What Is BCA’s New Complacency-Anxiety Index Signaling?

Equity markets finally took a breather last week, as investors digested spotty earnings and began to discount the possible economic downside of U.S. isolationism. While profits should dictate the trend in stocks over the long haul, equity valuations have soared since the election, it is critical to consider the durability of this trend and other influences at this juncture.

The recent string of positive economic surprises raises the risk that monetary conditions will tighten further, especially amidst rising inflation pressures and a tight labor market. As such, the broad market remains in a dangerous overshoot phase, predicated on hopes for a sustained non-inflationary global economic mini-boom.

The risk is that these hopes are dashed by nationalistic policy blunders (i.e. protectionism and trade barriers) or a more muted and drawn out improvement in global economic growth than double-digit earnings growth forecasts would imply.

There appears to be full buy-in to a durable bullish economic/profit outcome. We have constructed a ‘Complacency-Anxiety’ Indicator (CAI), using a number of variables that gauge investor positioning, sentiment and risk on/off biases (see chart). The CAI is at its highest level ever, signaling extreme confidence/conviction in the outlook for equities.

All of this argues for maintaining a capital preservation mindset rather than chasing market euphoria in the near run. Elevated complacency suggests that the consensus is focused solely on return rather than risk. It will be more constructive to put money to work when anxiety levels are higher than at present.

For additional details, please see the U.S. Equity Strategy report titled “Bridging The Gap”, available at uses.bcaresearch.com.

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Is FX Volatility Sending A Warning Signal?

Volatility across most asset classes remains tame, but currency volatility has been rising steadily since the U.S. election (see chart). This is notable, because it has often been a reliable precursor of a jump in equity market volatility. The MSCI All-Country World Index (ACWI) and currency volatility are joined at the hip, reflecting the impact of currency swings on policy decisions and corporate competiveness/profits.

Trade wars and protectionism rank high in investors’ worry list, but all this is best encapsulated under currency wars.

Risk is the fifth “R” of our “R” theme for 2017, and a potential further devaluation of the Chinese renminbi is one of the most important risks to monitor for the year. While stealthy yuan devaluation dominated 2016, the specter of a free floating Chinese currency may take center stage this year. This is the single biggest market risk, as the destabilizing global ramifications from such a move will take time to digest.

Why would the Chinese opt to shock the currency world? Free floating the yuan would send a retaliatory message to President Trump not to embark on a full-blown trade war, which is in no country’s best interest. Such a move would not only stem the outflows (anecdotes of Chinese moving renminbi – and not U.S. dollars per se – out of the country are mushrooming), but it would also stem the depletion of FX reserves.

Until the end of last year, the renminbi had been positively correlated with the MSCI ACWI. Our concern is that this correlation will be reestablished once the post-U.S. election sugar high has been burned off. Any meaningful Chinese currency devaluation could spell trouble for stocks: as a reminder, a 3.3% percent devaluation in August of 2015 caused a knee-jerk drop of at least 10% in global equity bourses.

This is a tail risk we are closely monitoring, and thus this week we are compelled to de-risk the portfolio and book profits in a deep cyclical sector.

For additional details, please access the report titled “The “Yuan” To Watch” available at gss.bcaresearch.com.

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Is it Time to Fade the Machinery Rally?

After the election, machinery stocks jumped sharply on the hope that only Trump’s growth-oriented policies will be successful while growth-restrictive proposals will be watered down, supporting commodity prices and ultimately reinvigorating machinery demand. However, the risk is that the waiting period will prove longer than expected, testing investor patience. While global manufacturing surveys have perked up on the back of inventory restocking, global machinery orders are still sinking, and U.S. machinery new orders are contracting. The strong U.S. dollar makes it dangerous to extrapolate firming global surveys into strong U.S. corporate performance. The chart shows that relative machinery EPS estimates have moved in the opposite direction of relative share prices. As a result, the bottom panel of the chart shows that relative valuations have skyrocketed. The S&P machinery sector’s forward P/E is now trading at a 20% premium to the broad market (over a two decade high, excluding the Great Recession) spiking 6% since November. If earnings fail to live up to extremely optimistic expectations, as we expect, then relative share prices are at risk of a retracement.

Bottom Line: Continue to underweight the S&P machinery index.

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Is The Industrials Honeymoon Over?

The ISM index offers useful leading information on the relative performance of industrials. Whenever the ISM index sinks below the boom/bust line for five or more consecutive months, it does not pay to underweight industrial stocks as too much bearishness is usually baked in the cake. The opposite is also true. We analyzed relative industrials performance since the early 1990s every time the ISM manufacturing new orders sub-index hit 60. The bottom panel of the above chart shows the median relative performance in the ensuing twelve months. The implication is that industrials stocks will suffer in the coming quarters as too much optimism is already discounted since the post-election reflex advance.

Bottom Line: We reiterate our recent high-conviction underweight stance on the S&P industrials sector.

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Is 2017 The Year Of The Letter “R”?

2017 will be dominated by a four ‘Rs’ theme: Recovery, Rates, Rotation, Re-leveraging, which will eventually lead to two additional ‘Rs’: Risk and Recession.

The global economy is in a modest recovery, whose roots predate the U.S. elections. The chart shows the number of times “reflation” has been mentioned in the news according to Bloomberg data. Such hype has been closely correlated with the extremely economic sensitive copper-to-gold ratio. Moreover, economic exuberance is signaling that global stocks have more room to run (top panel).

The back up in real yields is also noteworthy given the close correlation they enjoy with equities. Importantly, the U.S. 10-year TIPS yield has vaulted 47bps higher since the multi-year low hit just after Brexit, reflecting at the margin an improving economic growth outlook. Indeed, economic surprise indexes have firmed and financial conditions (as per Bloomberg) remain loose in every major region.

Another way to depict the reflationary effect on stocks is via a global equity EPS diffusion index. Using forward EPS data from I/B/E/S, we constructed a diffusion index of countries (both DM and EM) that have negative y/y EPS growth. This index has been steadily sinking since mid-summer with fewer and fewer country EPS in the contraction zone. This is a positive backdrop for global equities.

For additional details on the rest of the ‘Rs’, please refer to the Global Alpha Sector Strategy report titled ‘The Year Of The Letter “R”’, available at gss.bcaresearch.com.

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