Global Growth Is Accelerating, But Headwinds Persist

The global economy is on the mend. Measures of current activity are rebounding, as are a variety of leading economic indicators.

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Investors have taken notice: Market-based inflation expectations have risen, as have growth-sensitive commodity prices. Earnings growth expectations have surged, rising in the U.S. to nearly the highest level in a decade. Cyclical stocks have also bounced back, after having lagged the overall market for five years.

We agree with the market’s positive re-rating of global growth prospects, but worry that undue pessimism is starting to give way to excessive optimism. Two potential developments in particular could end up giving investors pause: a slowing of China’s economy later this year and the possibility that U.S. fiscal policy will end up being less stimulative than expected. Please see the next two Insights.

U.S. Equity Rally Is Fraying

While advance/decline lines have firmed, participation in the U.S. equity rally has been uneven and may be fraying around the edges.

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The number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth. The industrials (I) and financials (F) sectors (i.e. “IF”) have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The “IF” rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the “IF” rally will become iffy indeed, unless sector breadth improves.

Another unconventional sentiment gauge is observed from sub-surface market patterns. The number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunging to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks.

The Fed’s tightening bias, contracting U.S. dollar-based financial liquidity amid the strong U.S. dollar all threaten to keep a lid on corporate sector sales prospects. As such, we remain biased toward non-cyclical and consumer sectors. We expect momentum to steadily build in these sectors towards sustained outperformance by mid-year.

Is It Time To Buy The Dollar Again?

On a cyclical basis, the dollar will make new highs in 12-18 months. However, short-term considerations remain complex.

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Our FX strategists remain wary of betting on a strong dollar against the euro and the yen in the coming weeks, at least not until U.S. bond yields drop below fair value on our gauge. This would better reflect rising trade and geopolitical tensions between the U.S. and China from the new Trump administration.

For the next few weeks, a dichotomy could emerge between the narrow dollar index (DXY) and the broader trade-weighted measure. While lower U.S. bond yields will be supportive of the euro and the yen, they could do very little for EM and commodity currencies. With EM and commodity currencies highly leveraged to global trade and the Chinese economy, they will be vulnerable to any flare up of tensions between China and the U.S.

Bottom Line: The dollar correction is advanced but is now likely to become more differentiated. Tensions created by a protectionist and bellicose Trump are likely to push U.S. bonds into expensive territory. While the attending bond rally could support the euro, the Swiss franc and the yen against the dollar, these same tensions are likely to lift the dollar against EM and commodity currencies.

Outlook For EM Equities

The underperformance of EM equities has lasted for six years and is likely to persist for a while longer.

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The previous cycle of EM underperformance suggests we could have a drawn-out bottoming process rather than a quick rebound. Emerging equities look like decent value on the simple basis of relative price-earnings ratios (PER), but the comparison continues to be flattered by the valuations of just two sectors – materials and financials. Valuations are less compelling if you look at relative PERs on the basis of equally-weighted sectors.

More importantly, the cyclical and structural issues undermining EM equities have yet to be resolved. The deleveraging cycle is still at an early stage, the return on equity remains extremely low, and earnings revisions are still negative. The failure of the past year’s rebound in non-oil commodity prices to be matched by strong gains in EM equities highlights the drag from more fundamental forces.

Bottom Line: We expect EM equities to underperform developed markets.

U.S. Banks: Higher Rates Vs Weaker Loan Growth

Bank stocks have experienced a sentiment-driven surge since the U.S. election, supported by expectations for higher interest rates. Lost in the exuberance has been a marked deceleration in credit creation.

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Total bank loan growth has dropped to nil over the last three months, led by the previously booming C&I category. That is a sign that while businesses are expecting an economic improvement, they are not yet positioning for one via increasing working capital requirements. Coupled with increased bank staffing levels, the growth in bank loans-to-employment, a decent productivity proxy, has also dropped to zero. Importantly, the yield curve steepening trend has taken a breather, which may be a catalyst for some profit-taking.

Bottom Line: Our U.S. equity strategists are underweight banks.