The Signal From Commodities

Concerns over the Chinese economy, a withdrawal of speculative demand, and strong supply growth have all weighed on commodity prices over the past few months. All three of these forces should ebb over the coming months, providing a more benign cyclical backdrop for commodities and commodity-related investment plays.

To access the full report entitled “The Signal From Commodities”, please click here.

Break Glass In Case Of Impeachment

Impeachment is a political, not legal, process in the U.S. political system. If Democrats take control of the House of Representatives in 2018, Trump will almost certainly be impeached. Otherwise, it would require “smoking gun” evidence of criminal behavior to turn House Republicans against the president. For now, financial markets will largely ignore impeachment risks and focus on tax cuts. Midterm elections will accelerate their tax-cutting attempts.

To access the full report entitled “Break Glass In Case Of Impeachment”, please click here.

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.