Currencies
As demonstrated in the above chart, historically the bulk of EM equity return erosion has been due to currency depreciation. Exchange rates of structurally weak EM economies depreciate chronically. Common reasons include lack of productivity growth, high…
From the moment almost three years ago that the U.K. voted to leave the EU, it was clear that a rational and measured Brexit would require the U.K. to remain in a customs union with the EU. Rational and measured because a customs union would protect the…
Highlights Analysis on South Africa is published below. The “EM” label does not guarantee a secular bull market. None of the individual EM bourses has outperformed DM on a consistent basis over the past 40 years. EM share performance in both absolute terms and relative to DM has exhibited long-term cycles of around seven to 10 years. Getting these cycles right is instrumental to successful investing in EM. EM investing is predominantly about exchange rates. From a long-term (structural) perspective, EM equities are only modestly cheap in absolute terms but are very cheap versus the U.S. Feature We often receive questions from asset allocators about the long-term outlook for EM equities and currencies. The general perception among longer-term allocators is that while EMs may underperform over the short term, they always outperform developed markets (DM) in the long run. Consistently, the overwhelming majority of investors’ long-term return forecasts ascribe the highest potential return to EM equities and bonds among various regions and asset classes. This week we focus on the historical long-term performance of EMs. Contrary to popular sentiment, our findings show that EM stocks and currencies have not outperformed their U.S./DM peers in the past 40 years – as long as EMs have existed as an asset class. Hence, there is no guarantee that EM share prices and currencies will always outperform their DM counterparts on a secular basis going forward. Notably, EM share performance in both absolute terms and relative to DM has exhibited long-term cycles of around seven to 10 years. Getting these cycles right is instrumental to successful investing in EM. At the moment, the odds are that the current bout of EM equity and currency underperformance is not yet over, and more downside is likely before a major upturn emerges. The “EM” Label Does Not Guarantee A Secular Bull Market EM share prices have been in a wide trading range since 2010 (Chart I-1), despite the 10-year bull market in the S&P 500. Chart I-1Lost Decade For EM Stocks Remarkably, there is no single EM bourse that has been in a bull market during this decade (Chart I-2 and Chart I-3). This proves that this has indeed been a “lost” decade for EM. Chart I-2Individual EM Bourses: A Very Long-Term Perspective Chart I-3Individual EM Bourses: A Very Long-Term Perspective Historically, secular bull markets have been followed by bear markets not only in the boom-bust economies of Latin America, EMEA and Southeast Asia but also in former Asian tiger economies including Korea, Taiwan and Singapore (Chart I-4). This is despite the fact that per-capita real income has been growing rather rapidly in these Asian economies. Chart I-4Former Asian Tigers: Long-Term Equity Performance Remarkably, China and Vietnam have been exhibiting similar dynamics over the past 20 years – rapid per-capita real income growth and poor equity market returns (Chart I-5). Chart I-5China And Vietnam: Stock Prices And GDP Per Capita The message from all of these charts is as follows: Periods of industrialization and urbanization – even if successful – do not always entail structural bull markets. The U.S. fits this pattern as well. During the period between 1870 and 1900, the U.S. was experiencing industrialization and urbanization along with many productivity enhancements such as the steam engine, electricity and infrastructure construction. Even though America’s prosperity and real income per-capita levels surged during this period, corporate earnings per share and stock prices were rather flat (Chart I-6). Chart I-6The U.S. In The Late 1800s: Stocks, Profits And GDP Hence, rising per-capita real income and prosperity do not translate into higher share prices on a consistent basis. This is not to say that no country can ever deliver healthy stock market gains in the long run. Some certainly will, and it is our job to identify and expose these to clients. The point is that the “emerging market” status does not guarantee a structural bull market. Asset Allocation: Play Cycles Chart 7 illustrates that EM relative equity performance versus DM in general and the U.S. in particular has gone through several major swings over the past 40 years. Remarkably, none of the individual EM bourses has outperformed DM on a consistent basis over this time frame (Chart I-8A and I-8B). Chart I-7EM Versus DM: Relative Total Equity Returns Chart I-8ANo Single EM Bourse Has Outperformed DM In Past 40 Years Chart I-8BNo Single EM Bourse Has Outperformed DM In Past 40 Years Failure to outperform DM stocks is not only inherent for bourses in twin-deficit and inflation-prone regions/countries such as Latin America, Russia, Turkey, South Africa and South East Asia (including India), but it has also been true for share prices in rapidly growing countries such as China and Vietnam (Chart I-9). Chart I-9Chinese And Vietnamese Stocks Have Not Outperformed DM Remarkably, equity markets in the former Asian tigers – Korea, Taiwan and Singapore – have also failed to outperform their DM peers in the past 40 years (Chart I-10). This is in spite of the fact that real income per-capita growth in these Asian nations has by far outpaced that in both the U.S. and DM (Chart I-11). Chart I-10Former Asian Tigers Have Not Outperformed DM Equities... Chart I-11…Despite Economic Outperformance Evidently, the assumption that EM stocks will outperform DM equities on the back of higher potential growth rates is not validated by historical data. First, higher potential growth does not always ensure robust realized GDP growth. Second, even if real GDP-per-capita growth rises considerably, this does not always guarantee superior equity market returns. Some of the reasons for this include productivity benefits being transferred to employees rather than to shareholders, chronic equity dilution, and a misallocation of capital that boosts economic growth at the expense of shareholders. Bottom Line: EM relative stock performance versus DM has been fluctuating in well-defined long-term cycles. In our view, EM relative equity performance has not yet reached the bottom in this downtrend. We downgraded EM stocks in April 2010 and have been recommending a short EM equities / long S&P 500 strategy since December 2010 (please refer to Chart I-7 on page 5). EM Investing Is Primarily About Exchange Rates Exchange rates hold the key to getting EM equity cycles right for international investors. As demonstrated in Chart I-12, historically the bulk of EM equity return erosion has been due to currency depreciation. Chart I-12EM Investing Is All About Exchange Rates Exchange rates of structurally weak EM economies depreciate chronically. Common reasons include lack of productivity growth, high inflation, current account deficits, uncontrolled fiscal expansion, and reliance on volatile foreign portfolio flows. Periods of currency depreciation also occur in emerging Asian economies that have low inflation and typically run current account surpluses. Chart I-13 shows spot rates for Korea, Taiwan and Singapore versus the SDR which is a weighted average of USD, the euro, JPY, GBP, and CNY.1 Chart I-13Former Asian Tiger Currencies: Wide Fluctuations None of these Asian-tiger currencies has consistently appreciated versus the SDR. As in the case of share prices, there have been multi-year exchange rate swings. Further, U.S. dollar total returns on EM local bonds are also primarily driven by their currencies (Chart I-14). Consequently, the cycles in EM local currency bonds match EM exchange rate cycles. Chart I-14Total Return On Local Currency Bonds EM credit spread fluctuations are also by and large contingent on their exchange rates. Credit spreads on EM sovereign and corporate U.S. dollar bonds gauge debt servicing risk. The latter is highly influenced by exchange rates. Currency depreciation (appreciation) increases (decreases) debt servicing costs thereby affecting credit spreads. Bottom Line: Exchange rate fluctuations are driven by macro crosscurrents, making macro an indispensable know-how for EM investing. We maintain that EM currencies are susceptible to renewed weakness against the U.S. dollar as China’s growth continues to weaken, weighing on EM growth and thereby their respective exchange rates (Chart I-15). In turn, the U.S. dollar is a countercyclical currency and does well when global growth decelerates. Chart I-15EM Currencies Are Pro-Cyclical Valuations: The Starting Point Matters… In recent years, a long-term bullish case for EM equities and currencies has often been made on the grounds of cheap valuations. Chart I-16 illustrates the equity market-cap weighted real effective exchange rate for EM ex-China, Korea and Taiwan – a measure that is pertinent for both EM equity and fixed-income investors.2 It reveals that EM currency valuations are only slightly below their historical mean. Chart I-16EM Ex-China, Korea, Taiwan Currencies Are Modestly Cheap As to the CNY, KRW and TWD, their valuations are not at an extreme, and the CNY holds the key. The main long-term risk to the RMB is capital outflows from Chinese households and companies as discussed in February 14 report. For long-term investors, the pertinent equity valuation yardstick is the cyclically adjusted P/E (CAPE) ratio. The idea behind the CAPE model is to remove cyclicality of corporate profits when computing the P/E ratio – i.e., to look beyond a business cycle. Hence, the CAPE ratio is a structural valuation model – i.e., it works in the long term. Only investors with a time horizon greater than three years should use this valuation measure in their investment decisions. Our CAPE model gauges equity valuations under the assumption of per-share earnings converging to their trend line. The latter is derived by a regression of the cyclically adjusted EPS in real U.S. dollar terms on time. The EM CAPE ratio presently stands at 0.5 standard deviations below its historical mean (Chart I-17). This means EM stocks are modestly cheap from a long-term perspective. Meanwhile, the U.S.’s CAPE ratio is very elevated (Chart I-18). Chart I-17EM Equities Are Modestly Cheap From AA1 Structural Perspective Chart I-18U.S. Stocks Are Expensive From AA1 Structural Perspective On a relative basis, EMs are very attractive relative to U.S. stocks (Chart I-19). This entails that the probability of EM stocks outperforming U.S. equities is very high from a secular perspective – longer than three years. Chart I-19EM Equities Are Cheap Versus U.S. From AA1 Structural Perspective Nevertheless, a caveat is in order. Our CAPE model assumes that EPS in real U.S. dollar terms will rise at the same pace as it has historically. The slope of the time trend – the historical compound annual growth rate (CARG) of EPS in inflation-adjusted U.S. dollar terms – is 2.8% for EM and 2% for the U.S. Please note that we determined the earnings time trend (trend line) using historical ranges – 1983 to present for EM, and 1935 to present for the U.S. Hence, these CAPE models assume that EM EPS will grow 0.8 percentage points (2.8% minus 2%) faster than U.S. corporate EPS in inflation-adjusted U.S. dollar terms, as they have done historically. Under this assumption, EM stocks are considerably cheaper than the U.S. market. That said, in the medium term, corporate earnings are the key driver of EM share prices, and contracting profits pose a risk to EM performance, as discussed in our February 21 report. Bottom Line: From a long-term perspective, EM equities and currencies are only modestly cheap in absolute terms. Based on our CAPE ratio model, EM stocks are very cheap versus the U.S. However, the CAPE ratio is a structural valuation measure, and only investors with a time horizon of longer than three years should put considerable emphasis on it. …But Beware Of A Potential Value Trap If for whatever reason there is a change in the slope of the EM EPS long-term trend – i.e., per-share earnings fail to expand in the coming years at their historical rate, as discussed above, our CAPE model would be invalidated. In such a case, EM share prices are unlikely to enter a secular bull market in absolute terms and outperform their U.S. counterparts structurally. The key to sustaining the current upward slope in the long-term trajectory of EPS in real U.S. dollar terms is for EM/Chinese companies to undertake corporate restructuring and increase efficiency. Critically, recurring Chinese credit and fiscal stimulus as well as cheap and abundant money from international investors have not fostered corporate restructuring in China, nor in other EM countries. The basis is that easy and cheap financing and economic growth propped-up by periodic Chinese stimulus has made companies complacent, undermining their productivity and efficiency. The ultimate outcome will be weak corporate profitability over the long run. Another long-term risk to corporate earnings in China and some other EMs is the expanding role of the state in the economy. In these circumstances, China/EM corporate profitability will also suffer over the long run. The basis is that in any country the private sector is better than the government in generating strong corporate earnings. Bottom Line: Without structural reforms and corporate restructuring in EM/China, EM stocks are unlikely to outperform their DM peers on a secular basis. Investment Conclusions The medium-term EM outlook remains poor for the reasons we elaborated on in last week’s report titled, EM: A Sustainable Rally or A False Start? Further, investor sentiment on EM is very bullish, and positioning in EM equities and currencies is elevated (Chart I-20). We continue to recommend underweighting EM stocks, credit markets and currencies versus their DM counterparts and the U.S. in particular. Chart I-20Investors Are Very Bullish On EM From a long-term perspective, EM equity and currency valuations are modestly cheap. However, a durable long-term expansion in EM economies is contingent on a sustainable bottom in Chinese growth. The latter hinges on deleveraging and corporate restructuring in China, neither of which have occurred to a meaningful extent. For EM equity portfolios, we presently recommend overweighting Mexico, Brazil, Chile, central Europe, Russia, Thailand and Korean non-tech stocks. Our current (not structural) underweights are South Africa, Indonesia, India, the Philippines, Hong Kong and Peru. Within the EM equity space, two weeks ago we booked triple-digit profits on our strategic long positions in EM tech versus both the overall EM index and EM materials stocks, respectively. These positions were initiated in 2010. The basis for these strategic recommendations was our broader theme for the decade of being long what Chinese consumers buy, and short plays on Chinese construction, which we initiated on June 8, 2010. This week we are closing our long central European banks / short euro area banks equity position. We recommended it on April 6, 2016, and it has produced a 14% gain since then. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com South Africa: Debt Deflation Or Currency Depreciation? South Africa’s public debt dynamics are on an unsustainable track. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in South Africa. The gap between government local currency bond yields and nominal GDP growth is at its widest in over the past 10 years (Chart II-1). Meanwhile, the primary fiscal deficit is 0.75% of GDP (Chart II-2). Chart II-1South Africa: An Unsustainable Gap Chart II-2South Africa Has Not Had A Primary Fiscal Surplus In A Decade Faced with very low real potential GDP growth stemming from the economy’s poor structural backdrop, the authorities in South Africa ultimately have two choices to stabilize the public debt-to-GDP ratio: Tighten fiscal policy substantially, trying to achieve persistent large primary budget surpluses; or Inflate their way out of debt, which would require a large currency depreciation to boost nominal GDP growth above borrowing costs. With this in mind, we performed a simulation on public debt, assuming fiscal tightening but no substantial currency depreciation (Table II-1). The first scenario uses the 2019 consolidated budget government assumptions and projections for nominal GDP, government revenues and expenditures, i.e., it is the government's scenario. In this scenario, the public debt-to-GDP ratio rises only to 58% by the end of the 2021-‘22 fiscal year. However, government forecasts always end up being optimistic. We believe this scenario is implausible due to its overestimation of nominal GDP, and hence government revenue growth. As the government tightens fiscal policy, nominal GDP growth and ultimately government revenue will disappoint substantially. For the second scenario, we used government projections for fiscal spending in the coming years, but our own estimates for nominal GDP and government revenue growth. Notably, excluding interest payments and fiscal support for ailing state-owned enterprises like Eskom, nominal growth of government expenditures in the current year is at 7.5%, and estimated to be 6.8% the next two fiscal years. That is why we project nominal GDP and government revenue growth to be very weak. The basis of our assumption is as follows: Barring considerable currency depreciation, as the authorities undertake substantial fiscal tightening in the next three years, nominal GDP and consequently government revenue growth will plunge. Importantly, government revenues exhibit a non-linear relationship with nominal GDP – government revenues fluctuate much more than nominal GDP (Chart II-3). Chart II-3Government Revenues Are 'High-Beta' On Nominal GDP Growth As government revenue growth underwhelms, the primary deficit will widen and the public debt-to-GDP ratio will escalate, reaching 70% of GDP by the end of the 2021-‘22 fiscal year, according to our projections (Table II-1). Overall, without considerably lower interest rates and material currency depreciation, the government’s financial position will enter a debt deflation spiral. Fiscal tightening will hurt nominal growth damaging fiscal revenues. As a result, the fiscal deficit will widen – not narrow – and the debt-to-GDP ratio will rise. Therefore, the only feasible option for South Africa to stabilize public debt is to reduce interest rates dramatically and depreciate the currency. This will engender higher inflation and nominal growth, thereby boosting government revenues and capping the public debt burden. At 10%, the share of foreign currency debt as part of South Africa’s public debt is low. Hence, currency depreciation will do less damage to public debt dynamics than keeping interest rates at high levels. On the whole, the rand is a very structurally weak currency, and is bound to depreciate due to deteriorating public debt dynamics. Chart II-4 plots the real effective exchange rate of the rand based on CPI and PPI. It is evident that its valuation is not yet depressed. Chart II-4The Rand Is Modestly Cheap Meanwhile, cyclical headwinds also warrant currency depreciation (Chart II-5). Chart II-5Widening Trade Deficit Warrants Currency Depreciation Market Recommendations Continue shorting the ZAR versus the U.S. dollar and the MXN. Consistent with the negative outlook for the exchange rate, investors should underweight South African local currency government bonds and sovereign credit within respective EM portfolios. Finally, we recommend EM equity portfolios remain underweight South African equities. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Special Drawing Rights. The value of the SDR is based on a basket of five currencies: the U.S. dollar, the euro, the Chinese renminbi, the Japanese yen, and the British pound sterling. 2 We exclude these three currencies since their bourses have very large equity market cap in the EM stock index and, hence, would make any aggregate currency measure unrepresentative for the rest of EM. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Await the U.K. parliament to coalesce a majority on a on a credible strategy for Brexit that is also acceptable to the EU27. At that point, buy the pound, the FTSE250, and U.K. homebuilder shares. An eerie calm has descended over developed economy currencies. But the Chinese yuan has rebounded sharply. Stay tactically overweight emerging market currencies, cyclical equity sectors, and equities versus bonds. But don’t expect these rallies to last beyond the summer. Feature Chart of the WeekAn Eerie Calm Has Descended Over The Currency Markets. Why? End Of The Road For May From the moment almost three years ago that the U.K. voted to leave the EU, it was clear that a rational and measured Brexit would require the U.K. to remain in a customs union with the EU. Rational and measured because a customs union would protect the cross-border supply chains which are vital to so many U.K. businesses. Rational and measured because a customs union would avoid a hard customs border on the island of Ireland, and thereby prevent a break-up of the U.K. Rational and measured because a customs union would best deliver on the narrow 52:48 vote to leave the EU, which was driven by a desire to control migration and the supremacy of the European Court of Justice – both of which are compatible with remaining in a customs union – rather than a desire to strike independent trade deals – which is not. Yet Theresa May did not steer to this rational and measured Brexit, because she knew it would rip apart the Conservative party, a hard minority of which sees the sovereignty of trade policy as its Holy Grail. Beholden to this minority, May put her party interest above the national interest. But now, May has run out of road. Her Brexit deal has been rejected twice by huge parliamentary majorities. In the coming days, parliament, through a series of indicative votes, is likely to wrest control of the Brexit process from the government. So far, parliament has expressed what it is against (a no-deal Brexit), but it has yet to express what course of action it is for. We await the U.K. parliament to coalesce a majority on a credible strategy for Brexit that is also acceptable to the EU27. At that point, irrespective of the exact strategy, we will buy the pound, the FTSE250, and U.K. homebuilder shares. Important Message From The Currency Markets An unusually eerie calm has descended over the currency markets (Chart of the Week). For the past six months, GBP/USD has drifted within a tight 5 percent range, USD/JPY has also moved within a similarly narrow range, and EUR/USD has been trapped within an even tighter 3 percent range (Chart I-2 and Chart I-3). Chart I-2GBP/USD And EUR/USD Have Been Very Calm Recently Chart I-3USD/JPY Has Also Been Very Calm Recently The calm is eerie because Brexit tensions have actually intensified as the Article 50 clock has run down without a breakthrough; the Federal Reserve has made a dramatic volte-face from its sequential rate hikes; the ECB has pivoted back to dovish after the German economy narrowly avoided a technical recession; and the Japanese economy contracted sharply in the third quarter of 2018. Adding to the eeriness of the calm in currency markets, the equity and bond markets have experienced wild gyrations. Global equities plunged 20 percent before quickly recovering most of the losses, while long bond prices moved by close to 15 percent1 (Chart I-4 and Chart I-5).1 Chart I-4While Equities Have Been Turbulent, Currencies Have Been Calm Chart I-5While Bonds Have Been Turbulent, Currencies Have Been Calm Given all of this turbulence, why have currency markets remained a relative oasis of calm? The simple answer is that exchange rates are, by definition, relative prices. And in the major economies, growth and inflation rates have moved in the same direction by the same amount at roughly the same time. In fact, looking at quarter-on-quarter growth rates, the major economies have all recently experienced identical 1.5 percent slowdowns: from 4 to 2.5 percent in the U.S.; and from 2.5 percent to around 1 percent in both the euro area and the U.K.2 (Chart I-6 - Chart I-8). Chart I-6U.S. GDP Growth Slowed By 1.5 Percent Chart I-7Euro Area GDP Growth Slowed By 1.5 Percent Chart I-8U.K. GDP Growth Slowed By 1.5 Percent Markets do not care about the level of growth. They care much more about the change in growth. Financial markets are a discounting mechanism, and what matters most to the price is the change in the assumptions that are embedded within it. For example, if the price were discounting a major economy to grow at 4 percent and that rate of growth subsequently fell to 2.5 percent, then the seemingly benign outcome of respectable growth would cause interest rate expectations to decline. In another major economy, if growth slowed from 2.5 percent to 1 percent, it would precipitate a broadly similar decline in interest rate expectations. In this situation of synchronised and meaningful slowdowns across major economies, and the consequent policy responses, equity and bond absolute prices would experience wild gyrations. By contrast, currencies are relative prices. So if the decline in major economy growth rates and interest rate expectations were broadly similar, currency markets would remain a relative oasis of calm. Which perfectly describes the observation of the last six months. This observation of near-identical slowdowns in the major economies supports our thesis that their genesis came from outside the developed economies, which we expounded in A European Cycle ‘Made In China’. And now we present the smoking gun. While an eerie calm has descended over developed economy currencies, all the action has been in emerging economy currencies, especially the Chinese yuan which has rebounded sharply. The message from the currency markets reinforces our thesis: last year’s growth downswing and the current upswing were made in China (see final chart). Never Focus On Levels Of Economic Growth It is worth repeating that a head-to-head comparison of growth rates across different economies is a meaningless exercise. Here’s a simple way to grasp this crucial point: a 1.5 percent growth rate would be a very pleasing outcome for Europe, it would be a very unpleasing outcome for the U.S., and it would be a catastrophic outcome for China. The reason is that if a population is growing, the economy needs to generate real growth well in excess of the rate of population growth to improve (per person) living standards. That excess comes from productivity growth which lifts standards of living and wellbeing. In the case of Germany or Japan where the population is not growing, or is indeed shrinking, the GDP growth rate that is consistent with these rising standards of living is much lower than in those economies where the population is growing (Chart I-9 and Chart I-10). Chart I-9The Same Productivity Growth In The Euro Area And The U.S. ... Chart I-10... Generates Different GDP Growth Necessarily, an economy with weaker demographics – like Germany or Japan – will flirt with technical recessions much more often than one with population growth – like the U.S. or China. But this is just Arithmetic 101. It doesn’t mean that Germany or Japan are in a fundamentally worse shape when it comes to all-important productivity growth and improving wellbeing. Just as important for investors, earnings per share (eps) growth depends on productivity growth and not on GDP growth. Granted, higher GDP from an increasing population will boost a firm’s sales, but without increasing productivity, the firm will have to hire more staff to produce those sales. In essence, the firm will have to employ more capital – issue more shares – which means than earnings per share will not grow. To reemphasise, levels of GDP growth, in themselves, do not drive financial markets. The Perils Of Data-Dependency Recently, the world’s major central banks have become even more wedded to ‘data-dependency’, for two reasons: first, under ever increasing external scrutiny, objectivity to the economic data boosts the transparency and rationale of central bank policy; second, data-dependency acts as a foil to politicians who might want to influence or interfere with the independence of monetary policy. No names mentioned! We applaud the central banks for their good intentions. Yet enhanced data-dependency also carries perils, as it increases the amplitude of the ever-present and natural oscillations in economic growth. The reason is that the high-profile hard data on which monetary policy ‘depends’ such as CPI inflation and GDP growth record what happened in the past, and sometimes in the distant past. Meanwhile, a monetary policy shift today will act on the economy in the future due to the unavoidable lags in transmission. It follows that enhanced data-dependency is akin to a crop farmer who uses last season’s depressed price, from oversupply, to justify planting much less seed for next season. The inevitable undersupply at next season’s harvest will then cause the crop price to surge. Making the farmer plant much more for the following season, at which point the price will collapse again. And the oscillations will continue ad infinitum. Unfortunately, the more backward the data on which policy actions depend, the higher the amplitude of the price and output oscillations. Right now, growth sensitive investment positions are midway through exactly such an up-oscillation, justifying a near-term overweight in emerging market currencies, cyclical equity sectors, and equities versus bonds. But these rallies are highly unlikely to last beyond the summer (Chart I-11). Chart I-11The Recent Mini-Cycle Is ‘Made In China’ Stay tuned for the next turn. Fractal Trading System* We are pleased to report that long DAX versus the 30-year bund achieved its 2.5 percent profit target which is now crystallised and closed. This week we note that the sharp sell-off in AUD/CNY is close to the limit of tight liquidity that has signaled recent reversals in this cyclical currency cross. Accordingly, this week’s recommended trade is to go long AUD/CNY. Set a profit target of 1.5 percent with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 The German 30-year bund. 2 Based on annualised quarter-on-quarter real GDP growth rates. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
First, valuations and balance-of-payment dynamics favor the euro versus the CAD on a long-term basis. Second, we estimate there is more scope for long-term interest-rate expectations to rise in the euro area than in Canada. European rates are further below…
The European Central Bank left rates unchanged at Thursday’s policy meeting but the decision to launch a new Targeted Long Term Refinancing Operation (TLTRO III – or, in other words, cheap loans), could be paradoxically bullish for the euro. If a central bank…
Highlights The deceleration in global growth that began in 2018 is entering a transition phase. The bottoming out process could prove to be volatile, warning against betting the farm too early on pro-cyclical currencies. Tactical short USD bets should initially be played via the euro1 and Swedish krona. The poor Canadian GDP report last week could be a harbinger for more data disappointments down the road. Meanwhile, the dovish shift by the ECB could paradoxically be bullish for the euro beyond the near term. Go short USD/SEK and buy EUR/CAD for a trade. Feature A currency exchange rate is simply a measure of relative prices between two countries. As such, the starting point for any currency forecast should be how those values are likely to evolve over time. For much of 2018, U.S. growth benefited from the impact of the Trump tax cuts, a boost to government spending agreed in January of that year, and the lagged effect of an easing in financial conditions from December 2016 to January 2018. Outside the U.S., what appeared to be idiosyncratic growth hiccups in both Europe and Japan finally morphed into full-blown slowdowns. Slower Chinese credit growth and the U.S.-China trade war were the ultimate straws that broke the camel’s back, deeply hurting global growth (Chart I-1). Consequently, the greenback surged. Chart I-1The Global Growth Slowdown Persists Fading U.S. Dollar Tailwinds At first glance, the picture remains largely similar today, with global growth still slowing and U.S. growth still outperforming. However, a key difference from last year is that U.S. growth leadership is set to give way to the rest of the world. The U.S. ISM manufacturing PMI peaked last August and has been steadily rolling over relative to its trading partners. The U.S. economic surprise index tells a similar story, with last month’s disappointing retail sales numbers nudging the series firmly below zero. Relative leading economic indices also suggest that U.S. growth momentum has slowed relative to the rest of the world. Historically, the relative growth differential between the U.S. and elsewhere has had a pretty good track record of dictating trends in the dollar (Chart I-2). Chart I-2U.S. Growth Leadership Might Soon End Whether or not these trends persist beyond the first quarter will depend on the sustainability of China’s recent stimulus efforts. On the positive side, typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices have perked up in response to a nascent upturn in the credit impulse. On the other hand, policy shifts affect the economy with a lag, suggesting it is too early to tell whether the latest credit injection has been sufficient to turn around the Chinese economy, let alone the rest of the world. What is clear is that the bottoming processes tend to be volatile and protracted, suggesting it is still too early to bet the farm on pro-cyclical currencies. In the interim, investors could track the following indicators to help time a definitive turning point: Whether or not easing liquidity conditions will lead to higher growth is often captured by the CRB Raw Industrial index-to-gold, copper-to-gold, and oil-to-gold ratios. It is encouraging that these also tend to move in lockstep with the U.S. bond yields, another global growth barometer. The power of the signal is established when all three indicators peak or bottom at the same time, as is the case now (Chart I-3). The next confirmation will come with a clear break-out in these ratios. Chart I-3Reflation Indicators Are Perking Up Chinese M2 relative to GDP has bottomed. Historically, this ratio has lit a fire under cyclical stocks and, by extension, pro-cyclical currencies (Chart I-4). The growth rate is still at zero, meaning excess liquidity is not accelerating on a year-over-year basis. Meanwhile, our Emerging Markets team argues that broad credit growth is still decelerating.2 A break above the zero line, probably in the second half of this year, could be a catalyst to shift fully to a pro-cyclical currency stance. Chart I-4Chinese Excess Liquidity Improving On a similar note, currencies in emerging Asia that sit closer to the epicenter of stimulus appear to have bottomed. If those in Latin America can follow suit, it would indicate that policy stimulus is sufficient, and the transmission mechanism is working (Chart I-5). Chart I-5EM Currencies Are Trying To Bottom Finally, China-sensitive industrial commodities, especially metals and building materials, appear to have troughed and are perking up nicely. There was a supply-related issue with the Vale dam bursting in Brazil and a subsequent surge in iron-ore prices, but it is now clear that the entire industrial commodity complex has stopped falling (Chart I-6). Chart I-6Chinese Industrial Commodities Are Rallying Be Selective On USD Shorts Our strategy is to be selective as U.S. dollar tailwinds shift to headwinds, by initially expressing tactical USD shorts via the euro and the Swedish krona. Last week, we highlighted the fact that investors are currently too pessimistic on Europe’s growth prospects. More importantly, most of the factors that toppled European growth domestically – the implementation of new auto-emission standards in Germany, the rising cost of capital in Italy via exploding bond yields, and the populist Gilets Jaunes protests in France – are mostly behind us. Fiscal policy is also set to be loosened this year, and last year’s weakness in the euro will contribute to easier financial conditions. The improvement in European investor sentiment relative to current conditions could be a harbinger of positive euro area data surprises ahead (Chart I-7). Chart I-7Euro Zone Data Might Surprise To The Upside The European Central Bank left rates unchanged at yesterday’s policy meeting but the decision for a new Targeted Long Term Refinancing Operation (TLTRO III – or in other words, cheap loans), could be paradoxically bullish for the euro. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that this is bearish for the currency. Our Global Fixed Income team nailed the move by the ECB in this week’s report.3 European banks have been in the firing line of sluggish growth, negative interest rates, and increased regulatory scrutiny. In the case of Italy, an NPL ratio 9.4% is nearly triple that of the euro area. And with circa 10% of total bank lending in Spain and Italy funded by TLTROs, re-funding by the ECB is exactly what the doctor ordered. In the case of the Sweden, the undervaluation of the krona has begun to mitigate the effects of negative interest rates – mainly a buildup of household leverage and an exodus of foreign direct investment. The GDP report last week was well above expectations, with year-on-year growth of 2.4%. Encouragingly, this was driven by net exports rather than consumption. The Swedish manufacturing PMI release for February was also very encouraging. Orders jumped from 50.4 to 54.0 while export orders jumped from 51.5 to 53.4. The growth in wages is beginning to catch up to new borrowings, meaning domestic consumption could be increasingly financed through income. This will alleviate the need for the Riksbank to maintain an ultra-accommodative policy. On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, the cross is facing strong resistance at the triple top established from the 2009 highs around 9.45 (Chart I-8). Aggressive investors should begin accumulating short positions, while being cognizant of the negative carry. Chart I-8The Swedish Krona Looks Like A Buy Bottom Line: Our favorite indicator for gauging ultimate downside in the dollar is the gold-to-bond ratio. Ever since the global financial crisis, gold has stood as a viable threat to dollar liabilities, capturing the ebb and flow of investor confidence in the greenback tick-for-tick (Chart I-9). Any sign that the balance of forces are moving away from the U.S. dollar will favor a breakout in the gold-to-bond ratio. For now, USD short positions should be played via the euro and Swedish krona. Chart I-9Pay Close Attention To The Gold-To-Bond Ratio Buy EUR/CAD For A Trade Last week saw an extremely disappointing GDP report out of Canada, which prompted the Bank of Canada to keep interest rates on hold this week, followed by quite dovish commentary. In a 90-degree maneuver from its January policy statement that rates will need to rise over time, BoC Governor Stephen Poloz said the path for future increases had become “highly uncertain.” Like many central banks around the world, the BoC has been blindsided by the depth of the negative growth impulse outside its borders, which has begun to seep into the domestic economy. The economy grew at an annualized pace of 0.4% in the fourth quarter, the lowest in over two years. Capital expenditures collapsed at a rate of 2.7%, marking the third consecutive quarter of declines. The forward OIS curve is pricing in no rate hikes for Canada this year, meaning sentiment on the loonie is already depressed. However, our contention is that even if growth bottoms by the second half of this year, the Canadian dollar will offer little value to play this cyclical rebound. Our recommendation is to play the loonie’s downside via the euro. First, valuations and balance-of-payment dynamics favor the euro versus the CAD on a long-term basis. Second, we estimate there is more scope for long-term interest rate expectations to rise in the euro area than in Canada (Chart I-10). European rates are further below equilibrium, and the ECB’s dovish shift will help lift the growth potential of the euro area. Meanwhile, the Canadian neutral rate will be heavily weighed down by the large stock of debt in the Canadian private sector, exacerbated by overvaluation in the housing market. This means that expectations in the 2-year forward market are likely to favor the euro versus the CAD. Chart I-10Buy EUR/CAD For A Trade The biggest risk to this view is the price of oil. The EUR/CAD exchange rate is not as negatively correlated with oil as the USD/CAD, but nonetheless the CAD benefits more from rising oil prices than the euro does. BCA’s bullish oil view is a risk over the next six months. On the downside, the EUR/CAD could potentially test the bottom of the upward trending channel that has existed since 2012. This would put EUR/CAD in the vicinity of 1.45 (currently trading at 1.5049). However, initial upside resistance rests at the triple top a nudge above 1.6 (Chart I-11). Chart I-11EUR/CAD Technicals: Limited Downside Meanwhile, economically, Canada is benefiting less from oil prices today than it has in the past. First, the Canadian oil benchmark trades at a large discount to Brent, and second, Canada is having trouble shipping its own oil at a moderate cost due to lack of pipeline capacity.4 Bottom Line: Investors should buy the EUR/CAD for a trade. The Canadian dollar is likely to outperform its antipodean counterparts, but faces limited upside versus the U.S. dollar. There are better opportunities to play USD downside, namely via the Swedish krona and the euro. Stand Aside On The Australian Dollar For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities is rapidly morphing into a housing crash (Chart I-12). Chart I-12Australia: Anatomy Of A Hard Landing In addition, the upcoming general election could exacerbate the risks to the country’s banks and the housing market.5 The center-left Labour Party, which has moved further to the left in this electoral cycle, has promised several regulatory changes. First, the Labour government would want to get rid of “negative gearing,” the practice of using investment properties that are generating losses to offset one’s income tax bill. Second, the capital gains tax exemption from selling properties will be reduced from 50% to 25%. Third, the Labour government would end the policy of reimbursing investors for the corporate tax paid by the company. This would end the incentive for retirees to own high dividend yielding equities, such as those of Australian banks. This week, the Reserve Bank of Australia kept rates on hold and acknowledged risks to the housing market, but bank stocks suggest they remain well behind the curve (Chart I-13). The futures market is already pricing in 23 basis points of rate cuts by the end of the year, and the contention of our fixed income team is that more might be needed down the road. First, all the preconditions for a rate hike – underemployment below 8%, a rebound in Chinese economic activity and core CPI in the range of 2-3% – have not been met. The reality is that core CPI has lagged the target range since late-2015, and now faces downside risks. Chart I-13Australian Bank Stocks Are Pricing In A Curve Inversion That said, a lot of the bad news already appears priced into the Australian dollar, which is down 14% from its 2018 peak, and 37% from its 2011 peak. This suggests outright short AUD bets are at risk from either upside surprises in global growth, or simply the forces of mean reversion (Chart I-14). Chart I-14Stand Aside On The Australian Dollar For Now Bottom Line: Sentiment on the Aussie dollar is already bearish, warning against putting on fresh shorts. Our short AUD positions, expressed via the NZD and the CAD, are currently 6.74% and 1.99% in the money, respectively. Investors should hold onto these positions, but tighten stops to protect profits. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report titled “A Contrarian Bet On The Euro,” dated March 1, 2019 available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report titled “EM: A Sustainable Rally Or False Start?,” dated March 7, 2019 available at ems.bcaresearch.com 3 Please see Global Fixed Income Strategy Special Report, titled “The ECB’s Next Move: Taking Out Some Insurance,” dated March 5, 2019, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, titled “Oil Price Diffs: Global Convergence,” dated March 7, 2019, available at ces.bcaresearch.com 5 Please see Geopolitical Strategy Special Report, titled “A Year Of Change In Australia?,” dated December 5, 2018, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed: Annualized Q4 GDP growth came in line with expectations at 2.6%, but both the Atlanta and New York Fed models suggest sub 1% growth in Q1 this year. ISM manufacturing PMI missed expectations, falling to 54.2, while the non-manufacturing PMI increased to 59.7. Q4 unit labor costs increased to 2%, surprising to the upside. The DXY index has gained 1.17% this week. Upside on the dollar will be based on Fed’s capacity to continue tightening monetary policy later this year. However, there are increasing signs pointing to a weakening in leadership of U.S. growth this cycle, which could be a headwind for the counter-cyclical dollar. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area show some specter of stabilization: Yearly consumer price inflation increased to 1.5%, in line with expectations. Q4 GDP growth on a year-on-year basis fell to 1.1%, marginally in line. Encouragingly, the Markit composite PMI increased to 51.9. The manufacturing PMI came in at 49.3, while services PMI came in at 52.8. Finally, retail sales grew higher than expected, with a reading of 2.2%. EUR/USD has fallen by 1.3% this week. The ECB kept interest rates on hold with a dovish tilt. Paradoxically, this could be bullish for the euro, if it allows growth to definitively bottom. Easing financial conditions in the euro area are reflationary and risks to the periphery have been curtailed. Report Links: A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Yearly inflation surprised to the upside, coming in at 0.6%. The core inflation excluding fresh food also came in higher than expected at 1.1%. January unemployment rate missed expectations, climbing to 2.5%; while the jobs-to-applicants ratio stayed at 1.63. Nikkei manufacturing PMI surprised to the upside, coming in at 48.9. USD/JPY has risen by 0.4% this week. While we are positive on the safe-haven yen on a structural basis, we struggle to see any near-term upside amid significant Japanese stock and bond outflows. We will be discussing the outlook for the yen in an upcoming report. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been improving: February consumer confidence came in at -13, slightly higher than expectations. Markit manufacturing PMI came in at 52, in line with expectations; while the services PMI surprised to the upside, coming in at 51.3. The Halifax house price index surprised to the upside, rising 5.9% mom in February. GBP/USD has fallen by 1.2% this week. During the speech on March 5, the Bank of England governor Mark Carney highlighted the market underestimates the potential for interest rate hikes. Overall, we remain bullish on the pound in the long-term, but volatility is set to rise in the near term as we approach the Brexit March 29 deadline. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been dismal: The RBA commodity price index advanced by 9.1% year-on-year in February, but this was supply related. Building permits continue to contract at 29% year-on-year. Finally, the annualized Q4 GDP growth fell to 0.2%, more than 50% below expectations. AUD/USD fell by 1.2% this week. The RBA kept the interest rate unchanged at 1.5%. Governor Philip Lowe acknowledged the downside risks to the housing market and overall economy, and warned about the “significant uncertainties around the forecast.” That said, AUD/USD has fallen by a 13% since the January 2018 highs, warning against establishing fresh shorts at this juncture. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Seasonally adjusted building permits increased 16.5% month-on-month in January, a huge jump. However, the ANZ activity business confidence dropped to -30.9. Most importantly, terms of trade fell to -3% in the fourth quarter, underperforming expectations. NZD/USD depreciated by 0.9% this week. The key for the Kiwi will be a pickup in agricultural commodity prices, which remain in a definitive bear market. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been disappointing: Q4 current account balance has deteriorated, coming in at C$ -15.48 billion. Moreover, annualized Q4 GDP growth missed analysts’ forecast, coming in at 0.4%. Finally, the Markit manufacturing PMI weakened to 52.6 in February. USD/CAD has gained 2.1% this week. The BoC kept interest rates on hold at 1.75% given that domestic economic conditions have now coupled to the downside with a bleak external picture. The caveat for the Canadian dollar is that rising oil prices could provide some support. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Annualized Q4 GDP growth missed analysts’ expectations by 50%, coming in at 0.2%. In addition, the retail sales contracted 0.4% year-on-year. Lastly, CPI was in line at 0.6%, but this is a far cry from the March 2018 peak. EUR/CHF has been flat this week. Overall, we are bullish EUR/CHF on a cyclical basis. Stabilization in global growth will make safe-haven currencies like the franc less attractive. In addition, the foreign direct investment and portfolio investment outflows from Switzerland should put more downward pressure on the franc. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Monthly unemployment rate fell to 2.5%, in line with expectations. However, the Q4 current account balance fell to 46.8 billion from 91.36 billion in Q3. The manufacturing PMI has been stable for a few months now, coming in at 56.3 for the month of February. USD/NOK increased by 2.2% this week. We are optimistic on the NOK on a structural basis, given the positive outlook for oil prices. Moreover, the NOK is undervalued and trading at a large discount to its long-term fair value. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Retail sales was in line with expectations at 0.8% month-on-month. However, annualized Q4 GDP growth was double expectations at 1.2%. The February manufacturing PMI also came in higher at 52.5. In addition, industrial production yearly growth came in higher at 3.4%. Lastly, the Q4 current account balance increased to 39.6 billion. USD/SEK increased by 2% this week. The SEK is still trading at a large discount to its long-term fair value. We remain bearish on USD/SEK on a structural basis as we see many signs pointing to a recovery in the Swedish economy, which is a tailwind for the Swedish krona. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
First, on a 12-month forward P/E ratio basis, euro area equities are trading at the kind of deep discount to U.S. stocks normally symptomatic of a trough in relative sentiment toward Europe. Such a discount is often followed by a rally in EUR/USD. Second,…
Feature Recommendations Two Key Questions For Asset Allocators Stocks have rallied this year – MSCI ACWI is up 17% from its late December low – despite the fact that economic growth outside the U.S. has continued to deteriorate. The PMI in Germany has fallen to 47.6, in Japan to 48.5, and the average in Emerging Markets to 49.5 (Chart 1). Chart 1PMIs Ex-U.S. Still Falling U.S. growth remains robust, though recent data have showed some signs of weakness. The Citigroup Economic Surprise Index has fallen sharply, capex indicators have slipped, and December retail sales were terrible (Chart 2). The New York Fed NowCast for Q1 is now pointing at only 1.2% real GDP growth. Most of the slippage, however, was caused by the six-week government shutdown, and should be reversed in Q2. And the retail sales number appears “rogue”, perhaps caused by irregular data-collection methods during the shutdown, since other retail data do not support it (Chart 2, panel 3). The tightening of financial conditions in the last months of 2018 – which has now partly reversed – may have added to the slowdown (Chart 3). BCA’s view is that U.S. GDP growth is likely to come in well above 2% in 2019, slower than last year’s 2.9% but still above trend. Chart 2Should We Worry About U.S. Growth Too? Chart 3Financial Conditions Now Easing Our recommendation, therefore, is to continue to overweight equities (particularly U.S. equities), which should be supported by decent earnings growth (our top-down model points to 12% EPS growth for the S&P500 this year, compared to a bottom-up consensus forecast of only 5%), reasonable valuations, and sentiment that appears still to be damaged by the Q4 sell-off (Chart 4). Chart 4Environment Still Positive For U.S. Equities Two key questions will determine which asset allocation will be optimal this year. First, how long will the Fed stay “patient” and keep rates on hold? The futures market has almost completely priced out the possibility of any rate hikes in 2019, and even assigns a 15% probability of a cut (Chart 5). We still see upside risk to inflation, with core PCE likely to print above the Fed’s target of 2% by mid-year, partly because of the year-on-year base effect (in January 2018, monthly inflation was especially high), but also because underlying inflation pressures remain (Chart 6). Chart 5Is The Fed Really Going To Cut Rates? Chart 6Inflation Pressures Haven't Gone Away The market has misunderstood two of the Fed’s recent messages. Its mooted plan to end balance-sheet reduction by year-end is not intended as part of monetary policy. It is simply that bank excess reserves will have reached USD1-1.2 trillion, the level required to operate monetary policy using current tools, rather than those used before 2007 when reserves were zero (Chart 7). Second, recent discussions about changing the Fed’s inflation target from 2% a year to a price-level target will probably become effective only when the effective lower bound is hit in the next recession and, anyway, no decision will be taken until mid-2020. Chart 7Excess Reserves Will Be At Equilibrium Soon The market has taken this talk as dovish. We read recent comments by Fed Chairman Jay Powell to mean that if, by June, the economy is robust, risk assets are still rebounding, and inflation is ticking up, the Fed will continue to hike, maybe two or three times by year-end. This implies long-term bond yields will rise too. Equities may wobble initially but, as long as the Fed is hiking because growth is solid and not because of an inflation scare, this should not undermine the 12-month case for equity outperformance. The second key question is whether China has now abandoned its focus on deleveraging and switched to a 2016-style liquidity-driven stimulus. Certainly, the January total social financing number pointed in that direction, with new credit creation of almost 5 trillion RMB ($750 billion) and the first signs of an easing of restrictions on shadow banking (Chart 8). But the jury is still out on whether this is the massive reflation the market has been waiting for. Premier Li Keqiang criticized the increase, saying, “the increase in total social financing appears rather large…it may also bring new potential risks”. A PBOC official commented that the big increase was “due to seasonal factors” and emphasized that China was not embarking on “flood irrigation-style” stimulus. The recent more positive noises on the U.S./China trade war may also alleviate the pressure on China to stimulate. Chart 8First Signs Of Chinese Reflation? If and when Chinese growth does rebound, this will have major implications for asset allocation. It would signal a bottoming of the global cycle, which would favor stocks in Emerging Markets, Europe and Japan. It would push up commodity prices, and imply a weaker dollar. For now, we are not positioning ourselves like this, since global growth remains weak. Nonetheless, the first signs of a bottoming are appearing with, for example, the diffusion index of the global Leading Economic Index (which often leads the LEI itself) turning up (Chart 9). We may shift in this direction mid-year, and are now making some minor changes to our recommendations (see below) to hedge against this risk. But for the moment we prefer U.S. equities, expect further USD appreciation, and remain cautious on EM. Chart 9Is The LEI Close To Bottoming? Equities: We prefer U.S. equities given their better growth, reasonable valuations, and depressed sentiment (despite their outperformance year-to-date). But we are watching for an opportunity to increase our weighting in Europe, where growth still looks poor but may rebound in H2 due to fiscal stimulus, improving wage growth, a dovish turn by the ECB, and an eventual recovery in exports to China (Chart 10). We still see problems in EM, since earnings growth expectations need to be revised down further and stock prices have risen prematurely on expectations of a Chinese recovery (Chart 11). But we reduce the size of our underweight bet, to hedge against Chinese credit growth continuing to accelerate. We are also raising our recommendation for the industrials sector (with its large weight in capital goods companies dependent on exports to China) to overweight for the same reason. We fund this by cutting consumer staples to underweight. We also raise our weighting on the energy sector, given our positive view on oil prices (see below). This gives our sector weightings a slightly more cyclical tilt, in line with our macro view. Chart 10Some Good News In Europe Too Chart 11EM Has Further Downside Fixed Income: It has been a conundrum this year why equities have risen and credit spreads tightened significantly, but the 10-year Treasury yield remains stuck below 2.7%. One explanation is that inflation expectations have been dampened by the crude oil price and if, as we forecast, oil continues to recover, the inflation component of the yield will rise (Chart 12). U.S. yields have also been dragged down by weak growth in other developed markets, where bond yields have therefore fallen. The spread between U.S. and German and Japanese yields reached record high levels in late 2018 (Chart 13). The term premium also is deeply into negative territory because many investors remain highly bearish and have hedged this view by buying Treasuries. If our view of robust U.S. growth, rising inflation, and more Fed hikes is correct, we would see 10-year Treasury yields rising towards 3.5% over the next 12 months. Accordingly, we are underweight global government bonds. We raised credit to neutral last month, but continue to have some qualms about this asset class, and prefer equities as a way of taking exposure to further upside for risk assets. Besides high leverage among U.S. corporates, we are worried about the deterioration in the quality of the credit market, since duration has been extended, covenants weakened, and the average credit rating fallen (Chart 14). Chart 12Inflation Expectations Driven By Oil Chart 13U.S. Yields Pulled Down By Europe And Japan Chart 14Deterioration In Credit Market Fundamentals Currencies: We see some more upside in the U.S. dollar over the next few months, given U.S. growth and monetary policy relative to the euro area and Japan (Chart 15). This may reverse, however, if global cyclical growth rebounds in the second half. The dollar is particularly vulnerable if macro conditions change, since it looks around 10% overvalued relative to other major DM currencies, and speculative positions are predominantly long dollar (Chart 16). Chart 15Relative Rates Support USD Chart 16But Dollar Vulnerable To Macro Shifts Commodities: With demand likely to grow steadily this year, but supply under pressure because of production cuts by OPEC and Canada, lower U.S. shale oil output, and disruptions in Venezuela and elsewhere, our energy strategists see drawdowns in inventories throughout the year (Chart 17). They forecast Brent to average $75 a barrel during 2019 (compared to $66 now), with WTI $5 a barrel lower. Industrial commodities continue to be driven by China which means, given our view expressed above, that we may see further weakness short-term, with a possible rebound in H2 (Chart 18). Chart 17Oil Supply/Demand Is Tight Chart 18When Will Metal Prices Bottom? Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com GAA Asset Allocation