Real Estate
Highlights Beige Book highlights disconnect between inflation words and inflation data. Peak in auto sales is not a harbinger of recession. Capital spending still trending higher. Inflation and inflation surprise will need to move higher before Fed hikes again. Big disconnect between 10-year yield and our fair value model. Feature Disconnect On Inflation Chart 1Beige Book Monitors Support##BR##Fed's Outlook On Economy And Inflation The Beige Book released on September 6 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin trimming its balance sheet in September and boost rates by another 25 basis points in December if the CPI and PCE inflation readings turn higher. Our quantitative approach to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 1). At 64%, the BCA Beige Book Monitor was still near its cycle highs in September, providing further confirmation that economic growth was sturdy in the first two months of Q3. The Fed noted that "the information included in the report was primarily collected before Hurricane Harvey made landfall on the Gulf Coast." However, there was a mention of the storm's clout based on preliminary assessments of business and banking contacts across several districts. The U.S. dollar should not be much of an issue in the Q3 earnings season, according to the Beige Book. The greenback seems to have faded as a concern for small businesses and bankers, in sharp contrast with 2015 and early 2016 when Beige Book references to a strong dollar surged. The Q3 earnings reporting season will provide corporate managements with another forum to discuss the currency's impact on their operations. The 2% decline in the dollar over the past 12 months suggests that the dollar may even provide a small lift to Q3 results (Chart 1, panel 4). Remarkably, business uncertainty over government policy (fiscal, regulatory and health) has moved lower in 2017. The implication is that the business community is largely ignoring the lack of progress by Washington policymakers on Trump's agenda (Chart 1, panel 5). Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words (Chart 1, panel 3). Expressions of inflation dipped between the July and September reports. That said, a wide disconnect remains between the elevated inflation mentions and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will mount in the coming months, supporting a gradual removal of policy accommodation. Policy uncertainty in Washington and worries over the dollar seem to be fading. The divide between the quantity of inflation words in the Beige Book and measured inflation remains unresolved. Neither the soft data in the Beige Book nor the hard data on the economy suggest that an economic downturn is nigh. Recession Not Imminent Some investors have concluded that the peak in auto sales, a key component of consumer spending on durable goods, suggests that a recession is imminent (Chart 2). We take a different view. Zeniths in consumer durable goods, followed closely by consumer services, were primary harbingers of economic downturns in the post-WWII period. However, expenditures on autos, light trucks and other durables tend to peak seven quarters before the onset of recession. Consumer spending on nondurable goods and services provide less of a warning, topping out just five and four quarters out, respectively. The implication for investors is that the peak in auto sales suggests that a recession is still several years away (Chart 3, panels 1-4). Chart 2Vehicle Sales May##BR##Have Peaked Chart 3Consumer Spending And##BR##Housing Prior To Recessions Housing investment provides an even earlier indication that a recession is on the horizon (Chart 3, panel-panel 5). Housing peaked 17 quarters before the start of the 2007 recession and 20 quarters, on average, before the onset of the 2001 and 1991 recession. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. While housing's contribution to overall economic growth plunged in Q2, we expect housing to provide fuel for the next few years as pent up demand from the depressed household formation rate since the GFC is worked off. The implication from our upbeat view on housing is that the next recession is still several years away. Bottom Line: We expect the next recession to be triggered by an over aggressive Fed, not by imbalances in one of more segments of the economy. It is premature to say that the economy is headed into recession based on a peak in auto sales. Stay long stocks versus bonds, but we recommend that clients be prudent, paring back any overweight positions and holding some safe-haven assets within diversified portfolios. Business Capital Spending Still Up Elevated readings on capex in the first half of the year should persist into the second half. Corporate managements may be postponing investment decisions until they have more clarity on federal tax policy and the Trump administration's plans for infrastructure investment. In short, corporations continue to struggle with how much and when to spend, rather than whether to invest at all. The key supports for sustained corporate spending stayed in place despite the soft July factory orders report and lackluster C&I loan growth. BCA's model for capex (based on non-residential fixed investment, small business optimism and the speculative-grade default rate) suggests lending is poised to climb on a 12-month basis (Chart 4) despite the softening of C&I loan growth since November 2016. Moreover, the 3.3% month-over-month (m/m) drop in factory orders in July masked an upward revision to orders in June and a substantial 1.0% m/m gain in core orders. Core shipments, which feed directly into GDP, rose 1.2% m/m in July. Almost all of the weakness in orders and shipments in July was linked to a 71% plunge in the volatile aircraft orders segment. BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. Consumer expenditures averaged an above-trend 2.7% in 1H. We anticipate that household spending will continue to improve in the second half of 2017.1 Moreover, recent readings on core durable goods orders and shipments show that the uptrend that began in mid-2016 persists, despite recent monthly wiggles in the data (Chart 5). Chart 4BCA Capex Model Points##BR##To Further Improvement Chart 5Capital Spending##BR##Remains In An Uptrend CEO confidence, still a primary support for capex, recently soared to a 13-year high in Q1, but retreated modestly in Q2. The last reading on this survey was in mid-July, and the dip in sentiment reflects the lack of legislative progress in Washington (Chart 5, top panel). The next CEO survey is set for mid-October. The dip in CEO sentiment in Q2 stands in sharp contrast with the easing of concerns around policy in the Beige Book. Chart 6Surprising Drop In Policy##BR##Uncertainty This Year Surprisingly, the chaos in Washington during the first eight months of the Trump administration has not led to an increase in economic policy uncertainty (Chart 6). Instead, after rising sharply in the wake of the Brexit vote in mid-2016 and the U.S. presidential election in November, policy uncertainty has ebbed. While uncertainty over economic policy remains elevated relative to the past few years, the concern under Trump is surprisingly subdued. This metric is in line with the Beige Book's assessment of Trump's impact on sentiment. A series of business-friendly legislative wins for the GOP and President Trump would further reduce any qualms. Even so, a failure by Congress to boost the debt ceiling and fund the U.S. government later this month would increase business worries/fears. Late last week, Trump cut a deal with Congressional Democrats to extend the debt ceiling for three months and is in talks to do away with it altogether. Bottom Line: The fundamentals still support solid business spending. However, BCA's positive capex outlook in the U.S. could be blemished if the Republicans fail to deliver on their promises to cut taxes and boost infrastructure spending in the next several months. Inflation Surprise And The Fed Chart 7The Fed Cycle And Inflation Surprise We expect inflation surprise to move higher, which could spur the Fed to resume its rate hike campaign. A disconnect has opened between economic surprise and inflation surprise.2 In the past 13 years, there have been 15 periods when economic surprise has climbed after a trough. The inflation surprise index temporarily increased in 13 of those episodes. For example, in the aftermath of the oil price peak in the U.S. in mid-2014, both economic surprise and inflation surprise diminished through early 2015 and then began climbing. However, today's inflation surprise index has rolled over while economic surprise has gained. The inflation surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 7). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. Mounting inflation surprise also accompanied most of the Fed's rate increases from mid-1999 through mid-2000 under similar conditions. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. What Does This Mean For The Fed? The above analysis underscores that economic growth is in good shape and it is likely to remain so for the next year at a minimum, barring any nasty shocks. Normally, the positive U.S. (and global) growth backdrop would place upward pressure on bond yields. It has not been the case this time. Investors appear skeptical of the ability of strong economic growth to generate higher inflation. The attitude seems to be "we will believe it when we see it". Some on the FOMC are taking a similar attitude. Lael Brainard, a FOMC governor, presented an interesting speech last week that makes this point. She speculated that inflation has been lower post-Lehman for structural reasons related partly to a drop in long-term inflation expectations. The Fed has been reluctant in the past to even hint that inflation expectations have become unmoored, because that could reinforce the trend, thus making it harder for the Fed to move inflation up to target. Brainard, a voting member of the committee with a dovish bias, argued that unemployment may have to undershoot the full employment level for longer than normal because low inflation expectations will be a persistent headwind. She also implied that the central bank should allow inflation to temporarily overshoot the 2% target. At a minimum, she wants to see evidence of rising inflation and inflation expectations before the Fed delivers the next rate hike. In the past, Brainard's speeches have sometimes heralded shifts in the FOMC's consensus. An example is her December 1, 2015 speech at Stanford.3 It is not clear if this is the case this time, but it does reinforce the view that a strong economy and a falling unemployment rate is not enough to justify another rate hike this year according to the consensus on the FOMC. Bottom Line: Our inflation indicators are pointing mildly up. Nonetheless, timing the upturn in inflation is difficult and the Fed will not hike in December without at least a modest rise in inflation (together with higher inflation expectations). We are short duration because Treasuries are overvalued and market expectations for Fed rate hikes over the next year are overly complacent (see next section). Nonetheless, a rise in yields may not be imminent. Disconnect On Duration The Global Manufacturing PMI reached a more than 6-year high in August, climbing from 52.7 in July to 53.1 last month (Chart 8, panel 3). Meanwhile, bullish sentiment toward the U.S. dollar continues to plunge (Chart 8, bottom panel). Together, these two factors suggest that global growth is accelerating and becoming broader based. BCA's U.S. Bond Strategy service4 views the improving global economic backdrop as an extremely bond-bearish development. A wide global recovery means that when U.S. data turns surprisingly positive, it is less likely that any increase in Treasury yields will be met with an influx of foreign demand and surge in the dollar. Our Treasury model (based on Global PMI and dollar sentiment) currently places fair value for the 10-year Treasury yield at 2.67% (Chart 8, top panel). Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68% (not shown). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. After adjusting for changes in credit rating and duration over time, the average spread offered by the Bloomberg Barclays corporate bond index is fairly valued relative to similar stages of past business cycles. However, the Aaa-rated portion of the market looks expensive. Further, strong Q2 profit growth likely foreshadows a decline in net leverage. This lengthens the window for corporate bond outperformance. We recommend an overweight in the high-yield market. In the early stages of the previous two Fed tightening cycles (February 1994 to July 1994 and June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread (378 bps) almost in line with the average achieved during other similar monetary conditions (Chart 9). We continue to favor a "buy on the dips"5 approach in the high-yield market. Chart 8Treasury Fair Value Models Chart 9High-Yield Market Overview Regarding high-yield valuation, our estimated default-adjusted spread stands at 245 bps. Historically, this level is consistent with excess returns of just under 3% versus duration-matched Treasuries over the subsequent 12 months. Our estimated default-adjusted spread is based on an expected default rate of 2.6% and recovery rate of 49% (Chart 9, bottom panel). We remain underweight MBSs; While MBS are starting to look more attractive, especially relative to Aaa credit, we think it is still too soon to buy. The Fed will announce the run-off of its balance sheet when it meets later this month. The market has been pricing in this eventuality for most of the year, leading to a significant widening in MBS OAS. More recently, the option cost component of MBS spreads has joined in, widening alongside falling mortgage rates and expectations of rising prepayments. Bottom Line: Rates have tested their post-election lows, but BCA's fair value model suggests a bounce higher, which supports our stocks-over-bonds stance. In terms of U.S. bonds, we favor short duration over long and credit over high quality. MBSs will be hurt more than Treasuries as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy ryans@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", July 24, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Surprise, Surprise", August 28, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/newsevents/speech/brainard20151201a.htm 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report, "Keep Buying Dips," March 28, 2017. Available at usbs.bcaresearch.com.
Highlights Beijing's continued focus on reducing excess industrial capacity in the lead-up to the 19th National Congress of the Communist Party will keep iron ore and steel markets buoyant for the balance of the year. The trajectory of prices further out the curve will, however, depend greatly on how quickly China's reflationary policies wane next year. Energy: Overweight. U.S. gasoline inventories could fall by 7-10mm barrels in the first week following the storm (data to be reported today by the EIA), and another 5-10mm barrels (or more) over the next month, depending on how long it takes to restart all of the refineries knocked offline by Hurricane Harvey, according to estimates in BCA Research's Energy Sector Strategy. Current gasoline inventories sit about 20 million barrels above the 2011-2015 average, which, based on our calculations, could be completely evaporated within a month, materially changing the U.S. gasoline market and related crack spreads.1 Base Metals: Neutral. Following our analysis last month, we are recommending a tactical short Dec/17 COMEX copper position at tonight's close, expecting the market to correct in line with the fundamentals we highlighted.2 Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. The metal will be supported by low real interest rates and safe-haven demand. The position was recommended May 4, 2017, and is up 8.7%. Ags/Softs: Underweight. Another bumper crop is being priced into corn this year. Expectations for higher corn yields this year - ranging from 166.9 bushels/acre (bpa) to 169.2 bpa vs. 169.5 bpa expected by the USDA - will keep prices under pressure. We remain bearish.3 Feature In reaction to Chinese economic and environmental policies, iron ore and steel each rallied by ~78% in 2016. While steel continued its ascent in 2017 - gaining a further ~20% in the year-to-date (ytd), iron ore broke away from this trend and plummeted by more than 40% between mid-February and mid-June (Chart of the Week). Chart of the WeekSteel And Iron Ore Diverged Earlier This Year Although iron ore has since reversed its path and regained most of the loss, the divergence between steel and the ore from which it is produced comes down to a difference in fundamentals. Increased supplies of iron ore at a time of healthy inventories were bearish in H1. On the other hand, closures of both steel capacity as well as coal capacity kept the steel market tight. While China's supply-side policies have been the force behind the strength in both to date, Chinese demand - which accounts for ~50% of global iron ore and steel consumption, and steel production - will take center stage next year. The speed at which China's reflationary policies wane will determine the long-term trajectory of steel and iron ore markets. Granted while there are some early signs of a potential slowdown in China's economy, we do not expect this to hit metals generally in the near term. As Beijing continues its focus on reducing excess capacity in the steel sector, and as policymakers prepare for the 19th National Congress later this year, we expect steel and iron ore to remain buoyant in H2. China's Steel Production Paradox Eliminating Excess Steel Capacity At The Forefront Of Reform Agenda... The National Development and Reform Commission (NDRC) - China's top economic planning authority - has made clear that reducing overcapacity is at the forefront of its reform priorities. More concretely, Beijing aims to cut steel capacity by up to 100-150mm MT over the five-year period between 2016 and 2020. It has already made progress towards that end - shuttering a reported 65mm MT last year - and is on track to meet its targeted 50mm MT of steel capacity cuts by the end of 2017. Additionally, in January the central government announced its intention to eliminate all steel capacity from intermediate frequency furnaces (IFF) by the end of June 2017. So it is no surprise that steel has been performing so well. However, this narrative is inconsistent with Chinese data. ...Yet Chinese Production Is At All-Time Highs Steel production from China this year has been soaring, growing by more than 5% year-on-year (yoy) in the first seven months of 2017. In fact, latest production data from July came in at 74mm MT, marking a more than 10% yoy increase, and an all-time record high for monthly production (Chart 2). And since ~50% of global steel is produced in China, this has translated into strong global steel production figures in 2017. Production grew by 4.75% yoy in the first seven months of 2017, the most since 2011 and almost five times as much as the five-year average yoy increase for that period. In fact, the China Iron and Steel Association recently announced that the strength in steel prices does not reflect underlying fundamentals and is instead due to speculation and a misunderstanding of the market impact of China's policies. In an effort to deter speculation, China's commodity exchanges implemented several restrictions in August, including increasing margins on futures contracts and limiting positions (Chart 3).4 Chart 2Record Steel Production##BR##Amid Chinese Capacity Cuts Chart 3Pure Speculation Or Not?##BR##Beijing Cracking Down On Market Speculation It Comes Down To The Nature Of IFFs This paradox of record high production at a time of capacity closures comes down to the nature of IFF capacity that was shutdown. While for the most part, old, outdated and unproductive facilities were targeted for closure last year, the shift in focus towards IFFs had a different effect on the market in 2017. IFFs use scrap steel, rather than iron ore, as a raw material, which is melted through an induction furnace to produce low-quality steel. Because this steel fails to meet government specifications for high-quality steel, it is considered "illegal" and, although it is used to satisfy steel demand, it is not included in official production data. Thus, efforts to shut-down these producers are not evident in China's production figures. However, IFF steelmaking capacity is estimated to be 80-120mm MT a year, and accounts for ~10% of steel production capacity in China. In terms of output, this substandard steel accounts for almost 4% of Chinese production. Thus, traditional steelmaking facilities have been required to fill the supply void caused by IFF closures, raising the official production figures. Steel Exports Take A U-Turn As "Illegal" Capacity Is Shuttered Moreover, Chinese exports have reversed their trend and are on the decline. Steel exports registered a ~30% yoy fall in the first seven months of this year (Chart 4). This is further evidence that the capacity closures have had a real impact on actual steel production, and that domestic consumers have turned to steel that is typically exported, in order to fulfill their demand for the metal. Furthermore, as authorities crack down on IFFs, demand for scrap steel - the main raw material in IFFs - has declined. Amid waning demand, scrap steel prices fell by 9% in H1 before regaining almost 6% in July. This follows a ~70% rally last year (Chart 5). Chart 4Exports Are Down As##BR##Capacity Is Shutdown Chart 5Scrap Steel Rally Takes A Break##BR##As Demand From IFFs Eliminated Coking Coal Cost Push As part of its environmental protection plans, China's policymakers announced plans to replace 800mm MT of outdated coal mining capacity with 500mm MT of "advanced" capacity by 2020. Last year, coal-mining capacity closures exceeded the 250mm MT target, reversing the slump in coal prices and leading an almost 225% rally in coke futures. Coking coal, or metallurgical coal, is a key ingredient in the steelmaking process. Although coke dipped since its December high, it has rallied by 34% in the past two months. Thus, Chinese steel mills are now producing in an environment of higher input costs, which will translate to higher prices for the finished good. China's Capacity Closures Likely Peaked Given that China has set June 30, 2017 as the target for eliminating induction furnace-based steelmaking, we do not expect IFF shutdowns to continue impacting the steel market. Additionally, while excess steel capacity is conventionally estimated to be 325-350mm MT in China, the Peterson Institute for International Economics (PIIE) argues that this estimate does not account for the need for a certain amount of excess capacity. Instead, they cite 130mm MT as a more reasonable figure of Chinese excess steel capacity. According to PIIE estimates, this means that by the end of the year, China will have eliminated almost all of its excess capacity, and will be very close to the quantity of capacity closures it aims to achieve by 2020. Consequently, we do not expect shutdowns to continue driving up steel prices. However, plans to halve blast-furnace production at Northern China mills to reduce pollution during the winter will weigh on near term Chinese production and the steel market. Bottom Line: Chinese authorities are closing in on their targeted capacity shutdowns. We do not expect this reduction in capacity to continue impacting steel markets in the long term. Near-term supply dynamics will be driven by efforts to reduce winter pollution. IFF Closures Spur Demand For Iron Ore Chart 6Mid-Year China Inventories At Record High With the elimination of IFFs, which take in scrap steel as the main input, we expect greater demand for iron ore from traditional steel mills as they work toward filling the supply gap left by the loss of the so-called illegal steel. While steel prices have been on a consistent uptrend since 2016, iron ore - which usually moves in tandem with steel - diverged from its main demand market earlier this year, before resuming its rally in Q2. The deviation earlier this year was due to increased supplies from Australia and Brazil amid record levels of Chinese inventories (Chart 6). This has reversed, and iron ore has resumed its climb. Stronger demand for iron ore is consistent with import data, which shows that China has been hungry for Australian and Brazilian iron ore. However, since the average iron ore production cost in China - estimated at more than 60 USD/MT, or roughly three (3) times the cost of iron-ore production in Brazil and Australia - is greater than in other regions, many Chinese mines go offline during periods of low prices. By the same token, elevated prices tempt high-cost Chinese producers back online, increasing global supply. Bottom Line: Since the closure of induction furnaces has shored up demand for iron ore, pulling prices up with it, we do not anticipate further drops in prices. However, if prices remain elevated, increased production from China amid well stocked global markets will keep a tight lid on iron ore prices. Chinese Appetite Will Determine Long-Run Market Performance While steel and iron ore are currently well supported, their near term strength is in large part due to China's reflation policies which have revived demand. Given that it is a sensitive political year, we do not foresee downturns in the Chinese economy this year. Authorities will want to go into the 19th National Congress of the Communist Party in mid-October with solid economic data as a backdrop. However, waning Chinese growth would be a long-run negative for the markets (Chart 7). Specifically, official government data indicate: 1. There are early warning signs that the property market in China may be losing momentum. New floor space started, and new floor space completed contracted in July, while growth in floor space under construction and floor space sold have been easing. Furthermore, while total real estate investment has been growing at an average monthly rate of almost 9% yoy since the beginning of the year, July figures show a marked slowdown, at less than 5% yoy growth. We would not be surprised to see the property market winding down as China begins to tighten its real estate policies. 2. Chinese automobile production has slowed significantly from all-time highs recorded at the end of last year. The monthly average 4% yoy growth in the five months to July is a significant deceleration from the 10% yoy average witnessed during the same period last year. 3. However, infrastructure investment has been strong, recording its all-time high in June, and a 20% yoy increase in July. With the National Congress scheduled in October, we do not expect a slowdown in infrastructure spending this year. In addition, August manufacturing PMI data in China came in above expectations, and registered a slight increase from the previous month (Chart 8). The index has remained relatively stable since the beginning of the year, after gaining strength last year. Chart 7Despite Signs Of Fizzling,##BR##Slowdown Not Expected In 2017 Chart 8Accomodative Policies Will##BR##Keep Near Term Demand Solid Bottom Line: Although we expect China's appetite for steel will begin to wane as the economy unravels from its reflationary policies, steel demand will remain strong in 2017. Chinese authorities will want to ensure solid growth in the run-up to the National Congress scheduled for mid-October. Thus, the near-term focus will remain on supply, and the impact of its reforms on ferrous metals. Post-Harvey Rebuilding Will Spur Steel Demand Hurricane Harvey is expected to impact steel markets in three main ways: 30-35% of all U.S. steel imports come through Port Houston. However, the port resumed operations as of September 1 and there is no longer a threat posed on steel imports. The disruption in freight service resulting from Harvey is expected to temporarily push up trucking rates in the next few weeks. This will give U.S. steel firms, which have long been suffering from cheaper Chinese imports, an advantage and opportunity to fill the demand void which will be bullish for U.S. steel. Harvey will have a longer-run positive impact on steel markets through the demand that will be generated from the infrastructure rebuilding process. Still, increased demand for steel will be partially mitigated by a rise in scrap steel supply, in the aftermath of destruction. While it is still too early to measure the extent of damage and the impact of the rebuilding process on steel markets, estimates from the storm's damage run as high as USD 120 billion. Texas's governor estimated the damage to be much greater - between USD 150-180 billion. This compares to USD 110 billion from Hurricane Katrina, the most devastating storm to hit the U.S. prior to Harvey. Bottom Line: While it is still too early to determine the full extent of destruction, the infrastructure rebuilding phase will spur demand for steel. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Upgrading Refining Sector As Harvey Clears Out Inventories," published September 6, 2017 It is available at nrg.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," published August 24, 2017. It is available at ces.bcaresearch.com. 3 Please see "GRAINS - Corn lower as U.S. yield forecasts rise; soy, wheat climb," published by reuters.com on September 1, 2017. 4 Please see "Shanghai exchange urges steel investors to act rationally, hikes fees" published by reuters.com on August 11, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights Portfolio Strategy We reiterate our recent overweight calls in banks/financials and energy. Chemicals/materials and telecom services no longer deserve a below benchmark allocation. Pharma/health care and utilities are now in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature Equities poked higher early last week on the eve of a robust earnings season as quarterly EPS vaulted to all-time highs (Chart 1), only to give up those gains and then some as North Korea jitters spoiled the party and ignited a mini selloff later in the week. While geopolitical uncertainty is dominating the news flow and an escalation is possible, we doubt North Korea tensions in isolation can significantly derail the stock market. With regard to the SPX's future return composition, our view remains intact that the onus falls on earnings to do the heavy lifting. In other words, the multiple expansion phase has mostly run its course, and explains the bulk of the board market's return since the 2011 trough (Chart 2). Now it is time for profits to shine. Chart 1Earnings-Led Advance Chart 2EPS Has To Do The Heavy Lifting Low double-digit EPS growth is likely in calendar 2018. Three key factors drive our sanguine profit view. First, as we posited three weeks ago, financials and energy will command a larger slice of the earnings pie, a backdrop not yet discounted in sell-side analysts' estimates (please see Table 2 from the July 24th Weekly Report). Second, irrespective of where the U.S. dollar heads in the coming months, SPX earnings will benefit from positive FX translation gains in Q3 and Q4. Finally, as the corporate sector flexes its operating leverage muscle, even modest sales growth will go a long way in terms of profit growth generation. Operating profit margins are poised to expand especially given muted wage inflation (Chart 3). Nevertheless, lack of profit validation is a key risk to our bullish S&P 500 thesis. Considering the post-GFC period, global growth scares (and resulting anemic earnings follow through) were the primary catalysts for the 2010, 2011 and late-2015/early-2016 equity corrections. The SPX fell 16%, 19% and 14% in each of those episodes, respectively. As a reminder, early in 2010 the Fed's QE ended and the ECB was scrambling to contain the government debt crisis as the Eurozone and the IMF bailed out Greece, Portugal and Ireland. In 2011, recession fears gripped the world economy, when then ECB President Jean-Claude Trichet tightened monetary policy twice in the euro area, while in the U.S. QE2 ended (Chart 4) and the debt ceiling fiasco spiraled out of control in the late-summer. More recently, a global manufacturing recession took hold in late-2015/early-2016 and the commodity drubbing re-concentrated investor's minds. Chart 3Margin Expansion Phase Chart 4Liquidity Removal = Market Turmoil A persistent flare up in geopolitical risk (i.e. in addition to the possible escalation of North Korea tensions) may lead consumers and CEOs alike to pull in their horns and short circuit the synchronized global economic recovery. Putting this risk in perspective is instructive. Table 2 documents the historical precedent of geopolitical crises since the mid-1950s, the maximum SPX drawdowns, and bid up of safe haven assets courtesy of our Geopolitical Strategy Service.1 Under such a backdrop, low-double digit EPS growth would be at risk, also causing some equity market consternation. Table 2Safe-Haven Demand Rises During Crises Table 2Safe-Haven Demand Rises During Crises, Continued Importantly, the Chinese Congress is quickly approaching in October and the dual tightening in Chinese monetary conditions (rising currency and interest rates) is unnerving. A related Chinese/EM relapse represents a risk to our bullish overall equity market thesis. Commodity producers/sectors would suffer a setback, jeopardizing the broad-based earnings recovery. Chart 5Mini Capex Upcycle Second, lack of tax reform is another risk we are closely monitoring that could put our upbeat SPX view offside. Lack of traction on this front as the year draws to a close will likely sabotage business confidence and put capex plans on the backburner anew. Moreover, this would shatter the confidence of small and medium businesses, especially given their greatest bugbears: high taxes and big government. Finally, repatriation tax holiday blues would cast a double dark shadow primarily over the tech and health care sectors: not only would shareholder-friendly activities like dividends and buybacks get postponed, but so would capex plans (Chart 5). One final risk worth monitoring is the handoff of liquidity to growth. Historically, there has been significant turmoil every time the Fed has removed balance sheet accommodation in the post-GFC era. We are in uncharted territory and the unwinding of the Fed's balance sheet, likely to be announced next month, may have unintended consequences. Unlike QE and QE2 ending, this time around the ECB is also on the cusp of removing balance sheet liquidity, at the margin. Chart 6A shows that the equity market may come under pressure if history at least rhymes. While we doubt that a larger than 10% correction is in the cards -- in line with the historical S&P 500 average drawdown during geopolitical crises (middle panel, Chart 6B)2 -- and our strategy will be to "buy the dip", the time to purchase portfolio insurance is now when the S&P 500 is near all-time highs, especially given the seasonally-weak and accident-prone months of September and October. Chart 6ADay Of Reckoning? Chart 6BAsset Class Returns During Crises We are comfortable with our overall early-cyclical portfolio exposure, while simultaneously maintaining a bit of defense in the form of our overweight consumer staples and underweight tech positions. This week we are recapping and reiterating all the major portfolio moves we have made since early May. Banking On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7A), pointing to the potential for a broad-based bank balance sheet expansion. Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years (Chart 7B). Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers. BCA's view is that a better economy and rising inflation will materialize in the back half of the year, and serve as a catalyst to higher interest rates and a steeper yield curve. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 7A). Chart 7ABanks Flexing Their Muscle Chart 7BBCA Bank Loans & Leases Growth Model In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag. Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 7A). Finally, even a modest easing in the regulatory backdrop along with a more shareholder friendly outlook now that the banks aced the Fed's stress test should help unlock excellent value in bank equities. Bottom Line: We reiterate our overweight stance in the S&P banks index that also lifted the S&P financials sector to overweight. Buy Energy Stocks Chart 8Energy EPS Model Says Buy Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been reestablished; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel, Chart 8). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (Chart 8). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal. Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Bottom Line: Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 8), and gave us comfort to lift the S&P energy sector to a modest overweight position. DeREITing Chart 9Lighten Up On REITs REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs had been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first half lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (Chart 9). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 9). Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. If banks continue to close the credit taps, CRE prices will suffer a setback. Bottom Line: We reiterate our downgrade of the niche S&P real estate sector to a benchmark allocation. Positive Chemical Reaction? Chart 10Chemicals Are No Longer Toxic In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase, driven by weak revenues as chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and now three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 10). This has driven a relative weakening of the U.S. dollar, much to the benefit of U.S. chemical producers, whose exports appear to be displacing German exports. Global chemicals M&A supports our expectation of demand-driven pricing power gains. We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. This improving domestic final demand backdrop is reflected in higher resource utilization rates and solid pricing power gains have staying power (Chart 10). Bottom Line: Tentative evidence suggests that the bear market in chemicals producers is over. We reiterate our recent upgrade to neutral. Given that chemicals stocks comprise over 73% of the broad materials index, this bump also moved the S&P materials sector to a benchmark allocation. Utilities: Blackout Warning Chart 11Utilities Get Short Circuited While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 11), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 11). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 11). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Bottom Line: We reiterate our recent downgrade to underweight. Pharma: Tough Pill To Swallow Chart 12Pharma Relapse Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals and both have roughly doubled over the past decade. However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (Chart 12). If our cautious drug pricing power thesis pans out as we portrayed in the July 31st Weekly Report, then pharma earnings will suffer and exert downward pressure on relative share prices (Chart 12). Industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (bottom panel). While this metric does not suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Bottom Line: We recently trimmed the S&P pharmaceuticals index to underweight, which also took the S&P health care index to underweight. Telecom Services: Signs Of Life Chart 13Telecom: Climbing Out Of Deflation2 Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. We had been fortunate enough to underweight this niche sector since late January, adding alpha to our portfolio. Nevertheless, we did not want to overstay our welcome and recently booked profits of 12% and lifted the S&P telecom services sector to the neutral column. Our Cyclical Macro Indicator has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (Chart 13). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (Chart 13). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (Chart 13). Anecdotally, Verizon's first full quarter post the new pricing plans was solid and suggests that the peak deflationary impulse is likely behind the industry. Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading. This will also stabilize relative profitability. In sum, the bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Green shoots on the industry's pricing power front and impressive management focus on cost structures argue against being bearish this niche sector. Bottom Line: We reiterate the recent bump to neutral in the S&P telecom services sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 2 Ibid. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights July jobs report friendly for risk assets. Q2 earnings and July ISM confirm bullish profit environment. The Fed acknowledges softer inflation, but remains determined to tighten policy. 1H economic growth is just enough for the Fed. Housing weakness in Q2 is not a concern. Feature Chart 1Labor Market Conditions Favor Risk Assets The July jobs report suggests that the environment of solid economic growth and still muted wage pressures remains in place, a positive backdrop for equity markets. The report showed that the economy added 209,000 jobs in July, well above the consensus forecast of 178,000. Prior months were also revised higher by 2,000 pushing the 3-month moving average up to 195,000 jobs per month. Monthly job gains thus far in 2017 are nearly identical to the 187,000 jobs per month averaged in 2016. Despite an uptick in the participation rate to 62.9% from 62.8%, the unemployment rate dipped by 0.1% to 4.3%. At two decimal points, the dip in the jobless rate was from 4.36% to 4.35%. Although the monthly increase ticked up to 0.3%, the annual increase in average hourly earnings was flat at 2.5% for the fourth consecutive month (Chart 1). Nonetheless, the reacceleration in the 3-month change in average hourly earnings from 1.9% in January 2017 to 2.8% in July supports the Fed's view on inflation. Bottom Line: The July employment report paints a fairly stable picture of the U.S. economy. Job gains are continuing at a pace consistent with the 2% GDP growth rate of recent years. Meanwhile, wage gains remain modest and consistent with muted inflation. We still expect the Fed to announce the process of running down its balance sheet at the September FOMC meeting. The next rate hike will likely come at the December FOMC meeting, if inflation rebounds in the second half of the year. Steady growth, low inflation and a gentle Fed should continue to underpin U.S. risk assets. Q2 Earnings Update: Margin Expansion In Place EPS and sales growth in Q2 are running well ahead of consensus expectations as forecasted in our July 3 preview. Moreover, the counter trend rally in profit margins is still in place. More than 80% of companies have reported results so far with 73% of companies beating consensus EPS projections, just above the long-term average of 70% (Chart 2). Furthermore, 68% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 6% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to ultimately re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, over the nearer term, results thus far imply that Q2 will see another quarter of margin expansion. Average earnings growth (Q2 2017 versus Q2 2016) is strong at 12% with revenue growth at just 5%. The BCA Earnings model predicts EPS growth to hit roughly 24% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 3). Measured on this basis, S&P 500 EPS growth in Q2 would be 20%, compared with 13% in Q1. Chart 2Positive Earnings Surprises Continue Chart 3Strong EPS Growth Ahead Importantly, the strength in earnings and revenues is broadly based (Table 1). Earnings per share are higher in Q2 2017 versus Q2 2016 in all 11 sectors. Results are particularly strong in energy, technology and financials. Energy revenues surged by 15.7% in Q2 versus a year ago. Sales gains in technology (8.2%), materials (7.2%) and utilities (5.7%) are notable. Since the start of 2017, the trajectory of EPS estimates for 2017 and 2018 (Chart 4) has been encouraging. The forecast for 2017 is 12%, up from 11% at the outset of the Q2 reporting season and unchanged from the start of the year. The 2018 estimate (11%) is also little changed from estimates made in January 2017. In a typical year, earnings estimates tend to move lower as the year progresses. Table 1S&P 500:##BR##Q2 2017 Results* Chart 4Stability In '17 & '18 EPS##BR##Estimates Supports U.S. Equities BCA's U.S. Equity Strategy service noted1 that the lagged effect from a softening U.S. dollar will also likely underpin EPS in the back half of the year. We are surprised that mentions of the greenback are absent from Q2 conference calls; the domestic market appears front of mind for both investors and management teams. We are inclined to see fading concerns about the dollar from the next Beige Book (due in early September) as evidence in favor of our colleagues' view. The July reading of the ISM manufacturing Index supports our case for accelerating profits in the second half of 2017. From the perspective of risks to our stance, industrial production (IP) has historically been a good proxy for sales of S&P 500 companies (Chart 5); and a rollover in the 12-month change in IP would challenge our constructive view towards earnings. However, strong readings on the ISM, which tracks IP, suggest that IP should accelerate in the next six months (Chart 5, panel 1). Chart 5Favorable Macro Backdrop For Earnings And Sales At 56.3 in July, the ISM has rebounded from its recent low of 47.9 in 2015, but ticked down from the 57.8 reading in June. For many investors, the risk is that the index has peaked and will soon roll over. While a decline is certainly possible given that the index is already elevated, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 6). Moreover, the new export orders component of the ISM has also surged. The implication is that foreign demand (rather than domestic consumer or business spending) is leading the U.S. manufacturing sector. Consistent with this perspective, the 3- and 12-month changes in the industrial production indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 7). Chart 6IP Poised To Accelerate##BR##And Support EPS Growth Chart 7U.S. IP Growth Still##BR##Other Developed Markets Bottom Line: EPS growth will continue to accelerate through the end of 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth. The elevated level of ISM sets the stage for EPS growth to gather momentum in the second half of 2017. Firm readings on ISM indicate that our bullish profit story for 2017 is still intact, supporting an overweight stance towards stocks versus bonds. Fed Still On Track The July FOMC statement supports our view that the Fed will announce plans to shrink its balance sheet at the September FOMC meeting and hold off until December for the next rate hike. Policymakers upgraded their views of the labor market and downgraded their assessments of inflation. The reference to job gains moderating was dropped; instead, the Fed noted that employment growth has been robust. On inflation, the Fed stated that it is "running below" 2%, as opposed to "somewhat below" 2% in the June statement. These are only small tweaks and do not suggest any deviation from the Fed's plan to raise rates one more time this year as per its latest "dot plot" published in June. We still see the next rate hike in December if inflation begins to turn higher and shows signs of heading towards the 2% target. While the Fed is on the sidelines regarding rate hikes until the final meeting of 2017, it is creeping closer to begin shrinking its balance sheet. The July FOMC statement announced that the balance sheet normalization process will begin "relatively soon." The Fed had previously stated that the process would commence "this year." We view this shift in language as a signal that the balance sheet announcement will be made at the September meeting. Hesitation on tapering by the ECB, persistently weak readings on U.S. inflation or a tightening of U.S. financial conditions, would also give the Fed reason to reassess its plan. Bottom Line: Slight variations in the FOMC's statement indicate that rates are on hold at least until December. This will give the Fed time to determine whether inflation is moving back to its target and to assess the market impact of shrinking its balance sheet. 1H GDP: Just Enough U.S. GDP grew by 2.6% in Q2, following a revised 1.2% advance in Q1 (Chart 8). Given the potential distortions to the quarterly data from residual seasonality issues, an average of the first two quarters gives a better reading on the underlying trend in the economy. In the first half of this year, growth averaged 1.9%. On a year-over-year basis, the economy grew by 2.1%, and while that is only in line with the Fed's 2.1% forecast for 2017, it is above the central bank's view of 1.8% GDP growth in the "longer run." In addition, the NY Fed's Nowcast for Q3 is 2.0% and the Atlanta Fed's GDP now reading for Q3 is 3.7%. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time.2 Quarterly GDP has averaged 2.2% since the current expansion started in the second half of 2009. Chart 8GDP Growth Remains Below Average, But Above Fed's Long Run Target Looking beyond the quarterly fluctuations, the U.S. economy has been relatively stable at about 2% growth for nearly 10 years. This advance has been sufficient to lower unemployment, with trend GDP growth slowing due to weak productivity gains and demographics. However, the expansion has not yet led to a material acceleration in wage growth or inflation. Inflation, a lagging indicator, warrants more attention from investors. BCA's Global Investment Strategy,3 team recently argued that both cyclical and structural forces will boost inflation in the next year and far into the next decade. In making this assessment, it was noted that inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended. The implication is that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. This also suggests that the central bank already may be behind the curve on raising rates. The implication for investors is to stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Bottom Line: Despite historically weak readings on economic growth, the U.S. economy is advancing quickly enough to reduce slack and ultimately, push up inflation. We agree with the Fed that gradual increases will forestall more aggressive hikes later in the cycle. Strong Housing Sector Dips In Q2 We expect housing to continue to add to GDP growth in 2017 and beyond. Housing - as measured by residential fixed investment - subtracted 0.27% from GDP growth in Q2 2017. However, since early 2011, the sector has contributed to growth in 20 of 25 quarters. Moreover, the Q2 decline appears to be a one off, with all of the weakness coming in "other structures," which measures broker commissions, manufactured housing and home improvement. The more economically sensitive single-family sector added 0.31% to GDP in Q2. There are few signs of the severe imbalances in housing and housing-related debt that sparked the 2007-2009 global financial crisis. Chart 9 shows that housing investment is running behind other long "slow burn" recoveries.4 These recoveries lasted well beyond the point at which the economy hit full employment, and inflationary pressures were also slower to emerge. The housing sector's lag is not surprising given the bloated inventory of vacant, unsold and foreclosed homes that needed to be absorbed in the early part of this recovery. Chart 10 shows the overhang has disappeared. Moreover, recent anecdotal reports suggest that the limited supply of homes in areas where people want to live is hurting sales. Chart 9We Are In A "Slow Burn" Expansion Chart 10Solid Housing Fundamentals In Place Other positive factors for housing include: A rise in FICO scores, which indicates that more renters now qualify for loans and could move from a rental unit to a single family house. We highlighted this factor in a recent Special Report on housing.5 Housing affordability: although off its all-time high, it remains favorable and the cost of owning remains cheap relative to renting. The rate of home ownership is now well below its long-term average (Chart 10, panel 2). If the pre-Lehman bubble in the homeownership rate has been unwound, it removes a headwind for construction activity because renting favors multi-family construction that produces less GDP per unit compared with single-family homes. The supply of foreclosed homes on the market is almost nil. While this may not directly impact home construction and GDP directly, it supports higher home prices. Lending standards have not eased much in this cycle, and accordingly, have not been a net plus for the housing market. Nonetheless, more selective mortgage lending by banks in this cycle stands in sharp contrast to the lax lending in the last cycle, with the net result being better credit quality for bank mortgage portfolios and less systemic risk in the banking sector. This is an area the Fed is paying close attention to in this cycle.6 That said, with lending standards tight, there is room for them to loosen and provide an additional boost to housing in the future. Household formation is still recovering from a period in which young adults stayed home with their parents for longer than normal for economic reasons. Although mild by historical standards, the tightening labor market and cyclical rebound in disposable incomes have allowed millennials to move out of their parents' basements, which has boosted housing demand (Chart 11). Chart 12 estimates the remaining pent up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the remaining gap implies an extra 540,000 housing units. The equilibrium number of housing starts needed to cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' occurs during the next two years, adding another 250,000 units per year, then total demand could be 1.6 to 1.7 million in each of the next two years. This compares with the July housing starts level of 1.2 million. If starts rise smoothly from today's level to 1.7 million at the end of 2018, then the housing sector will contribute about 0.25 percentage points and 0.52 percentage point to real GDP growth in 2017 and 2018, respectively (Chart 13). Chart 11Household Formation##BR##Following Incomes Higher Chart 12A Catch Up In Housing Construction##BR##Will Occur If This Gap Narrows Chart 13Housing Catch Up##BR##Will Boost GDP Growth The implication for the economy is that this already-aged expansion phase could persist for a couple of more years as long as it is not hit by an adverse shock and inflationary pressures remain muted, which would allow the Fed to proceed slowly. Bottom Line: Housing starts remain well below the equilibrium level implied by underlying household formation and a "catch up" phase could stoke the current "slow burn" expansion in the coming years. Residential investment will continue to add to GDP growth in 2017 and beyond, and keep economic growth on track to hit the Fed's modest target. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see U.S. Equity Strategy Weekly Report "Growth Trumps Liquidity", dated July 31, 2017, available at uses.bcarearch.com. 2 Please see U.S. Investment Strategy Weekly Report "Waiting For The Turn", dated June 26, 2017, available at usis.bcarearch.com. 3 Please see Global Investment Strategy Weekly Report "A Secular Bottom In Inflation", dated July 28, 2017, available at gis.bcarearch.com. 4 Please see The Bank Credit Analyst Monthly Report, dated November 24, 2016, available at bca.bcarearch.com. 5 Please see U.S. Investment Strategy Special Report "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcarearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", dated July 24, 2017, available at usis.bcaresearch.com.
Highlights Key Portfolio Updates Synchronized global economic growth is driving real yields higher and boosting equities (Chart 1). Meantime, core inflation remains muted which will ensure that Fed policy stays sufficiently accommodative (Chart 2). Outside of the U.S., monetary tightening cycles are kicking into high gear, and this will sustain downward pressure on the greenback for now (Chart 3). Easy financial conditions are a boon for S&P 500 profit margins, and a slow moving Fed suggests that investors will extrapolate this goldilocks equity scenario for a while longer (Chart 4). Almost all of the S&P 500's advance year-to-date has been earnings driven (Chart 5). Buoyant EPS breadth bodes well for additional gains, a message in line with our SPX profit model. In terms of how far the broad market can advance from current levels before the next recession hits, we posit three ways to SPX 3,000 (Table 1). The ongoing sector rotation is a healthy development, and is not a precursor to a more viscous and widespread correction (Chart 6). Historically, receding sector correlations represent fertile ground for the overall equity market (Chart 7). Our macro models are signaling that investors should position for a sustained rebound in economic growth. Our interest rate-sensitive models are coming out on top, deep cyclicals are attempting to trough, while defensives took a turn for the worse (Chart 8). Deep cyclical sectors are the most overvalued followed by early cyclicals, while defensives remain in undervalued territory. Interest rate sensitives have recently become overbought, while both deep cyclicals and defensives are in the oversold zone (Charts 9 & 10). The most attractive combination of macro, valuation and technical readings are in the financials and consumer discretionary sectors. The least attractive combinations are in materials, technology and utilities sectors. Prospects for a durable synchronized global economic growth, a coordinated tightening G10 central bank backdrop and cheapened U.S. currency warrant an early cyclical portfolio tilt, with the defensive/deep cyclical stance shifting to a more neutral setting. Chart 1Synchronized Global Growth Chart 2Muted Core Inflation Chart 3G10 Central Banks Map Chart 4Easy Financial Conditions Boost Margins Chart 5Buoyant Breadth Bodes Well Table 1SPX Dividend Discount Model SPX EPS & Multiple Sensitivity ERP Analysis Chart 6Healthy Rotation Chart 7Falling Correlations Boost The S&P 500 Chart 8Interest Rate Sensitives Come Out On Top Chart 9Underowned... Chart 10...And Undervalued Defensives Chart 11Earnings Growth Set To Accelerate Chart 12Consumers Are Feeling Flush Chart 13Improving Fundamentals Signal A Trough Chart 14Staples Remain The Household's Choice Chart 15Weaker Rents And Higher Vacancies Bode Ill Chart 16Profits Look Set To Downshift Chart 17Cyclical Recovery Driving Backlogs Lower Chart 18Margin Recovery Appears Priced In Chart 19Pricing Collapse Driving Earnings Decline Chart 20Productivity Declines Will##br## Keep A Cap On Valuations Chart 21Valuations At Risk##br## When Inflation Returns Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI) has climbed to new cyclical highs, supported by broad-based improvement among its components. Firming employment data, historically a precursor to credit growth and capital formation, has been a primary contributor to the lift in the CMI. Importantly, a tight labor market has not yet driven sector costs higher, which bodes well for near term profits (Chart 11 on page 8). A budding revival in loan demand is corroborated by our bank loan growth model, which points to the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival underpin our loans and leases model (Chart 11 on page 8). Expanding housing prices, increased housing turnover and rebounding mortgage purchase applications support household capital formation (Chart 11 on page 8). A recent lift in share prices partially reflects this much-improved cyclical outlook. Still, the message from our valuation indicator (VI) is that there is significant running room. Our technical indicator (TI) has retreated from overbought levels, but remains solidly in the buy zone, setting the stage for the next leg up in the budding relative bull market. We expect sentiment to steadily improve, buoyed by deregulation moving closer to reality as a partial Dodd-Frank replacement passed the House. Chart 22 S&P Consumer Discretionary (Overweight) Our CMI has snapped back after a tough year, driven by improving real wage growth. Higher home prices, a tighter labor market and increasing disposable income have consumers feeling flush, which should boost discretionary outlays. Importantly, consumer deleveraging is far advanced with the debt service ratio hovering near decade lows (Chart 12 on page 9). Further, our Consumer Drag Indicator remains near its modern high, suggesting EPS gains will prove resilient (Chart 12 on page 9). Although somewhat expensive from a historical perspective, our VI remains close to the neutral zone, underscoring that profits will be the primary sector price driver. Our TI has fully recovered from oversold levels, and is flirting with the buy zone, underscoring additional recovery potential. We continue to recommend an overweight position, favoring the media-oriented sub-indices. Chart 23 S&P Energy (Overweight) Our CMI has recently ticked up from its all-time lows, and is now diverging positively from the share price ratio. Ongoing gains in domestic production, partially offset by a still-high sector wage bill, underlie the recent CMI uptick. The steepest drilling upcycle in recent memory is showing some signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, U.S. crude oil inventories are contracting, which could presage a renormalization of domestic inventories, market share gains for domestic production and at least a modest rally in energy shares (Chart 13 on page 9). Our S&P energy sector relative EPS model echoes this cautiously optimistic industry backdrop, indicating a burgeoning recovery in sector earnings (Chart 13 on page 9). The TI has returned to deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are gravitating back to earth. Chart 24 S&P Consumer Staples (Overweight) The consumer staples CMI has turned lower recently, held back by healthy economic data, particularly among confidence indicators. That should drive a preference for spending over saving after a long period of thrift, although a relative switch from staples into discretionary consumption has not yet taken firm hold. The savings rate has also stayed resilient, despite consumer euphoria (Chart 14 on page 10). The good news is that tamed commodity prices and a soft U.S. dollar should provide bullish offsets for this global-exposed (Chart 14 on page 10) and commodity-input dependent sector. A modestly weaker outlook for staples is more than reflected in our VI, which is still parked in undervalued territory. Technical conditions are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 25 S&P Real Estate (Neutral) Ongoing improvements in commercial & residential real estate prices continues to push our real estate CMI higher. However, the outlook for REITs has darkened; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (Chart 15 on page 10). Further, bankers appear less willing to extend commercial real estate credit; declines in credit availability will directly impact REIT valuations. Our VI is consistent with our Treasury bond indicator, indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 26 S&P Health Care (Neutral) Our CMI has rolled over, driven by a steep decline in pharma pricing power (Chart 16 on page 11). In fact, the breadth of sector pricing power softness has spread, just as the majority of the industries we cover is enjoying a selling price revival. The divergence between the CMI and recent sector relative performance suggests that the latter has been mostly politically motivated, and may lack staying power. Worrisomely, the sector wage bill has spiked; in combination with a weaker top line, the earnings resilience of the sector could be at risk. Relative valuations remain appealing, but technical conditions are shaky, as our TI has bounced from oversold levels but is still in negative territory. Taken altogether, we would lean against the recent advance in relative performance. Chart 27 S&P Industrials (Neutral) The CMI has recovered smartly in the past couple of quarters, lifted mostly by a weaker U.S. dollar. The sector has moved laterally since the U.S. election. The improved export outlook is a positive, but a lack of response in hard economic data to the surge in confidence is a sizable offset. An inventory imbalance has largely unwound over the past six months, as durable goods orders are easily outpacing inventories, coinciding with a return of some pricing power to the sector (Chart 17 on page 11). Still, years of capacity growth in excess of production and the resulting low utilization rates mean that pricing gains may stay muted unless demand picks up substantially. Our valuation gauge is near the neutral zone, but there is a wide discrepancy beneath the surface, with construction & engineering trading cheaply and railroads and machinery commanding premium valuation multiples. Our TI has returned close to overbought levels, potentially setting the stage for another move higher. Chart 28 S&P Utilities (Neutral) Our CMI for the utilities sector remains in a long-term downtrend, albeit one with periodic countertrend moves. Most of the weakness in the CMI relates to external factors, such as robust leading indicators of global economic growth (Chart 18 on page 12). Encouragingly, the sector's wage bill has slowed from punitively high levels, and combined with improving pricing power should allow for some margin recovery (Chart 18 on page 12). Utilities have outperformed other defensive sectors, likely due to the expectation that the new U.S. administration's long-awaited tax reform will have outsized benefits to this domestic-focused industry. As a result, valuations have been creeping up, though not sufficiently enough to warrant an underweight position. Our TI has reversed its steep fall over the past year, but is unlikely to bounce through neutral levels in the absence of a negative economic shock. Ergo, our preferred strategy is to remain at benchmark, but look for tradable rally opportunities. Chart 29 S&P Telecom Services (Underweight) Our CMI for telecom services has moved laterally, as much-reduced wage inflation is fully offset by the sector's plummeting share of the consumer's wallet and extremely deflationary conditions (Chart 19 on page 12). Our sales model paints a much darker picture, pointing to double-digit topline declines for at least the next few quarters, owing to the plunge in pricing power deep into negative territory (Chart 19 on page 12). The sector remains chronically cheap, and has all the hallmarks of a value trap, as relative forward earnings remain in a relentless secular downtrend. It would take a recession to trigger a valuation re-rating. Our Technical Indicator has nosedived but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. Chart 30 S&P Materials (Underweight) Recent Fed rate hikes have driven down the CMI close to all-time lows. The sector has historically performed very poorly in tightening cycles owing to U.S. dollar appreciation and the ensuing strains on the emerging world. Weak signals from China have also helped take the steam out of what looked like a recovery in the CMI last year. Commodity-currencies have rallied, but not by enough to offset a relapse in pricing power and weak sector productivity (Chart 20 on page 13). The heavyweight chemicals group (comprising more than 73% of the index) continues to suffer; earnings growth relies heavily on global reflation, an elusive ingredient in the era of a globally synchronized tightening cycle. Sagging productivity warns that profitability will remain under pressure. Valuations have now spent some time in overvalued territory; without a recovery in earnings growth, a derating is a high probability outcome. Our TI has dipped into the sell zone, indicating a loss of momentum and downside relative performance risks. It would be highly unusual for the sector to stay resilient in the face of a negative TI reading. Chart 31 S&P Technology (Underweight) The technology CMI is in full retreat, driven by ongoing relative pricing power declines and new order weakness. However, the sector had been resilient, until recently, as a mini-mania in a handful of stocks and the previously red-hot semiconductor group have provided resilient support. That reflected persistently low inflation and a belief that interest rates would still low forever. After all, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 13). Nevertheless, a recovering economy from the first quarter's lull and tight labor market suggest that an aggressive de-rating in sky-high valuations in previous juggernauts is a serious threat, especially if recent disinflation proves transitory. Our relative EPS model signals a profit slide this year. In the context of analyst estimates of double-digit earnings growth, sector downside risk is elevated. Our VI is not overdone, but that partly reflects the massive overshoot during the bubble years. Our TI is extremely overbought, suggesting that profit-taking is likely to persist. Chart 32 Size Indicator (Overweight Small Vs. Large Caps) Our size CMI has retraced some of its 2016 climb, but remains firmly above the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher. A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. The prospect of trade barriers clearly favors the domestically focused small cap universe and underlie part of the post-election euphoria. Top line growth will need to persist if small businesses are to offset a higher wage bill, as labor looks more difficult to import and the economy pushes against full employment. Valuations have improved and the share price ratio has fully unwound previously overbought conditions. We expect the recent rally to gain steam.\ Chart 33 Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor chrisb@bcaresearch.com
Highlights The strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. China's PPI inflation will continue to drift lower. Disinflation in PPI is less positive for the economy, but is not outright negative, unless PPI deflates. Odds are low that PPI will deflate anytime soon. Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. Feature China's GDP figures to be released next week will likely show that the economy continued to accelerate in the second quarter, as indicated by recent high-frequency macro indicators (Chart 1). Looking forward, the near-term outlook remains promising, but the strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months, which could lead to softer growth down the road. However, the Chinese economy has regained some self-sustaining momentum, which will allow it to glide at cruising speed without major growth difficulties. For investors, H-shares and onshore corporate bonds should continue to advance, aided by the profit cycle upturn and a largely accommodative policy setting over the next six to nine months. Chart 1Chinese GDP Likely Accelerated In Q2 Chart 2Exports And Monetary Conditions ##br##Drive Chinese Industrial Activity Tailwinds Are Waning... China's seemingly static GDP growth figures disguise much greater volatility in the underlying economy, especially in the industrial sector. The famed Keqiang index, named after China's incumbent premier which incorporates electricity consumption, railway transportation and bank lending, has shown dramatic swings in the past two decades (Chart 2). The index has roared back from rock bottom in late 2015 to currently a one sigma overshoot above its long-term trend, underscoring a sharp recovery in industrial activity. Some have attributed this to a massive dose of fiscal and monetary stimuli - we disagree. In our view, the swings in China's industrial sector performance can be fully explained by the performance of exporters and the country's Monetary Conditions Index (MCI). Our "Reflation Indicator," a combination of export growth and MCI, shows a very tight correlation with the Keqiang Index in the past several cycles. In other words, the rapid recovery in industrial activity since early 2016 was boosted by tailwinds from both accelerating export growth and easing monetary conditions. Currently, the tailwinds are likely passing maximum strength and will wane on both fronts going forward: Global demand appears to be in a synchronized upturn, which bodes well for Chinese exports. The manufacturing PMI new export orders component has been in expansionary territory for eight consecutive months and made a new recovery high in June, pointing to upside surprises in export growth in the near term. Looking further out, our model predicts export growth will likely peak out before the end of the year (Chart 3). After all, it is unrealistic to expect Chinese exports to always grow at double-digit rates - particularly with global trade having downshifted structurally post-global financial crisis. On monetary conditions, the depreciation of the trade-weighted RMB, a major reflationary force for the Chinese economy since late 2015, has stalled in recent weeks. Broad dollar weakness of late has failed to further push down the trade-weighted RMB - either because of the People's Bank of China's intervention, or because bearish bets on the RMB by investors are now off the table (Chart 4). Regardless, a stable RMB exchange rate decreases investors' anxiety on China's macro situation, but also reduces a reflationary source for the overall economy. Overall, recent changes in China's macro environment suggest growth tailwinds are diminishing, but have not yet become headwinds. This on margin is bad news for the economy, but should not lead to a significant growth slowdown. Chart 3Exports: Upside Is Limited Chart 4The RMB Is No Longer Falling ...But Growth Drivers Remain Largely In Place We expect Chinese business activity to remain reasonably buoyant going into the second half of the year. It is not realistic to expect growth figures, measured by year-over-year growth rates, to accelerate in perpetuity, but downside risks to the economy will stay low. Some major growth drivers in the economy remain largely in place. Looking at the consumer sector, the growth recovery and labor market improvement have significantly lifted consumer confidence, which historically is positive for retail sales (Chart 5). Chinese households are under-levered and over-saved, and improving confidence should on margin reduce savings and further boost consumption. Retail sales have already bottomed out and will likely accelerate. The corporate sector's inventory restocking cycle is likely still at an early stage, as the inventory component of the manufacturing Purchasing Managers' Index (PMI) surveys has never moved above 50 since 2012, underscoring increasingly lean stock of finished goods. Industrial firms' inventory levels relative to sales are still standing at close to record low levels (Chart 6). Going forward, inventory re-stocking may supercharge production, should new orders remain elevated. At a minimum, very lean inventory levels limit the downside in industrial production - even if the improvement in new orders stalls. Chart 5Consumer Spending Should Remain Strong Chart 6Inventory Restocking Has Further To Go Furthermore, China's capital spending cycle has likely bottomed out, especially among private enterprises and in the resource sectors. The corporate profit cycle recovery has continued to unfold, and business confidence has improved sharply - both of which are conducive for private sector expansion (Chart 7). There has been dramatic improvement in resource sector profits, which at a minimum will put a floor under the relentless contraction in capex these industries have experienced in recent years. Overall, it is premature to expect a major boom, but the case for a modest upturn in private capital spending continues to strengthen. Finally, the risk of a significant housing growth slowdown due to the government's tightening measures, a major concern among investors earlier this year, has abated. Home sales have cooled off due to local government restrictive policies, but developers' inventories have declined substantially following booming sales in previous years. Therefore, housing starts have continued to improve, which should lift real estate investment going forward (Chart 8). Anecdotal evidence suggests land purchases by developers have been buoyant. Meanwhile, developers' stocks have been outperforming the benchmark, which historically has led housing transactions. All of this means a sharp reduction in real estate investment is highly unlikely, at least from a cyclical point of view. Chart 7Private Sector Capex ##br##Will Likely Accelerate Chart 8Real Estate: Near Term Outlook Improving ##br##The Chain Reactions In Housing In short, we see limited downside risks in the Chinese economy in the near term. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. Will PPI Deflate Again? Chinese producer prices have quickly rolled over in the past several months, falling from a peak of 7.8% in February to 5.5% in June. Rising PPI last year was regarded as a key signpost of China's reflationary trend; in this vein, the latest deterioration in PPI indeed raises a red flag. Our model predicts that PPI inflation will likely drift even lower, reaching 3% before year end (Chart 9). We rely on our models to understand the trend rather than to make number forecasts. It now appears a sure bet that Chinese PPI will continue to surprise to the downside in the coming months. How investors will react to likely increasingly disappointing PPI numbers remains to be seen. Our sense is that disinflation in PPI is less positive, but is not outright negative, unless PPI deflates. For now, we see low odds that PPI will deflate anytime soon. Chart 9PPI Will Continue To Moderate Chart 10Industrial Goods Prices Are Fairly Robust A key reason for the rapid decline in PPI inflation is an increasingly unfavorable "base effect," where the year-over-year growth rate naturally tapers off after a period of rapid acceleration. In terms of levels, overall PPI should remain largely stable, according to our model. The recent softness in Chinese PPI largely reflects weakness in crude oil prices, while prices of most basic industrials prices have been fairly robust, including some products that are widely perceived as suffering chronic overcapacity (Chart 10). This suggests the weakness in PPI is fairly concentrated, and likely reflects the unique supply demand dynamics of the oil market, rather than a demand slowdown in the broader economy. More importantly, China's PPI deflation that lasted between February and June was to a large extent due to policy tightening by the Chinese authorities, which, together with weak global demand amplified strong deflationary pressures in the Chinese economy. This time around, the PBoC is highly unlikely to repeat the policy mistakes of draconian credit and monetary tightening. Even if the central bank intends to tighten policy, it will be a lot more cautious and data-dependent. We will follow up on this issue in the coming weeks. The bottom line is that falling PPI inflation should be closely monitored. For now, we expect continued disinflation rather than outright PPI deflation. Profits And Markets Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. For stocks, net earnings revisions of Chinese companies have been rising, confirming the profit cycle upturn (Chart 11). Even if profit growth rolls over along with other macro numbers, a profit contraction is unlikely. Meanwhile, Chinese stocks are among the cheapest of the major bourses (Chart 12), particularly H shares. Overall, Chinese stocks should continue to do well from a cyclical perspective, and will outperform global and EM peers. For bonds, we went long onshore corporate bonds after the sharp selloff earlier this year - namely because the selloff was entirely triggered by the authorities' liquidity tightening rather than corporate fundamentals. The upturn in the profit cycle should also improve the corporate sector's balance sheet, which should be good news for corporate bonds. This trade has been profitable so far, but we expect further narrowing in corporate bond spreads, as they are still elevated both compared with their global counterparts and their historical norms (Chart 13). Investors should hold. Chart 11Earnings Outlook ##br##Will Continue To Improve Chart 12Chinese Stocks Multiples ##br##Are Among The Lowest Globally Chart 13Chinese Corporate Bond Spreads Set ##br##To Narrow Further Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (middle panel). Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. If banks continue to close the credit taps, CRE prices will suffer a setback (bottom panel). Net, we are trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list.