BCA Indicators/Model
The GAA DM Equity Country Allocation model is updated as of July 31st, 2017. The model has continued to reduce its allocation to the U.S. and now the U.S. allocation is the largest underweight. The funds from the U.S. are largely used to reduce the large underweight in the U.K. such that now the U.K. is in slight overweight. Other changes in the non-U.S. universe are the downgrade of Spain in favor of Germany, Italy and Netherland. These adjustments are mainly due to changes in liquidity indicators, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 88 bps in July, entirely due to the 213 bps outperformance of Level 2 model where the overweight in Italy, Spain , Australia and Netherland vs the underweight in Japan, Germany, Sweden and Switzerland worked very well. Since going live, the overall model has outperformed its benchmark by 257 bps. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of July 31, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continue to be bullish on global growth and hence the cyclical tilt. However, consumer discretionary is the only cyclical sector to have an underweight. This recommendation is mainly driven by the unfavorable liquidity and technical backdrop. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com.
We are pleased to introduce version 2.3 of ETS. This version brings an important new addition to the platform: the ability to backtest your own strategies. As of today, you have access to our online backtesting tool as part of your subscription. This powerful feature will allow you to develop, analyze and implement quantitative trading strategies by leveraging the power of our proprietary quantitative model.
Highlights BCA's Central Bank Monitors support the case for less stimulus. Yellen's "dovish" testimony does not change our Fed call. The BCA Beige Book Monitor and related indicators support our view on the economy and Fed. Maximum central bank policy divergence has not been reached. Too early to predict Trump's replacement for Yellen. Now that economic surprise index has bottomed, risk assets can outperform as the metric mean reverts. Some wage measures are accelerating as the economy approaches full employment. Feature Chart 1Sell-Off In Global Bond Markets##BR##Triggered By Central Bank Talk Global bond investors were shocked in June when central bankers announced at the ECB's Forum on Central Banking what appeared to be a global recalibration of monetary policy. Until that time, investors had been lulled into a false sense of security that growth headwinds would prevent the Fed from hiking by more than once a year and keep the other major central banks on hold "indefinitely." The heads of the Bank of England (BoE), the Bank of Canada (BoC) and the Riksbank all took a less dovish tone, as they signaled less need for ultra-stimulative policies because the threat of deflation had diminished. Together with some better-than-expected U.S. economic data, this shift in tone led to a sharp sell-off in global bond markets (Chart 1). The BoC followed up last week by kicking off a prolonged tightening cycle. The central bank now expects the Canadian economy to reach full employment and hit the BoC's inflation targets by mid-2018, which is much earlier than expected. The global bond mini-rout actually began before the ECB Forum, when the ECB President gave a very upbeat description of the underlying strength of the Euro Area economy. BCA's Global Fixed Income Strategy service highlights that the Euro Area is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum.1 European core inflation is admittedly below target today, but so was the U.S. rate leading up to the 2013 Tantrum. Draghi's comments confirm that the ECB will announce this fall that a further tapering of its asset purchase program will take place in early 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank Monitors (CB), which measure pressure on central bankers to raise or lower interest rates (Chart 2). The Monitors became less useful when rates hit the zero bound and quantitative easing became popular, but the measures are relevant again. All of our CB Monitors are in "tighter policy required" territory except for Japan (although even that one appears on the verge of breaking above the critical zero line). The Monitors have been rising due more to their growth than their inflation components. Bond investors may be startled by the ECB's posture because inflation remains well below target in all the major economies except the U.K. What is most worrying is the recent deceleration in U.S. inflation, where the economy is very close to or at full employment. Almost all of the major central banks point to temporary factors that will soon fade, which would allow inflation to escalate toward the target. Our Aggregate Inflation Indicators have all signaled a modest building of underlying inflation pressure over the past year (although they have softened recently in the U.S. and Eurozone; Chart 3). In terms of the components of these indicators, rising core producer price inflation has been partly offset by slower gains in unit labor costs in some economies. Chart 2All In The "Tighter Policy Required" Zone Chart 3BCA Aggregate Inflation Indicators These and other indicators support our view that core consumer price inflation will grind higher in the coming months in most of the advanced economies, including the U.S. Admittedly, all models and indicators have been poor predictors of inflation in this recovery. Nonetheless, historical relationships might begin to re-establish now that capacity utilization is rising and labor market slack has moderated significantly. Did Yellen Turn Dovish? June's FOMC minutes indicated that the consensus among Fed policymakers is willing to "look through" low inflation and maintain the current timetable on rate hikes. Yellen's Congressional testimony last week did not deviate from that view, although investors interpreted her remarks as dovish. The financial press focused on her statement that "...the policy rate is not far from neutral." However, this was followed up by the statement that "...because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal." The Fed asserts there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is close to the short-term level, which is depressed by economic headwinds. However, Yellen and others have made the case that the short-term neutral rate is trending up as headwinds diminish, and will converge with the long-term neutral rate over time. The Fed Chair is at risk of confusing investors by discussing the concept of two neutral rates, although this may have been to head off demands by some Congressional lawmakers that the Fed should follow a mechanical policy rule when setting policy (such as the Taylor Rule). Nonetheless, the important point is that Yellen is not saying that the actual policy rate is close to the peak for the cycle. Yellen's testimony has not altered our Fed call for this year: balance sheet runoff beginning in the fall, followed by a rate hike in December. The latter hinges importantly on at least a modest rise in core PCE inflation in the coming months. We expect more rate hikes in 2018/19 than are discounted in the bond market. That said, the soft June CPI data challenges our view that inflation will move higher in the second half. The bottom line is that the backdrop has turned decidedly bond-bearish now that central bankers in the advanced economies are in the process of scaling back the easier monetary policy that followed the deflationary 2014/15 oil shock. Global bond yields have already taken a step up in recent weeks, but they will have to rise further to catch up with the solid pace of global growth and diminishing economic slack. Duration should be kept short. The Beige Book: Another Inflation Anomaly The Beige Book released on July 12 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin to trim its balance sheet in September and boost rates by another 25 basis points in December. Our quantitative approach2 to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 4). Chart 4Beige Book Monitors Support Fed's Outlook##BR##On Economy And Inflation At 62%, the BCA Beige Book Monitor remained near its cycle highs in July, providing more confirmation that the economy rebounded in Q2 after a desultory Q1. The July 12 Beige Book covered the period from late May through June 30. Based on the Beige Book, the dollar should not be much of an issue in Q2 earnings season. The greenback seems to have faded as a concern for small businesses and bankers, which is in sharp contrast to 2015 and early 2016 when mentions of a strong dollar in the Beige Book surged. The Q2 earnings reporting season will provide corporate managements with another forum to express their views of currency impact on their operations. Business uncertainty over government policy (fiscal, regulatory and health) remained elevated in the most recent Beige Book (not shown). The implication is that the business community is mindful of the lack of progress by Washington policymakers on Trump's agenda. Our analysis of the Beige Book also shows that real estate was still stout as Q2 ended. This implies that both residential and commercial real estate, the former a source of strength in Q1, will add to growth again in Q2. Moreover, the latest reading on the BCA Real Estate Monitor further widened the gap between the BCA Beige Book Real Estate Monitor and the relative performance of REITS to the S&P 500. Nonetheless, BCA's U.S. Equity Strategy service recently downgraded REITS to neutral,3 citing our expectation of higher Treasury yields, modest rent growth, some cracks in CRE credit quality, and tightening standards for bank lending in the CRE marketplace. Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words. Inflation words hit a new peak in July, in sharp contrast with the recent soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will move higher in the coming months, supporting a gradual removal of policy accommodation. Uncertainty in Washington is distressing, but worries over the dollar seem to be fading. Max Policy Divergence Has Not Been Reached What about the dollar? Tighter Fed policy is dollar-bullish on its own, but some of the major central banks are also starting to remove the monetary punchbowl as well. Recent dollar action suggests that investors have decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but raising interest rates is a long way off because there is still a lot of economic slack in the Eurozone. In contrast, the Fed is increasingly concerned that allowing the unemployment rate to fall further below its estimate of full-employment risks too large an overshoot of the 2% target. We still believe that market pricing for the fed funds rate is too benign. As Fed rate hike expectations ratchet up in the coming months, interest rate differentials versus Europe will widen in favor of the dollar. It is the same story for the dollar/yen rate. The major exception is the Canadian dollar, which we expect to appreciate versus the greenback. Does Gary Cohn Have What It Takes? A key wildcard in the financial outlook is the Fed Chair's replacement. Yellen's term as Chair will end in February 2018 and the markets have not yet shown any concerns about her potential replacement. The current frontrunner is Gary Cohn, the Chairman of President Trump's National Economic Committee; his appointment would conform to some historical precedents but violate others. Our March 6 Weekly Report4 provides a list of potential Fed appointees and also provides some background on the potential for the Fed to become more politicized under Trump. Since the late 1970s, Presidents have selected the Fed Chair based on their trust relationship with a candidate. Arthur Burns (Chair from 1970-1978) was the head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to President Nixon. William Miller (1978-1979) worked for the presidential campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987-2006) served as the Chair of President Reagan's Social Security Commission in the early 1980s, was the Chair of President Ford's CEA and advised President Nixon's campaign in 1968. Ben Bernanke (2006-2014) was George W. Bush's chief economist in 2005 and 2006 before Bush chose him to lead the Fed. Janet Yellen (2014-present) was Chair of Bill Clinton's CEA in the late 1990s, when she worked with many of Obama's economic team members. Paul Volcker (1979-1987) was the lone exception to this rule; he worked for Nixon, but not Carter, before becoming Fed Chair (Table 1). Table 1Characteristics Of Fed Chairs Since 1970 Cohn does not have any experience as a central banker, but that does not preclude him from holding the position. Volcker, Bernanke and Yellen, all held posts in the Federal Reserve System before their appointments as Chair. However, Miller was an outside director for the Boston Fed, and Burns and Greenspan had no prior experience at the monetary authority. Party identification is one area where Gary Cohn would stand out. Since at least 1970, the party affiliation of a new Fed Chair has matched that of the President. However, Presidents have crossed party lines to reappoint sitting Fed Chairmen to additional terms. Volker, Greenspan and Bernanke were reappointed to lead the Fed by Presidents from opposing political parties. The timing of Trump's announcement on Yellen's replacement may be critical. In the summer of 2013, names were already being floated by the Obama White House (and mainly rejected) by markets, before he finally settled on Yellen. The official announcement came in early October 2013. In August 2009, President Obama reappointed Bernanke for a second four-year term. Bernanke was initially nominated to be Fed Chair by George W. Bush in October of 2005. If the appointment comes in October and the nominee is perceived to be hawkish, the risk is that markets may begin to price in the regime change sometime in the next few months. Our U.S. Bond Strategy service argued in a recent report5 that rate hike expectations may already be ramping up, while the data on the economy and inflation begin to beat expectations again. Bottom Line: It is too early for the markets to be concerned about the next Fed Chair and their policies. The names mentioned in the summer may not be the ones offered the job in the fall. Surprise Index Finally Bottomed Out The June employment report marked a turning point for the Citigroup surprise index, following an extended period of disappointment that depressed the dollar and bond yields. The June reports on CPI and retail sales were disappointing, but June industrial production exceeded expectations. What does this mean for relative asset returns? After 86 days, expectations moved low enough to allow economic reality to begin to run ahead. It took as few as 8 business days (in 2009) and as many as 164 (2015) for the surprise index to return to the zero line, an average of 52 days (Chart 5). Chart 5Risk Assets Tend To Outperform As Economic Surprise Index Rebounds Mean-reversions in the surprise index following troughs have generally been good for risk assets in this recovery (Table 2). We have identified 11 periods since late 2009 when the surprise index bottomed out and then moved up toward zero. In 8 of those episodes, the total return on stocks was higher than 10-year Treasuries. Equities beat Treasuries by an average of 286 bps across all 11 periods, with a median outperformance of 400 basis points. Table 2U.S. Financial Market Performance As Economic Surprise Index Rises The total return on investment-grade corporate debt outperformed Treasuries in 6 of 11 episodes. In those six instances, investment grade credit outperformed on average by 132 bps. Nonetheless over all 11 episodes, the excess return was 0%. In contrast, high-yield bonds beat Treasuries in 7 of the 11 periods, with a median outperformance of 188 basis points. Similarly, small caps beat large caps 72% of the time as the economic surprise index moved back toward the zero line. The median outperformance of small over large in all 11 periods was 124 basis points. The performance of commodities was mixed as economic surprises climbed. Gold rose in 6 of the 11 times, but fell in 5. Oil prices posted increases in only 5 of the 11, but the median return for oil after economic surprise bottomed was -2.7%. Bottom Line: Economic expectations that ramped up post-election have now declined and allowed the economic surprise index to trough. The implication for investors is that risk assets tend to outperform as the economic surprise index moves back to zero. This supports our tactical views of stocks over bonds, small over large caps, and credit over Treasury. What's Up With Wages? The June jobs report released in early July6 only added to the market's fears that the Phillips Curve is dead because wage growth softened even as the labor market tightened. Unfortunately, no Fed officials including Yellen have addressed the topic in depth recently. The market does not believe the Fed when it says that the tighter labor market is pushing up wages. We see it another way. Chart 6 shows that wage inflation has accelerated since mid-to-late 2012, but some measures of wages have made more progress than others. Chart 7 and Chart 8 reinforce that, setting aside the rollover in average hourly earnings (AHE), wage inflation is accelerating, albeit modestly. Chart 6Plenty Of Signs That##BR##Wages Are Accelerating Chart 7Compositional Effects Do Not##BR##Explain Recent Rollover Chart 8Acceleration In Hours Worked Should##BR##Lead To Faster Wage Growth The Employment Cost Index (ECI) excluding bonuses (Chart 6, panel 1) is our favorite measure of labor compensation. It has accelerated steadily since 2010. It adjusts for compositional changes in the labor market (unlike the average hourly earnings measure) and is the broadest and most comprehensive wage metric. Its drawbacks are that it is released with a long lag. For example, the Q2 ECI data will not be released until the end of July. The AHE data is already available for June and Q2. On the other hand, unit labor costs (ULC) (panel 2) have stagnated for the past five years. Data starts in 1947, so it has the most history of any of the wage measures. However, it is even more delayed than the ECI: it is released five weeks after the end of the quarter. Moreover, these data are subject to revisions and tend to be more volatile than other wages measures, which makes it difficult to identify a change in trend. Productivity, which is used to construct ULC, is also very difficult to estimate. A recent BIS report7 notes that there is evidence that the relationship between ULC and labor market slack has diminished over time, but that ULC is a better measure of inflationary pressures than AHE. Median usual weekly earnings (panel 3) have also accelerated. This is not a pure wage measure; it combines hourly pay and hours worked and, therefore, is a good proxy for incomes. Income growth has picked up the pace, providing a solid underpinning for consumer spending. Panel 4 shows compensation per hour worked. It, too, has stalled and is subject to the same strengths and weakness as ULC because it is part of the quarterly Productivity and Costs report. This metric has run near 2% with no trend. Finally, average hourly earnings (panel 5) have sped up since 2012, but rolled over in late 2016. This wage gauge gets most of the market's attention although it is only one of many measures that the Fed watches. AHE is a timely data set, released alongside monthly payroll numbers. It includes average earnings of private non-farm production and non-supervisory positions. The major disadvantage of this measure is that hourly wage earners represent only about 58% of workers and do not account for trends in salaried jobs. Earnings do not include bonus pay or employee benefits. The data are available beginning only in 2006. In Chart 7, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. The Atlanta Fed wage tracker (not shown) is in a distinct uptrend. The Tracker has the advantage that it is not biased by compositional shifts. Chart 8 shows our update to a study by the Kansas City Fed8 that found only a few industries (mostly in the goods-producing sector of the economy) have accounted for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have seen faster growth than in the goods-producing sector. We concur with the author that labor demand was strong in the past few years in areas that have not experienced much wage growth. As the labor market continues to tighten, wages in these industries may accelerate, but patience will be required. Bottom Line: The various measures of wage inflation provide a mixed picture. Taken as a group, however, we believe that wage growth has indeed accelerated as the labor market has tightened. The acceleration has admittedly been modest, but it is only recently that unemployment reached a full employment level. The real test for the Phillips curve will be in the coming quarters as the economy moves further into "excess labor demand" territory. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up", dated July 4, 2017. Available at gfis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report "The Great Debate Continues", dated April 17, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report "SPX 3000?, dated July 10, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report "Trump And The Fed", dated March 6, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report "Summer Snapback", dated July 11, 2017. Available at usbs.bcaresearch.com 6 Please see U.S. Investment Strategy Weekly Report "Sizing up the Second Half", dated July 10, 2017. Available at usis.bcaresearch.com. 7 Monetary policy: inching towards normalization", Bank for International Settlements (BIS), 25 June 2017. 8 Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings", Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.
Highlights Portfolio Strategy The energy bear market is drawing to a close. Lift exposure to above benchmark. Firming refining operating conditions, at the margin, suggest that it no longer pays to underweight this energy sub-group. Book gains and lift to neutral. Softening profit fundamentals are weighing on the real estate outlook. Trim REITs to neutral. Recent Changes S&P Energy - Lift to overweight. S&P Oil & Gas Refining & Marketing - Upgrade to neutral, lock in profits of 14.3%. S&P Real Estate - Trim to neutral and remove from high-conviction overweight list. Table 1 Feature Equities wrestled to hold on to gains last week, fighting a spike in geopolitical tensions, synchronized global central bank hawkish rhetoric and sector rotation. Investors continued to shed tech stocks in favor of financials, pushing our recently initiated long financials/short tech pair trade return near double digits. Our view remains that a rotational correction is the dominant market theme. Nevertheless, on the eve of earnings season, profits will soon take center stage and serve as a catalyst for the overshoot equity phase to resume. Our sense is that before the end of the business cycle, there are high odds that the S&P 500 will hit the 3,000 mark. That does not mean it will be a straight line advance from here. Garden variety 5-10% corrections are all but inevitable. Rather, our point is that before the next recession hits late in the decade, the SPX can attain 3,000. How did we come up with this figure? We derived the S&P 500's peak cycle value using three different methods: Dividend Discount Model (DDM) Forward P/E and EPS growth sensitivity analysis Equity Risk Premium (ERP) Table 2SPX Dividend Discount Model Table 2 shows our DDM on the S&P 500. It assumes healthy dividend growth in 2017 and 2018. Our expectation of a 2019 recession drives a steep decline in dividends that year, followed by a slow climb in 2020 and 2021, in line with the 2009-2011 experience (Chart 1). 2022 is our terminal year when dividend growth settles at 6.6%, close to the long-term average. Our discount rate assumes a 3.2% 10-year Treasury yield and a 5% equity risk premium (the past decade's average, Chart 2). This discount rate mirrors the historical average corporate junk bond yield. This valuation model delivers an S&P 500 value of 2904. Chart 1Joined At##br## The Hip Chart 2FX10 ERP And The Economy##br## Are Inversely Correlated Alternatively, we examine the S&P 500's sensitivity to EPS growth rates and forward valuation multiples. If we use the street's 160.8 (or 10.6% implied CAGR) S&P 500 2019 EPS estimate and assign the current 12-month forward multiple as a starting point, Table 3 shows an S&P 500 value of just under 3,000. Downside risks look limited. Using this EPS forecast, even a 2-turn multiple contraction results in the S&P 500 appreciating 10% from here. Table 3SPX EPS & Multiple Sensitivity Lastly, a conservative ERP analysis reveals that SPX 3,000 is a realistic peak cycle estimate. Our assumptions include: a 200 bps ERP, a 3.2% 10-year Treasury yield and 160.8 SPX EPS. These assumptions result in an S&P 500 value of slightly over 3,000. How do we justify a decline in the ERP from its current level of 338 bps to our assumed 200 bps? G10 central banks are no longer putting out GFC-related fires; in fact, a slew of them are briskly turning from dovish to hawkish following the Fed's lead (Chart 3). As a result, a sustained decline in the ERP should follow as interest rates rise. Chart 3G10 Central Banks Map Chart 4Negative Correlation Is Re-Established The bottom panel of Chart 2 drives this point home. Since the history of SPX forward EPS data, the year-over-year change in the ERP has been almost perfectly inversely correlated with the ISM manufacturing index, i.e. an improving economy is synonymous with a receding ERP and vice versa. Lastly, keep in mind that a 200 bps ERP is still significantly higher than the 80 bps mean ERP that prevailed in the 1998-2007 decade (middle panel, Chart 2). The depreciating greenback is another source of support for our SPX 3,000 view. The yearlong positive correlation between the U.S. dollar and commodities has likely come to an end and the three plus decade inverse correlation has been re-established (Chart 4). As the cycle matures and enters its late stages, commodities and resource-related equities tend to pick up steam as profits rebound. Even energy stocks may catch a bid. Buy Energy Stocks... Energy equities are down roughly 20% year-to-date versus the broad market. In fact, the energy sector has broken down to a level last seen in 2004, when oil traded near $30/bbl (Chart 5). The three main culprits have been rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. While going overweight the energy space has been a "widow maker" trade recently, we are now tempted to take a punt on the S&P energy sector from the long side. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, as we mentioned above, the inverse correlation between the U.S. dollar and the commodity complex has been re-established after a one-year hiatus. Synchronized global growth suggests that a corresponding tightening interest rate cycle is brewing (Chart 3). Thus, there are high odds that a number of G10 central banks will hike rates later this summer or early this fall, now that the Fed has paved the path.1 As long as the greenback drifts lower, even energy stocks should catch a bid (Chart 6). Chart 5Crude Oil... Chart 6...And The Dollar Say Buy Energy Stocks Second, on the domestic operating front, the steepest drilling upcycle in recent memory is showing signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 7). Predicting OPEC's compliance is tricky. However, BCA's Commodity & Energy Strategy service believes that little to no cheating will occur and in a worst case scenario Saudi Arabia will step in and curtail production were Libya and/or Iraq to pump oil above quota. Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal (Chart 8). Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Chart 7Improving Supply Dynamics Chart 8S&P Energy Unloved And Fairly Valued Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 9). Simultaneously, the budding recovery in our S&P energy Cyclical Macro Indicator also signals that profits should best those of the overall market (second panel, Chart 8), giving us comfort to lift the S&P energy sector to a modest overweight position. ... As Refiners Are No Longer Cracking Under Pressure We are executing the upgrade to overweight in the broad energy sector via booking gains of 14.3% since inception in the S&P oil & gas refining & marketing sub-group and lifting exposure to neutral from underweight. It no longer pays to remain bearish on the pure play downstream energy business. Back in late September 2015, when we turned negative on refiners, we were anticipating a cyclical earnings downturn on the back of a refined product glut in this low margin / high volume industry. Fast forward to 2017 and that bearish profit view has materialized as relative EPS have fallen by roughly 60 percentage points from the most recent peak, and have only lately managed to stabilize (Chart 10). Chart 9EPS Model Waves Green Flag Chart 10Refining Profit Contraction Is Over If relative EPS have indeed troughed, then relative performance should soon find a bottom. Relative profit fortunes move with the ebb and flow of gasoline consumption. The latter is on the cusp of expanding for the first time since last November, heralding the same for relative profitability (bottom panel, Chart 10). Industry shipments tell a similar story. After recently bottoming at levels similar to those reached during the GFC, refinery shipments have staged a mini V-shaped recovery (top panel, Chart 11). Crack spreads have not collapsed to razor thin levels as the nearly eliminated Brent/WTI spread would suggest, but have remained resilient in the high-teens per barrel (third panel, Chart 11). Three forces are likely in play. First, not only is domestic gasoline demand underpinning refining margins, but petroleum products are also finding their way into foreign markets with net exports running at over 3 million bbl/day (bottom panel, Chart 11). Second, the U.S. dollar selloff since mid-December is making U.S. refined products more competitive in global markets. Finally, crude oil inventories are nearly 40% higher than gasoline inventories. Lower industry feedstocks represent a boost to refining margins (third, Chart 11). Nevertheless, we refrain from turning outright bullish on refiners. Refinery production hit all-time highs recently, refinery runs are climbing steadily and utilization rates are running hot north of 90%. Tack on, historically high refined products inventories and rising industry capacity growth and the profit backdrop darkens (Chart 12). Chart 11Three Positives... Chart 12...But Do Not Get Carried Away Netting it out, we expect a balanced refining profit outlook in the coming quarters. Bottom Line: Upgrade the S&P oil & gas refining & marketing index (PSX, VLO, TSO, MPC) to neutral and lock in profits of 14.3%. This also pushes the S&P energy index to an above benchmark allocation. Downgrade REITs We are making space for the energy sector upgrade to overweight via trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel, Chart 13). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 13). Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin. The bottom panel of Chart 13 shows that retail and office delinquency rates have taken a turn for the worse, and represent a yellow flag. Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs. If banks continue to close the credit taps, CRE prices will suffer a setback (Chart 14). Chart 13Time To Move To the Sidelines Chart 14Conflicting Signals Chart 15 puts the CRE price appreciation in historical perspective. Currently, CRE prices are on track to climb to two standard deviations above the long-term trend. Such exuberance is a cause for concern as it has historically marked the beginning of a corrective phase in CRE prices. Nevertheless, there are some positive offsets that prevent us from throwing in the towel in the S&P real estate sector. The tight labor market and accelerating industrial production explain the reacceleration in our REITs Demand Indicator, while the recent selloff in the bond market is a modest offset. If CRE appetite remains upbeat, this in turn suggests that CRE prices have a bit more room to run before reaching a cyclical peak (bottom panel, Chart 14). In addition, compelling relative valuations and washed out technicals argue against becoming overly bearish on REITs (Chart 16), as some of the bad news is already reflected in relative share prices. Chart 15An Historical Perspective Chart 16Positive Offsets Bottom Line: Trim the S&P real estate sector to neutral and remove it from the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the June 30th, 2017 Foreign Exchange Strategy Service Special Report titled "Who Hikes Next?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of June 30th, 2017. The model has continued to reduce its allocation to the U.S. and now for the first time the U.S. allocation is slightly below benchmark. Within the non-U.S. universe of the 11 countries, the model has also made significant adjustments to shift weights to Italy (now the largest overweight) and Australia (now for the first time it is overweight by the model), while underweight Germany and France. These adjustments are mainly due to liquidity and technical indicators, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 14 bps in June, largely due to the underperformance of Level 2 model where the overweight of the Euro area v.s. the underweight of Australia and Canada hurt the performance. Since going live, the overall model has outperformed its benchmark by 139 bps. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of June 30, 2017. Chart 3GAA Non U.S. Model (Level 2) Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continues to overweight cyclicals versus defensives. Additionally, the model has turned overweight financials and underweight consumer discretionary on the back of momentum. This overweight in financials is now in line with our global sector recommendations published yesterday. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com