BCA Indicators/Model
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of March 31, 2017. The model has not made significant changes compared to previous month as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, Level 2 model ( the allocation among the 11 non-U.S. DM countries) sharply outperformed its benchmark by 338 basis points (bps) in March, largely a result from the overweight of Spain and Italy versus underweight in Japan and Canada. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 27 bps in March due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 71 bps in March and by 117 bps since going live. 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 March 31, 2017. Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance The momentum component has shifted Materials from overweight to underweight and Consumer Discretionary from underweight to overweight. The growth component has become less optimistic on global growth given the weakness in metals prices. For mode 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 Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Highlights EM equity valuations are neutral. Relative to the U.S., EM share prices do offer some value, but this primarily reflects elevated valuations within the S&P 500. According to the cyclically-adjusted P/E ratio, EM stocks are cheap for investors with a long-term time horizon - longer than two to three years. Corporate profits are much more important than equity valuations in driving share prices in the next 12 months. Our outlook for EM EPS is downbeat for the next 12 months. Maintain a defensive posture and an underweight allocation in EM stocks versus DM. A new trade: go long Russian energy stocks / short global energy ones. Feature Chart I-1EM P/E Ratio And EPS There is ongoing debate in the investment community concerning whether emerging markets (EM) equities are or are not cheap, in both absolute terms and relative to developed markets (DM). In this week's report we review various equity valuation indicators and reiterate that EM stocks are neither cheap nor expensive in absolute terms. For example, the average of trailing and forward P/E ratios is slightly above its historical mean (Chart I-1, top panel). Relative to the U.S., EM share prices do offer value, but this reflects elevated valuations within the S&P 500. Despite this, we recommend underweighting EM vs U.S./DM because the cyclical growth dynamics is much better in DM than EM. EM stocks are cheap if one assumes a strong earnings recovery (Chart I-1, bottom panel). If earnings per share (EPS) begin contracting anew, as we expect, then the current rally will be reversed sooner than later. Overall, we continue to recommend a defensive posture for absolute-return investors and maintaining an underweight allocation in EM stocks versus DM for asset allocators. Valuation Perspectives Below we consider several valuation ratios: The equal-sector weighted trailing P/E ratio is 17.7 for EM (Chart I-2). Table I-1 displays equal-sector weighted P/E ratio, price-to-book value ratio and dividend yields for major equity markets globally. This is an apples-to-apples comparison, as it assigns equal weights to each of the 10 MSCI sectors - i.e., it removes sector biases. Chart I-2Equal-Sector Weighted Trailing P/E Ratio Table I-1Equal-Sector Weighted Valuation Ratios Across EM And DM Hence, on a comparable basis, EM equities are only slightly cheaper than DM stocks as is evident in Table I-1. Besides, the composite valuation indicator based on equal-sector weighted trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yield indicate that EM stocks are fairly valued (Chart I-3). The cyclically-adjusted P/E (CAPE) ratio. The CAPE ratio is a structural valuation measure, i.e. it matters in the long run. Importantly, it assumes that real (inflation-adjusted) EPS will revert to its historical mean or trend. In short, the CAPE ratio tells us what the P/E ratio would be if EPS were to revert to its historical trend. Chart I-4 illustrates the EM CAPE ratio. If EM EPS in inflation-adjusted U.S. dollar terms reaches its historical time trend, one can safely assume that EM stocks are cheap and currently worth buying. In a nutshell, the current CAPE ratio of 15 assumes that EM EPS should rise by about 30% in nominal U.S. dollar terms over an investor's time horizon. Chart I-3EM Equities Valuations Are Neutral Chart I-4EM CAPE Ratio Given that our time horizon is 12 months, the assumption that EM EPS will surge by about 30% in U.S. dollar terms is in our view ambitious. Therefore, we posit that EM share prices do not offer compelling value at all in the next 12 months. If one's investment horizon were two-to-three years or longer, the assumption that EPS will rise by 30% or more in U.S. dollar terms is much more plausible. In this sense we would concur that EM share prices offer decent value from a longer-term perspective. Our methodology of calculating the CAPE ratio for EM varies from the well-known Robert Shiller's CAPE ratio for the U.S.1 However, even when applying our CAPE methodology to U.S. equities, the resulting ratio is not very different from Shiller's CAPE (Chart I-5). Trimmed-mean equity valuation ratios. Chart 6 illustrates 20% trimmed-mean trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yields for the EM equity universe. A 20% trimmed-mean ratio excludes the top 10% and bottom 10% of industry groups, and then calculates the average. All calculations are based on 50 EM industry group data available from MSCI. Why look at trimmed-mean valuation ratios? Because by removing the top and bottom 10% of industry groups, this measure excludes outliers and provides a better perspective on valuation. A few observations are in order: First, according to the trimmed-mean valuation ratios, EM equities are not cheap. The trimmed-mean ratios are close to their historical mean (Chart I-6). Second, the trimmed-mean ratios are well above their market cap ones. This indicates that there are a few industry groups with large market caps that pull EM multiples lower. In other words, market-cap weighted multiples are skewed to the downside by a few large industry groups. There are reasons why some sectors and countries have low or high equity multiples. It makes sense to exclude them. Finally, the composite valuation indicator based on trimmed-mean trailing and forward P/Es, PBV and price-to-cash earnings ratios and dividend yield demonstrates that EM equity valuations are neutral (Chart I-7). Chart I-5U.S. CAPE Ratios Chart I-6EM Stocks Are Close to Fair Value Chart I-7EM Equities Have Neutral Value Bottom Line: EM equities by and large command a neutral valuation. According to the CAPE ratio, EM equities are cheap for investors with a long-term time horizon, say two-to-three years or longer. Profits Hold The Key Valuations are not a good timing tool. For low equity valuations to be realized, i.e., to produce solid price gains, corporate profits should grow. The reverse is also true: for an overvalued market to decline, company earnings should contract, or at least disappoint. When valuations are neutral - as they currently are for the EM equity benchmark - a recovery in EPS should entail higher share prices, while EPS shrinkage should lead to a selloff. EM EPS will continue to recover in the next three to six months, given the rally in commodities prices in 2016, amelioration in China's business cycle and the technology sector boom in Asia. However, this moderate and short-lived EPS recovery is already priced in. For the market to rally further, EPS will need to expand beyond the next three to six months. Remarkably, there has been little improvement in EM ex-China domestic demand. Besides, the risk to bank loan growth remains to the downside both in China and EM ex-China. Slower loan growth and the need to recognize and provision for potentially large NPLs will pressure banks' profits in many EM countries. Finally, we expect oil and industrial metals prices to decline considerably over the course of this year. If and as this view plays out, energy and materials stocks will fall. Energy and materials share prices correlate not with their past or current profits but rather with underlying commodities prices. One area where we remain bullish is the technology sector. Even though tech share prices are overbought and could correct in absolute terms in the months ahead, they will continue to outperform the benchmark. Bottom Line: Corporate profits are much more important in driving share prices in the next 12 months than equity valuations. Our outlook for EM EPS is downbeat for the next 12 months or so, even though EPS will continue to recover in the next three to six months. Timing Reversal: Watch Credit Quality Spreads Chart I-8Credit Quality Spreads: ##br##A Correction Or Reversal? Following are some of the indicators we are monitoring to gauge a reversal in EM share prices. EM corporate spreads have widened a notch relative to EM sovereign spreads (Chart I-8, top panel). Similarly, Chinese off-shore corporate spreads have widened versus Chinese sovereign spreads (Chart I-8, middle panel). Credit quality spreads - the gap between B- and BAA-grade corporate bonds - have widened slightly in the U.S. (Chart I-8, bottom panel). These moves are still very small, and do not constitute a definite sign of a major trend reversal. Nevertheless, such widening in credit quality spreads is an important development. If they persist, they will certainly sound the alarm for the reflation trade. Interestingly, this is the first time a simultaneous widening in credit quality spreads has occurred since the risk assets rally began in early 2016. Bottom Line: Major equity market selloffs will occur when lower quality credit begins to persistently underperform better quality credit. There have been budding signs of quality spread widening that are worth being monitored. Identifying Relative Value Within the EM equity universe, valuation ratios differ greatly. For example, banks trade at a trailing P/E of 9.7, while consumer staple stocks trade at 24.8. Table I-2 portrays the trailing P/E ratio and its historical mean as well as 12-month forward EPS growth and the forward P/E ratio for each sector - as well as average of trailing and forward P/E ratios. Table I-3 shows the same valuation measures but for EM countries. Table I-2Stock Valuation Snapshot: EM Sectors Table I-3Equity Valuation Snapshot: EM Countries It is difficult to draw any definitive conclusions from these tables. On a general level, a simplistic approach to investing based on trailing and forward P/E ratios would not have produced great outcomes in EM in recent years. When analyzing EM stock valuations, we prefer to use the trailing rather than forward P/E ratio because historically, EM forward EPS have had a very poor record forecasting actual EPS. One of our favorite ways to identify relative value is to compare the PBV ratio and return on equity (RoE) across countries/sectors. Chart I-9 plots RoE on the X-axis and the PBV ratio on the Y axis. Countries and sectors located in the bottom right corner (at the low end of the shaded area) have a low PBV ratio compared to their RoE. In contrast, in the north-west side of the distribution (at the upper end of the shaded zone), these have an elevated PBV ratio, taking into account their RoE. Chart I-9Searching For Relative Value Among countries, Korea, Russia, Hungary, the Czech Republic and China appear cheap, while Mexico, Brazil, South Africa, Colombia, Malaysia and Poland are on the expensive side. Chart I-10EMS's Recommended ##br##Equity Portfolio Performance Concerning equity sectors, utilities and financials/banks are cheap, yet consumer staples and consumer discretionary, health care, telecom and materials appear expensive in relative terms. Our recommended country equity allocation is based on a qualitative assessment of many variables including but not limited to valuation. Chart I-10 displays the performance of our fully invested EM Equity Portfolio Model versus the EM benchmark. Our overweights presently include: Korea, Taiwan, India, China, Thailand, Russia and central Europe. Our underweights are Brazil, Turkey, Indonesia, Malaysia and Peru. We are neutral on Mexico, Chile, Colombia, South Africa and the Philippines. The lists of our country allocation and other equity investment recommendations are presented each week at the end of our reports. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Bet On Russia's Non-Compliance With OPEC Odds of Russia's compliance with the OPEC agreement to cut oil output by 300k b/d in the next two months are low. This poses downside risk to oil prices. Russia has so far done only 120k b/d cuts. Hence, in the next two months it should reduce its output by 180k b/d which amounts to 1.6% of the nation's oil output. One way to bet on Russia's non-compliance, regardless the direction of oil prices, is to go long Russian energy stocks / short global energy ones (Chart II-1). There are a number of political, economic and financial motives why Russia might care less about lower oil prices than Saudi Arabia in the next 12-18 months or so. As a result, Russia might not cut as much as it is expected by the OPEC agreement. Russia is able to increase oil production due to a cheaper ruble and technology advances. BCA's Energy Sector Strategy team has been highlighting that there have been concerted efforts by Russia's largest producers to employ horizontal drilling and multi-zone hydraulic fracturing in Western Siberia.2 These have stemmed declines from those aging fields and allowed production to rise (Chart II-2). Chart II-1Long Russia Energy / ##br##Short Global Energy Stocks Chart II-2Russian Oil ##br##Production Will Increase Russia will not shy away from being opportunistic and increase its market share when it can ramp up oil production. A rising global oil market share will allow Russian companies to outperform their global peers regardless the direction of oil prices. There are major cyclical divergences between Russian and Saudi economies. Russia's economy is gradually picking up while there is less certainty about Saudi's growth recovery. The reason is that Russia has allowed the ruble to depreciate and act as a shock absorber. Meanwhile, Saudis have stuck to the currency peg. Oil prices are down by 27% from their top in rubles and 55% in Saudi riyals (Chart II-3). This has reflated Russia's fiscal revenues and the economy, while Saudi Arabia is still struggling with the consequences of low oil prices. On the fiscal front, Russia went through a notable fiscal squeeze and its budget deficit is projected to be 3.2% of GDP in 2017 (Chart II-4). In contrast, the Saudi Arabian fiscal deficit in 2016 reached an outstanding 17% of GDP, accounting for the drawdown in reserves by our estimates.3 Chart II-3Ruble's Depreciation ##br##In 2014-15 Made a Difference Chart II-4Fiscal Deficit: Small In ##br##Russia & Large In Saudi More importantly, Russia's federal budget for 2017 was constructed on the oil price assumption of $40/bbl. The 2017 Saudi budget assumes oil price of $50/bbl.4 Therefore, Russia would not mind if oil prices drop toward or slightly below $40 in the second half of this year. Therefore, Saudis care much more about sustaining oil prices at a higher level than Russians do. Finally, Rosneft has already conducted its IPO while Aramco's IPO has not taken place yet. As such, the need for higher oil prices is much greater in Saudi Arabia - to justify a higher value of their oil giant - than in Russia. Bottom Line: Odds are considerable that Russia will not comply with the OPEC deal and this could cause oil prices to selloff more. Regardless of direction of oil prices, we expect the Russian energy sector to outperform their global peers due to Russia's rising market share in the global oil market. Go long Russian energy stocks / short global ones. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 For more detailed discussion on our methodology of CAPE, please refer to January 20, 2016 Emerging Markets Strategy Special Report titled "EM Equity Valuations: A CAPE Model", available at ems. bcaresearch.com 2 Please refer to the Energy Sector Strategy Weekly Report titled, "Russian Oil Production: Surpassing Expectation", dated December 14, 2016, available at nrg.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled, "Saudi Arabia: Short-Term Gain, Long-Term Pain", dated February 1, 2017, available at ems.bcaresearch.com 4 https://mof.gov.sa/en/budget2017/Documents/The_National_Budget.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Portfolio Strategy Internal dynamics warn that a broad market consolidation phase has begun. The jump in growth vs. value stocks has provided an opportunity to shift to a neutral style bias. Transports have sold off sharply, but downside risks have not yet been fully expunged, especially for the airline group. Recent Changes Growth Vs. Value - Shift to a neutral stance. Table 1Sector Performance Returns (%) Feature The perceived dovish Fed shift and doubts about the achievability of Trump's policy goals are causing equity market consternation. To the extent that the run up in stocks has largely reflected an improvement in sentiment and other 'soft' economic data, the lack of follow through in 'hard' data has created a validation void. While a weaker U.S. dollar, lower oil prices and less hawkish Fed imply easier monetary conditions, which are ultimately positive for growth, profits and the stock market, a digestion phase still looms. Financials, and banks in particular, had been market leaders, driven up by hopes for a meaningful upward shift in the yield curve and unleashing of animal spirits. But these assumptions are being challenged and there is limited fundamental support. Indeed, bank lending growth remains non-existent and there is no tailwind from improving credit quality. Our view remains that banks carry the most downside risk of all financial groups (please see the March 6 Weekly Report for more details). Regional banks are now down on a year-to-date relative performance basis (Chart 1). In fact, our newly constructed gauge of the equity market's internal dynamics suggests that additional tactical broad market turbulence lies ahead. A composite of relative bank stock, relative transport, small/large cap and industrials/utilities share prices has been a good coincident to leading market indicator in recent years (Chart 2). While no indicator is infallible, the message is that overall market risk is elevated and a choppy period lies ahead, reinforcing our defensive vs. cyclical bias. Nevertheless, it will be important to put any corrective action into a longer-term context. Over the years, we have kept an eye on several qualitative 'unconventional indicators' that have helped time major market turning points. They are meant to augment rather than replace fundamental factors. Chart 1Market Leaders Are Stumbling Chart 2A Yellow Flag From Internal Dynamics Below we highlight five critical variables to gauge whether a correction will devolve into a sustained sell-off. Each of the indicators measures either; profits; business confidence; investor confidence; and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated (Chart 3), there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income. M&A activity is losing momentum (Chart 4). A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds. Economic signals are mostly positive. Durable goods orders have tentatively perked back up (Chart 5), reinforcing that profits and confidence have improved after a soft patch. Temporary employment continues to rise (Chart 5). When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist (Chart 4, bottom panel). If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Chart 3Borrowing Costs Are Not Yet Restrictive Chart 4M&A Is Starting To Labor Chart 5Economic Signals Are Decent In all, these indicators suggest that any pullback will be corrective rather than a trend change. If the profit cycle continues to improve and the Fed has no inflationary need to become restrictive, then any broad market correction could provide an opportunity to selectively add cyclical exposure to portfolios in the coming weeks. In the meantime, we are revisiting our growth vs. value view and providing an update on transports. Growth Vs. Value: Shifting To Neutral Our last style bias update in the December 19 Weekly Report concluded that we would likely recommend moving to a neutral stance over the coming weeks/months from our current growth vs. value (G/V) stance, but expected to do after growth stocks had staged a comeback. That recovery is now well underway and so we are revisiting the outlook. Growth indexes have outperformed value since the depths of the Great Recession. The preference for growth reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. In addition, the composition of the growth index is much longer duration than that of the value space. The surge in long-term earnings growth expectations suggests that investors have increased conviction in the durability of the expansion, which has aided the G/V recovery (Chart 6). That monetary experiment has recently begun to pay off, as global economic growth has finally demonstrated evidence of self-reinforcing traction, led by developed countries. As a result, most central banks are well past the point of maximum thrust, which would mean the loss, albeit not a reversal, of the primary support for the secular advance in growth vs. value indexes. Keep in mind that growth benchmarks have a massive technology sector weight, at just over 1/3 of the total index capitalization. Value indices carry only a 7% weight. As shown in previous research, the technology sector underperforms when economic growth is fast enough to create inflationary pressure and therefore, the interest rate structure. Furthermore, value benchmarks have more than 25% of their weight in the financials sector vs. less than 5% for growth indexes. The upshot is that a meaningful interest rate increase would pad the profits of financials-rich value indices while having little to no impact on growth benchmarks by virtue of their tech-dependence. It is no surprise that the G/V ratio trends with technology/financials relative sector performance (Chart 7). The latter has clearly peaked, with an assist from the renormalization in Fed policy. Chart 6Time To Shift Chart 7Two Key Sector Influences These sector discrepancies mean that a critical question for the style decision is what is the path for government bond yields? The U.S. economy is exhibiting signs of self-reinforcing behavior. The small business sector's hiring plans have surged, and the ISM employment index remains solid (Chart 8). Chart 8Economy No Longer Favors Growth Chart 9A Mixed Bag While at least a modest employment slowdown is probable given that the corporate sector is feeling the profit margin pinch from higher wage costs, these gauges do not suggest a major crunch is imminent. The personal savings rate is drifting lower, supporting consumption growth (Chart 8). Value indexes have a higher economic beta than growth benchmarks, owing to their exposure to shorter duration sectors. The gap between growth and value operating margins tends to close when the economy enjoys a meaningful acceleration (Chart 8). Chart 10Volatility Is A Style Driver Other markers of global economic growth are more mixed. The global manufacturing PMI survey is very strong, but oil and other commodity prices have started to diverge negatively (Chart 9). That may soon change if the U.S. dollar has crested, which would provide a much needed fillip to emerging markets and remove a source of deflationary pressure. Real global bond yields are grinding higher, suggesting that in all, economic prospects have improved, and alleviating a major constraint on value stocks. Against this backdrop, it is timely to shift to a neutral style preference after the sharp rebound in the G/V ratio since late last year. Why not a full shift into value indexes? Developing countries are conspicuously lagging developed countries, which caps the outlook for commodities and their beneficiaries. EM capital spending is still very weak in real terms. Deep cyclical sectors are much more heavily-weighted in value benchmarks. A global recovery that has a greater thrust from consumption than investment, at least at the outset, argues against expecting value stocks to outperform. Moreover, the fallout from potentially protectionist U.S. trade policies remains unknown, which could restrain economic growth momentum and unleash volatility in the equity markets. The latter has been incredibly muted in recent months. In fact, BCA's VIX model, which incorporates corporate sector health and interest rate expectations, is heralding a higher VIX. Clearly, elevated volatility has supported the G/V ratio over meaningful periods of time (Chart 10). Bottom Line: Shift to a neutral style bias. A full shift to a value preference would require BCA to forecast a much weaker U.S. dollar and/or demand-driven inflationary pressure. Transports: Stuck In Neutral The S&P transports index peaked in mid-December versus the broad market, the first major sub-group to fizzle after the post-election sugar high (Chart 11). The recent setback has been broad-based. We had been overweight both the rails and air freight & logistics industry sub-groups, but booked gains in both prior to their respective pullbacks. Is it time to get back in? Transportation equities are ultra-sensitive to swings in global economic growth. Chart 12 shows that the relative share price ratio is an excellent leading indicator of both the ISM manufacturing survey and Citi's economic surprise index. The message is that at least a mild mean reversion in both of these indexes looms in the coming months, i.e. beware of some form of economic cooling. Chart 11Transports Have Cracked... Chart 12... Signaling Economic Cooling Ahead Against this backdrop, we are revisiting our last remaining underweight, the S&P airlines index. While rails and air freight & logistics stocks are directly linked to global trade, the same does not hold true for the S&P airlines index. Business and consumer travel budgets are the key drivers of industry demand. A revival in animal spirits and a healthy U.S. consumer could be clear positives for air travel. Moreover, the recent pullback in fuel costs should cushion profit margins for unhedged airline operators (Chart 13). Finally, renowned investor Warren Buffett has recently become a major shareholder in the U.S. airline industry, raising its profile. While betting against Buffett is always fraught with risk, our cautious take on the airline industry boils down to our view that excess capacity will continue to hold back profitability. If the overall transport index is accurately signaling that some loss of economic momentum looms, then a rapid expansion in business and travel spending may not be quick to materialize. A pricing war has already gripped the industry, as airlines are scrambling to fill up planes. Revenue-per-available-seat-mile and U.S. CPI airfare are contracting (Chart 14), reflecting a fight for market share. That is a serious impediment to profit margins. Chart 13Airlines Are Losing Altitude... Chart 14... As Price Wars Persist The headwinds extend beyond the U.S. Chart 15 shows that global airfare deflation also bodes ill for top line industry growth. The lags from previous U.S. dollar strength could compound this source of drag. Absent a decisive recovery in total travel spending, there does not appear to be any catalysts to reverse deflationary conditions. Carriers are still allocating an historically high portion of cash flow to capital spending. While upgrading aging fleets to become more fuel-efficient in an era of low interest rates is a long-term positive, the payback period may be extended. Revenue has failed to keep up with the increase in capital expenditures (Chart 16, bottom panel), suggesting that capacity growth continues to outpace industry demand, a recipe for ongoing pricing pressure. Chart 15Deflation Is Global Chart 16Too Much Capacity This difficult backdrop has begun to infect analyst earnings estimates. Net earnings revisions have nosedived. Relative performance momentum is tightly lined with the trend in earnings estimates (Chart 16). The message is that the breakdown in cyclical momentum has further to run. Indeed, the 52-week rate of change rarely troughs until it reaches much lower levels, warning of additional downside relative performance risks. Bottom Line: The S&P transports group is heralding a period of economic cooling, but the airline sub-component has not yet fully discounted such an outcome. Stay underweight. The ticker symbols for the stocks in the S&P airlines index are: UAL, AAL, DAL, LUV & ALK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Dear Client, In addition to an abridged Weekly Report, we are also including a Special Report written by our Global ETF Strategy team. BCA's Global ETF Strategy, launched in September joins comprehensive ETF analysis with BCA's global macroeconomic thematic research: its aim is to help clients connect the dots from BCA themes to individual ETF ticker symbols with real-time market expressions of our views. The team is currently producing a series of reports on smart-beta ETF selection, whereby they examine the key factors recognized by academia and investment practitioners as persistent drivers of market performance. In this second installment, the team focuses on dividend-focused funds. Although the team finds that dividends do not qualify as a true standalone factor consistently explaining equity returns, dividend policy can add to multi-factor models' explanatory power at the margin. Given the popularity of dividend investing, we think dividend policy could be a fruitful subject for further research. Best regards, Lenka Martinek Feature U.S. financial markets breathed a collective sigh of relief last week when the FOMC followed through on a fully discounted 25 bps rate hike, but did not increase the number of expected rate hikes for the year. In other words, the Fed successfully delivered a "dovish hike", thus reassuring investors that the policy sweet spot - the period when interest rates are rising but have not become restrictive - will last a while longer (Chart 1). Chart 1A "Dovish Hike" Chart 2Low Structural Unemployment Rate The Fed's assessment of the economy is not very different from our own, though there were a few details in the economic projections worth highlighting. First, the estimate for the structural rate of unemployment was scaled down further by a tenth of a percentage point to 4.7%. This may seem minor, but it suggests that policymakers believe the labor market has more running room before wage inflation moves higher. Granted, any forecast for structural unemployment should be taken with a dose of salt, but our bias throughout this cycle - and as outlined in our November Special Report - has been to expect wage inflation to lag relative to past cycles due to structural factors (Chart 2). And as can be seen in Chart 3, Japan provides a roadmap: in that country, demographic factors helped push the unemployment rate to below 3% without creating inflationary pressures. Of course, the U.S. economy is very different from Japan and we do not expect unemployment to drop as low. However, as occurred in Japan, we would not be surprised to see the FOMC trim its forecast for the structural unemployment rate further in the coming quarters. A related point is that the Fed also adjusted the wording of the FOMC statement regarding its inflation targets. The statement said that the Fed was looking for a "sustained" return to 2% inflation, while also referring to its inflation target as a "symmetric" one. Our interpretation is that the Fed is trying to clarify that it will not react too aggressively if core inflation were to drift somewhat above 2%. Clearly, the Fed is beginning to see the balance of risks toward higher inflation. That makes sense, given that the economy is operating close to full employment. However, we maintain that a sustained rise in inflation above the Fed's 2% core PCE target is not imminent. Indeed, the message from last week' CPI report reinforces our view that with the exception of a few components, inflation is very well contained (Chart 4). Our diffusion index of the major inflation components is in negative territory. Importantly, price surveys continue to show that businesses are not able to easily raise prices. For example, despite the continued optimism in the headline components of the NFIB small businesses survey, small businesses have not been able to - and do not yet anticipate being able to - raise prices. This reinforces our long-held view that after a long period of disinflation - and outright deflation in the retail sector - inflation expectations are extremely well-anchored and savvy consumers know how to extract a better deal. Core PCE inflation may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next 6-12 months. Chart 3Japan: A Low Unemployment Rate ##br##And Little Wage Inflation Chart 4Inflation ##br##Still Low In the end, it is Fed Chair Yellen's least sophisticated remarks that provide the best summation. During the FOMC press conference, she stated that "the simple message is the economy is doing well". Indeed, the moderate pace of growth that has prevailed since the beginning of the recovery means that the typical imbalances and pressure points that accumulate in the advanced stages of a business cycle are so far still absent. The backdrop overwhelmingly favors stocks relative to government bonds on a cyclical horizon. To be sure, equities are expensive, but as we wrote last week, relative to competing assets, valuations are not extreme. The greater near-term risk continues to be a phase of economic and earnings disappointments that could develop later this year, since there remains a tremendous amount of optimism in the business community regarding regime change in Washington. Note that the policy uncertainty index remains very elevated (Chart 5) and Trump's "skinny budget", which aims to slash spending across all discretionary items save military and veterans affairs, will be contested. Our geopolitical team notes that Democrats could threaten a government shutdown later this year to try to force Republicans' hand at removing the most controversial elements of the budget. Democrats can filibuster parts of the appropriations process which makes the concrete budget allocations. Chart 5Political Uncertainty Still Elevated On this basis, we remain skeptical that fiscal policy will be clean fuel for the equity bull market. However, we adhere to Yellen's "simple message" that the economy is on a stable footing. That implies that Washington disappointments will most likely lead to equity setbacks rather than a painful breakdown. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommendation weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), neutral Treasury allocation at 30% (benchmark 30%) and cash at 10% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component "buy" signal strengthened, with sturdy advances for both the breadth & trend and momentum indicators. The monetary component, which measures overall liquidity conditions within the financial and economic system and designed to lead equity prices, is slightly more bullish and still favorable for equities. The earnings-driven component continues to give a cautious signal. Real operating earnings remain at a significant distance from positive economic expectations which have moved higher yet again. Moreover, earnings momentum is still sluggish, based on our earnings diffusion index, which compares nominal earnings growth relative to four key macro proxies for business costs. The model's recommendation for bonds remains at benchmark which still fits with our neutral qualitative stance for Treasuries in balanced portfolios since November 7, 2016. Although the cyclical component of the bond model is more constructive than the valuation component, the further deterioration in the technical component maintains the "sell" signal for Treasuries firmly in place. Chart 6Portfolio Total Returns Chart 7Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Highlights Factor attribution began a half-century ago with the Capital Asset Pricing Model ("CAPM"). Although the CAPM itself has been superseded, selected factors have exerted a consistent influence on equity performance. The empirical evidence does not support including dividends among the proven factors, yet dividend-focused funds are the most numerous in the smart-beta universe. The ambiguity surrounding dividends' effect on equity performance leaves plenty of room for smart-beta purveyors to build a better mousetrap, but our own research suggests that they will have to do so with something other than purely dividend-related metrics. Reflecting the fact that many of the dividend funds already incorporate multi-factor inputs, we evaluate them based on their exposure to all of the metrics within our Equity Trading Strategy service's multi-factor model. Feature Welcome to the second installment of our series on smart-beta ETF selection. Over the course of the series, we intend to examine the factors widely recognized by academia and investment practitioners as persistent drivers of equity performance. Each Special Report will weigh the evidence for the factor's efficacy, consider the metrics that best reveal its presence and compare our ideal metrics with the metrics utilized by our proprietary Equity Trading Strategy ("ETS") multi-factor model. It will then evaluate the menu of smart-beta ETFs using either our ETS model's metrics or an augmented version of them. The series began last month with a review of the Value factor, enshrined by Fama and French's research, and the current subset of Value smart-beta ETFs.1 This month we examine Dividend smart-beta ETFs. Subsequent installments will examine Quality, Momentum and Volatility,2 and we will likely wrap up the series with a review of Multi-Factor smart-beta ETFs. This installment provides some background on factor investing and the smart-beta process before subjecting Yield (Dividends) to scrutiny to determine whether or not it really constitutes a standalone equity factor. Back To The Beginning The ubiquity of beta in discussions of investing performance originates from the Capital Asset Pricing Model ("CAPM"), as advanced by William Sharpe and other researchers in the early 1960's. The CAPM posits that the expected return of stock XYZ is solely a function of XYZ's riskiness relative to the overall equity market. XYZ's riskiness is a function of its covariance with the market, and is represented in the CAPM's simple linear model as the coefficient "beta.3" The elegantly simple CAPM holds that any stock's expected return (E(rs)) is the sum of the risk-free rate (rf) and the product of its beta (ßs) and the difference between the expected market return (E(rm)) and the risk-free rate (rf): E(rs) = rf + ßs x (E(rm) - rf) As noted by several researchers, including Eugene Fama and Kenneth French,4 CAPM's return predictions are woefully errant when applied to stocks. As Chart 1 indicates, the returns projected by the CAPM bear little relationship to empirical results. It turns out that low-beta stocks have systematically outperformed high-beta stocks on a risk-adjusted basis (Chart 2), just as low-book-multiple stocks have crushed high-book-multiple stocks without regard for beta (Chart 3). This is powerful evidence for value, and for the low-volatility factor that we will examine in a subsequent report, but it is damning for the simple application of the CAPM to stocks. Chart 1CAPM Sounded Great In Theory ... Chart 2... But It Flopped In Practice Chart 3Low-Book-Multiple Stocks Systematically ##br##Flout CAPM Predictions A New Vocabulary Despite its empirical shortcomings, the CAPM provides an intuitive way of conceptualizing the risk-return tradeoff, and it paved the way for the asset-pricing research that followed it. The notion that individual securities' risks come in two flavors, market and idiosyncratic, is a critical element of portfolio theory and its thou-shalt-diversify commandment. It is also the basis, as we shall see, for beta, alpha and the factor-investing approach enabled by smart-beta ETFs. For that application, let us add an alpha term to the CAPM to account for the component of realized returns that cannot be explained by market exposures: rs = rf + ßs x (E(rm) - rf) + a Rearranging terms to solve for alpha shows it to be the difference between the realized return and the return expected by CAPM: a = rs - (rf + ßs x (E(rm) - rf)) From CAPM To Factors To Smart Beta In today's accepted usage, alpha is the ex-post difference between portfolio and benchmark return, adjusted for risk. It is the component of return attributed to portfolio manager skill, whereas beta is the return accruing to simple market exposure. As return-attribution research has uncovered the systematic factors underpinning performance, beta has claimed an increasing share of the pie from alpha. The salubrious effect for investors, especially those who employ third-party managers, has been to demystify the sources of portfolio returns. Beta's expanding share has also opened the door to a middle course between purely active and purely passive portfolio management strategies. Factor research has made it possible to join the main advantages of passive strategies - transparency, predictability and low cost - with active strategies' aim of delivering a risk-adjusted return profile distinct from those offered by cap-weighted benchmarks. Investors have embraced the factor approach and traditional asset managers have obliged them with a torrent of smart-beta ETF choices. Both should put investors on alert: according to the late Barton Biggs, there is no investment idea so good that it can't be destroyed by too much money, and fund company enthusiasm may correlate more closely with its own profits than its clients'. Biggs' admonition is always on our mind, but we don't think the established factors are in imminent danger of losing their zest. Factor excess returns are not new news. 25 years after Fama and French's paper, low-book-multiple stocks continue to outperform high-book-multiple stocks and smaller stocks continue to outperform larger stocks. We do not see the comparatively modest aggregate smart-beta ETF AUM as a catalyst for bidding away the returns that have durably accrued to factors. Are Dividends Really An Equity Factor? For the purposes of this report, our first objective is to determine whether or not Dividends can properly be considered a factor alongside the big five (Value, Quality, Momentum, Volatility and Size). Unable to find compelling evidence for their inclusion, we do not think they should. Yield may be a promising factor in fixed income, but extending the concept to equities is problematic. Across all capitalization buckets for the last 20 years, it cannot even be said that dividend payers outperform non-dividend payers (Chart 4). The empirical record for more sophisticated slicing and dicing is mixed, depending on the level of granularity. Breaking the universe of U.S. equities into non-dividend payers and dividend payers, and then segmenting the latter by yield into the lowest three deciles, the median four deciles and the highest three deciles, Fama and French's 90-year dataset supports the idea that higher-yielding stocks generate higher total returns (Chart 5). The breakout is neatly consistent, with dividend payers outperforming non-dividend payers, and each yield cohort of the dividend payers outperforming the lower-yielding cohorts beneath it (Chart 6, top panel). Zoom into the dividend payers at the quintile and decile levels, however, and the consistency disappears as the tidy staircase pattern begins instead to resemble a jagged picket fence (Chart 6, lower panels). Chart 4Dividends Have Been Hazardous To Investors' ##br##Wealth Over The Last 20 Years ... Chart 5... Though They've Rewarded Investors ##br##Over Nine Decades Chart 6Not Ready For A Close-Up Adjusting for risk makes the picture even murkier. While the non-payers and the lowest-yielding cohorts always post the smallest risk-adjusted returns, they are the only cohorts the highest-yielders manage to beat. The median 40 is the winner among our 30-40-30 cohorts, while the fourth and the second quintiles bracketing the median 40 easily outpace the top quintile, and the eighth, fourth and seventh deciles break away from the rest of the decile pack (Chart 7). It should come as no surprise that our long top 30%/short bottom 30% litmus test failed to reveal any viable excess return strategies based on dividend yields. Our attempts to develop simple portfolio construction rules based on markers of dividend quality and sustainability failed to conclusively advance the dividend cause. Long/short strategies founded on dividend growth added no value to a simple portfolio built from dividend yield and change in share count (Chart 8). Payout ratio metrics, which might shed some light on both quality and sustainability, provided pretty solid results, but they weren't enormous winners (Chart 9). Our analysis left us unable to conclude that Yield merits inclusion among the established equity factors. Chart 7No Theme To Risk-Adjusted Return Profiles Chart 8No Viable Long/Short Dividend-Growth Strategy ... Chart 9... But Payout Ratios Work Pretty Well An Ideal Dividend Index The fact that the way forward for dividend strategies is not obvious is good news for smart-beta sponsors. The ambiguity leaves plenty of room for developing better index-construction methods. Some sources of improvement might include: A means of identifying and sidestepping "yield traps," high and/or growing yields that are actually a distress signal. A way to review historical metrics to gain a sense of ongoing dividend growth. An evaluation of a dividend's source, valuing dividends supported by operating cash flows more highly than those supported by financing activities or asset dispositions. A process for limiting sector exposures, and an awareness of the most auspicious backdrops for taking on exposure to specialized yield plays like mortgage REITs, MLPs and BDCs. Ticking off every item on this wish list, however, would necessarily involve infringing on other factors' turf. Quality, Value, Size and Volatility could all spill into the process of assessing dividend quality and sustainability. Given that our attempts at creating our own tests to measure up to the wish list came up empty, it seems that a cross-disciplinary approach might be the only option. Even if the indexes are not based completely on dividend-derived metrics, it may be possible for a few dividend accents to add some incremental value to the overall stew. Smart-Beta Fund Evaluation These issues were on our mind when we set out to define the metrics that we would use to evaluate the indexes created by our Dividend smart-beta ETF subset. The two payout metrics in the ETS model, dividend yield and change in shares outstanding, are pretty thin gruel for evaluating the dividend ETFs. The ETS payout metrics were selected based on their interaction with the Value, Safety, Quality, Momentum and Sentiment metrics, 23 in all, that comprise the rest of the stock-level inputs into our model. They were not intended to be stand-alone measures. Many of the ETFs in our subset explicitly screen for Quality, Value and/or Low Volatility. They could just as accurately be described as multi-factor funds in a dividend-first wrapper, and we have therefore deployed the entire ETS model to evaluate them. To assess whether or not their constituent selection process consistently improves upon a simple dividend strategy, we compare their ETS scores to those of VIG, the Vanguard Dividend Appreciation ETF, which tracks the NASDAQ US Dividend Achievers Select Index of stocks (ex-REITs and LPs) with at least 10 consecutive years of dividend increases. First Trust Rising Dividend Achievers ETF (RDVY) RDVY's ETS scores have stood out from its smart-beta peers' since the fund's inception at the beginning of 2014. Its concentrated 50-stock portfolio allows it to focus on exposure to its preferred growth and sustainability metrics. Only stocks that have grown their dividends over 3- and 5-year periods, and their non-zero earnings per share over a 3-year period, make it through the growth filters. The sustainability filters admit only stocks with cash-to-debt ratios of at least 50% and dividend payout ratios of 65% or less. Chart 10Good Things Come To Those Who Wait Although the fund has outperformed VIG since inception, its relative performance has not been nearly as consistent as its relative ETS scores (Chart 10). It has taken a 40% surge over the 12 months ended February 28th to put RDVY over the top. We recognize that performance can be capricious, however, and place more weight on RDVY's consistently stellar relative ETS scores, which are 20% more, on average, than its smart-beta peers'.5 RDVY's 50-basis-point ("bps") expense ratio exceeds the 36-bps group average, but we think its screens and concentration are worth the incremental 14 bps. The fund is on the smaller side with $127 million of AUM, and daily turnover of just over $2 million, but larger investors can make use of the creation/redemption unit process to transact in larger volumes without concern. We recommend RDVY for investors seeking large- and mid-cap dividend exposure. FlexShares Quality Dividend Index Fund (QDF) QDF stands second to RDVY on an ETS score basis. Its relative scores have been remarkably stable, rarely falling below 110% en route to averaging 113% of the aggregate Dividend smart-beta score. QDF's selection process is proprietary, and it incorporates measures of cash flow, profitability, and management's skill at deploying capital and financing its activities. The mix has enabled QDF to outperform VIG from the get-go, and steadily pad its lead ever since (Chart 11). Its 37-bps expense ratio is right in line with the group's and its $1.7 billion AUM and $5 million average daily turnover provide a nice sense of ballast. We recommend QDF, along with RDVY, as the best Dividend smart-beta options. Chart 11Wire-To-Wire Outperformance WisdomTree MidCap Dividend Fund (DON) O'Shares FTSE US Quality Dividend ETF (OUSA) WisdomTree has been a pioneer in creating dividend-weighted indexes, but the formula it's applied to selecting constituents for DON, its mid-cap dividend ETF, has not found favor with the ETS model. The fund's constituents have repeatedly earned an aggregate ETS score below 40, holding its relative score below 80% for extended periods. OUSA is a newer fund, with less than a year of history, but its ETS scores have been noticeably weak. We would avoid OUSA until it compiles enough of a track record to permit more conclusions about its process and we would advise investors seeking targeted mid-cap exposure to gain it via funds other than DON. Dividends' Curious Attraction Our work in researching this Special Report has brought dividends' many contradictions to light. In countries like the U.S., where ordinary income is taxed at a higher rate than capital gains, dividends represent an especially tax-inefficient way of redeeming a portion of one's investment. Either share buybacks or sales to third parties would yield more after-tax cash. Humans feel a strong pull to book gains, and steadily redeeming portions of a successful investment has an intuitive emotional appeal: "Let's quit while we're ahead, let's go while the getting is good." It's exactly the wrong thing to do with investments, however. If the quarterly dividend flow assuages the remorse over a mistaken investment, encouraging an investor to stick with a losing position, it's even worse. It is possible that dividends, even though they're small, help reinforce our innate resistance to selling losers and letting winners run. From management's perspective, legacy dividend payments can act as handcuffs. Fearful of issuing a signal that is sure to be interpreted negatively by the market, firms take pains to refrain from cutting dividends. Dividend declarations, then, are a part of the capital budgeting process that is not rooted in economics. A rigorously utility-maximizing visitor from outer space may have found the oil majors' borrowing to fund their dividends in the midst of the severe downturn in crude prices to be very odd indeed. All of these shortcomings may help explain why we were unable to find clear evidence that dividends exert a clear and consistent influence on stock prices. And yet, dividends are enormously popular, with dividend funds by far outnumbering every other flavor of smart-beta ETF. We, too, like to think of positions in balanced portfolios on a total-return basis, as does our U.S. Investment Strategy service, which has successfully recommended the Dividend Aristocrats much longer than we have. Total return is important, but we are increasingly leaning toward the view that specialty dividend plays, purchased at the right point of the cycle, are the best way for an investor to capture income from equity holdings. Such an all-or-nothing approach may well be superior to the one-foot-in, one-foot-out stance that is embodied by the average 2% large-cap dividend yield. Our U.S. Investment Strategy service has successfully surfed the cyclical wave in mortgage REITs, and we are attempting to do so now with the inclusion of BIZD, the business development company ETF, in our U.S. portfolios. Adding cycle analysis would make our smart-beta studies too long, but we are conducting research into the interaction between factor performance and cycle phases, and we will share our findings with our clients in standalone Special Reports if they are insightful enough to merit their attention. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com Jennifer Lacombe, Research Analyst Global ETF Strategy Jenniferl@bcaresearch.com Philippe Morissette, Associate Vice President Equity Trading Strategy philippem@bcaresearch.com 1 Please see Global ETF Strategy/Equity Trading Strategy Special Report, "Smart-Beta ETF Selection, Part I - Value Funds," published February 15, 2017, at etf.bcaresearch.com. 2 Size may be too straightforward to allow for an index-construction edge. 3 Stock XYZ's beta is equal to the covariance of its returns with the market's returns, divided by the variance of the market's returns, where its covariance with the market equals its returns' correlation with the market's times the product of XYZ's volatility and the market's volatility. 4 Fama, Eugene F. and French, Kenneth R., "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, Volume 18, Number 3 (Summer 2004), pp. 25-46. 5Befitting its benchmark status, VIG’s ETS scores have averaged 99.8% of the entire subset’s since inception.
Highlights Risk assets have rallied smartly, yet key indicators like the relative performance of Swedish stocks or the price of kiwi equities are not corroborating these moves. With the Fed now very likely to increase rates in March, the broad-trade-weighted dollar could be about to resume its rally. This would prompt a correction in metals, and EM as well as commodity currencies. We think the tactical correction in the broad-trade-weighted dollar is over, and the cyclical dollar rally can resume. EUR and JPY will not suffer as much as the commodity currencies, go long EUR/AUD, short NZD/JPY. Feature In the Roman calendar, the Ides of March corresponds to the 15th of that month. Consigning that date to posterity in the year 44 BCE, Julius Caesar was assassinated on the floor of the senate in Rome, with his adoptive son Brutus, being among the conspirators. This event prompted yet another round of civil war in the republic, and ultimately a regime shift: the end of the Roman Republic and the Beginning of Imperial Rome under Augustus in 27 BCE. Fast forward 2061 years to the present. March 15th will be the day when the FOMC meeting ends. Will the period around the Ides of March represent a regime shift once again - albeit on a much different scale - where risk assets finally correct? Can the dollar resume its ascent? We believe the answer to both questions is yes. Unusual Market Moves Strange market dynamics have piqued our interest. In recent weeks, DM stock prices, and bond yields have been moving up (Chart I-1). This is consistent with investors pricing in an improving growth outlook and a Fed moving toward a tighter policy. On the other hand, EM stocks, metals, and gold in particular have also been moving up (Chart I-2). This move is more disturbing as it tends to imply an easing in monetary conditions, especially the strength in gold, even if it may have ended yesterday. This strange performance could be explained if the dollar was weakening or inflation expectations were moving up. However, the dollar has been strengthening in recent days and inflation expectations have been flat. Additionally, the U.S. yield curve has flattened, suggesting that the adjustment in the Fed's expected rate path is beginning to have marginally negative implications for future growth (Chart I-3). Chart I-1More Growth, More Hikes Chart I-2More Reflation As Well Chart I-3No Sign Of A Fed Behind The Curve So based on current information, how are these market moves likely to resolve themselves? Let's look at indicators. In the past, we have followed the common-currency performance of Swedish relative to U.S. equities as a gauge for the global growth outlook, and particularly non-U.S. growth relative to U.S. growth. This reflects the fact that U.S. stocks tend to be defensive, while Swedish stocks are very pro-cyclical. This dynamic is accentuated by the nature of the Swedish economy. Sweden is a small open nation that trades heavily with EM. While its biggest trading partner is the euro area, where it tends to export many intermediate goods and machinery, which are then re-exported as finished products to the EM space. Currently, Swedish equities continue to underperform U.S. ones. What is most striking is that this underperformance has happened despite a strong performance in EM stocks and metals, a very rare divergence (Chart I-4). Another worrying signal comes from New Zealand stocks in USD terms. New Zealand is another small open economy with deep trade links to the EM space. It is therefore very sensitive to global growth dynamics. While Kiwi equities did flag the rebound in EM growth and global manufacturing activity that happened in 2016, since late January, they have stopped participating in the rally in global risk assets despite a booming New Zealand economy. They have even begun swooning in recent weeks (Chart I-5). Chart I-4A Strange Divergence Chart I-5Are Kiwi Stocks Telling Us Something? Finally, two other reliable indicators of global growth are also not corroborating any further improvement in global growth from here: Small caps are underperforming large caps and oil is underperforming gold (Chart I-6). Obviously the next question becomes: are all these indicators likely to converge back toward EM equities, the AUD and the BRLs of the world or are the risk assets mentioned above likely to be the ones experiencing a downward adjustment? Here economics should give us a clue. For one, the 2016 rally in EM and risk assets can be explained by the large improvement in economic conditions. G10 and EM surprise indexes have moved up vertically in recent months (Chart I-7). However, this move might reflect the past not the future. Chart I-6Some Growth Indicators Are##br## Not Doing Well Anymore Chart I-7Too Much Of##br## A Good Thing? China has been a key reason explaining why EM assets and economic activity have been so positive. However, the large dose of fiscal stimulus that has supported that economy has dissipated (Chart I-8). Based on the IMF's October Fiscal Monitor, the fiscal thrust in China was 1.7% of potential GDP in 2015 (heavily loaded to the second half of that year), and 0.3% in 2016. It is moving to 0% in 2017. This means that as the lagged effects of the late 2015 fiscal surge dissipate, a key reflationary wind behind the global economy will disappear. The Keqiang index is mirroring these dynamics. After flirting with cyclical highs, and therefore highlighting a sharp improvement in the Chinese industrial sector, it has begun to roll over (Chart I-9). More weakness is likely in the cards. Fiscal dynamics have followed a similar pattern on a global level. The overall EM fiscal thrust was at its strongest in 2015, at 0.6% of EM potential GDP, fell to 0.1% in 2016, and is expected to hit -0.2% in 2017. In the DM, the pattern is slightly different. The high point of fiscal stimulus was 2016, when the fiscal impulse hit 0.4% of potential GDP. However, this measure is moving back to -0.1% in 2017. Chart I-8Losing A Source ##br##Of Reflation Chart I-9Chinese Industrial Activity ##br##May Be Rolling Over Additionally, the monetary environment is not as stimulative as it once was. Bond yields have risen in the whole DM space, with Treasury yields now more than 110bps higher than in July, Bund yields having moved from -0.18% to 0.31%, and JGB yields having adjusted 37bp higher to 0.07%. High-frequency loan data out of the U.S. already shows some strains caused by this rise in borrowing costs (Chart I-10). This combination points toward a deceleration in the growth impulse, especially in the goods sector. As such, we do expect the EM and G10 surprise indexes to roll over in coming weeks. Even if this phenomenon may prove temporary, the market is not priced for this event. Highlighting this vulnerability is the high level of complacency we have already flagged last week, which suggests that global investors are positioned for a continuation of the improvement in the growth outlook (Chart I-11). So high seems the conviction that growth will continue to accelerate that it is outweighing the move toward a tighter Fed going forward. Finally, the implied correlation in the S&P 500 has fallen to post 2010-lows. This could incentivize investors to take on more leveraged bets on portfolios of stocks. A low correlation results into higher diversification benefits and therefore, a lower portfolio volatility (Chart I-12). A rise in correlation would cause volatility to rise and thus a mini-deleveraging and de-risking cycle to take hold amongst investors. Chart I-10Response To Higher Yields Chart I-11Lots Of Complacency Globally Chart I-12Correlation-Induced Derisking On Its Way? Bottom Line: DM stocks are up, yields are up, the dollar is firming, yet EM equities, metals and gold especially have risen as well, and the U.S. yield curve is flattening while inflation expectations have recently been stable. We expect risk assets to end up buckling. Some reliable indicators of the trend in risk assets are pointing south, global investors are expecting further growth improvement in the coming months while global growth may in fact temporarily decelerate, and finally, if the low level of implied correlation in stocks normalizes, a correction may be catalyzed. What About The Fed Because Lael Brainard has been such a reliable dove on the FOMC, when she says that a hike is coming soon, we must listen. The fact that the market has come to price in an 83% probability of a Fed hike in March will only give the FOMC more comfort in increasing interest rate when it meets in two weeks (Chart I-13). While we have been expecting the Fed to move in line with its Summary of Economic Projection's interest rate forecast, and thus increase three times this year, we are surprised by the fast change of tune in recent days. Nonetheless, we are acknowledging this reality. Is this publication moving toward expecting four rate hikes in 2017? Not yet. We want to see how the market handles the coming hike going forward. A correction in risk assets, commodities, and EM is likely to force the Fed to pause again before resuming its hiking path. We are clearly expecting such a development. The broad dollar is likely to be caught in a bullish cross current. However, differentiation between the minors vis-à-vis the EUR and JPY might be essential for investors. Chart I-14 shows that recently, the broad-trade-weighted dollar has not kept pace with the increase in interest rate expectations for the U.S. With our capitulation index for this measure of the dollar moving closer to "oversold" territory, the weeks leading up to the Fed meeting could witness a stronger broad trade-weighted dollar. We are therefore removing our tactical short bias and moving in line with our cyclical bullish dollar stance. Chart I-13The Fed Tends To Telegraph ##br##Its Intention To Hike Chart I-14The Dollar Should ##br##Catch Up We believe that in this process, the dollar will be strongest against EM and commodity currencies. To begin with, the USD is trading near 19, 18, and 17 months lows against the BRL, ZAR, and RUB respectively. As recently as Wednesday, the AUD was also trading near the top of its distribution of the past two years (Chart I-15). Moreover, EM and commodity currencies are heavily geared to global growth. As such, the combination of a tightening Fed, rising bond yields, and a potential roll-over in global economic surprises may weigh especially heavily on them. On the other hand, in 2015 and 2016, the dollar has tended to be softer against the EUR and the JPY in periods of market turbulence. Thus, the call on EM and commodity currencies seems much cleaner than on these two currencies. In this regard, two crosses have caught our eye. One is EUR/AUD. Not only is it at the bottom end of a trading range established since June 2013, it has only traded lower at the apex of the euro area crisis between 2011 and the first half of 2013 (Chart I-16). The recent rollover in French / German bund spreads is potentially a good signal to buy this cross. The picture for JPY is now muddied. While higher interest rates should hurt the JPY, a period of risk-asset selloff should support the JPY. To play the cross-current described above, we are opening a short NZD/JPY position, a cross historically levered to rising volatility (Chart I-17). Chart I-15AUD Is Elevated Chart I-16To Fall From Here, EUR/AUD Needs A Euro Crisis Chart I-17Short NZD/JPY: A Risk-Off Play Bottom Line: The Fed moving forward its planned rate hike to March could be the ultimate catalyst to prompt a correction in risk assets, especially the segment of the market most levered to EM and growth conditions: EM and commodity currencies. We are removing our tactical USD stance and we are moving in line with our bullish cyclical stance. We are also buying EUR/AUD and shorting NZD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data paints a healthy picture for the U.S. economy: Fourth quarter annualized GDP came in unchanged from the previous quarter at 1.9%; PCE Price Index increased at a 1.9% annual pace, near the Fed's target; Core PCE remained steady at 1.7% annually and increased to 0.3% monthly, indicative of a robust economy; ISM Manufacturing PMI went up to 57.7. The market is now pricing in an 83% probability of a rate hike. Further enhancing growth prospects were Trump's remarks at his Joint Address to Congress, where he stated that there will be a "big, big cut" in corporate tax, and that he will seek to gain approval for a $1 trillion infrastructure plan. Hawkish comments from the previous FOMC meeting strengthened the dollar in February; Trump's comments may be an additional tailwind to the dollar's upside this month. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro EUR Technicals 1 EUR Technicals 2 Fundamentally, the euro area economy remains resilient: Services sentiment, business climate, and industrial confidence all picked up in February, outperforming expectations; Germany recorded a decrease in unemployed persons of 14,000; German CPI picked up to a 2.2% annual pace, also beating expectations Nevertheless, EUR/USD is unlikely to see any substantive upside in the coming months. With the Dutch elections in around 2 weeks, considerable volatility could rise up, something which has not been priced in. The Euro Stoxx 50 Volatility Index is showing a low reading of 16.55, just above the all-time low of 12. The ECB will meet next week and is likely to display a dovish bias due to potential political turmoil. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen JPY Technicals 1 JPY Technicals 2 On a cyclical basis we are still bearish on the yen, as the BoJ will continue to pursue radical measures to pull Japan out of its liquidity trap. Recent data seems to indicate that these measures have been somewhat successful: Retail trade YoY growth outperformed expectations coming in at 1%. Housing starts YoY growth also outperformed, coming in at 12.8%. On a tactical basis the picture is more nuanced. While it is very possible that the coming rate hike could lift rate expectations in the U.S., lifting USD/JPY, there is a risks that the hike might trigger a sell-off in risks assets, which could be very positive for the yen. For this reason we are shorting NZD/JPY, as this cross is very vulnerable to an increase in volatility. Report Links: JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 British Pound GBP Technicals 1 GBP Technicals 2 The past week has not been kind to the pound, with GBP depreciating by about 2% against both the Euro and the U.S. Dollar. This was in part due to the prospect of a Scottish Independence referendum. On the economic side, data for the U.K. continue to be mixed: House prices annual growth outperformed expectations coming in at 4.5% M4 broad money annual growth continues to climb higher and it is now at 7%. On the other hand manufacturing PMI, although still high, underperformed expectations, coming in at 54.6. Although the cyclical dollar bull market should continue to weigh on cable, we are more bullish on the pound, particularly against the euro, as expectations for the U.K. economy continue to be too pessimistic, while the dark cloud of this year's election cycle looms on the euro. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar AUD Technicals 1 AUD Technicals 2 AUD lost 1.3% of its value Thursday morning amid disappointing trade data. It seems that the market largely ignored stronger data this week: GDP grew at a 2.4% annual rate Q42016 and both NBS and Ciaxin Chinese Manufacturing PMI beat expectations. Exports, however, contracted at a 3% pace and the surplus missed expectations by 66%, most likely due to the AUD's strength this year, even alongside higher commodity prices. This is also particularly worrying seeing that exports failed to pick up despite a previously strong Chinese PMI reading. Now, alongside a Keqiang Index that is topping out, the future for Australian exports could be limited. Additionally, this outlook is further supported by investment diverting to the non-resource sector. It is difficult to see whether the RBA will respond to this export slump, as the contractionary Q32016 GDP data was largely overlooked and dismissed. Nevertheless, we stand by our bearish outlook on AUD. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The RBNZ continues to assert its neutral bias. On Wednesday, RBNZ Governor Graeme Wheeler stated that "there is an equal probability that the next OCR adjustment could be up or down". This caused the kiwi to come close to reaching 0.71, its lowest point since mid-January. We continue to believe that the RBNZ stance is not hawkish enough, as powerful inflationary forces continue to brew in New Zealand. That being said, it is very likely that the RBNZ will continue with its neutral tone up until the middle of the year, when we start to have a clearer picture about the outcome in European elections. Therefore, given that the Fed is likely to hike in March, diverging monetary policies should continue to weigh on NZD/USD until then. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Canadian Dollar CAD Technicals 1 CAD Technicals 2 The BoC left their overnight rate target unchanged at 0.5% despite a high CPI reading of 2.1% in January. A further surprise was a particularly dovish tone, highlighting that higher energy prices will have a temporary effect on inflation, and indicating "material excess capacity in the economy". Additional weaknesses were highlighted with regards to competitiveness challenges for the export sector and subdued wage growth accompanied by contracting hours worked. Trade developments are an additional headwind for the Canadian economy that the bank is monitoring and will continue to do so until the outlook clarifies. CAD has lost more than 2% of its value against the USD in 3 days due also to a stronger dollar based on Fed rate hike expectations and Trump's potential infrastructure spending and tax cuts. It is unlikely that CAD will see any strength in the near future as the Bank has set forth a rather cautious tone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data has been mixed, which indicates that although economic activity in Switzerland is improving, it still is very tepid: The KOF leading indicator outperform expectations coming in at 107.2 Retail sales outperformed expectations. However they are still contracting by 1.4% GDP annual growth was 0.6%, falling significantly from last quarter reading of 1.4% The SNB is currently in a tight spot, as improvements are very marginal and it is evident that the economy is still plagued by strong deflationary forces. Meanwhile EUR/CHF is under 1.065 and has been unable to climb above this level this month, as the SNB continues to fight risk off flows coming into the franc due to the risks of the European election cycle. As these risks increase, the floor in this cross will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone NOK Technicals 1 NOK Technicals 2 Risks continue to point for further upside in USD/NOK. Oil is unlikely to rally much further from current levels, even if the OPEC agreement continues. Thus the movements in USD/NOK should be dominated by monetary divergences between the United States and Norway. These are likely to continue to favor the dollar, as the Fed should continue its hawkish tone. Meanwhile the Norges Bank is likely to stay dovish, as their economy has been to be very weak. GDP growth is negative, the output gap is over -2% of GDP and employment and real wages continue to contract. Meanwhile, the high inflation that Norway experiences last year is likely to continue its slowdown, as the effects of the currency depreciation should start to dissipate. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona SEK Technicals 1 SEK Technicals 2 In past reports, we have argued that the Swedish economy is robust and inflation is picking up. This has been corroborated by strong consumer and business confidence, and high resource utilization and inflation expectations. Recent data has supported this view: Retail sales picked up 2.2% annually; Producer price index was up 8.2% from last year in January; Annual GDP growth came in at 2.3% at the end of last year. Growth and inflation have been supported by expansionary monetary policy. With the Riksbank stating that "there is still a greater possibility that the rate will be cut than... raised in the near future", these conditions are unlikely to falter. Nevertheless, it is important to note that it is this cautionary stance by the Bank that is the reason for the SEK's recent weakness, not fundamentals. It is now the probable case that any upside in the SEK will be noted and limited by the Riksbank, capping the upside on the krona. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of February 28, 2017. The model has maintained its large overweight in the U.S. Within the non-U.S. level 2 model, Spain and Italy weights have been increased at the expense of Japan and Switzerland. Japan and U.K. remain the two largest underweight countries. (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, both the level 1 and level 2 models outperformed their respective benchmarks in February, resulting in a 39 bps outperformance of the aggregate model vs. the MSCI World. Since inception, the GAA model has outperformed its benchmark by 30 bps. 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. 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) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2017. The momentum component has shifted Consumer Discretionary from overweight to underweight. For mode 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. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Associate Editor patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com
Highlights U.S. Treasuries - Fair Value: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. U.S. Treasuries - Technicals: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market and possibly sets the stage for another leg higher in yields. China: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Feature Bonds rallied strongly late last week without any obvious economic catalyst. Now that the dust has settled we find the 10-year U.S. Treasury yield trading at 2.34%, 7 bps below our estimate of fair value (Chart 1). Chart 12-Factor U.S. Treasury Model Updating Our U.S. Treasury Model That fair value estimate comes from our 2-factor U.S. Treasury model, based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. In our view, these two factors capture the most important macro drivers of U.S. bond yields. Stronger global growth, as proxied by the Global Manufacturing PMI, tends to push yields higher. However, to the extent that stronger global growth coincides with an appreciating U.S. dollar, the amount of monetary tightening that needs to be achieved through higher interest rates is limited. This caps the upside in long-dated U.S. bond yields. Put differently, it is not just the magnitude of the global growth impulse that matters for U.S. bond yields, but also the breadth of the recovery. The more broad-based the recovery, the less upward pressure on the U.S. dollar and the higher U.S. Treasury yields can rise. Last week we received Flash PMI estimates for the U.S., Eurozone and Japan that we can use to estimate the Global PMI for February. According to the Flash estimates, the U.S. PMI declined slightly in February, but this was more than offset by accelerations in both the Eurozone and Japan. Altogether, these three regions account for 48% of the Global PMI and, assuming PMIs in all other countries remain flat, we can calculate that the global PMI will nudge higher from 52.7 in January to 52.9 in February. Of course one month of data is much less important than the longer run trend. Taking a step back, we see that manufacturing PMIs are trending higher in every major economic bloc (Chart 2). Our diffusion index also shows that the global manufacturing recovery is more broadly based than at any time during the past three years (Chart 2, top panel). The synchronized nature of the recovery is also reflected in the behavior of the U.S. dollar, which has not appreciated during the past month even though Fed rate hike expectations have shifted up (Chart 3). The message from the survey of bullish dollar sentiment - the series that is included in our Treasury model - is more mixed. Bullish dollar sentiment plunged from elevated levels in January but has recovered somewhat during the past few weeks (Chart 3, panel 2). Meantime, U.S. Treasury spreads over German bunds and JGBs are also sending mixed signals. Short-maturity spreads have widened alongside increased U.S. rate hike expectations, while long-maturity spreads have been well contained (Chart 3, bottom 2 panels). Chart 2Synchronized Global Recovery Chart 3Keep Watching The Dollar Global bond investors should closely monitor trends in the U.S. dollar, bullish sentiment toward the dollar, and U.S. Treasury spreads over bunds and JGBs. Each of these indicators provides information about the breadth of the economic recovery. If Fed rate hike expectations remain firm, or even move higher, and that trend is not matched by a stronger dollar or wider Treasury spreads, then that would signal that the global recovery is becoming more synchronized, suggesting additional upside for bond yields. Bottom Line: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. Chart 4Positioning Becoming More Balanced Treasury Technicals Less Stretched This brings us back to last Friday's bond rally. Puzzlingly, the 2-year U.S. Treasury yield declined 6 bps and the 10-year yield fell 7 bps on a day without any significant economic or political news. In fact, Treasury yields managed to decline even though rate hike expectations embedded in the overnight index swap curve were unchanged and the probability of a March rate hike priced into fed funds futures actually increased from 31% to 33%! The unusual disconnect between Treasury yields and rate hike expectations is probably related to the expiry of the March bond futures contracts. Last week, traders had to decide whether to let their March contracts expire or roll them over into June. Positioning data show that speculators carried large net short positions into last week (Chart 4), so it is possible that it was the capitulation of these large short positions that drove yields lower on Friday. More timely data from the skew between payer and receiver swaptions show that swaption investors are no longer betting on rising rates (Chart 4, panel 4). Net speculative positions in Treasury futures could follow suit when the data are released later this week. In addition, our composite sentiment indicator has just recently ticked back above the zero line (Chart 4, panel 2). Bottom Line: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market, and possibly sets the stage for another leg higher in yields. China's Bond Market Balancing Act Chart 5Easy Money Spurs Chinese Growth In the context of the 2-factor U.S. Treasury model presented above, there are two reasons why developments in China matter for U.S. bond markets. The first is that China accounts for the single largest weighting in the Global Manufacturing PMI, so stronger growth in the Chinese manufacturing sector will pressure bond yields higher, all else equal. But the Chinese economy can also influence U.S. bond yields if changes in the RMB exert meaningful influence on the trade-weighted U.S. dollar. For example, faster Chinese growth pressures U.S. bond yields higher, but some of that upward pressure could be mitigated if that strong growth is engineered through a rapid depreciation of the RMB relative to the U.S. dollar. On the first point, China's manufacturing PMI is in a clear uptrend although the recent contraction in the government's fiscal expenditures is a potential warning sign (Chart 5). Our China Investment Strategy service views the fiscal contraction as a risk but still expects the Chinese economy to remain buoyant this year.1 This is because Chinese monetary conditions remain supportive of further gains in the manufacturing sector, and the rebound in China's PMI that began early last year is more tied to easing monetary conditions - a weaker exchange rate and falling real interest rates - than to increased fiscal spending. On the second point, while a weaker trade-weighted RMB has helped spur the recovery in Chinese manufacturing, the impulse from a weaker RMB has so far not been potent enough to move the needle on the trade-weighted U.S. dollar (Chart 6). From the perspective of U.S. fixed income markets a continuation of this trend would be the most bond-bearish outcome. Chinese monetary policy remains easy enough to spur economic growth but not so easy that it causes the U.S. dollar to spike. For the time being at least, China has been actively selling Treasuries in order to mitigate the extent of its currency depreciation (Chart 7). If China were to suddenly stop selling Treasuries, then the RMB would likely depreciate sharply. This would actually have an ambiguous impact on U.S. Treasury yields since it would probably lead to both a stronger U.S. dollar and faster global growth. Chart 6USD So Far Not Impacted By RMB Chart 7China Is A Treasury Seller More likely, however, is that China will continue to manage the gradual depreciation of its currency unless it is forced to take more dramatic action in the face of a negative growth shock. Our China Investment Strategy team notes that the annual People's Congress in early March should offer some important clues about the Chinese government's growth priorities and policy direction going forward. Bottom Line: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In February, the model underperformed global equities and the S&P 500 in USD and local-currency terms. For March, the model slightly increased its allocation to stocks and cut its weighting in bonds (Chart 1). Within the equity portfolio, the allocation to Europe was increased. The model boosted its weightings to French and Australian bonds at the expense of Canadian and Swedish paper. The risk index for stocks, as well as the one for bonds, deteriorated in February. Feature Performance In February, the recommended balanced portfolio gained 2.1% in local-currency terms, and 0.2% in U.S. dollar terms (Chart 2). This compares with a gain of 3% for the global equity benchmark and a 3.3% gain for the S&P 500. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide suggestions on currency risk exposure from time to time. The high allocation to bonds continued to hold back the model's performance. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and cut its bond weighting from 47% to 43% (Table 1). Table 1Model Weights (As Of February 23, 2017) The model increased its equity allocation to Dutch and Swedish equities by 4 points each, Germany and New Zealand by 2 points each, and France and Emerging Asia by 1 point each. Weightings were cut in Italy by 4 points, Latin America by 3 points, Spain by 2 points, and Switzerland by 1 point. In the fixed-income space, the allocation to Australia was boosted by 8 points, France by 6 points, and Germany by 4 points. The model cut its exposure to Swedish bonds by 9 points, Canadian bonds by 6 points, U.S. and U.K. bonds by 3 points each, and Kiwi bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The most recent bout of dollar depreciation was halted in February. Our Dollar Capitulation Index is below neutral levels. However, it is not extended, meaning that it does not preclude renewed dollar weakness in the near term. That said, assuming no major negative economic surprises, a relatively more hawkish Fed versus its peers should provide support for the dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities was little changed in February. The model continues to avoid this asset class (Chart 4). The risk index for global equities rose to its highest level since early 2010, mostly on the back of deteriorating value. Despite this, the model slightly increased its allocation to equities (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The rally in U.S. stocks - driven by optimism about the economic outlook - pushed the value component of the risk index into expensive territory. The model kept a small allocation in U.S. equities. A change in the perception about the ability of the new U.S. administration to boost growth remains a risk for this market (Chart 6). The risk index for euro area equities continues to deteriorate. However, it remains lower than its U.S. counterpart. The continued flow of solid economic data and a weaker currency should bode well for euro area stocks, although political uncertainty is a potential headwind (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk All three components of the risk index for Dutch equities are close to neutral levels. As a result, despite the recent deterioration in the overall risk index, it remains one of the lowest among the markets the model covers (Chart 8). The risk index for Swedish stocks worsened. However, the model increased its allocation to this bourse. Swedish equities would be a beneficiary of the continued risk-on environment (Chart 9). Chart 8Netherlands Stock Market And Risk Chart 9Swedish Stock Market And Risk The momentum indicator for global bonds is less stretched in February. Meanwhile, despite its latest decline, the cyclical indicator continues to signal that the positive global economic backdrop is firmly bond-bearish. Taken all together, the risk index for bonds deteriorated in February, although it still remains in the low-risk zone (Chart 10). U.S. Treasury yields moved sideways in February as investors await more guidance from the Fed on the timing of the next hike. A bond-negative cyclical indicator coupled with the unwinding of oversold conditions - as per the momentum measure - led to a deterioration in the risk index for U.S. Treasurys. The latter is almost back to neutral levels. The model trimmed the allocation to this asset class (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The momentum indicator remains the main driver of the risk index for Canadian bonds. As a result, the less extreme momentum reading translated into an increase in the risk index for this asset class. (Chart 12). The risk index for Australian bonds moved lower in February, reflecting improvements in all three of its components. The model included the relatively high-yielding Aussie bonds in the portfolio. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13Australian Bond Yields And Risk The cyclical indicator for euro area bonds is near expensive levels, and the momentum indicator shows heavily oversold conditions. These two measures are offsetting the cyclical one that is sending a bond-bearish message. While the overall risk index for euro area bonds is in the low-risk zone, the country allocation is concentrated in French paper (Chart 14). The risk level for French bonds is seen as low thanks to oversold momentum. French presidential elections are probably the most important political event in Europe this year. Whether the models' heavy allocation to this asset pans out hinges to a certain extent on the reduction of investor anxiety about this political risk (Chart 15). Chart 14Euro Area Bond Yields And Risk Chart 15French Bond Yields And Risk The 13-week momentum measure for the dollar broke below the zero line, and is currently sitting on its upward-sloping trendline, drawn from the 2010 lows, that has been broken only once before. Meanwhile, the 40-week rate of change measure is still suggesting that the dollar bull market has more legs on a cyclical horizon. Monetary divergences should lend support to the dollar over the cyclical horizon, although the new administration's attempts to talk down the dollar as well as heightened policy uncertainty could translate into more volatility (Chart 16). The weakening trend in the yen hit a snag two months ago, as the 13-week momentum measure reached the lows that previously foreshadowed a consolidation phase after sharp depreciations. This short-term rate-of-change measure has bounced smartly this year reaching a critical level. Meanwhile, the 40-week rate-of-change measure is not warning of a major change in the underlying trend which remains dictated by BoJ's dovish bias (Chart 17). EUR/USD has been gravitating towards 1.05 over the course of February. The short-term rate-of-change measure seems to be holding at the neutral level, while the 40-week rate-of-change measure is in negative territory, but hardly stretched. Political uncertainty has the potential to drive the euro in near term, but the longer-term outlook is mostly a function of the monetary policy divergence between the ECB and the Fed (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com