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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BCA Research’s Oil Recommendations Up 95% in 2016

BCA Research’s Commodity & Energy Strategy reported returns on its oil recommendations were up 95% last year, during one of the most difficult trading markets in memory. CES is run by Bob Ryan, SVP and Chief Commodity Strategist. The service early on expected global oil supply and demand would rebalance on the back of fierce supply destruction, and the Saudi-Russia detente, which was apparent as early as January 2016. BCA’s CES started looking for ways to get long back in January 2016, and its recommendations paid off handsomely. CES recommended an energy overweight to oil Feb. 4, 2016, and remains bullish as the supply cuts negotiated by Saudi Arabia and Russia take hold.

Our results are not a P&L — we don’t run trading books. We report simple percent returns on recommendations we make following our assessment of the market. Our analysis is driven by fundamentals – supply, demand, inventories and monetary policy – and by our assessment of the geopolitical landscape, which is the product of Mr. Ryan’s 30-plus years of experience in the commodity trading markets, and access to BCA’s world-leading Geopolitical Strategy service run by Marko Papic. Where the returns are positive, we’ve correctly judged where the market was going; where they’re negative, it tells us we are missing something and need to reassess.

For a complimentary recap of 2016 results, and our view of the important issues affecting commodity markets this year, please contact us here.

BCA Commodity Recommendations in 2016
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The 2017 Outlook: Shifting Regimes

Mr. X, BCA’ loyal client paid us his annual visit to discuss the economic and market outlook. He is suspicious of the optimism in the macro and market air, and grilled us on the disconnect between the post US election euphoria in global markets and his more sober view that many of the secular drags on global growth will remain with us, even if policy shifts into a more pro-growth gear on a cyclical basis.

The US election did not trigger the flip of a switch in global growth momentum. It was already improving. The window between the end of deflation and the rise of inflation is a fertile macro environment for risk assets. Global inflation is likely to remain subdued for another couple of years because the global economy still suffers from a fair amount of spare capacity. Even though the global output gap has indeed declined from its post crisis 2009 peak, it’s still as large as in the early 1990’s.

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Mr. X was quick to remind us that in addition to high debt levels and the apex of globalization, many other structural macro forces have driven down the advanced economies’ growth potential. We agree with Mr. X that it is premature to declare the death of secular stagnation, but over the coming 12 months, stronger cyclical economic momentum will be the dominant driver of bond yields, which we see grinding higher as inflation expectations continue to recover. American consumers are brimming with confidence, and the business sector is celebrating the prospect of a reduced regulatory and corporate tax burden under Trump as the 2-year US profit recession has ended. A surge in capex spending intentions registered in the regional Federal Reserve bank surveys foretells a pickup in overall economic growth. The contrast between rising optimism and flat current revenue growth, particularly in the small business sector, underscores how high expectations are…

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With all the focus on the US of late, Europe is getting less attention for its above trend growth momentum. The euro area’s composite PMI survey has a good track record of leading European growth, and is consistent with a 2% level. Moreover, in its November report, the European Commission actually suggested that a rise in member states’ budget deficits in 2017 might make sense, no doubt partly a response to the populist backlash sweeping the region. The ECB estimates that the euro area’s output gap is still a wide 4% of potential GDP; wage growth is still weak, and declining, relative to the US. Europe is on the mend, but has a long way to go, and is still lagging the US in terms of business cycle expansion.

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In contrast to the euro area, Japan has almost absorbed all the slack in its economy. The Bank of Japan actually estimates that it has a positive labor input gap, meaning the economy has run out of surplus workers. A tight labor market and pause in fiscal consolidation will be reflationary, but unlike the Fed, the BOJ has committed to letting inflation significantly overshoot before removing any accommodation. This commitment will sustain the US’s real rate advantage over Japan, a welcome development for Japanese equities.

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So even as the euro area and Japan are recovering, neither central bank will pursue policies that interrupt the virtuous cycle sustaining upward pressure on the US’s real interest rate advantage which has been a powerful driver of dollar strength since 2014. The recent recovery in inflation expectations in both the euro area and Japan has outpaced the rise in their nominal yields, depressing real yields. We concede that bullish sentiment towards the dollar is stretched, but still think it can rally another 5% in broad trade weighted terms over the coming 12-18 months.

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The virtuous feedback loop between dollar strength and lower real rates applies less to China and the rest of the developing world, even though they too are experiencing currency weakness. The end of wholesale deflation belies anxiety about the durability of the recovery in China’s ‘old’ highly levered and asset-heavy economy. The government engaged in hefty fiscal stimulus, increasing government spending significantly throughout 2015 and early 2016, but the growth tailwind from that fiscal thrust is now fading. The decline in real rates and return on invested capital in China has stoked capital flight, the politically destabilizing optics of which have prompted policymakers to impose a variety of restrictions to stem outflows. Meanwhile, because the RMB has weakened faster than factory prices have recovered, Chinese export prices are still deflating in dollar terms, which doesn’t bode well for pricing power throughout the rest of the global manufacturing and industrial materials complex.

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While the reflationary window for global growth makes us bullish on global equities over a 12 month horizon, the US market appears to have discounted this goldilocks scenario. Bullish sentiment is stretched, earnings growth expectations at 12% y/y seem high in an environment where a tight labor market is driving up wage costs and a strong dollar will challenge industrial pricing power. Optimism about the economic benefits of the new administration’s policies could last while plans for tax cuts, increased infrastructure spending, and regulatory relief are being debated, but policy uncertainty is still sky high. U.S. profit growth may well come in just positive enough to sustain momentum, but we continue to have more faith in the constellation of monetary policy support, margin expansion potential, and lower valuation hurdles available in the Euro area and Japan.

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Emerging markets are a tougher call. The combination of a strengthening US dollar, growing protectionist sentiment in the developed world, high debt levels, and weak productivity, are all bad news for emerging markets, which have lagged the post-election surge in global and cyclical relative to domestic and defensive sectors. This underscores that EM valuations are not cheap on an equal sector weighted p/e basis; non-financial return on equity is at a 10 year low; and net forward earnings revisions are still negative. Developed markets should outperform this year, even given the reflationary window that typically flatters EM equities. The burst of speed in deep cyclicals in the post-election period is likely to fade as the reality of a surging US dollar saps margin prospects. The more consumer-oriented, domestic plays will then shine. We are even more comfortable with that theme since the post-election relative valuation reset.

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Amid this reflationary window over a cyclical horizon, in the very near term, investors should heed the rising risk of a correction, spurred either by the recent rise in bond yields or the unprecedented divergence between global policy uncertainty and market momentum.

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To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s January 11th Webcast.

What Are BCA’s Top Ten High-Conviction Equity Sector Calls For 2017?

Our biggest out of consensus call is to overweight the much maligned consumer staples sector.

One of the most glaring divergences between our macro indicators and relative share price performance exists in the consumer staples sector.

Since the U.S. election, this sector has been used as a source of capital to fund more speculative investments in areas levered to global economic growth, such as industrials. An exploitable undershoot has developed in a sector with one of the best 12 and 24-month track records during Fed tightening cycles. The sector is undervalued, and is resting at an oversold extreme, based on our Technical Indicator.

Our Cyclical Macro Indicator for the sector is grinding higher, Supported by consumers’ persistent preference for saving vs. spending, a plus for retail sales at non-discretionary stores. Tack on a budding recovery in consumer staples exports (bottom panel), and the nascent acceleration in sector sales growth should strengthen further, supporting earnings outperformance.

For our complete list of high-conviction calls, please refer to Monday’s Weekly Report titled “2017 High-Conviction Calls“, available at uses.bcaresearch.com.

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