U.S. Equities: A Growth Scare Ahead?

An economic growth reacceleration is vital to sustaining the U.S. equity rally and P/E expansion from the February lows. So far, no such confirmation has materialized. Instead, the U.S. appears to be edging closer to a growth scare according to our equity strategists.

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Now that U.S. profit margins are narrowing more rapidly and top-line growth remains non-existent, there is a more urgent need for companies to retrench. As seen in the chart above, leading indicators warn that consumption, investment, manufacturing and employment all have the capacity to disappoint in the second half of the year.

Ominously for equity markets, the Fed continues to harbor a deep desire to lift interest rates from what it still considers to be emergency levels at a time when the economy is nearing full employment. Consequently, financial conditions could tighten anew, exacerbating an already challenging profit outlook.

As discussed in the next Insight, several market indicators suggest that the Fed is too complacent about the downside risks to growth.

Is The Latest Equity Market Euphoria Justified?

Stocks have breathed a sigh of relief following earnings season. Nevertheless, cracks are spreading beneath the surface. The chart shows a compilation of nonconventional indicators that are waving a yellow flag. Breadth is thinning, as evidenced by the downtrend in the NYSE A/D line. Sentiment is also poor, with bullish investors throwing in the towel at an accelerating pace (second panel). Rather than view this contrarily, it can often be a sign that selling may accelerate. Moreover, once vibrant M&A activity is cooling rapidly (top panel), and the news has been recently dominated not by deal making, but by deal break ups. This may reflect increased trepidation about further adding debt to already bloated corporate sector balance sheets (third panel). Bottom Line: Resist the temptation to deplete cash balances, and continue to favor defensives over deep cyclicals. A capital preservation mindset is still warranted.

For additional information, please visit our U.S. Equity Strategy website at uses.bcaresearch.com.

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The Playbook For U.S. Treasuries

Whether the Fed lifts rates in June, July or September has little bearing on our recommended U.S. bond investment strategy.

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With the OIS curve discounting barely one more rate hike by the end of the year, we think that U.S. Treasury yields have scope to rise further in the near-term. For this reason we maintain duration at benchmark for now, but are looking for an opportunity to move back to above-benchmark before financial markets discount too much Fed tightening.

Risk assets, as proxied by the stock-to-bond total return ratio, have been trading in a wide range since late 2014. We have now witnessed three examples of the stock-bond ratio approaching the top of its range, leveling off for a time and then selling-off abruptly. In each episode, the catalyst for the steep decline in risk assets has been market expectations of an unduly restrictive Fed, as illustrated by the 10-year Treasury yield near the top-end of its similar trading range.

Recently, the stock-bond ratio has once again been leveling off near the upper end of its range. A persistent hawkish shift from the Fed seems likely to send yields higher in the near-term, until they become too elevated for risk assets to handle. The subsequent decline in risk assets will then be the catalyst for the next down-leg in Treasury yields.

If the next rate hike occurs in June, then this move higher in yields will occur very quickly. If the next rate hike is delayed until September, then it could take a few more months. Regardless, in our view the correct investment strategy is to maintain duration at benchmark for now and look to extend duration as the 10-year yield rises to 2%.

EM Credit Markets: Dichotomies And Complacency

The frequently made point by commentators and market-watchers these days that emerging markets (EM) are unloved and under-owned might be true for EM equities, but it is certainly misplaced with respect to EM bonds.

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  • The stark divergence between EM credit markets (sovereign and corporate credit spreads) and EM share prices is most vivid in China. Chinese offshore corporate and quasi-sovereign spreads are very tight (credit spreads are shown inverted in the chart), while Chinese H shares, which are dominated by similar companies, are not far from their cyclical lows.
  • Emerging Asian corporate spreads are at multi-year lows, while global (mostly, U.S. and European) industrials spreads are wider than they were a year ago. This is also puzzling, as the deflationary shock that led to global credit spread widening last year and in early 2016 originated from Asia/China.
  • Many EM banking systems are overstretched and unhealthy. They have failed to recognize and provision for non-performing loans. In some countries banks will likely experience a liquidity crunch going forward. Credit spreads for EM banks remain tame. This, however, contrasts with a notable decline in EM banks’ share prices.

Overall, there is a considerable dichotomy between the EM equity universe and corporate/sovereign credit markets. Our EM strategists believe that EM credit markets have been driven by the ongoing blind search for yield globally, and remain mispriced/overvalued. In short, complacency reigns in EM credit markets. Please see the next Insight, (Part II) EM Credit Markets: Dichotomies And Complacency.

China Needs More Debt

The latest Global Investment Strategy Weekly Report entitled “China Needs More Debt” focuses on the premise that China has fallen into the same sort of “fiscal trap” that ensnarled Japan in the 1990s. Unprofitable investment projects undertaken by Chinese state-owned enterprises are a necessary evil, comparable to Japan’s “bridges to nowhere”. China’s underlying problem is not that the economy suffers from overinvestment. Instead, the country is demand deprived; discussions of overinvestment confuse the symptom with the disease. Structural factors will ensure that China continues to churn out ample savings for years to come. Any efforts by the Chinese authorities to curb credit growth will result in a sharp economic downturn. China will continue to generate excess capacity and export deflation to the rest of the world, which is positive for bonds. The government will stealthily backstop bank loans in order to ensure that banks keep lending without the embarrassment of having to undertake highly-dilutive capital raises. We recommend going long the most hated equity sector in the world: Chinese banks.

To access the report entitled “China Needs More Debt”, please click here.

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