The Reflationary Window: Open How Wide For How Long?

The global manufacturing purchasing manager index is comfortably above the 50 threshold signaling expansion. Importantly, the upturn is fairly synchronized, with improvement visible in the US, Europe, and Asia. This corroborates the upward adjustment in global bond yields we’ve seen in recent months.

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A big source of recovery in global industrial momentum in the past year has emanated from China. But growth tailwinds from real interest rate relief and fiscal expansion are set to wane in the second half of 2017, while protectionist elements of proposed US tax reform pose risks to EM growth prospects more generally. Those countries with the highest percentage of exports to and trade surplus with the US as a share of GDP are most at risk of any combination of tariffs or border adjusted elements of US corporate tax reform.

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One of the primary axes of debate around the sustainability of US growth momentum revolves around how to interpret the surge in soft, survey measures of economic activity – namely consumer and business confidence – relative to expectations, running well ahead of the hard data – barometers of the health in the housing, industrial, labor, household, and retail sectors. We have some sympathy for the view that the survey data usually leads hard data, and that the pickup in confidence reflects a revival in long dormant animal spirits which is feeding higher capacity expansion and hiring plans, particularly among small firms in the NFIB survey. But the large gap between the sentiment-oriented readings of the growth outlook and the mediocre pulse of coincident real time data underscores how great expectations for a sizeable upgrade in the plane of US economic growth are. Fears of secular stagnation have done a 180 degree turn to supreme confidence about the growth outlook in the last few months. The New York Fed’s primary dealers’ survey has extended expectations for the longevity of this business cycle, such that the median respondent now thinks the expansion will last twice as long as expected just a year ago.

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We agree that US growth is likely to remain firm over the next 12 months, because the economy has a lot of momentum behind it right now. But the reflationary window is likely to start to close as the economy reaches the upper limits of its potential from a supply perspective. Exuberant growth expectations and equity market momentum reflect expectations that tax and regulatory reform will reinvigorate the economy’s longer term growth potential, via increased spending leading to higher productivity growth. We think the dysfunction in Washington portends a long, protracted debate on tax policy and infrastructure spending, such that the impact on growth is a story for 2018, not 2017. But once again, markets are forward looking. A positive shock to aggregate demand from looser fiscal policy applied to an economy already operating near capacity would translate into higher inflation rather than increased output. This dynamic would drive up real interest rates and reduce spending on rate-sensitive goods such as consumer durables, housing, and business equipment. In addition, higher interest rates will cause the dollar to strengthen, crowding out the pro-growth pulse of fiscal stimulus. Fiscal multipliers are much smaller when an economy is close to full employment.

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But the global profit recovery is real, for the coming few quarters at least, supporting our cyclically bullish stance on global equities through the coming 12 months.

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The dollar remains in a cyclical bull market. The recent pause in its advance has not keyed off a reversal in the 2 year real rate differential between the US and its trading partners, which continues to expand. More likely the ‘weak dollar’ rhetoric from the Trump administration, consolidation of crowded long dollar positioning, and the benign pulse of the average hourly earnings read in the latest US employment report have cooled sentiment, temporarily at least. We assign low odds to another Plaza-Accord type coordinated agreement. History suggests that currency intervention only works when it is consistent with underlying macroeconomic fundamentals. With the Fed signaling a tightening bias which America’s trading partners’ economies don’t currently justify, a globally coordinated pact to weaken the US dollar would lack market credibility. With respect to the value of the US dollar, President Trump cannot suck and whistle at the same time.

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The risk-adjusted value proposition in US equities has deteriorated, but over a 12 month horizon, moderately above trend growth, benign inflation, and a still relatively accommodative Fed will prolong the cyclical equity bull market. One way to indemnify an equity portfolio against a near term pullback would be to reduce exposure to the sectors that have overpaid for dividends from business-friendly policy changes, namely deep cyclicals and industrials. Conversely, the outperformance of developed economy growth relative to emerging economies suggests that defensive sectors will enjoy a revival if EM growth remains relatively lackluster and the dollar remains well bid.

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As for credit markets, we continue to expect the economy to track towards the Fed’s dual employment and price stability mandate over the course of 2017. There is still 30-40 bps of upside in breakeven inflation yields before that threshold is reached, leaving scope for TIPS to outperform nominal Treasuries, and the yield curve to steepen via a rise in longer dated yields. There is no immediate urgency for the Fed to tighten in March, but we still see scope for three rate hikes in this calendar year, more than markets discount. We place high odds on the 10-year US Treasury yielding more than the current 12 month forward rate of 2.77% in a year’s time.

To find out more, click here to listen to BCA Global Strategist Caroline Miller’s February 16th Webcast.

What Is The Equity Market Implication Of The Spike In The “Soft” Vs. “Hard” Data?

A number of indicators we track are signaling that the global equity market is extremely stretched.

First, our Complacency-Anxiety Indicator is flashing red (please refer to this post). This sentiment indicator has recently vaulted to an all-time high, and warns of a challenging near-term equity backdrop.

Second, the “Soft” vs. “Hard” economic data Indicator (compiled using Bloomberg data) is also approaching an historic zenith. Such a divergence in survey vs. actual economic data has typically been a precursor of an equity market wobble (see chart). An economic validation period looms and the specter of a soft-patch could serve as a corrective catalyst.

Finally, U.S. dollar based liquidity has plunged to a level associated with recession. The draining in U.S. dollar liquidity is worrisome as it represents a de-facto tightening in global monetary policy. We substituted commodity price inflation for the MSCI All-Country World Index cyclical momentum. The U.S. dollar liquidity message remains similar, warning that at least a digestion period in equities is imminent.

Our sense is that in order for the equity market overshoot phase to prove lasting, a pullback is a prerequisite at this juncture. Were such a phase to materialize in Q1 as we expect, we would view it as a “buy-the-dip” opportunity.

For additional details, please refer to the report titled “Eerie Calm”, available at gss.bcaresearch.com.

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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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