fair value projections. Investors should shift from an above-benchmark to a benchmark duration stance.

Reduce portfolio duration to neutral, while also cutting exposure to European bonds (both in the core and Periphery) and Canadian government bonds.