BCA, Independent Investment Research Since 1949

Weak Global Vital Signs

According to our U.S. equity strategists, to forecast that a weaker U.S. dollar will revitalize rather than simply stabilize profits on a broad-basis, it is critical for the rest of the world to demonstrate an internal demand impulse. That would signal that other countries can cope with currency strength, otherwise U.S. dollar depreciation would simply redistribute a shrinking global profit pie back to the U.S.

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Profit redistribution may be enough to avert a serious crunch in stocks, but it is hardly fodder for a sustained breakout when P/E multiple compression is already underway.

The contraction in global exports, particularly in Asia, underscores that global final demand is still sub-par. Our global leading economic indicator, excluding the U.S., is still below the boom/bust line. The global ex-U.S. PMI has also sunk below the key expansion/contraction line. These subdued readings suggest that growth outside the U.S. is not yet on the cusp of a reacceleration.

That is consistent with the message from the bond and equity markets. Global stocks outside the U.S. are barely off their lows, suggesting that foreign profits remain weak. Treasury yields and inflation expectations remain historically low, and yield curves continue to flatten.

We remain wary of global deep cyclicals, but selling pressure in the domestic and interest rate-sensitive S&P consumer discretionary sector may have run its course, particularly if the long end of the U.S. yield curve continues to rally. Our U.S. equity strategist recommend lifting this sector to neutral from underweight.

An Update On Global Growth

According to our EM strategists, there is not much evidence to argue that global growth is improving:

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  • Global trade volumes are contracting and EM share prices – advanced by six months – indicate that the pace of global trade volume contraction will escalate.
  • EM import volumes are contracting, and U.S. import volume growth is heading to zero.

Indicators shown in the next Insight also point towards downbeat growth conditions.

When To Favor U.S. Cyclical Equities?

Our U.S. equity strategists are monitoring a number of key signposts that would help signal when the tide would turn sustainably in favor of cyclical sectors:

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  • Broad-based and sustained U.S. dollar weakness, particularly against a basket of EM currencies in countries with large current account deficits. That would show these regions were poised to gain better access to much needed foreign capital after having regained some competitiveness. So far, these currencies have made an effort to stabilize, but not by enough to signal better economic times ahead.
  • The Chinese manufacturing GDP deflator stops deflating. While the rate of manufacturing pricing cuts has eased, the sector continues to deflate.
  • Global PMIs firm, especially in EM. Inventory liquidation is ongoing, but not fast enough to avoid piling up relative to shipments in many key manufacturing centers.

Please see the next Insight for other indicators that warrant monitoring.

Stuck In A Rut

Mr X. – more conflicted than ever about the 2016 outlook – poses some tough questions to BCA’s editorial board.

Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook.

This year, he rightly pointed out that extreme monetary policies continue to create major economic and financial distortions that ultimately will have significant unintended negative consequences. As well, he forced us to acknowledge that there has again been little progress in reducing elevated debt levels around the world. Meanwhile, economic growth remains dangerously fragile and deflation is a risk.

Indeed, we were not able to assuage Mr. X’s fears.

We wish we had grounds for being more optimistic, but it is a challenging investing environment. A more positive stance on risk assets would be warranted should the corporate earnings outlook improve significantly, though the odds of that seem low at the moment. The other way to improve future return prospects is for asset prices to decline and establish attractive valuations. That is enough of a threat to warn against an aggressive investment stance and is why we recommend no more than a benchmark weighting in equities. And we would not argue strongly against a modest underweight.

To read the edited transcript of our recent conversation, please click here: Stuck In A Rut.

Global Fixed Income Strategy: Where To Hide

We have recommended a long duration stance for some time because we believe that the Fed will not be able to tighten as quickly as the dot-plot suggests. Global deflationary pressures, and quantitative easing in Europe and Japan, will anchor the long-end of the curve across the major countries. Nonetheless, we have emphasized the near-term risk of a convergence of the OIS curve toward the Fed’s ‘dots’, leading to a temporary U.S. Treasury selloff.

In each of the past U.S. rate hike cycles, there is a period of rapid upward adjustment in market expectations for the pace of Fed rate hikes that occurs near the time of policy lift-off. It is an “ah-ha” moment, when investors are shaken from their complacency about the outlook for short-term interest rates. This is the phase of maximum pain in terms of total return losses in the bond market.

The mid-2000s “conundrum years” provide a roadmap for how things could play out. Treasury investors suffered losses during the period of rapid increase in the 12-month Fed Funds Discounter, which occurred just prior to the start of the rate hike cycle. However, once this phase was complete, the Treasury index provided a positive return over the course of the tightening cycle. The yield curve flattened massively.

Markets discount some upward movement in the fed funds rate over the next year, but we have not yet seen the same violent upward adjustment that has occurred in rate hike cycles since the 1980s. This raises the question of where absolute-return focused, long-only bond investors can hide during the rapid adjustment phase. Please see the next Insight, “Hawkish Fed” Yield Curve Scenario.