BCA, Independent Investment Research Since 1949

High Speculation In U.S. Equities

While the BCA’s cyclical stance on U.S. equities remains positive, it is critical to be aware of the high degree of speculation.

BCA’s Equity Speculation Index (ESI) signals that the U.S. stock market’s advance is at a very high risk stage. That said, the ESI can stay in elevated territory for a prolonged period before a market decline unfolds, as it occurred in 2014/2015. The eventual weakness in equities in early 2016 turned out to be a mid-cycle correction. However, the elevated ESI readings in 2000 and 2007 flagged the deep bear markets.

Without a recession on the immediate horizon, given the still upward sloping yield curve, it is premature to expect a repeat of 2000 and 2007. However, a market correction cannot be ruled out. While BCA’s 9-12 month outlook for U.S. equities is positive, investors should maintain some non-cyclical exposure in the event of a short-term market pullback.

Has China’s Cyclical Recovery Peaked?

There is a rapidly emerging consensus that China’s growth peaked in the first quarter and the economy is facing growing downward pressure.

China’s latest PMI numbers released this week seemed to validate the increasingly consensus view of an imminent growth top. Most major components of the PMI surveys in both the manufacturing and service sectors had setbacks, which is also reflected in softer commodities prices.

Although tighter on the margin, Chinese monetary conditions remain fairly stimulative, which should continue to help the economy. The trade-weighted renminbi is still depreciating, albeit at a slower pace, and real interest rates deflated by PPI remain negative.

On the fiscal front, the government significantly reduced the fiscal stimulus toward the end of last year, but has since reversed course. Both direct fiscal spending and infrastructure investment have picked up notably, and the impact will continue to ripple through the broader economy.

In short, China’s policy settings remain expansionary. This is a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Our China Investment Strategy team believes there is little chance that the Chinese authorities will commit a similar policy mistake that could lead to a major growth downturn.

European Inflation: An Inflection Point?

This year’s late Easter may have contributed to an outsized gain in April’s CPI. However, there are signs that underlying inflation in the euro area is turning the corner.

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The timing of Easter distorted the March and April inflation data. The March CPI was unduly weak due to this year’s late Easter. The stronger April CPI is partly a payback from last month’s weakness. With headline CPI rising 1.9% y/y, inflation is effectively at the ECB’s “close to but below 2%” target.

The ebbs and flows in headline inflation will be dictated by oil prices. According to the futures market, the annual rate of change in oil prices will moderate, which will lead to slower headline inflation in the latter half this year.

Looking beyond the monthly seasonal noise in the data and the swings in energy prices, there are signs that core inflation is bottoming as the broad disinflationary pressures in the economy are abating. Our CPI diffusion index, which measures the breadth of price movements and leads core inflation, has recovered from the depths of 2013/14. It currently stands at 64%, meaning that the majority of the CPI subcomponents are accelerating. If the eurozone economy continues to grow at an above-trend pace (as our models predict), the output gap will close further and underlying inflation will gradually drift higher.

Bottom Line: The ECB will need to keep dialing back the dovishness as the euro area economy grows above potential and underlying inflation starts to trend higher.

Global Profit Growth On The Upswing

Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year.

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Global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Our profit indicators remain constructive for the U.S., Eurozone and Japan. In fact, our model suggests that U.S. EPS growth has a very good shot at matching perpetually optimistic bottom-up estimates for 2017.

Admittedly, it is disconcerting that the rally in oil prices has faltered in recent days as investors worry that increased U.S. shale production will thwart OPEC’s plans to trim bloated inventories. Without trimming stockpiles to more normal levels, storage capacity remains too close to topping out, which raises the risk of another price collapse.

A breakdown in oil prices could spark a major correction in the broader equity market. However, our commodity strategists expect the OPEC/Russia production cuts to be extended when OPEC meets on May 25. Consequently, we expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020.

Bottom Line: Stronger global growth will lead to stronger corporate earnings growth and underpin global equities. Weaker oil prices pose a downside risk, which we are monitoring.

Opposing Market Signals

Global equities are near their cyclical highs, but several safe-haven assets are rallying.

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Three safe-haven assets have been undergoing a recovery since mid-December: gold, the Japanese yen and 10-year U.S. Treasuries. Gold has retraced all of its post-U.S. election decline. USD/JPY has given back about 62% of its rally following the election, while the10-year Treasury yield has retraced 50% of its advance. In relation to these trends, the equity market is the so-called “odd man out”.

BCA’s cyclical view of global risk assets remains bullish, but a variety of asset prices are indicating a subtle shift towards risk aversion. This could be due to geopolitical worries and/or a downgrading in growth expectations. Whatever the reason, a continuation of these trends could signal a broader retrenchment in global risk assets. We would view this as a long overdue technical setback from overbought levels. Any such correction would represent a buying opportunity on a 9-12 month cyclical investment horizon.