Staying Power Of The U.S. Equity Rally

U.S. equities have soared higher, and are increasingly expensive: the underlying reward/risk tradeoff remains poor. That said, several of our indicators suggest that the high-risk rally is not over.

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There are several reasons why the equity prices could continue to rally for a time:

For one, the Fed is sensitive to dollar strength. Officials have acknowledged that monetary ease in the rest of the world will impact U.S. interest rate decisions because a strong dollar would tighten U.S. monetary conditions. This increases the likelihood that European and Japanese monetary ease will benefit both U.S. equities and bonds.

Second, deflation tail risks in remission: Continued compression of emerging market sovereign and U.S. corporate bond spreads suggest easing abroad is keeping the tail risks that plagued equities in late 2015/early 2016 in remission.

Third, the Fed has room to “wait and see”: Subdued inflation pressures across the board are letting both Fed hawks and doves mark down their terminal rate, or resting spot for the Federal funds rate.

Finally, early-warning indicators not flashing warning signs: Investment bank share prices are rising, both in absolute terms and relative to the S&P 500. Market breadth is improving, judging from the ratio of the equal-weighted Value Line Index to the market cap-weighted S&P 500. Junk bond yields continue to decline in absolute terms and vis-à-vis Treasury yields. In previous cycles, junk bonds have tended to lead equity prices.

The next Insight looks at some potential catalysts for an equity selloff.

Implications Of Declining Returns On Capital In EM

Our EM strategists maintain their bearish view on EM risk assets based on poor credit and economic fundamentals. Persistent foreign capital flows are the biggest threat to their view.

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Capital should flow to areas where the return on capital is (RoC) is high and rising. EM RoC has plunged in recent years and has not yet recovered. Importantly, the drop in RoC has not only been due to commodity prices.

The decline in RoC can be attributed to both cyclical and structural factors. The cyclical ones include: a slowdown in top line growth, strong wage/employee compensation growth, poor cost discipline (swelling costs during the boom years), as well as companies raising excessive capital and allocating capital inefficiently (the projects of the past several years have produced low/negative returns on investment). Meanwhile, structural factors include slower productivity growth and a general lack of structural regulatory reforms.

Overall, we do not detect many changes in EM cyclical and structural dynamics, except insofar as the rally in commodities prices over the past six months justifies a turnaround in commodities-producing EM economies. Please see the next Insight.

Trump And U.S. Treasury Yields

Given recent improvements in global growth and breakouts in global bourses post-Brexit, the low bond yields represent a conundrum. Could Trump really be an answer to the puzzle?

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The 10-year nominal rate is inversely correlated with the probability of Donald Trump winning the U.S. election. So why buy Treasurys as a hedge against a Trump presidency? Generally speaking, Trump is a reason to own safe-haven assets for two reasons:

Trade: Trump could start a trade war with China in 2017. The consequences of a mercantilist America would be profound, potenitally throwing the world economy into a 1930s-like “beggar-thy-neighbor” spiral at a time when global trade is already weak.

Geopolitics: Trump is right when he says that the world is a mess because America is weak. The rest of the world has become a lot more powerful in the last two decades of relative peace and prosperity. The end result is global multipolarity, where numerous countries can pursue their interests independent of one another. We know from political science theory, formal modeling, empirical analysis, as well as the last five years of conflagrations that such a distribution of power is the most likely to create the sort of “messy world” that Trump claims he will “fix”.

Our U.S. bond strategists are not too surprised by the above relationship. They have pointed out that economic factors alone cannot explain the most recent downleg in bond yields. Rising “policy uncertainty”, which includes U.S. politics, has also been depressing bond yields.

Is China Transitioning Into A Free Market Economy?

The financial community still tends to assume that China will eventually become a Western-style developed market economy. Our geopolitical strategists do not think this is realistic.

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There is no doubt that the service sector continues to improve at the expense of the long-dominant manufacturing and resource sectors. However, it is very unlikely that China will abandon investment-led growth anytime soon. Chinese people are admirable savers, which necessitates a high level of investment. Exporters are unable, and consumers unready, to pick up the slack in GDP growth if investment is cut. Poverty and regional disparities remain challenges that only large-scale investment can address. Further, the investment model may be inescapable until China’s leaders embrace political decentralization and rule of law, and accept the socio-political realities of “consumer sovereignty.”

As for state involvement, the government currently supports SOEs as the backbone of key sectors and prevents liquidation even of non-strategic and failing quasi-state companies. As long as this continues, truly private business will operate at a disadvantage.

As for foreign access, China is getting more, not less, protectionist as it moves up the production value chain and develops a consumer economy. There is no reason to think the Xi administration will reverse course on this front.

Bottom Line: Weak but stable growth, financial instability, and simmering but not boiling social discontent do not encourage aggressive reform initiatives.

Are Chinese Equities Breaking Higher?

Chinese H shares have broken above their 200-day moving average, a key technical level. Can the up-trend continue?

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Fiscal measures have boosted Chinese business activity and corporate sector top-line growth. According to our China Investment Strategy service, the bigger factor behind improving profits is monetary easing that has lifted corporate profitability and margins.

Our Monetary Conditions Index (MCI) for China has eased considerably since the beginning of the year, due to a combination of falling interest rates and the depreciation in the trade-weighted renminbi. Given the Chinese corporate sector’s lofty debt levels and its high exposure to overseas markets, monetary conditions fundamentally matter for performance, particularly manufacturers of tradable goods. Therefore it is not at all surprising that the easing MCI in recent months has begun to boost corporate profits and lift overall business conditions.

Looking forward, we expect the Chinese authorities will remain accommodative, which means the MCI should continue to ease. Despite recent easing, the MCI remains tighter than historical norms, which calls for more monetary stimulus. At minimum, it is highly unlikely that the People’s Bank of China will allow for another round of dramatic tightening in monetary conditions. The risk of a growth relapse and significant negative earnings surprises due to monetary tightening is very low.

Bottom Line: An accommodative policy stance and improving growth conditions are positive for Chinese equities.