Market Returns
Highlights Global Growth: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Credit Curve: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Feature Chart 1Growth Divergence Redux Two factors influenced our recent decision to reduce the recommended exposure to credit risk in our U.S. bond portfolio.1 First, our indicators show that we are in the late stages of the credit cycle, meaning that small positive excess returns are the best case scenario for corporate bonds. Second, a large divergence in growth has emerged between the United States and the rest of the world, much like in 2014/15 (Chart 1). As was the case in 2014/15, such a divergence will put upward pressure on the U.S. dollar and eventually lead to a period of turmoil in U.S. risk assets - i.e. wider credit spreads and lower equity prices. Whether this turmoil translates into a playable rally in U.S. Treasuries will depend on how the Fed responds. First Spreads, Then (Maybe) Yields Chart 2The 2015 Template Using the 2015 episode as a template, we see that credit spreads widened sharply beginning in mid-2015. But despite the risk-off sentiment in credit markets, Treasury yields stayed roughly flat (Chart 2). This should not be too surprising. Since the weakness in global growth was concentrated outside the United States and a significant proportion of corporate profits are driven by foreign demand, a non-U.S. growth shock will have a more immediate impact on the U.S. corporate sector than it will on overall U.S. aggregate demand. Most of the latter is driven by the U.S. consumer who actually stands to benefit from a stronger dollar. Treasury yields and the Federal Reserve take their cues from overall GDP growth, not corporate profits. In fact, we contend that the 2015 widening in credit spreads was exacerbated by the fact that the Fed maintained its focus on overall U.S. growth and continued to signal a relatively steady pace of rate hikes. Spreads widened even further as the notion that the Fed would not bail out corporate bond investors took hold. Eventually, credit spreads widened enough by early 2016 that the Fed was forced to conclude that tighter financial conditions weighed significantly on the growth outlook. It then signaled a slower pace for rate hikes (Chart 2, panel 2), and only then did Treasury yields fall (Chart 2, bottom panel). The Fed's retreat also marked the peak in corporate bond spreads. We envision a similar pattern playing out this time around. Weaker foreign growth will first impact corporate credit, and eventually financial conditions may tighten so much that the Fed is forced to back away from its "gradual" 25 bps per quarter rate hike pace. However, with inflation much closer to target than in 2015, the Fed will be more reluctant to respond. A Less Responsive Fed Our Fed Monitor shows why this is the case (Chart 3). The Monitor is composed of indicators related to economic growth, inflation and financial conditions. It is designed so that a reading above zero signals that the Fed should be hiking rates and a reading below zero signals that it should be cutting. If we consider the three components of the Fed Monitor individually, it is clear that we have recently seen a fairly substantial tightening of financial conditions (Chart 3, bottom panel), but this has barely made a dent in the overall Monitor. The reason is that the components related to economic growth and inflation are on solid footing, and they are offsetting the message from the financial conditions component. In other words, with the output gap much narrower and inflation much closer to target than in 2015, the Fed will need to see more market pain before putting rate hikes on hold. Even if financial conditions tighten so much that a pause in rate hikes is justified, it is highly unlikely that such a delay will last for more than a quarter or two. The end result could be that Treasury yields see only limited downside, even as credit spreads widen. Chart 3Fed Can Tolerate More Market Pain China To The Rescue? Another possibility is that we never even reach the point of significant market turmoil and much tighter financial conditions. Non-U.S. growth might recover in the months ahead, ushering in a renewed synchronized global recovery that prevents corporate bond spreads from widening. The most likely driver of such a revival would be significant policy easing from China that puts a floor under global growth before U.S. financial markets feel much pain. Chart 4 shows that China did ease monetary conditions dramatically in 2015 as U.S. credit spreads widened. That easing was achieved through a combination of lower real interest rates, stronger credit growth and a weaker exchange rate. The evidence also suggests that Chinese authorities have started to devalue the renminbi in recent weeks, but so far the weakness is limited and overall monetary conditions have not eased at all. If China is attempting to spur a rebound in global growth, a lot more easing will be required in the coming months and it is not at all obvious that policymakers are willing to go down that path.2 If China does engage in a significant currency devaluation, it will obviously increase the foreign demand for U.S. Treasuries. However, in general, we think that foreign demand will exert less downward pressure on U.S. Treasury yields than it did during the 2014/15 period. This has less to do with Chinese official demand than with the simple fact that U.S. government bonds are now a much less attractive investment vehicle for conventional non-U.S. fixed income investors. After we account for the cost of currency hedging on a 3-month horizon, a typical European investor who wants to gain exposure to the U.S. bond market without taking currency risk is faced with a lower realized yield from a 10-year U.S. Treasury note than from a 10-year German bund (Chart 5). This was not the case at all in 2014/15 when hedged U.S. yields offered a huge advantage over bunds. Japanese investors are faced with a similar quandary. The 10-year U.S. Treasury yield hedged into yen still looks attractive relative to a 10-year JGB, but the yield advantage is nowhere near the levels seen in 2014/15 (Chart 5, panel 3). Chart 4Policy Easing In China? Chart 5Less Foreign Demand For USTs U.S. bonds are much less enticing for foreign investors on a currency hedged basis because the Fed has raised rates seven times since 2015, while European and Japanese interest rates are still at the floor. This large rate divergence means that investors must pay a lot more to swap foreign currency for dollars. Essentially, foreign investors are faced with an unpalatable choice. They can gain access to elevated un-hedged U.S. Treasury yields only if they are willing to take on the substantial currency risk. If not, then they are better off keeping their money at home. The end result should be less foreign demand for U.S. bonds. Bottom Line: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: The Good News Is Priced In Our measure of the excess spread available in the High-Yield index after accounting for default losses has recently widened to 260 bps, slightly above its long-run historical average (Chart 6). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 260 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. While the default-adjusted spread suggests that junk bonds are fairly valued relative to history, it's important to also consider the balance of risks surrounding our default loss assumptions. To calculate the default-adjusted spread we start with the Moody's baseline default rate projection for the next 12 months. It is currently 1.99% (Chart 6, panel 2). Then, we project the recovery rate based on its historical relationship with the default rate. This gives us a forecasted recovery rate of 48% (Chart 6, panel 3). Combined, the forecasted default rate and recovery rate give us expected high-yield default losses of 1.03% for the next 12 months (Chart 6, bottom panel). The only historical period to show significantly lower default losses was 2007, a time when non-financial corporate balance sheets were in much better shape than they are today. This is not to suggest that our default forecasts are unrealistically low. The economic and corporate landscape is consistent with a relatively low default rate. But that outlook can change quickly, and the historical record shows that the risk that we are underestimating future default losses is far greater than the risk that we are overestimating them. Gross non-financial corporate leverage is highly correlated with the default rate over time (Chart 7, top panel). It has flattened off during the past few quarters, but is likely to rise modestly in the second half of the year. As we have discussed in prior reports, corporate revenue growth is elevated but close to peaking, and labor costs are just now starting to ramp up. Even a small moderation in profit growth will be enough for leverage to start moving higher.3 Chart 6High-Yield Expected Returns Chart 7Macro Drivers Of The Default Rate Interest coverage is also still consistent with a low default rate (Chart 7, panel 2). But the combination of peaking profit growth and rising interest rates clearly biases it lower going forward. Other indicators that correlate strongly with corporate defaults, such as layoff announcements and C&I lending standards, also remain supportive for the time being (Chart 7, bottom 2 panels). Bottom Line: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Considering The Credit Curve Two weeks ago we examined the risk/reward proposition of moving down in quality within an allocation to investment grade corporate bonds.4 We concluded that a move down the rating scale has a greater positive impact on risk-adjusted portfolio performance when excess return volatility and index duration-times-spread (DTS) are low. With index DTS currently elevated, now is not the best time to move down-in-quality. This week we perform a similar analysis using the maturity buckets of the investment grade corporate bond index. Charts 8-11 show four excess return Bond Maps. The horizontal axes of these maps show the number of months of average spread widening required for each maturity bucket to underperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting further to the left require more months of spread widening, and are thus less risky. Chart 8Investment Grade Corporate Excess Return ##br##Bond Map: +/- 50 BPs Threshold Chart 9Investment Grade Corporate Excess Return ##br##Bond Map: +/- 100 BPs Threshold Chart 10Investment Grade Corporate Excess Return##br## Bond Map: +/- 200 BPs Threshold Chart 11Investment Grade Corporate Excess Return ##br##Bond Map: +/- 300 BPs Threshold The vertical axes of the maps show the number of months of average spread tightening required for each maturity bucket to outperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting closer to the top require fewer months of spread tightening, and thus provide greater potential reward. Much like what we found with the different credit tiers, the maturity buckets tend to cluster together when we set a low return threshold. The risk/reward trade-off becomes more linear as the return threshold increases. We can therefore conclude that shorter maturities offer similar return potential to longer maturities when return volatility is low, along with less risk. The risk-adjusted advantage in low maturity buckets disappears as we transition into higher volatility environments. At the moment, average index DTS is elevated compared to other non-recession periods. There is no obvious advantage to maintaining a bias toward the short maturity buckets. Fundamental Drivers In addition to the risk/reward trade-offs shown in our Bond Maps, we also identify two fundamental drivers of relative performance across the corporate maturity spectrum. First, we notice that while long maturities offer a substantial spread advantage over short maturities, the advantage is entirely driven by differences in duration (Chart 12). Logically, if the duration difference between the short and long ends of the curve were to decline, then the option-adjusted spread term structure would flatten. In fact, this is exactly what should transpire as Treasury yields rise (Chart 12, bottom panel). The second factor that can influence the credit spread curve is the outlook for default losses. Short-maturity spreads widen more than long-maturity spreads when default losses increase. This is because only the highest quality firms are able to issue long maturity debt. Chart 13 shows that, after controlling for differences in duration, the credit spread curve is inversely correlated with default losses. Higher default losses coincide with a flatter spread curve, and vice-versa. A model of the credit spread curve (duration-adjusted) versus expected default losses shows that the curve is currently fairly valued relative to our optimistic default loss assumptions (Chart 13, bottom panel). In other words, if default losses were to surprise to the upside, then the credit spread curve would appear too steep. Chart 12IG Term Structure Is Steep Chart 13Rising Defaults Flatten The Spread Curve All in all, our outlook for higher Treasury yields and the negative balance of risks surrounding our default loss forecast both suggest that investors should favor the long-end of the maturity spectrum within an allocation to investment grade corporate bonds. Bottom Line: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Please note that we are also publishing a Special Report on Mexico. Highlights The selloff in EM financial markets has been induced by slowing global trade amid lingering poor EM fundamentals. The Federal Reserve's resolve to tighten is aggravating the situation but is not the main cause of the EM turmoil. Consequently, the necessary conditions for a reversal in ongoing EM turbulence are not the Fed turning dovish but rather a bottom in the global trade cycle and China's growth. The latter two are not on the horizon, and we therefore believe there is much more downside in EM risk assets and currencies. Feature In our trip to Asia last week, the majority of investors we met attributed the current emerging market (EM) selloff to Federal Reserve tightening and trade wars. While we are not suggesting that the Fed tightening or trade war rhetoric have not impacted EM risk assets, we do contend that these reasons are inadequate to explain the selloff. In our opinion, the EM selloff has as much been driven by a slowdown in global trade as by expectations of higher U.S. interest rates and other factors. Diagnosing the underlying bases of a market move correctly is instrumental in gauging its sustainability and an eventual reversal. If one believes that the EM selloff has been due to the Fed, it would require the Fed turning dovish for the selloff to halt and reverse. If, however, the EM carnage has been driven by slowing global trade, the necessary condition for a reversal would be a bottom in the global trade cycle. In such a case, a dovish turn by the Fed or a drop in U.S. bond yields in and of themselves are unlikely to be sufficient. While EM risk assets could rebound for a couple of weeks on lower interest rate expectations in the U.S., any rebound will prove to be short-lived, and EM will resume their downtrend. Assessing the dynamics of both financial markets and the business cycle has led us to conclude that the EM selloff has been not only due to Fed tightening and the U.S.-China trade confrontation, but even more so due to a slowdown in global trade. The latter has transpired even though U.S. economic growth remains very robust. Chart I-1 illustrates that EM currencies and sovereign spreads correlate well with global trade growth. Since the beginning of this year, global trade and EM manufacturing have been decelerating, despite ongoing strength in U.S. demand. This, in our opinion, has been the main reason for the selloff in EM risk assets. In fact, EM manufacturing PMI and EM non-financials' corporate profit growth have rolled over since early this year, explaining widening in EM credit spreads (Chart I-2). Chart I-1EM Cracks Have Opened As Global Trade##br## Has Begun Slowing Down Chart I-2Slowdown In EM Corporate Profits ##br##Explains Widening Of EM Credit Spreads In turn, Chart I-3 demonstrates that the correlation between EM corporate spreads and share prices on one hand and U.S. bond yields on the other is rather loose. Notably, U.S. bond yields are at the same level they were in early April when the EM-centred selloff began. Meanwhile, EM equity and credit markets have diverged from their U.S. peers since early April (Chart I-4). Chart I-3EM Risk Assets And U.S. Bond Yields: ##br##Loose Correlation Chart I-4The Recent Divergence##br## Between EM And U.S. In this context, an important question is as follows: Why are EM economies and financial markets more vulnerable to rising U.S. borrowing costs than the U.S. itself? In reality, the American economy, stock market and corporate credit should be more exposed to Fed tightening than EM economies and financial markets. Yet the U.S. economy, stocks and corporate credit market have so far weathered rising borrowing costs quite well. Most interest rate-sensitive segments such as mortgages for home purchases and the junk corporate credit market have remained resilient. Historically, the correlation between EM risk assets and the Fed funds rate has been mixed - albeit more positive than negative (Chart I-5). On this chart, we shaded the periods when EM stocks rallied despite rising Fed funds rate. Chart I-5EM Stocks And Fed Tightening Cycles The episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals - elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Chart I-6The 1997/98 EM Crises Pushed U.S. Bond Yields Lower Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-'98. These late 1990 EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields (Chart I-6). In contrast, EM stocks, credit markets and currencies did well during a period of rising Fed funds rate in 1988-89, 1999-2000, and 2017 as illustrated in Chart I-5. Altogether, we conclude that rising U.S. interest rates in and of themselves are not a sufficient condition for EM to sell off. Only in combination with poor EM fundamentals and a weakening global business cycle are rising U.S. borrowing costs negative for EM financial markets. EM fundamentals have been and remain indigent since early this decade. The 2016-'17 rally in EM was due to improving global growth. Yet the global business cycle has rolled over since early this year. This, in combination with lingering weak fundamentals throughout EM and the Fed's tightening, has produced the current EM selloff. All in all, the ongoing selloff in EM risk assets has been mainly due to the slowdown in global trade/business cycle. When global trade expands, weak parts of the chain do well. Conversely, when global trade growth dwindles, these same weak links are the first to break. As we have argued repeatedly, EM fundamentals have remained destitute in spite of 2016-17 rally. Indeed as soon as global trade began decelerating, the weakest parts of the global chain cracked. Specifically, China's import volumes for many raw materials and commodities have decelerated significantly (Chart I-7A and Chart I-7B). Imports of consumer goods, machinery, and transport equipment remain strong (Chart 7A, bottom panel). We believe it is a matter of time before the ongoing slowdown in credit and capital spending brings about weaker imports of industrial goods and machinery. Chart I-7AChina: Imports Volumes Have Been Slowing Down Chart I-7BChina: Imports Volumes Have Been Slowing Down Even though consumer spending in China remains robust, it has had a limited impact on the global economy in general and the rest of EM in particular. Most consumer goods and services that Chinese households buy are produced and sold domestically by mainland companies. In short, China's impact on EM and the rest of the world are primarily via its imports of commodities/raw materials and industrial goods, which are very vulnerable. On-shore listed Chinese stocks are also signaling that a pronounced growth deceleration is underway. Even though the MSCI China investable equity indexes remain elevated, their onshore peers have plunged. Chart I-8A and 8B demonstrate that China's onshore listed stock prices - large cap, small cap and many sectors - have plunged to or below their early 2016 lows. Chart I-8AChinese Share Prices: Onshore And Offshore Markets Chart I-8BChinese Share Prices: Onshore And Offshore Markets Chart I-9New Cyclical Lows For EM Relative Performance This downbeat message from Chinese onshore equity prices along with the recent sharp depreciation of the RMB corroborate that the mainland growth slowdown is gaining speed, which in turn argues for a bearish outlook for EM financial markets. Bottom Line: Our diagnosis is that the selloff in EM financial markets has been induced by slowing global trade and China's growth deceleration amid lingering poor EM fundamentals. The Fed's resolve in tightening is aggravating the situation, but it is not the main cause behind the EM turmoil. Consequently, the necessary conditions for a reversal of the ongoing EM turbulence are not the Fed turning dovish but a bottom in the global trade cycle and Chinese growth. The latter two are not on the horizon, and we therefore posit there is much more downside in EM risk assets and currencies. EM relative equity performance versus DM has broken to new cycle lows for the small-cap and equal-weighted indexes (Chart I-9, top and middle panels). The market cap-weighted overall index will likely be heading to new lows for this cycle too (Chart I-9, bottom panel). Investors should stay short/underweight EM risk assets. Our recommended country allocation is presented below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Oil markets are on tenterhooks, as unplanned outages; continued losses in Venezuela's output; pipeline bottlenecks in the U.S. shales; and a higher likelihood of sharper losses of Iranian exports are priced into global benchmarks. In our updated base-case balances model, we expect core OPEC 2.0 to front-load their just-agreed production increase, with ~ 800k b/d added to the market in 2H18, and just over 210k b/d in 1H19.1 This will lift the core's total output ~ 1.1mm b/d by the end of 1H19 vs. 1H18. This is offset by losses in the rest of OPEC 2.0 of ~ 530k b/d in 2H18, and just under 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels (Chart of the Week). We keep demand growth at 1.7mm b/d in 2018 and 2019. Our base case is augmented with three scenarios: i) Venezuela production collapses; ii) a reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks; and iii) both of these occurring simultaneously in the Oct/18 - Sep/19 interval. Our revised Brent ensemble forecast for 2H18 now stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded OPEC 2.0 production increase. We expect the global benchmark to average $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months (Chart 2). Chart of the WeekOPEC 2.0's Core's Production Increase##BR##Offset By Non-Core Losses Chart 2Updated Ensemble Forecast Reflects Venezuela Deterioration, Shale Bottlenecks Highlights Energy: Overweight. We remain long call spreads along the Brent forward curve, given our belief upside risks will dominate oil markets. These positions are up 34.1% on average over the past four months they've been open. We expect backwardation to increase as OECD storage falls, supporting our long S&P GSCI trade, which is up 13.8%. Base Metals: Neutral. In a tit-for-tat response to U.S. tariffs on steel and aluminum, the EU imposed import duties on U.S. products this past Friday. Canada plans to impose tariffs beginning July 1, while Mexico has already implemented duties on U.S. exports. Risks that ongoing trade disputes could escalate into a trade war are weighing on the metals complex. Copper retraced its early June jump, despite ongoing contract renegotiations at Chile's Escondida mine. Precious Metals: Neutral. Gold traded down to the low $1,250/oz level as a stronger broad trade-weighted USD and rising real rates pressure the market. Ags/Softs: Underweight. In effort to diversify its source of imports amid the ongoing trade row with the U.S., China announced the removal of import tariffs on animal feed from five Asian countries earlier this week.2 Ag prices have fallen since the beginning of June amid fears escalating trade fights will bear down on U.S. farmers. Nevertheless, May trade data show China's ag imports have remained robust. Feature In recent weeks, markets have been buffeted by reports of a 350k b/d unplanned outage in Canada; 400k b/d of losses in Libya; continued force majeures in Nigeria's Bonny system; and indications Venezuela's production decline is accelerating: The country's U.S. refiner Citgo was left to fend for itself on the open market, in the wake of the failure of state-run supplier PDVSA to deliver crude. On top of that, markets appear to be pricing in as much as 1mm b/d of lost Iranian exports, on the back of increased pressure from the Trump Administration in the U.S., which is leaning on American allies to take Iranian imports to zero. In our modeling, we continue to expect 500k b/d will be lost to export markets, as a result of the re-imposition of sanctions by the U.S., but are watching the situation closely. The Kingdom of Saudi Arabia (KSA) is attempting to get out ahead of an almost-certain tightening of the global market. In what appears to be hastily arranged leaks, the Kingdom signaled it already has undertaken a two-month production ramp - lifting its output to record levels this month and next: 10.8mm b/d in June, 11mm b/d in July. This is up from ~ 10mm b/d earlier this year, per over-compliance by KSA on its OPEC 2.0 quota of 10.54mm b/d. Russia, the other putative leader of OPEC 2.0, is signaling it will be able to contribute ~ 200k b/d over 2H18, vs production of ~ 11.2mm b/d at present.3 OPEC 2.0 Front-Loads Output Hike Lacking detail from OPEC 2.0, we are front-loading the coalition's just-agreed production increase in our updated base-case balances model, with ~ 800k b/d added to the market in 2H18, and just over 210k b/d in 1H19. This lifts core OPEC 2.0's output ~ 1.1mm b/d compared to 1H18 levels. Core OPEC 2.0's increased production will be offset by continued losses in the rest of the coalition amounting to ~ 530k b/d in 2H18, and ~ 640k b/d in 1H19. This leaves OPEC 2.0's net output up ~ 275k b/d in 2H18, and down ~ 430k b/d in 1H19 vs. 1H18 levels. Globally, we expect global supply to rise ~ 2mm b/d this year and next, averaging 99.9mm b/d and 101.7mm b/d, respectively. Our base case is augmented with three scenarios: i) Venezuela production collapses to 250k b/d from current levels of ~ 1.3mm b/d, which allows it to support domestic refined product demand and nothing more; ii) a reduction in our forecasted U.S. shale production increase arising from pipeline bottlenecks; and iii) both of these occurring simultaneously in the Oct/18 - Sep/19 interval. In our simulations, a Venezuela collapse would be met by OPEC 2.0's core producers lifting production another 200k b/d, which takes its total output hike to 1.2mm b/d in 2019. OPEC 2.0 does not respond to the temporary lower-than-expected U.S. shale growth contingency we're modeling, which is brought on by pipeline bottlenecks in the Permian Basin. On the demand side, we are keeping annual growth at ~ 1.7mm b/d in 2018 and 2019. For all the agita in the market at present - largely a function of increasingly acrimonious trade frictions between the U.S. and its allies and China - fundamentals remain well supported. Indeed, one of our key gauges, EM trade import volumes, remains well supported (Chart 3). EM import volumes are closely aligned with income levels - as income grows, import volumes grow. Likewise, as EM incomes grow, demand for commodities - particularly oil and copper - grows. Chart 3Growing EM Incomes Support Import Volumes,##BR##And Oil Demand Chart 4Balances Remain##BR##In Deficit As always, EM demand growth paces global growth, rising at a rate of ~ 1.3mm b/d over the 2018 - 19 interval. In 2018, we expect consumption to average just over 100mm b/d globally, while next year we're expecting demand to come in at 102mm b/d. Even with OPEC 2.0's production hike, the contingencies we're modeling - in Venezuela and the U.S. shales - along with weak net growth in overall production volumes for the better part of the next 18 months, leaves global balances in deficit (Chart 4 and Table 1). This continues to force OECD inventories lower over the next 18 months (Chart 5). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Chart 5Physical Deficits Draw Inventories Lower Our revised Brent ensemble forecast for 2H18 now stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded OPEC 2.0 production increase. We expect the global benchmark to return to $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months (Chart 2). OPEC 2.0 Likely Taps Spare Capacity At this point it appears OPEC 2.0 could be forced to revisit its just-concluded deal to lift production, particularly if, as appears increasingly likely, Venezuela's production collapses, and the market loses its 1mm b/d or so of exports. The country reportedly is falling behind in meeting commitments to its customers, which deprives it of the cash to pay for additives needed to run its heavy oil as a charging stock in refineries. Venezuela's state-owned Citgo refinery operating in the U.S. reportedly is being forced to source crude away from Venezuela, as the barrels it relied on in the past no longer are shipping on schedule. Chart 6Unplanned Outages Are Back Unplanned outages are once again picking up, following a relatively tranquil period (Chart 6). We expect continued volatility in crude oil markets over the next 18 months, particularly if unplanned outages continue to rise, and OPEC 2.0 is forced to cover another event(s) similar to the most recent loss of production in Libya, where civil unrest took ~ 400k b/d off the market, and Canada (~ 350k b/d), where a power failure at Syncrude Canada's oil sands facility in Alberta shut down production. Chart 7Global Spare Capacity Stretched Thin On this score, the market is extremely vulnerable - the U.S. EIA estimates OPEC's spare capacity presently is ~ 1.8mm b/d, most of which is found in KSA. By next year, the EIA expects spare capacity to be slightly over 1mm b/d (Chart 7). Estimated 2018 spare capacity translates into 1.8% of global consumption this year, and a little over 1.0% next year, given our demand estimates of 100mm and 102mm b/d this year and next. By way of comparison, in 2007, spare capacity stood at 2.4% of global demand - 2.1mm b/d vs. 86.4mm b/d. This was the period when WTI prices were headed to $150/bbl, and OPEC was meeting demand out of spare capacity. EM Consumers Exposed China and India pressed OPEC 2.0 leadership to raise production, because, along with other large EM economies, they implemented fuel-subsidy reforms, which expose their consumers to higher fuels costs. This is a key difference in the current cycle vs history: Many more consumers are directly exposed to higher prices. Recent academic research suggests higher prices resulting from strong demand are not destabilizing to economic growth if they reflect rising consumer incomes. However, rising prices due to supply shocks are destabilizing to economic growth, and typically are followed by recession. Higher oil prices resulting from a supply shock - e.g., if Venezuela were to go off line for a long enough period of time - would force OPEC 2.0 and the U.S. shales to replace more than 3mm b/d of lost production. At this point, it is not clear they can do this in short order. Indeed, given the inelasticity of oil demand, it is likely demand destruction - via higher prices - would be required to balance supply and demand globally. Higher prices required to equilibrate markets almost surely would reduce EM oil demand - the dominant source of growth in our models - and derail the global economic recovery, if households' budgets are hit too hard by higher oil prices. Bottom Line: In our revised ensemble forecast for 2H18, we expect Brent crude prices to average $70/bbl, reflecting the front-loaded OPEC 2.0 production increase. We expect the global benchmark to average $77/bbl next year. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months. Higher volatility is expected. We remain long call spreads along the forward curve, and expect backwardation to steepen, which will support our long S&P GSCI recommendation. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. This past week it agreed to raise production 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman, and Qatar. 2 Please see "China drops tariffs on animal feed from Asian countries as U.S. dispute escalates," dated June 26, 2018, available at reuters.com. 3 Please see "Oil rises on supply losses, U.S. push to isolate Iran," published by reuters.com June 27, 2018, for reporting on KSA's intention to go to 11mm b/d. The number reported by Reuters for KSA's June production is slightly less than 800k b/d over the 10.03mm b/d production level for May KSA self-reported in this month's OPEC Monthly Oil Market Report. See also "OPEC, Russia Agree to Raise Production," published June 24, 2018, by egyptoil-gas.com. 11mm b/d would be record production for KSA. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
NOTE: We will not be publishing a report next week. The next Global Fixed Income Strategy Weekly Report will be published on Tuesday, July 10th. Highlights Global Corporates: The clash between monetary policy and the markets that we have been expecting to unfold in 2018 is upon us. Downgrade global spread product exposure to neutral (3 of 5) from overweight, and raise government bond exposure to neutral. Maintain a below-benchmark portfolio duration, however, as global bond yields have not yet peaked for this cycle. Country Allocation: Move to neutral on U.S. investment grade and high-yield corporates, while staying underweight (2 of 5) on euro area corporates. Downgrade emerging market hard currency sovereign and corporate debt to maximum underweight (1 of 5) - the combination of a rising dollar, Fed tightening and slower Chinese growth will remain a huge problem for emerging market assets. Feature Chart Of The Week3 Big Reasons To Downgrade Spread Product Last week, BCA as a firm moved to a less positive stance on global equities and credit, downgrading both to neutral from overweight on a cyclical (6-12 month) horizon.1 Dating back to our 2018 Outlook published at the end of last December, we had anticipated that we would be shifting to a less aggressive asset allocation sometime around mid-year.2 The expected trigger would be a move by central banks to a more restrictive policy stance that would start to impact future growth expectations. That time has come, and we are now recommending moving to a less bullish stance on global credit. Many of the tailwinds that supported the stellar performance of risk assets in 2017 - most importantly, coordinated global growth, accommodative monetary policies and a weakening U.S. dollar - have transformed into headwinds over the course of 2018 and are unlikely to reverse before risk assets suffer a setback (Chart of the week). At a minimum, there is now enough uncertainty, at a time when many asset classes are richly priced, to make the risk/reward balance for being long growth-sensitive assets like equities and corporate debt less attractive. This week, we are downgrading our recommended stance on global spread product to neutral (3 out of 5) from overweight, while upgrading our recommended allocation for government bonds to neutral from underweight. This represents an unwind of a long-standing recommendation that dates back to January 31st, 2017 when we strategically downgraded U.S. Treasury exposure and upgraded U.S. corporate debt.3 We are closing that recommendation at a relative total return gain of 2.3% for U.S. investment grade and 6.7% for U.S. high-yield over Treasuries (Chart 2). Chart 2Closing A Successful Overweight Stance ##br##On U.S. Corporates We still believe that global bond yields will remain under upward pressure from both higher inflation and a less favorable supply/demand balance for fixed income (more issuance, less central bank buying). The fact that bond yields will NOT be able to fall much to reinvigorate softening global growth - because of rising inflation at a time of diminished economic slack - is a critical reason why we are turning more cautious on global credit. Thus, we are maintaining our recommended below-benchmark overall portfolio duration stance, even as we upgrade our government bond allocation to neutral. We recommend placing the proceeds of a reduction of global corporate debt exposure into shorter-maturity government bonds, which we are doing in our model bond portfolio (see page 15). At the country level, we are downgrading U.S. corporate bonds, both investment grade and high-yield, to neutral from overweight. We still are of the view that U.S. corporates are better positioned to outperform non-U.S. credit, however, even in a more challenging environment for credit returns. Thus we are keeping our recommended underweight allocations to euro area corporate debt (2 out of 5 for both investment grade and high-yield). We see a much nastier backdrop brewing for emerging markets (EM), however - a stronger dollar, higher U.S. interest rates, slowing Chinese growth, diminished global capital flows - so we are downgrading both EM hard currency sovereign and corporate debt to maximum underweight (1 out of 5). In terms of other spread product categories, we are maintaining our neutral allocation to U.S. mortgage-backed securities, while downgrading U.K. and Canadian corporate debt to underweight. For those that can invest in U.S. muni debt, we are upgrading that sector to overweight (4 out of 5). The Reasons To Cut Corporate Credit Exposure Now Global credit has not performed well in the first half of 2018, with only U.S. high-yield corporates providing a positive return year-to-date among the major markets: U.S. investment grade: -3.6% total return, -1.7% excess return over duration-matched Treasuries U.S. high-yield: +0.7% total return, +1.5% excess return Euro area investment grade: -0.3% total return, -1.1% excess return Euro area high-yield: -0.5% total return, -1.0% excess return EM USD-denominated sovereign debt: -5.5% total return, -3.6% excess return EM USD-denominated corporate debt: -2.9% total return, -1.7% excess return Chart 3The Start Of Something Big? While there have been plenty of geopolitical tensions for markets to fret over this year (U.S. trade policy, North Korea), the biggest reason for the underperformance of credit is due to the most typical of reasons - tightening global monetary policy. One way to measure the stance of monetary policy is to look at the slope of government bond yield curves. According to the Bloomberg Barclays government bond index data, the "global yield curve" - the spread between the Global Treasury index yield for the 7-10 year and 1-3 year maturity buckets - is now a mere 6bps (Chart 3). That is the flattest the global curve has been since the first quarter of 2007. That is a potentially ominous sign given that the Global Financial Crisis began brewing around the same time. The global yield curve became deeply inverted in the late 1990s, as well, which preceeded the 1998 EM crisis and, later, the global telecom bust. Fundamentally, we see four main reasons to downgrade global credit now: 1. Global growth is slowing and becoming less synchronized The first half of 2018 has seen a deceleration of global economic activity from the robust pace of 2017. This has been a broad-based cooling of activity so far, with cyclical indicators like manufacturing PMIs still well above the 50 level that suggests expanding growth in all major economies. Yet there are signs that the pullback in growth may persist throughout 2018 and into 2019. The OECD's global leading economic indicator (LEI) is rolling over and our LEI diffusion index - a leading indicator of the LEI - suggests additional weakness should be expected. This is significant for credit markets, as returns on corporate bonds are highly correlated to the swings in the global LEI (Chart 4). This is true even in the U.S., which is bucking the slowing global growth trend and where confidence is booming and domestic leading indicators are accelerating (Chart 5). Chart 4Corporate Bonds Follow The Global LEI Chart 5Upside Risks For U.S. Growth That easing of non-U.S. growth is likely rooted in the slowdown underway in China. Policymakers there have been tightening monetary conditions and acting to reign in excessive debt growth. This has resulted in a slowing of overall economic growth after the stimulus-fueled boom in 2016 that helped kick-start global growth last year through robust Chinese imports and consumption of industrial commodities. Given the sheer size of Chinese demand, the global economy will look very different when Chinese imports are growing at a 30% pace rather than the current pace below 10%. Our most reliable forward-looking indicators for Chinese growth, like our Li Keqiang leading indicator, are calling for additional cooling of Chinese economic activity in the latter half of 2018 (Chart 6). This reinforces the signal given by our global LEI diffusion index, with both indicating that additional struggles in the performance of global credit markets should be expected (based off the relationship shown in Chart 4). One additional point: the ongoing trade tensions between the Trump administration and all of the major U.S. trading partners represents an additional potential downside risk to global growth. The story is still quite fluid, as it always is with this president, but the uncertainty created by the trade frictions is definitely a negative for risk assets, at a minimum. 2. Global inflation pressures are rising, most notably in the U.S. Even with the latest dip in non-U.S. growth, the global economy is still operating with the least amount of spare capacity since the mid-2000s boom. The U.S. unemployment rate is down to 3.8%, the lowest level in eighteen years. 75% of OECD countries now have unemployment rates below the OECD's estimate of the full-employment NAIRU, with capacity utilization rates also rising. The pricing backdrop is as healthy as it has been since 2011, according to the measure of world export prices from the Netherlands-based Bureau for Economic Policy Analysis which is now growing at a 10% annual rate (Chart 7). Chart 6Downside Risks For Chinese Growth Chart 7A More Inflationary Global Backdrop, Especially In The U.S. The previous two times export prices grew that rapidly in 2008 and 2011 - two very challenging years for financial markets - global CPI inflation rates expanded rapidly, especially in the U.S. Headline CPI inflation ended up reaching peaks of 6% and 4%, respectively, during those prior two episodes. Non-U.S. inflation rates also accelerated, but not to the same degree as in the U.S. A similar dynamic is playing out in 2018, with U.S. inflation rates accelerating (both headline and core), at a faster pace than in the other major developed economies. With the U.S. labor market growing tighter each month, and with U.S. growth likely to continue expanding at an above-potential pace for the next few quarters, it is unlikely that the current upturn in U.S. inflation will slow on its own. This will ensure that the Fed will continue on its planned monetary tightening path that will soon take U.S. monetary conditions into restrictive territory - eventually weighing on U.S. growth expectations and raising concerns over future downgrade and default risks, and returns, in U.S. corporate bond markets. 3. Growth and monetary policy divergences will continue to boost the value of the U.S. dollar The divergences between growth, inflation and monetary policy in the U.S. and the rest of the world are now helping raise the value of the U.S. dollar, which had declined nearly 10% on peak-to-trough basis in 2017. The dollar has been rising in 2018, which has been weighing on EM currencies and financial markets as is typically the case during periods of dollar strength. EM economies have been rapidly accumulating dollar-denominated debt in recent years, leaving EM borrowers as highly exposed to the swings in the dollar and interest rates as they have been since the late 1990s. The current backdrop is setting itself up for a repeat of the 2015/16 period when pro-U.S. growth divergences caused the dollar to soar and triggered major selloffs in EM financial assets that spilled over into U.S. and developed market equities and credit (Chart 8). Right now, the moves have been far more modest than seen in the 2015/16 period. Since the start of 2018, the U.S. trade-weighted dollar is up 4% and EM equities are down -6% (in U.S. dollar terms), while U.S. investment grade credit spreads have risen 37bps from the February lows. This is far less than the moves seen in 2015/16, where the dollar rose 16%, EM equities sold off -34% and U.S. credit spreads widened nearly 100bps. Those moves were enough to cause the Fed to delay its rate hike plans after the initial post-QE rate hike in December 2015, triggering a significant decline in U.S. bond yields (bottom panel) and the dollar that eventually stabilized global financial markets. With the U.S. economy in a much healthier position today than two years ago, and with U.S. core inflation running close to the Fed's 2% target, it will take much larger market moves than have been seen of late before the Fed would consider taking a pause on its current 25bps-per-quarter pace of rate hikes. The mechanism for that to happen will be a stronger dollar and any associated impact on U.S. financial markets. However, it must be a very large move (as it was in 2015/16) to have enough of a negative impact on the U.S. economy, U.S. corporate profits or U.S. inflation for financial markets, and the Fed, to take notice. In Chart 9, we show the U.S. trade-weighted dollar with three different scenarios for the change in the currency to the end of 2018: flat, up 5% and up 10%. We show the dollar in level terms in the top panel, while showing the year-over-year growth rate of the dollar (on an inverted scale) in the bottom three panels. In those last three panels, we also show the potential areas where a strong dollar would impact the U.S. economy the most: net exports, corporate profit growth from earnings earned outside the U.S. (using top-down profit data) and headline inflation. Chart 82015/16 Revisited? Not Yet Chart 9A Much Stronger USD Is Needed To Impact U.S. Growth & Inflation The charts show that a 10% rise in the dollar by year-end would likely take enough of a bite out of U.S. growth and inflation for U.S. equity and credit markets to sell off and for the Fed to take a pause on its rate hike plans. A more modest 5% rise in the dollar will have a more muted impact, especially with stronger underlying U.S. growth and inflation pressures than was the case in 2015/16. That latter scenario of a more moderate rise in the dollar would be our most likely scenario - one that would prove to be challenging for U.S. credit market performance. The dollar increase would be enough to keep EM financial markets on the defensive, but would not be large enough to get Fed rate hikes out of the way and allow for a big decline in Treasury yields that would help support risk assets. A slowly rising dollar is another reason to reduce credit exposure in fixed income portfolios. 4. Central bank liquidity provision through asset purchases is slowing rapidly One of our major themes for 2018 has been that the removal of the extraordinary liquidity expansion by central banks would weigh on asset returns. This would occur through the Fed allowing maturing bonds accumulated during its QE program to begin running off its balance sheet, and through a slower pace of bond buying in the case of the European Central Bank (ECB) and the Bank of Japan (BoJ). Already, the increase in developed market bond yields, and the lowering of returns in global equities and credit, have largely followed the path laid out by our indicator of central bank liquidity provision - the annual growth in the balance sheets of the Fed, ECB, BoJ and Bank of England (Chart 10). Our central bank liquidity indicator suggests that there is still more upside for global government bond yields as central banks become less directly active in bond markets. At the same time, the diminished liquidity growth means there is less investor money to be forced out of risk-free government bonds into risky assets like corporate credit, which should help erode credit market returns on the margin. This will occur through reduced inflows into credit that are just chasing yield, and a return to more fundamental drivers of credit market valuation like growth, inflation, leverage and downgrade/default risks - all of which are now on the rise in the U.S. Bottom Line: The clash between monetary policy and the markets that we have been expecting to unfold in 2018 is upon us. Tightening monetary policies, rising bond yields, slowing global growth, widening growth divergences, increasing U.S. inflation pressures, a strengthening U.S. dollar, emerging market instability, diminished central bank liquidity, reduced global capital flows, global trade tensions - all are now creating a backdrop that is more challenging for risk assets. Downgrade global spread product exposure to neutral (3 of 5) from overweight, and raise government bond exposure to neutral. Maintain a below-benchmark portfolio duration, however, as global bond yields have not yet peaked for this cycle. Asset Allocation Decisions To Be Made So in terms of our fixed income asset allocation recommendations, but in our strategic tables on page 16 and our model bond portfolio on page 15, we are making the following changes: Downgrade U.S. Investment Grade & High-Yield Corporates To Neutral (3 out of 5) The bulk of our primary indicators for U.S. credit are at levels that are consistent with a neutral allocation (Chart 11). Our top-down Corporate Health Monitor is right at the line dividing the deteriorating health and improving health regimes (although this is only because of a cyclical improvement in some of the underlying indicators). U.S. monetary policy is close to neutral, as measured by the real fed funds rate versus the Fed's r-star estimate. The U.S. Treasury curve is very flat, although it is not yet inverted as typically precedes the end of a credit cycle. Finally, bank lending standards are only modestly in "net easing" territory according to the Fed's senior loan officer survey. Chart 10Fading Impact Of Global QE On Bond Markets Chart 11Downgrade U.S. IG & HY Corporates To Neutral With all these indicators hovering around neutral levels, a neutral allocation to U.S. corporates seems justified. Additionally, we recommend cutting across all credit tiers for both investment grade and high-yield, rather than focusing on cutting a specific tier more than another. Our preferred valuation metric - the 12-month breakeven spread relative to its history - is near the bottom quartile for all credit tiers (Charts 12 & 13) without one looking particularly more expensive than the others. Chart 12Not Much Of A Spread Cushion In U.S. Investment Grade ... Chart 13... Or U.S. High-Yield Keep Euro Area Investment Grade & High-Yield At Underweight (2 out of 5) We have maintained this strategic view based on the convergence between our top-down Corporate Health Monitors for both the U.S. and euro area. Right now, the cyclical improvement in U.S. financial metrics has come at the same time as a cyclical deterioration of euro area metrics from very healthy levels (Chart 14). The spread between the two Monitors has proven to be a good directional indicator for the relative performance between U.S. and euro area credit. That spread continues to point to additional expected outperformance by U.S. corporates, even in an overall more challenging environment for global credit markets. Throw in increased Italian political turmoil, softer euro area growth and the upcoming ECB tapering of its asset purchases - which will include corporate debt that the ECB has been buying steadily for the past three years - and the case for underweighting euro area corporates, especially versus U.S. equivalents, is a strong one. Downgrade EM Hard Currency Sovereign & Corporate Debt To Maximum Underweight (1 out of 5) We have been favoring U.S. investment grade credit over EM credit the past several months. The growth divergence between the U.S. and EM has been widening, while EM market valuations had gotten very rich. Now, EM spread widening is starting to correct that mis-valuation, although is still early in the process. The spread differential between U.S and EM credit is a good leading indicator of the relative returns between the two asset classes (Chart 15), thus last year's EM outperformance is leading to this year's underperformance. Chart 14Stay Underweight Euro Area Corporates Chart 15Move To Maximum Underweight EM Credit We wish to maintain the same "two notch" gap between our recommended level of U.S. and EM credit exposure, so by downgrading U.S. corporates to neutral (3 of 5), we must downgrade EM corporates to maximum underweight (1 of 5). All of the above changes will be reflected in our model bond portfolio on page 15. One final point - we should lay out the case for out next move from here. If the Fed tightening cycle goes as we envision it will, with U.S. growth staying strong and inflation expectations rising back to levels consistent with the Fed's inflation target, then we expect the next move will be to downgrade U.S. corporates to underweight. However, if there is enough of a market setback to cause the Fed to delay its rate hike cycle, as was the case in 2016, then we may consider moving back to overweight U.S. corporates on a tactical basis. We suspect, however, that the moves today are the beginning of the end game for the current credit cycle - the negatives for corporates are now outweighing the positives, and that gap is likely to get wider in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19th 2018, available at gis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure", dated January 31st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Portfolio Strategy Selling in the S&P cable & satellite index is overdone. Recession type valuations fully reflect the acquirer discount heavyweight CMCSA is still commanding. Lift exposure to neutral. Content providers' assets are highly coveted, and these firms remain in play as media is undergoing a tectonic shift. The industry's demand backdrop is also on the rise, signaling that it no longer pays to underweight the S&P movies & entertainment index. Increasing construction expenditures, ballooning balance sheets, soft relative selling prices and a rising U.S. dollar all suggest that restaurant profits will underwhelm. Downgrade to underweight. Recent Changes Raise the S&P cable & satellite index to neutral today. Lift the S&P movies & entertainment index to a benchmark allocation today. Act on the downgrade alert and trim the S&P restaurants index to underweight today. Table 1 Feature Geopolitical risks held equities hostage last week as President Trump toughened his tariff rhetoric toward China. While the risk of a global trade spat remains acute, the market is becoming desensitized to daily trade-related headlines and remains resilient. Given the plethora of political risks and upcoming midterm elections, I look forward to hearing Greg Valliere's keynote speech in BCA's Toronto Investment Conference on September 24-25. Importantly, last week rising protectionism along with "Three Policy Puts Going Kaput" compelled BCA's Global Investment Strategy service to turn more cautious toward global risk assets over its 6 to 12 month cyclical horizon, prompting them to downgrade global equities from overweight to a neutral stance.1 We have sympathy for this view and acknowledge that the risks to our still sanguine U.S. equity market view, which we have been flagging in recent publications, have increased a notch. We are especially worried about the greenback's appreciation and increasing potential to infiltrate SPX EPS in calendar 2019 (please see Chart 2 and Chart 4 from the June 4th Weekly Report). Given that technology has the highest foreign sales exposure (58% of total sales) among GICS1 sectors, and a 26% market cap weight, we are closely monitoring leading indicators for tech profits. Indeed, for calendar 2019 the S&P tech sector's contribution to S&P 500 profit growth is the highest at 21%, with financials right on its tail at 20% (Chart 1). Energy sector EPS base effects are filtered out in 2019, but industrials, that have a 37% foreign sales exposure and are at the epicenter of President Trump's tariff rhetoric, also explain 13% of SPX EPS growth in calendar 2019 (Chart 1). Chart 1Contribution To S&P 500 2019 EPS Growth In fact, over a structural (2-3 year) time horizon we are aligned with BCA's more bearish equity outlook. We have been advocating this longer term thesis in our travels visiting BCA clients (please download our latest marketing slide deck here that highlights our bearish secular equity market view). Importantly, the three signposts we are monitoring to help us time the end of the business cycle, and thus equity bull market, are: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). There are currently no ticks in any of these three boxes, and we conclude that the S&P 500 has yet to peak for the cycle (Chart 2). Crucially, the Fed is inflating a massive bubble by staying too easy for too long. It is rather obvious to us that the U.S. economy is firing on all cylinders with real non-residential investment growing near 10% in Q1, but the real fed funds rate is still near the zero line (Chart 3). In addition, recent Fed minutes signaled that the Fed is willing to take some inflation risk, which will further push equity markets into steeper disequilibrium. It would be unprecedented for the cycle to end with the real fed funds rate glued to zero (Chart 3). Chart 2Recession Indicators Chart 3Real Fed Funds Rate Is Still Zero! Moreover, the U.S. economy just received a two year fiscal stimulus injection which is rare in both duration and magnitude during the late stages of the expansion and thus inherently inflationary. Worrisomely, the last time this happened was in the mid-to-late 1960s that led to the inflationary 1970s (please see Chart 1 and Table 2 from our October 9th "Can Easy Fiscal Offset Tighter Monetary Policy?" Weekly Report). Tack on the starting point of a World War-like debt-to-GDP ratio and the only regulatory mechanism for government profligacy is the bond market (Chart 4). Chart 4Interest Rates Have Nowhere To Go But Up Another way to make the debt arithmetic work is if one believes the White House's real GDP projections of 3%+ as far as the eye can see, which stand in marked contrast to the IMF's, the CBO's and the Fed's own projections (Chart 5). Therefore, the path of least resistance for interest rates is higher as a way to slow down the economy and also rein in debt excesses. Typically, this overheating late in the cycle is synonymous with a blow off phase in equities (Chart 6), before the bottom falls out. Chart 5Don't Believe The White House Chart 6Blow Off Phase In sum, while BCA downgraded global equities to neutral last week on a cyclical time horizon, we are deviating from the BCA House View and still believe that the S&P 500 will make new all-time highs in absolute terms before the next recession hits. This week we are making a few subsurface changes to the S&P consumer discretionary sector, but we maintain an underweight allocation to this interest rate-sensitive sector. New Media Landscape: (Pipelines Vs. Content Providers) Vs. Netflix At last count Netflix broke into the top 25 largest companies (market cap based) in the S&P 500, and if it keeps up its frenetic pace it is on track to surpass Boeing. While legacy media giants had a chance to scoop up Netflix in the past few years, its current stratospheric valuation makes it uneconomical and nonsensical. Instead, the specter of Netflix, as well as other tech giants circling the space, has accelerated an inter- and intra-industry consolidation (bottom panel, Chart 7). Why? Because Netflix not only went straight to the consumer on a new medium, the internet, and sped up cord cutting, but also blurred industry lines by becoming a content provider producing its own original content in addition to offering third party content. The media landscape is thus still trying to adjust to the Netflix induced "creative destruction" and media executives are scrambling to compete with/protect legacy franchises from Netflix. The recently cleared AT&T/Time Warner merger has intensified the bidding war of remaining crown jewel assets in the legacy content media world. We were well positioned for this shake up in the space as we went underweight the media complex in early March.2 But now, we deem that the easy money has been made and most of the negative narrative is reflected in bombed out relative valuations despite depressed relative profit and sales growth estimates (second & third panels, Chart 7). As a result we recommend lifting exposure back to benchmark in the broad S&P media index. Beyond these industry related intricacies, the macro backdrop is starting to turn in favor of media outfits, warning that it no longer pays to be bearish. Chart 8 shows that relative consumer outlays on media have spiked recently. The implication is that industry revenue growth has more upside. BCA's ad spending indicator also corroborates this firming top line growth message, as does the latest ISM services survey that remains squarely above the 50 boom/bust line on a broad array of measures. Unsurprisingly, this budding demand recovery has translated into a pick up in industry pricing power with our media selling price gauge even surpassing overall inflation. The implication is that media profits could surprise to the upside. Chart 7M&A Frenzy Continues Chart 8Overlooked Demand Recovery While our sense is that pipelines (S&P cable & satellite index) are the likely losers and content providers (S&P movies & entertainment) are the likely winners from the ongoing broad media deck reshuffling, the way we are executing the S&P media upgrade to neutral is by lifting both the S&P cable & satellite and S&P movies & entertainment sub-indexes to neutral. On the cable front, M&A activity is weighing heavily on relative share prices as index heavyweight Comcast is a possible acquirer of the Murdoch empire assets. However, this bellwether company is not a pure pipeline play and were it to win the FOX-related assets bidding war, it would further diversify its cash flow. Monetizing those assets involves execution risk, especially as the legacy cable business is wrestling with decelerating selling prices and still has to contend with cord cutting (top & middle panels, Chart 9). Encouragingly, the bottom panel of Chart 9 shows that likely all the negative news flow is already baked into compelling relative valuations. With regard to the content providers, not only are some of these assets currently caught up in a bidding war, but every remaining independent content provider is now in play, and deal hungry investment bankers are aggressively pitching M&A to media (and likely other industry) CEOs. Macro headwinds are also morphing into tailwinds for the S&P movies & entertainment group. Consumer confidence is pushing multi decade highs and given the fact that the economy is at full employment any increase in discretionary consumer incomes will likely further boost recreation outlays (Chart 10). Industry pricing power is also expanding at a healthy clip at a time when industry executives are showing labor restraint (Chart 11). If selling prices stay firm on the back of improving demand as we expect, then movies & entertainment profit margins will enter an expansion phase (middle panel, Chart 10). Chart 9Cable's Blues Are ##br##Well Discounted Chart 10Firming ##br##Recreation Outlays... Chart 11And Recovering Operating Metrics##br## Remain Underappreciated None of this rosy outlook is reflected in cyclically low S&P movies & entertainment relative valuations (bottom panel, Chart 10). Bottom Line: Book relative profits of 13.5% in the S&P cable & satellite index since inception and lift to neutral. Boost the S&P movies & entertainment index to a benchmark allocation for a relative loss of 8.3% since the early March inception. As a result the broad S&P media index also commands a neutral weighting. The ticker symbols for the stocks in the S&P cable & satellite and S&P movies & entertainment indexes are: BLBG: S5CBST - CMCSA, CHTR, DISH and BLBG: S5MOVI - DIS, FOXA, FOX, VIAB, respectively. Portion Control In Restaurants Restauranteurs are eternal optimists; at least that is the lesson we take from the National Restaurant Association's Restaurant Performance Index (RPI) which only rarely dips below the expansion line (Chart 12, second panel). However, changes in this overly optimistic sentiment survey are useful as they closely lead the S&P restaurants index's relative performance. This indicator has recently rolled over and we think the timing is right to turn negative on restaurants (Chart 12, bottom panel). The recent evaporation of industry pricing power echoes the RPI's early indications of a downturn (Chart 13, second panel). In view of how tightly it moves with relative industry sales, the growth outlook for restaurants has darkened considerably. The underlying driver of weakening pricing power is the industry's collapsing share of the consumer's wallet over the past two years, which has been at least as destructive to industry growth as the Great Recession (Chart 13, bottom panel). While both relative consumption and sales, which move in lockstep, have been staging a recovery in 2018, they both remain firmly in deflationary territory. Meanwhile, industry wages - the largest input cost - have been expanding above trend for the better part of the past four years (Chart 14, second panel). Though restaurant wage growth has recently slowed considerably it has not been enough to bring our margin proxy out of negative territory, implying sliding relative earnings growth is set to continue (Chart 14, bottom panel). Chart 12Optimism Reigns In Restaurants Chart 13Falling Pricing Should Weigh On Sales Chart 14Labor Costs Are A Profit Headwind A rising U.S. dollar is an additional profit headwind for this heavily internationally-geared consumer discretionary sub-index. Despite dollar strength offering an input cost tailwind via lower food commodity costs, declining translation of foreign profits will likely swamp those gains. McDonald's and Starbucks, which together represent 80% of the weight of the S&P restaurants index, had 62% and 49%, respectively, of their locations outside the U.S. at the end of last year. To compensate for a tough profit outlook, restaurants have embarked on a construction spending spree that shows no signs of abating (Chart 15, second panel). The predictable result has been a near-doubling of leverage ratios over the past three years (Chart 15, bottom panel). A weak profit backdrop signals that relief from these levels will be hard to find. Chart 15Restaurants Are Binging On Debt Chart 16Valuations Do Not Reflect Risks Valuations have been treading water at above-normal levels for several years (Chart 16, second and third panels). Perky valuations seem poised for a fall given the cloudy profit outlook and the higher risk premium that recently geared up balance sheets typically command. Bottom Line: Still-high valuations are not supported by falling returns in an increasingly capital intensive industry. Accordingly, we are pulling the trigger on last month's downgrade alert on the S&P restaurants index and moving to an underweight allocation. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG. What Does All This Mean For The S&P Consumer Discretionary Index? Chart 17Stay Underweight Consumer Discretionary Despite the S&P media's heavy weighting in the broad consumer discretionary sector, our S&P restaurants downgrade sustains the below benchmark allocation in the S&P consumer discretionary sector. Importantly, the three key factors weighing on this early-cyclical sector we identified in early March remain intact: rising fed funds rate, quantitative tightening and higher prices at the pump (Chart 17). Meanwhile, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (middle panel, Chart 17). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 17). Bottom Line: Earnings underperformance will eventually result in relative share price underperformance. Stay underweight the S&P consumer discretionary index. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 19, 2018, available at gis.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Short oil and gas versus financials. Stick with underweights in the classically cyclical sectors. Downgrade the FTSE100 to neutral. Overweight France, Ireland, Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Overall market direction will be range-bound through the summer. Feature Two market oddities stood out in the first half of the year. The first oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-2). For many years, bank equity performance and bond yields have been joined at the hip (Chart I-3). The faithful relationship exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart of the WeekWhen Technology Outperforms, European Equities Struggle Versus Emerging Market Equities Chart I-2Oddity 1: Banks Abruptly Decoupled##br## From Bond Yields Chart I-3Banks And Bond Yields Have Been ##br##Joined At The Hip For Years The second oddity was the abrupt decoupling of crude oil from industrial metal prices (Chart I-4). It is rare for crude oil to outperform copper by 30% in the space of just six months (Chart I-5). Chart I-4Oddity 2: The Crude Oil Price Abruptly ##br##Decoupled From Metal Prices Chart I-5It Is Rare For Crude Oil To Outperform ##br##Copper By 30% In Six Months Explaining The Oddities In The 1st Half The underperformance of banks is consistent with similar underperformances in the other classically growth-sensitive sectors - industrials, and basic materials (Chart I-6). Furthermore, the underperformances of these cyclicals is closely tracking the downswing in the global 6-month credit impulse (Chart I-7). Chart I-6The Odd Man Out: ##br##Oil And Gas Chart I-7The Underperformance Of Cyclicals Is Closely ##br##Tracking The Global 6-Month Credit Impulse Note also that these underperformances started well before any inkling of a trade spat. Hence, the recent escalation in the trade skirmishes is reinforcing a change of trend that was already in place. Taken together, this evidence would strongly suggest that global growth is not accelerating; it is decelerating. Oil is the odd man out because its supply dynamics, rather than demand dynamics, have been dominating its price action, lifting its year-on-year inflation rate to 60%. However, a large part of this surge in year-on-year inflation is also to do with the 'base effect', the dip in the oil price to $45 a year ago. The base effect is a statistical quirk, and shouldn't really bother markets. After all, most people do not consciously compare today's price with that exactly a year ago. Unfortunately, central banks' inflation targets are based on year-on-year comparisons, and this could explain why bond yields have decoupled from growth. If oil price inflation is running at 60% it will underpin headline CPI inflation, central bank reaction functions, and thereby bond yields. So here's the explanation for the oddities in the first half. Banks, industrials, and the other classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation and on central bank reaction functions. Spotting An Opportunity In The 2nd Half Chart I-8Crude Oil's 12-Month Inflation Rate Is 60% Ultimately, an oil price spike based on supply dynamics without support from stronger demand is unsustainable - because the higher price eventually leads to demand destruction (Chart I-8). On the other hand, if global demand growth does reaccelerate, it is the beaten-down bank equity prices that have the recovery potential. Either way, this leads us to a compelling intra-cyclical trade: short oil and gas versus financials. In aggregate though, we expect cyclical sectors to continue underperforming defensives through the summer. Based on previous credit impulse mini-cycles, we can confidently say that mini-deceleration phases last at least six to eight months and that the typical release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating growth and slow-to-budge bond yields risks protracting this mini-deceleration phase. Therefore, through the summer, it is appropriate to stick with underweights in the classically cyclical sectors. The strategy has worked well since we initiated it at the start of the year, and it is too early to take profits. Likewise, the portfolio of high-quality government 30-year bonds which we bought in early May is performing well, and we expect it to continue doing so for the time being. Don't Over-Complicate The Investment Process! To reiterate, stick with an underweight to the classical cyclicals versus defensives; and within the cyclicals, short oil and gas versus financials. These sector stances then have a very strong bearing on regional and country equity allocation. This is because up to a quarter of the market capitalisation of each major stock market is in one dominant sector, and this dominant sector gives each equity index its defining fingerprint (Table I-1): for the FTSE100, it is oil and gas; for the Eurostoxx50 it is financials; for the Nikkei225 it is industrials. So all three of these regional indexes are dominated by classical cyclicals. Table I-1Each Major Stock Market Has A Defining Sector Fingerprint For the S&P500 and MSCI Emerging Markets indexes, the dominant sector is technology. Although the technology sector is not strictly speaking defensive, it is much less sensitive to growth accelerations and decelerations than the classical cyclicals. There is another important factor to consider: the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in London in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining sector fingerprints for the major indexes turn out to be: FTSE100 = global oil and gas shares expressed in pounds. Eurostoxx50 = global banks expressed in euros. Nikkei225 = global industrials expressed in yen. S&P500 = global technology expressed in dollars. MSCI Emerging Markets = global technology expressed in emerging market currencies. Professional investors might argue that this trivializes an investment process on which they spend a lot of time, resource, research, and ultimately money. But we would flip this argument around. To justify the large amounts of time and resource spent on the investment process, professional investors are often guilty of over-complicating it! We fully admit that many factors influence the financial markets, but these factors follow the Pareto Principle, also known as the 80:20 rule. A small number of causes explain the majority of effects. And the 20% that explains 80% of a stock market's relative performance is its defining sector fingerprint. The Chart of the Week and Chart I-9-Chart I-12 should dispel any lingering doubts that readers might have. Chart I-9FTSE 100 Vs. S&P 500 = Global Oil And Gas##br## In Pounds Vs. Global Tech In Dollars Chart I-10FTSE 100 Vs. Nikkei 225 = Global Oil And Gas ##br##In Pounds Vs. Global Industrials In Yen Chart I-11FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas ##br##In Pounds Vs. Global Banks In Euros Chart I-12Euro Stoxx 50 Vs. S&P 500 = Global Banks ##br##In Euros Vs. Global Tech In Dollars So what does all of this mean for investors right now? A stance that is short oil and gas versus financials necessarily implies that the FTSE100 will struggle versus the Eurostoxx50, given the FTSE100's oil and gas fingerprint and the Eurostoxx50's banks fingerprint. Hence, today we are taking profits in our overweight to the FTSE100, and downgrading this position to neutral. This leaves us with overweight positions to France, Ireland, Switzerland and Denmark, and underweight positions to Italy, Spain, Sweden and Norway. Meanwhile, a stance that is underweight the classical cyclicals necessarily implies that European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Finally, in terms of overall market direction, we expect the range-bound pattern established in the first half of the year to hold through the summer. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. However, we reiterate that the outperformance of oil and gas versus financials is technically very stretched, which reinforces the fundamental arguments in the main body of this report to go short oil and gas versus financials. 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-13 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