Currencies
Highlights The current trajectory in global share prices resembles what took place in 2000 and early 2001. The early 2001 rebound in global and EM stocks lasted several weeks only, despite ongoing easing by the Federal Reserve. Corporate profits – not the Fed – was the key driver in 2001 and remains the principal driver of global and EM stocks today. EM corporate profits are set to contract this year due to China’s continuing slowdown and weakening global trade. This suggests the current EM rally is unsustainable; continue underweighting EM. In Chile, bet on lower swap rates. Continue shorting the peso but overweight the local bourse within an EM equity portfolio. Feature The dovish shift by the U.S. Federal Reserve in the past month has boosted EM risk assets and currencies. Yet, we find that in the medium and long term there is a very low correlation between Fed policy and U.S. interest rates, on the one hand, and EM financial markets on the other. Instead, EM risk assets and currencies correlate with EM/China business cycles and global trade (Chart I-1). We have not detected any improvement in China/EM growth, nor in global trade (Chart I-1). What’s more, we expect Chinese growth and world trade to continue to weaken in the coming six months. Therefore, the EM rebound and outperformance will be reversed sooner than later. Chart I-1Global Growth Indicators Do No Confirm EM Rally Please note this is the view of BCA’s Emerging Markets Strategy team. BCA’s house view is presently positive on global risk assets and global growth. The basis for this difference between our current position and that of the majority of our colleagues is the outlook for China’s growth. A Replay Of 2016 Or 2001? Most investors are betting that 2019 will be a replay of 2016, when the Fed’s dovish turn and China’s stimulus propelled the EM and global equity rallies. It is enticing to compare the current episode in financial markets to the one that occurred only three years ago. To be sure, there are a lot of similarities: the global trade slowdown driven by China/EM, selloffs in global equity and credit markets, a dovish shift in the Fed’s stance and policy stimulus in China are all reminiscent of early 2016. Not surprisingly, this has created a stampede into EM. According to the most recent Bank of America Merrill Lynch survey, as of mid-January some 29% of investors were overweight EM stocks compared to 1% overweight in the U.S., 11% underweight in the euro area and 1% underweight in Japan. By now, the overweight in EM equities is most likely even higher, given the stampede into EM assets that has occurred over the past several weeks. This stands in contrast to the 33% underweight in EM equities in January 2016. It is apparent that the majority of investors are indeed extrapolating 2016 into 2019. We hold a different view and believe China’s slowdown will be more protracted than in 2015-’16, and that EM corporate earnings are set to contract (please refer to Chart I-5 on page 6). A key distinction between China’s current policy efforts and what was implemented in 2015-‘16 is the absence of stimulus for real estate. The odds are that China’s property market will continue to languish, weighing on household and business sentiment as well as spending. Further, the efficiency of monetary transmission mechanisms could be lower today than it was in 2016 due to the regulatory tightening on both banks and non-banks. The fiscal multiplier could also be lower due to the fragile sentiment among consumers and businesses. We discussed these issues in detail in our January 17, 2019 report. Remarkably, it appears that global share prices are tracking the pattern of 1998-2001 – their trajectories are identical in terms of both magnitude and duration (Chart I-2). Chart I-2Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration That said, there are substantial differences between today and 2001 in respect to the economic backdrops in the U.S. and China. Our focal point is to demonstrate that the Fed easing is not sufficient to prop up share prices if it does not lead to a recovery in corporate earnings. We conclude that the latest rebound in EM risk assets is probably late because neither the Fed’s pause nor China’s stimulus will revive EM corporate profits in the next nine months. In terms of market action, one can draw a number of parallels between the trajectory in global share prices today and in 2000-’01. Following an exponential rally in 1999, the global equity index peaked in January 2000 (Chart I-3). The equity selloff accelerated in the last quarter of 2000, with stocks plunging in December of that year. Chart I-3Is Rebound In Global And EM Stocks Late? Oversold conditions in global share prices and the Fed’s intra-meeting 50-basis-point rate cut on January 3, 2001, generated a 7% and 15% rebound in global and EM stocks, respectively. The bounce lasted from late December 2000 until early February 2001. The current trajectory in global share prices – the rollover in late January 2018, the top formation lasting several months followed by a dramatic plunge, the bottom in late December, 2018 and the subsequent rebound – closely resemble the path global share prices took in 2000 and early 2001 (Chart I-3, top panel). The same holds true for EM share prices (Chart I-3, bottom panel). Critically, the Fed continued to cut interest rates in 2001 and 2002, yet the bear market in global equities, including EM, persisted until March 2003 (Chart I-4A and I-4B, top panels). The culprit was shrinking corporate profits (Chart I-4A and Chart I-4B, bottom panels). Chart I-4AFed Easing Did Not Help Global Stocks In 2001 Chart I-4BFed Easing Did Not Help EM Stocks In 2001 Odds are that EM earnings are set to contract this year as discussed below and shown in Chart I-5. As a result, this view bolsters our conviction that EM equities are likely to roll over soon and plunge anew in absolute terms, and certainly underperform U.S. stocks. Bottom Line: There are many economic differences between today and 2001. Our main point is that the Fed easing-inspired rally in global equities in early 2001 lasted several weeks only and was followed by a new cycle low. The key factor was not Fed policy but corporate profits. Provided our view that corporate earnings in EM and global cyclical sectors will contract this year, the rally in these segments is not sustainable regardless of Fed policy. What Drives EM: Chinese Or U.S. Growth? Predicting the outlook for China and global trade correctly is key to getting the EM call right. First, China’s credit and fiscal spending impulse leads EPS growth of companies included in the EM MSCI equity index by nine months, and it currently points to continued deceleration and contraction in EM EPS in the months ahead (Chart I-5, top panel). The average of new and backlog orders within China’s manufacturing PMI also portends a negative outlook for EM corporate earnings (Chart I-5, bottom panel). Chart I-5EM Profits Are Heading Into Contraction The primary linkage between China’s credit and fiscal spending impulse and EM profits is as follows: China impacts EM and the rest of the world via its imports. This explains why EM share prices correlate with Chinese PMI imports (Chart I-6). Chart I-6Chinese Imports And EM Equities Second, China’s imports are to a large extent driven by capital spending, especially construction. Some 85% of mainland imports are composed of various commodities, industrial goods and materials, and autos. Consumer goods make up only about 15% of imports. Major capital expenditures in general and construction, in particular, cannot be undertaken without financing. This is why the country’s credit and fiscal spending impulse leads its imports cycles (Chart I-7). This impulse is presently foreshadowing a deepening slump in mainland imports and by extension its suppliers’ revenues and profits. Chart I-7Chinese Imports Are Heading South Third, as EM shipments to China dwindle, not only will EM corporate revenues and profits disappoint but EM currencies will also depreciate. The latter bodes ill for EM U.S. dollar and local currency bonds. The basis is that exchange rate depreciation makes U.S. dollar debt more expensive to service, and also pushes up local bond yields in high-yielding EM fixed-income markets. Fourth, The majority of developing economies sell more to China than to the U.S. Remarkably, global trade and global manufacturing decelerated in 2018, even though U.S. goods imports were booming (Chart I-8). Crucially, the more recent strength in the U.S.’s intake of goods was in part due to frontloading of shipments to the U.S. before the import tariffs went into effect on January 1, 2019. Chart I-8U.S. Imports Are Very Robust Yet despite robust U.S. demand, aggregate exports of Korea, Taiwan, and Japan have done poorly and their manufacturing have slumped (Chart I-9A and Chart I-9B). Chart I-9AAsian Exports: Flirting With Contraction Chart I-9BAsian Manufacturing: Flirting With Contraction This highlights the increased significance of Chinese demand and the diminished importance of U.S. domestic demand in world trade. In particular, at $6 trillion, EM aggregate goods and services imports, including Chinese imports (but excluding China’s imports for processing and re-exporting), is greater than the combined imports of the U.S. and EU, which currently stand at $4.7 trillion ($2.5 trillion plus $2.2 trillion, respectively). Finally, the media and many investors have exaggerated the impact of U.S. tariffs on the Chinese economy. We are not implying that the tariffs are not relevant at all, or that they have not damaged sentiment among mainland businesses and households. They have. The point is that China’s exports to the U.S. constitute 3.8% of Chinese GDP only (Chart I-10). This compares to Chinese capital spending amounting to 42% of GDP and total annual credit origination and fiscal spending of 26% of GDP. Chart I-10China's Exports To U.S. Are Small (3.8% of GDP) Overall, China’s growth slowdown in 2018 was not due to its plunging shipments to the U.S. – actually, the latter were rising strongly till December due to frontloading – but due to weakness in credit origination, primarily among non-banks (shadow banking). Bottom Line: The Chinese business cycle – not the U.S.’s – is the key driver of EM share prices and currencies and more important than the Fed. EM And The Fed On the surface, it seems that EM is tracking Fed policy. To us, however, this is akin to“not seeing the forest for the trees”. Investors need to stand back and examine the medium- and long-term relationships between U.S. interest rates, DM central banks’ balance sheets, and EM financial markets. In this broader context, the following becomes apparent: There is no stable correlation between EM share prices, EM currencies and EM sovereign credit, on the one hand, and U.S. 10-year bond yields, on the other (Chart I-11). Chart I-11EM And U.S. Bond Yields: No Stable Correlation Historically, the correlation between EM share prices and the Fed funds rate has been mixed, albeit more positive than negative (Chart I-12). On this 40-year chart, we shaded the periods when EM stocks did well during periods of a rising fed funds rate. These time spans are 1983-1984, 1988-1989, 1999-2000, 2003-2007 and 2017. Chart I-12EM Stocks And Fed Funds Rate: A Historical Perspective The only two episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican peso crisis. Yet, it is essential to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Remarkably, there is also no correlation between the size and the rate of change of DM central banks’ balance sheets, on the one hand, and EM risk assets and currencies on the other. In particular, Chart I-13 validates that the annual growth rate of G4 central banks’ balance sheets does not correlate with either EM share prices or EM local currency bonds’ total returns in U.S. dollars. Chart I-13Pace Of QEs And EM: No Correlation Finally, there is a low correlation between U.S. real interest rates and the real broad trade-weighted dollar (Chart I-14). Notably, Chart I-15 illustrates that the greenback often acts as a countercyclical currency, appreciating when global growth is slowing and depreciating when the global business cycle accelerating. Please note that the dollar is shown inverted on this chart. Chart I-14The U.S. Dollar And U.S. Real Rates Chart I-15The U.S. Dollar Is Countercyclical Bottom Line: Many analysts and investors assign more significance to the Fed policy’s impact on EM risk assets than historical evidence warrants. Unless Fed policy easing coincides with EM growth recovery, the Fed’s positive impact on EM will prove to be fleeting. Investment Considerations Widespread bullish bias on EM among investors currently and a continuous slew of poor growth data in China and global trade give us the conviction to argue that the current EM rally is not sustainable. Even if the S&P 500 drifts higher, EM stocks and credit will underperform their U.S. counterparts (Chart I-16). Chart I-16Stay Short EM / Long S&P 500 The EM equity index is sitting at a major technical resistance, and a decisive break above this level will challenge our view (Chart I-17, top panel). The same holds true for many EM currencies and copper (Chart I-17, bottom panel). However, for now, we are maintaining our negative bias. Chart I-17EM Equities And Copper Are Facing Resistance Within the EM equity universe, our overweights are Brazil, Mexico, Chile, Russia, central Europe, Korea, and Thailand. Our underweights are Indonesia, India, Philippines, South Africa, and Peru. We continue to recommend shorting the following EM currency basket versus the U.S. dollar: ZAR, IDR, MYR, CLP, and KRW. The full list of our recommended positions across EM equities, local rates, credit, and currencies is available on pages 17-18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Chile: Favor Bonds Over Stocks Local currency bonds will outperform equities in Chile over the next six to nine months (Chart II-1). Chart II-1Chile: Favor Bonds Over Stocks The central bank is raising interest rates to cap inflation. However, we believe this is misguided because China’s ongoing deceleration along with lower copper prices, will slow growth in Chile over the course of this year. In addition, the current domestic inflation dynamics are less worrisome than the central bank contends. There is ongoing debate in the policy circles of Santiago over whether the recent large net immigration wave, particularly from Venezuela, is inflationary or disinflationary. On the one hand, net immigration expands the supply of labor and puts downward pressure on wages, and hence is disinflationary (Chart II-2). On the other hand, net immigration bolsters demand, and thereby inflation. Chart II-2Chile: Labor Force Is Expanding At 2% The central bank has acknowledged both effects but has cited that the latter will overwhelm the former. We disagree with this assessment and believe that current immigration in Chile will be more disinflationary. There are a number of factors that make us believe so: Both nominal and real wage growth are cooling off rapidly (Chart II-3). This corroborates the thesis that the expanding supply of labor is capping wage increases. Chart II-3Chile: Wage Growth Is Decelerating Central banks in any country need to be concerned with rising unit labor costs and service sector inflation. Energy and food prices are beyond a central bank’s control. Monetary policy should not respond to fluctuations in these prices unless there are second-round effects on wages and other prices. There is presently no genuine inflationary pressures in Chile. The average of Chile’s core and trimmed mean inflation rates stands at 2.5%, and service sector inflation is at 3.7% (Chart II-4). This is within the central bank’s inflation target range of 3% +/-1%. Chart II-4Chile: Inflation Is Within Target Range Finally, Chile’s exports are set to shrink due to the ongoing deceleration in China and lower copper prices (Chart II-5). With exports accounting for 30% of GDP, a negative external shock will slow domestic demand too. This will be disinflationary. Chart II-5Chilean Exports Are About To Contract The fixed-income market in Chile is pricing in rate hikes (Chart II-6). We continue to recommend receiving 3-year swap rates. Even if the central bank continues to tighten, long-term interest rates will decline, anticipating rate cuts down the road. Chart II-6Chile: Receive 3-Year Swap Rates Chilean share prices, in absolute terms, are at risk from the EM and commodities selloff. However, we recommend dedicated EM equity portfolios overweight Chile. The economy is fundamentally and structurally solid, and local equity markets are supported by large local investment pools. Importantly, unlike many other commodity producers, currency depreciation in Chile does not stop the central bank from cutting interest rates. Banco Central de Chile does not target the exchange rate and will cut rates to mitigate the adverse external shock. This will ensure that business cycle fluctuations in Chile will be milder than in other developing economies where central banks tighten to defend their currencies. This is positive for Chilean stocks versus other EM bourses. Finally, the peso is at risk of depreciation from lower copper prices. Bottom Line: Local investors should favor domestic bonds over stocks. Fixed-income traders should bet on lower three-year swap rates. Dedicated EM investors should overweight Chilean equities. Currency traders should maintain a short CLP / long USD trade. Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to further tightening emanates from stock markets and risk spreads. Through the next couple of years U.S. long bonds will strongly outperform German bunds… …and USD/EUR will trend lower. Since October 2017, no stock market rally or sell-off has lasted more than three months. Overweight equities tactically, but don’t get too comfortable. The broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. Feature More than a decade has passed since the Global Financial Crisis. Yet through the past ten years, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then swiftly reverse course. 2019 is a pivotal year for monetary policy because it will answer a fundamental question: will the 2 percent limit for monetary tightening that has held since 2008 continue to hold, or finally break? (Chart of the Week). The answer will have a huge bearing on European investment strategy for equities, bonds and currencies. Chart of the WeekSince 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent... So Far A History Of Policy Reversals Swedish interest rates peaked near 5 percent in 2008 before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Admittedly, Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. But on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening of only 1 percent; Korea could manage just 1.25 percent (Chart I-2); the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again. Chart I-2Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent The Federal Reserve has sequentially raised interest rates by 2 percent, and guess what? It has just decided to take a breather! Last week, Chairman Jay Powell was asked the question as plainly as possible: is the next move in interest rates as likely to be up as down? And his answer: “we don’t have a strong prior… we will patiently wait and let the data clarify.”1 There is no requirement at BCA for strategists to agree. In fact, the opposite is true in that we encourage independent thinking and diverse ways of looking at the world. BCA’s house view is that the Fed will resume its sequential hiking later in the year. But I believe this takes a too rosy view on the global financial system’s capacity to tolerate further tightening. The Vulnerability Is In Stock Markets And Risk Spreads Monetary policy operates on an economy by adjusting its financial conditions: its bond yields, credit availability, currency, stock market, and risk spreads. And the neutral monetary policy stance – the so-called ‘neutral real interest rate’ – is the policy stance consistent with the economy growing at trend. In the past, a simple rule of thumb was that real rates, over time, should approximate to the real growth in the economy. But some studies argue that the neutral real rate may now be close to zero. All the Fed has done is bring the real interest rate out of negative territory to barely above zero. Yet its recent hikes have been blamed for extreme volatility in stock markets and risk spreads. Last week, Powell acknowledged that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” Furthermore, “the policy stance is now in the range of the Committee’s estimates of neutral… and when you get to that (neutral) range we have to put aside our own priors and let the data speak to us.” All of which raises a salutary observation from my colleague Martin Barnes, BCA Chief Economist: if a real interest rate that is barely above zero is enough to trigger extreme market volatility and threaten the economic expansion, then the system is much more vulnerable than generally assumed.2 Martin has hit the nail on the head. At the current level of tightening, the system is much more vulnerable than generally assumed. But the vulnerable components of financial conditions are not bond yields, credit availability, or currency; the vulnerability emanates from stock markets and risk spreads, and specifically their potential for extreme volatility. Previous reports have focused on the source of this vulnerability. To recap, at low yields, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But when the 10-year global bond yield rises back to around 2 percent, the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets.3 Put simply, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. The consequent plunge in risk-asset prices aggressively tightens financial conditions and thereby sets an unusually low ceiling for nominal interest rates and bond yields. This dynamic proved to be the major feature of the financial market landscape in 2018 and will loom large in 2019 too. It also solves the riddle as to why the neutral real rate may now be close to zero. An unusually low ceiling for the nominal interest rate combined with inflation hovering around 2 percent, translates into a neutral real interest rate that is not much higher than zero. The Investment Implications When the Riksbank paused after its near 2 percent of hiking, it proved to be a good structural entry point for Swedish long bonds, and a good structural exit point for the Swedish krona (Chart I-3 and Chart I-4). Likewise, when the Reserve Bank of Australia paused after its near 2 percent of hiking, it was an excellent moment to buy Australian long bonds and to sell the Australian dollar (Chart I-5 and Chart I-6). Chart I-3When The Riksbank Paused, It Was A Good Structural Entry Point In To Swedish Bonds... Chart I-4...And A Good Structural Exit Point Out Of The Swedish Krona Chart I-5When The RBA Paused, It Was A Good Structural Entry Point In To Australian Bonds... Chart I-6...And A Good Structural Exit Point Out Of The Australian Dollar Will the the 2 percent limit for monetary tightening that has held since 2008 continue to hold? If, as we expect, the answer is yes the implication is that through the next couple of years U.S. long bonds will strongly outperform German bunds. Over the same time frame, USD/EUR will trend lower (Chart I-7 and Chart I-8). Chart I-7A Good Structural Entry Point In To Long T-Bonds/Short Bunds Chart I-8A Good Structural Exit Point Out Of USD/EUR Finally, as regards the broad stock market, a quick glance at the MSCI all country world index shows a striking feature. Since October 2017, no rally or sell-off has lasted more than three months (Chart I-9). Given the current highly non-linear relationship between equities and bond yields, this pattern is set to continue. Chart I-9Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months In essence, the broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. The current stance is tactically long, but don’t get too comfortable! Fractal Trading System* The sharp recent rally in government bonds has hit a point where tight liquidity conditions could trigger a temporary reversal. Accordingly, the 65-day trade is to go short 30-year T-bonds, setting a profit target at 3 percent with a symmetrical stop-loss. All of the five other open positions are in healthy profit. 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-10 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. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com * 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 Footnotes 1 The Federal Reserve has raised the federal funds rate by a total of 2.25 percent comprising an isolated 0.25 percent hike at the end of 2015 and a sequential 2 percent hike from December 2016 through December 2018. 2 Please see the BCA Special Report “A Grumpy View Of The Outlook” January 28, 2019 available at www.bcaresearch.com 3 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com 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
Highlights Our main leading indicator for China’s economy and the broad trend in coincident measures both suggest that investment-relevant Chinese growth is set to slow over the coming months. Even in a trade deal scenario, an earnings recession for Chinese investable stocks looks likely unless the flow of credit soon increases to an annual pace of RMB 26 Trillion. The recent trend in money & credit growth is not yet consistent with this outcome. The RMB has risen relative to several currencies over the past two months, meaning that it does not simply reflect a weaker dollar. The RMB rally is linked to the trade negotiations with the U.S., suggesting that further gains are likely if a genuine truce emerges. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, our Li Keqiang (LKI) leading indicator continues to point to weaker activity over the coming 6-12 months, even though the LKI itself has actually trended higher over the past year. We maintain that trade frontrunning has caused this gap (which is in the process of unwinding), as broader measures of coincident activity have been trending lower and are poised to decelerate further. The growth rate of housing construction also seems set to decline, given that the current pace of starts is still running substantially above the pace of sales volume. Finally, while we do not expect the speed at which Chinese import and export growth decelerated in December to continue, the export components of China’s PMIs and the end of trade frontrunning both suggest that trade growth will remain weak over the coming few months. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary From an investment strategy perspective, we continue to recommend a neutral stance towards Chinese stocks within a global equity portfolio over a 6-12 month horizon, and remain tactically long until the end of this month. The recent outperformance of investable stocks vs. the global benchmark reflects global investor expectations of a trade deal between China and the U.S. later this month, but a deal alone will not reverse slowing domestic demand (which will negatively impact earnings). Even in a trade deal scenario, an earnings recession looks likely unless the flow of credit soon increases to an annual pace of RMB 26 Trillion, and the recent trend in money & credit growth is not yet consistent with this outcome. Finally, the rally in the RMB over the past two months does not simply reflect a weaker dollar, as it has risen relative to several currencies. The timing of the rally is clearly linked to the trade negotiations between the U.S. and China, suggesting that further gains are likely if a genuine truce emerges later this month. In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: Both the Bloomberg Li Keqiang index (LKI) and our alternative LKI rose to 9.3 in December, maintaining an uptrend that has been in place for the majority of the past 12 months. As we noted in last week’s report,1 this uptrend is not only in contrast to our leading indicator for China’s old economy, but also other coincident measures of economic activity. Chart 1 highlights that China’s investment-relevant economic activity is trending lower when broadly measured, implying that the uptrend in the LKI over the past 12 months is anomalous and is set to wane. Chart 1China's Investment-Relevant Economic Activity Is Trending Lower Our LKI leading indicator ticked down in December, as a rise in the RMB reversed some of the improvement in monetary conditions that had previously lifted the indicator. More important, however, is the very recent trend in the money & credit components of the indicator: while the YoY growth rates in M2, BCA’s calculation of M3, and adjusted total social financing (TSF) have recently stabilized, Chart 2 shows that the trend over the past three months has been down. We highlighted in last week’s report that Chinese credit growth needs to accelerate this year to avoid an earnings recession even assuming a trade deal with the U.S., and Chart 2 illustrates that the recent trend in money & credit growth is not yet consistent with this outcome. Chart 2The Recent Trend In Money & Credit Growth Is Down Based only on the trend in construction, China’s housing market is healthy and growing at a robust pace. However, fundamental support for the housing market is materially weaker: housing sales volume growth is in negative territory, growth in PBOC pledged supplementary lending injections has turned negative, and our house price diffusion indexes are rolling over from elevated levels. Housing sales volume has historically led the trend in construction, suggesting that China’s housing inventories are rising anew and that the pace of construction is set to cool significantly. The NBS and Caixin manufacturing PMIs for January provided conflicting readings: the former ticked up fractionally, whereas the latter deteriorated meaningfully further. The fact that the new export orders components of both PMIs moved higher in January suggests two things: 1) exporter sentiment is stabilizing (at a low level) in response to expectations of a trade truce with the U.S., and 2) the domestic demand outlook is weaker than the external outlook. This underscores that a framework trade deal with the U.S. at the end of the month is not, on its own, likely to lead to a significant reacceleration in the Chinese economy. Chinese investable stocks have rallied significantly in absolute US$ terms since the beginning of 2019, up over 11% year-to-date. Given that Chinese stocks are comparatively high-beta, most of this performance can be attributed to the rally in global stocks (up 8% YTD). However, it is notable that Chinese stocks outperformed global stocks both when the latter sold off aggressively in December, and in response to the recent global rally. This likely reflects global investor expectations of a trade deal between China and the U.S., which was the basis for our recommendation of a tactical overweight towards Chinese stocks in our December 5 Weekly Report.2 Chart 3 provides some additional evidence that global investors have driven the recent rally in investable stocks. First, panel 1 highlights that domestic stocks have underperformed investable stocks meaningfully over the past two months. Second, panel 2 shows that domestic infrastructure stocks, likely beneficiaries of a policy-driven reaccleration in domestic demand, have not rallied at all in absolute terms over the past few months. Chart 3Global Investors Drove The Recent Rally In Investable Stocks Within the equity sector space, the most notable development over the past month has been the substantial outperformance of Chinese consumer discretionary stocks (up almost 11% relative to global consumer discretionary in US$ terms year-to-date). For the most part, these gains reflect the idiosyncratic performance of Alibaba, due to recent changes to the global industrial classification standard (GICS).3 Prior to the changes, the automobiles & components industry group competed with retailing as a driver of the Chinese investable consumer discretionary sector; today, retailing accounts for 3/4ths of the index, with Alibaba accounting for all of the increase in retailer market cap (from 26% in November). Alibaba’s stock price recently bounced in response to a positive Q4 earnings surprise, but disappointing revenue growth underscores the challenges facing investable consumer discretionary stocks from deteriorating consumer sentiment in China.4 Despite the rally in China-related global financial assets over the past two months, Chinese onshore corporate bond spreads remain elevated in reflection of concerns over rising defaults (Chart 4). While we believe that investors are pricing in excessively high default rates over the coming year (i.e. the level of spreads is probably wider than warranted), the trend in onshore corporate spreads is highly informative and served as an early indicator that China’s economy was set to slow. Somewhat concerningly, the trend in spreads of different quality are not moving in a direction that would be consistent even with a stabilization in the Chinese economy. Panel 2 shows that AAA-rated corporate bond spreads have recently been trending higher, in contrast to that of bonds rated AA-. The former has reliably led the latter over the past year, implying that the odds of overall onshore spreads rising have gone up. Chart 4High-Quality Corporate Spreads Are Moving Higher The budding rally in the RMB that we identified last month has continued, with CNY-USD having recently broken above its 200-day moving average (Chart 5). Panels 2 and 3 highlight that this does not simply reflect a weaker dollar, as the RMB has risen relative to the euro and the basket of currencies included in the Bloomberg U.S. dollar spot index. It remains unclear whether this recent strength has been driven by trade talk-related intervention or market expectations of a trade deal, but its link to the negotiations is clear. This suggest that further gains are likely if a genuine truce emerges later this month. Chart 5A Genuine Rebound In The RMB Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report “A Gap In The Bridge”, dated January 30, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “GICS Sector Changes: The Implications For China”, dated September 26, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report “Chinese Household Consumption: Full Steam Ahead?”, dated November 14, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
After years of commodity booms and strong domestic demand supported by rising household wealth, the Canadian and Australian manufacturing sectors have been greatly diminished. Much capacity has vanished, and it will be difficult to replace the lost output…
Feature Half Way Back Since BCA went overweight global equities in late December, the MSCI ACWI index has rallied by 8% and the S&P 500 is back to only 8% off its September historical high. So far, this has been little more than a technical rally from the extreme oversold position in Q4. But with U.S. economic growth still resilient, earnings likely to grow healthily again this year (albeit more slowly than in 2018), and the valuation of risk assets (both equities and credit) no longer a headwind, we expect the rally to continue for some time, and so reiterate our overweight on equities. Recommendations True, there have been some disappointments in U.S. data in recent weeks. In particular, the December manufacturing ISM fell sharply to 54.3 from 59.3, raising fears that the U.S. is starting to decelerate in line with other regions (Chart 1). But the ISM may have been affected by the government shutdown and, overall, U.S. data still look solid, with the Citigroup Economic Surprise Index beginning to rebound, and stronger than in other regions (Chart 2). The residential housing market, which was exhibiting signs of stress last year, with existing home sales -6.4% YoY in December, is showing the first signs of stabilization, helped by mortgage interest rates that are now 50 BPs off their recent peak (Chart 3). Chart 1How Worrying Is The U.S. Slowdown? Chart 2U.S. Data Surprisingly Positive Chart 3Housing Market Should Stabilize In particular, the outlook for consumption looks healthy, with average hourly earnings growing at 3.3% YoY, consumer confidence close to an historic high, and the savings rate above 6%. Unsurprisingly, then, retail sales have boomed in recent months (Chart 4). Unless consumer confidence is dented by a repetition of the government shutdown or some other shock, consumption (68% of GDP, remember) should grow strongly this year. Add to this a residual positive impact of close to 0.5% of GDP coming from last year’s fiscal stimulus, and it is hard to imagine the U.S. going into recession over the next 12 months. Chart 4Consumption Booming The Fed will probably go on hold for now, however, given the market jitters in Q4. We are likely back to a situation like that in 2015-2016, where the Fed Policy Feedback Loop becomes the key factor for markets (Chart 5). When financial conditions tighten, with stock prices falling and the dollar appreciating, the Fed turns more dovish. However, this triggers a rally in risk assets and loosens financial conditions, allowing the Fed to start hiking again. With the tightening in financial conditions over the past six months, the Fed is likely to err on the side of caution for now (Chart 6). However, if our macro view is correct – and as inflation starts to pick up again after April, partly due to the base effect – the Fed will want to continue withdrawing accommodation over the course of this year. The Fed Funds Rate, at around 2.4% is still two hikes below what the FOMC sees as the neutral level of interest rates (the 2.8% terminal rate in the FOMC dots). We see the Fed, therefore, raising rates in June and perhaps hiking two or even three times this year. By contrast, the futures market assigns only a 25% probability of even one rate hike this year, and is even pricing in a small probability of a cut. Chart 6Tighter Conditions Mean More Cautious Fed Clearly, there are plenty of risks to the scenario of growth continuing. But those in the hands of President Trump, especially the trade war with China and the fight over funding of the wall on the border with Mexico, we don’t see as being serious impediments. Trump is fully aware that he is unlikely to be reelected in November 2020 if the U.S. is in recession by then. Every incumbent U.S. president since World War Two who fought for reelection during a recession failed to be reelected (Chart 7). The view of BCA’s geopolitical strategists, therefore, is that the White House and Congressional Democrats will agree to concessions to end the shutdown before the end of the current three-week stop-gap period. Less likely, Trump will declare a national emergency that will cause much controversy but have little impact on the economy. Our strategists also argue that there is a 45% probability of trade negotiations with China producing a result (at least a short-term one the president can boast about) before the March 1 deadline, and a further 25% probability of the deadline being extended without further sanctions being imposed.1 Chart 7Trump Won't Be Reelected In A Recession Equities: Analysts have become overly pessimistic about the earnings outlook for this year, cutting 2019 U.S. EPS growth to 7% (and only 2% YoY in Q1). Our top-down model (based on, admittedly optimistic, U.S. growth assumptions, but also headwinds from a stronger dollar) indicates 12% growth. If analysts are forced to revise up their numbers as better earnings come through, that should be a catalyst for further equity performance (Chart 8). We continue to prefer U.S. over European equities. The steady slowdown in European growth over the past 12 months has not yet bottomed, banks in Europe remain troubled, the earnings picture is less positive, and valuations relative to the U.S. are not especially attractive. We also remain underweight on EM equities: they may produce a positive return in a risk-on environment, but we see them underperforming DM as rising U.S. interest rates and a stronger USD put pressure on EM borrowers with excess foreign-currency debt. Chart 8Analysts Have Overdone Downward Revisions Fixed Income: The recent fall in U.S. Treasury yields was mainly caused by the inflation expectation component, itself very sensitive (if rather illogically so) to the oil price (Chart 9). As the oil price recovers (see below), inflation picks up moderately, and the Fed hikes by more than the market expects, we see the 10-year Treasury yield rising to 3.5% during the course of the year. BCA’s fixed-income strategists recently raised their recommendation on global credit to overweight, given more attractive spreads and the likelihood that the Fed will be on hold for the next six months.2 Their recommendation is for 3-6 months, and the Fed restarting the hiking cycle, say in June, might terminate the positive story. We are following their lead, by raising both high-yield and investment-grade bonds to overweight within the (underweight) fixed-income asset class. That means we are neutral credit in the overall portfolio. We would warn, though, that this is a somewhat short-term call: we still prefer equities as a way to play the continuing risk-on rally. Given the high level of U.S. corporate leverage, and the over-owned nature of the credit market, this is likely to be an asset class that performs very poorly in the next recession (Chart 10). Chart 9Inflation Expectations Should Recover Chart 10Corporate Leverage Is A Concern Currencies: Currencies will continue to be driven by relative monetary policy. With the growth desynchronization between the U.S. and other DMs set to continue (to a degree), we see modest further USD appreciation this year. The Fed (as argued above) will probably hike more than the market expects. But, given slow European growth, the ECB is unlikely to be able to hike in Q4 this year, as it currently is guiding for and the futures market implies (Chart 11). We see the ECB reopening the Targeted Long-Term Repo Facility (TLTRO), which expires soon. Italy and Spain have been big borrowers from this facility, and bank loan growth is likely to slow as it ends (Chart 12). A renewed TLRTO would be seen as a dovish move. Tighter dollar liquidity conditions also point to a stronger USD. U.S. credit growth continues to accelerate (to 12% YoY – Chart 13) in an environment where the monetary policy has tightened: credit growth is outpacing U.S. money supply growth by 7%. Historically this has been negative for global growth (mainly because the deteriorating liquidity is a problem for EM dollar borrowers) and positive for the dollar (Chart 14).3 Chart 11Can ECB Really Hike In 2019? Chart 13...U.S. Loan Growth Accelerating... Chart 14... Which Will Tighten Liquidity Further Commodities: The supply/demand situation for oil should improve over coming months. With Saudi Arabia and Russia committed to cut supply by 1.2 million barrels/day, U.S. shale production growth slowing given the low one-year forward price for WTI, Canada reducing production, and Venezuela on the verge of collapse (which alone could remove 700-800k b/d from the market), our energy strategists see the crude oil balance in deficit over the next four quarters (Chart 15). Given this, they forecast Brent crude rebounding to above $80 a barrel. Other commodity prices are mostly driven by Chinese demand. We see China continuing to slow, until the accumulated effects of its fiscal and mild monetary stimulus start to come through in H2 and stabilize growth. Our analysis suggests that China remains very disciplined about the size and nature of its stimulus: it is not turning on the liquidity taps as it did in early 2016. Bank loan growth has stabilized, but shadow banking activity continues to contract, as the authorities persist with their crackdown and their emphasis on deleveraging (Chart 16). Industrial commodities prices are therefore likely to weaken over the next six months. Chart 15Oil Balance In Deficit This Year Chart 16China Sticking To Credit Crackdown Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation Footnotes 1 Please see Geopolitical Strategy Weekly Report, “So Donald Trump Cares About Stocks, Eh?”, dated 9 January 2019, available at gps.bcaresearch.com 2 Please see Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis,” dated 15 January 2019, available at gfis.bcaresearch.com 3 For a detailed explanation, please see Foreign Exchange Strategy Weekly Report, “Global Liquidity Trends Support The Dollar, But…,” dated 25 January 2019, available at fes.bcaresearch.com
Highlights We advocate implementing asset allocation not across EM assets, but rather relative to their DM counterparts. EM stocks should be part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is beneficial. We continue recommending below benchmark allocation to EM equities, credit and local bonds. The rebound in various EM financial markets is reaching a critical technical level where it will either stop or, if broken, will carry on for some time. In Peru, further decline in industrial metals prices and ongoing involuntary monetary tightening bode ill for share prices; continue underweighting. Feature We frequently receive questions from our clients on how they should be positioning their portfolios within EM asset classes such as equities, EM U.S. dollar bonds (credit markets) and local currency government bonds – whether they should be overweight EM stocks versus EM credit markets and domestic bonds, or vice versa. While BCA’s Emerging Markets Strategy service covers EM stocks, credit and domestic bonds and exchange rates, we do not make asset allocation calls between EM equities, EM credit and local currency bonds. The reason is very simple: in a risk-on market, EM equities always outperform EM credit and local bonds, and in a risk-off environment, stocks always underperform fixed income (Chart I-1). Chart I-1EM Stocks Versus EM Credit And Local Bonds With respect to the relative performance of EM credit markets versus domestic bonds, the performance of EM currencies is key. A large portion of total returns on EM local currency bonds comes from exchange rates (Chart I-2). Hence, when EM currencies appreciate, domestic bonds outperform EM credit markets (U.S. dollar bonds), and vice versa (Chart I-3). Chart I-2EM Currencies Are Key To EM Local Bonds Returns Chart I-3EM Local Bonds Versus EM Credit: It Is A Currency Call For investors willing to allocate across EM asset classes, a directional view on financial markets should drive allocation between equities and fixed-income. In rallies, equities should be favored, while during risk-off periods, fixed income should be preferred. It follows that investors should overweight EM credit markets versus domestic bonds when EM currencies depreciate, and tilt allocation toward local currency bonds versus EM credit markets when EM exchange rates appreciate. Recommended Approach To Asset Allocation We advocate implementing asset allocation not across EM assets, but relative to their DM counterparts: EM stocks should be part of a global equity portfolio. A pertinent asset allocation decision should be whether to be overweight, neutral or underweight EM within a global equity portfolio. In short, EM stocks should not be compared with EM credit or local bonds, but rather versus their DM counterparts. Having mentioned that, we are maintaining our underweight recommendation on EM within a global equity portfolio for now. EM sovereign and corporate credit should be part of a global credit portfolio – i.e., asset allocators should compare them with other credit instruments such as U.S. and European corporate bonds. Total returns on EM U.S. dollar-denominated sovereign and corporate bonds can be deconstructed into the total return on U.S. Treasurys and the excess return of these EM bonds over U.S. Treasurys. Investors can obtain exposure to U.S. Treasurys by owning them outright. Hence, the unique feature of EM sovereign and corporate bonds is their spreads over U.S. government bonds. EM sovereign and corporate bond spreads over U.S. Treasurys reflect issuers' ability and willingness to pay. Thereby, investors should treat EM dollar-denominated bonds as a pure credit product and this asset class should be part of a global credit portfolio. At the moment, we recommend asset allocators underweight EM sovereign and corporate credit versus U.S./DM corporate credit, in line with our short EM equities/long U.S./DM equities strategy (Chart I-4). Within credit markets, EM investment-grade and high-yield credit should be compared with their peers in U.S./DM, respectively. The reason we are negative on EM credit markets relative to the U.S. and DM universe is that the majority of EM sovereign and corporate bond issuers in Latin America and the EMEA are commodity producers. Hence, their revenues fluctuate with commodity prices, and their spreads should be under upward pressure as commodity prices drop further and EM currencies correspondingly depreciate (Chart I-5). Chart I-4EM Credit Versus U.S. Credit Chart I-5EM Credit Spreads Are Sensitive To Commodities And EM Currencies In the meantime, Chinese property companies, financials and industrials/materials remain the largest issuers of corporate debt in emerging Asia. Specifically, U.S. dollar bonds issued by Chinese companies account for 32% of the Barclay’s overall EM USD Credit index and 56% of the EM Asia USD Credit index. Crucially, Chinese corporate credit is essential to trends in emerging Asian credit markets. We are bearish on the fundamentals of Chinese corporate bond issuers due to our negative view on Chinese capital spending, particularly in the real estate sector. With respect to EM local-currency government bonds, this is an entirely different asset class with returns often uncorrelated with any other asset. Table 1 shows that EM local currency bond returns in U.S. dollars have a low correlation with most other asset classes. Therefore, adding EM local-currency bonds to a global multi-asset class portfolio will help achieve risk diversification provided an expectation of a positive return on this asset class in the long run. EM domestic bond returns are comprised of local yield carry and capital gains/losses, as well as currency appreciation/depreciation. Business cycles and monetary policies could from time to time be desynchronized across EM countries, and EM currencies could also at times diverge. In short, all of this will add idiosyncratic risk to any global multi-asset class portfolio and push out the portfolio’s efficient frontier – i.e., the portfolio could achieve higher returns for the same amount of risk (volatility). The exposure to EM local currency bonds should be altered according to the view on this asset’s absolute performance. Presently, we recommend below benchmark allocation to this asset class because we expect the majority of EM currencies to depreciate versus the U.S. dollar, the euro and the Japanese yen. The key driver of EM currencies is not U.S. interest rates but the global business cycle (Chart I-6). Odds are high that global trade will continue disappointing as China’s growth weakens further. This will lead to tumbling EM currencies and outflows from high-yielding EM domestic bonds. Chart I-6What Drive EM Currencies Within an EM local currency bond portfolio, our recommended overweights are Mexico, Brazil, Chile, Russia, central Europe, Thailand and Korea. The list of our overweights and underweight across EM stocks, credit markets, local bonds and currencies is always published at the end of our reports. Bottom Line: Global asset allocation should treat EM stocks as part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. In turn, EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is recommended given an expectation of a positive return in the long run. A Make It Or Break It Juncture The rebound in various EM financial market segments is reaching a critical technical level. At that point, it will either reverse, or will break through and carry on the upward momentum for some time: EM share prices have troughed at their three-year moving averages but are now facing resistance at their 200-day moving averages (Chart I-7). Failure to break above their 200-day moving averages would signal higher risks of a major breakdown. Conversely, a decisive break above their 200-day moving averages would suggest that the recent rebound has much farther to go. Our Risk-on versus Safe-Haven currency ratio has found support at its 6-year moving average but is now facing resistance at its 200-day moving average (Chart I-8, top panel). This ratio is highly correlated with EM share prices, and its breakout or breakdown will be an important signal for the direction of EM, commodities and global cyclical assets in general (Chart I-8, bottom panel). Chart I-7EM Share Prices Are Between Support And Resistance Chart I-8This Currency Ratio Is Key To EM And Commodities Trend A relapse from this level would be a major bearish signal, as it would confirm the formation of a head-and-shoulders pattern in this currency ratio. The latter would entail a major breakdown. A number of EM currencies such as ZAR, MXN, KRW, TWD, MYR and CNY are at a critical juncture (Chart I-9). A breakout or failure to do so will entail a major move. Chart I-9AEM Exchange Rates Are At Make It Or Break It Juncture Chart I-9BEM Exchange Rates Are At Make It Or Break It Juncture Meanwhile, the BRL may be forming an inverted head-and-shoulders pattern (Chart I-10). Hence, continuous BRL strength would signal rising odds of an extension to the rally in Brazilian markets. Chart I-10The Brazilian Real: An Inverted Head-And-Shoulder? Finally, industrial metals prices have failed to rebound and appear to be forming a head-and-shoulders formation. This pattern foreshadows considerable downside from current levels (Chart I-11, top panel). In the meantime, oil prices have bounced off their long-term moving average and might have a bit more room to advance before hitting a major resistance between $65-$70 for Brent (Chart I-11, bottom panel). Bottom Line: Our fundamental view on EM risk assets remains negative due to our expectations of further weakness in China’s growth. However, we are monitoring various signals and indicators to gauge whether the latest rebound can last much longer, which would cause us to change our stance tactically. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: Involuntary Monetary Tightening Peru’s central bank is tightly managing the country’s exchange rate. As a result, it has little control over local interest rates. The Impossible Trinity thesis stipulates that in a country that has an open capital account, the central bank can control either interest rates or the exchange rate, not both simultaneously. Provided Peru has an open capital account, its central bank can have tight control over either the exchange rate or interest rates. So long as the central bank focuses on exchange rate stability, local interest rates will fluctuate with its balance of payments (BoP). Therefore, Peru’s credit cycle and hence domestic demand swings and bank share prices are driven by BoP (Chart II-1). Negative BoP dynamics – shrinking inflow of U.S. dollars – causes local interest rates to move higher while a positive BoP leads to lower borrowing costs (Chart II-2). Chart II-1Commodities Prices & Bank Stocks Are Correlated Chart II-2Trade Balance Drives Interbank Rates We expect negative BoP dynamics for Peru going forward – metals prices will drop as China’s growth continues to decelerate, and EM countries will likely experience a bout of portfolio capital outflows. If Peru’s central bank continues to favor limited currency depreciation, its interbank rates will march higher. Chart II-3 illustrates that the pace of net foreign exchange reserves accumulation often negatively correlates with interbank rates and leads loan growth by around 12 months (Chart II-4). Chart II-3Peruvian Local Rates Have Risen Chart II-4Peru: Bank Loan Growth Will Relapse When the monetary authorities purchase foreign exchange reserves, they inject local currency excess reserves (liquidity) into the banking system. More plentiful banking system liquidity drives down interbank rates and allows banks to expand credit, boosting domestic demand. The reverse also holds true. The Peruvian central bank was able to mitigate upside in local rates amid the negative terms-of-trade shock in 2014-‘15 by conducting foreign currency swaps with banks. This swap led to an injection of local currency reserves into the system. Currently these swaps are being unwound and banks’ excess reserves are dwindling, putting upward pressure on local rates. Hence, the rise in interbank rates in the past 12 months has not only been due to negative terms of trade but also due to the expiration of foreign currency swaps. As metals prices drop and exports contraction deepens, the currency will come under selling pressure (Chart II-5). To prevent the currency from depreciating considerably, the central bank has to tighten liquidity, producing higher interbank rates. The latter bodes ill for domestic demand. Chart II-5Money Growth Is Contingent On Trade Bottom Line: We continue to underweight the Peruvian bourse because of its exposure to mining companies and banks. The former is at risk from falling industrial metals prices, while the latter will suffer from rising interbank rates. Within the mining sector, gold and silver stocks should outperform copper producers because we foresee more downside in industrial metals than precious metals prices. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Due to slowing Chinese credit growth and the tightening in global liquidity conditions, global growth has suffered. However, the global and U.S. stock-to-bond ratios, two financial market metrics finely tuned to global economic gyrations, have already fallen…
Highlights Excess dollar liquidity is still deteriorating. The U.S. economy’s robustness suggests this trend will continue. Elevated EM-dollar debt and declining dollar liquidity point to lower global growth and a stronger dollar. Despite these cyclical forces, a tactical dollar correction is unfolding. Slowdowns do not evolve in straight lines, and deep investor pessimism is setting the stage for a temporary bout of positive surprises. DXY could correct to 93, EUR/USD could rebound to 1.17-1.18, and USD/CAD could fall to 1.27. Buy NOK/SEK. Feature Investment legend Stanley Druckenmiller often refers to the primacy of liquidity trends when making investment decisions. BCA is highly sympathetic to this view, as our DNA is rooted in the analysis of global liquidity trends. Under this lens, a peculiar trend has caught our attention: U.S. commercial and industrial (C&I) loans are currently accelerating, and easing lending standards point to further gains (Chart I-1). This is in sharp contrast with the 2015-2016 market riots and subsequent slowdown – an episode where banks tightened lending standards and loan growth decelerated sharply. While this represents a good omen for the U.S. economy, it is a dangerous evolution for the rest of the world. Chart I-1Resilient Corporate Sector Credit Growth Growing credit is good for the U.S. because it points to robust domestic demand. However, it is problematic for the rest of the world for two reasons. First, if U.S. credit growth is more robust today than in 2016, it also implies that the Federal Reserve is unlikely to pause its rate-hike campaign as much as it did back then. Thus, U.S. rates, the key determinant of the global cost of capital, may have additional upside as interest rate markets anticipate a year-long pause. This is not yet a problem for the U.S. economy, but it is one for rest of the world, which is exhibiting poorer growth trends. Second, U.S. credit growth is already outpacing the expansion of U.S. money supply by 7%, pointing towards a decline in dollar liquidity available for international financial markets. The reduction in the Fed’s balance sheet will contribute to a continuation of this trend. The fall in the amount of dollars available for the international financial system creates a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, our Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart I-2). Chart I-2Deteriorating Excess Liquidity Hurts Global Growth The large dollar debt of emerging markets lies behind this relationship. If less dollars are available outside the U.S. financial system, EM borrowers have to bid more for these greenbacks, raising their cost of capital. Additionally, borrowers are likely to hoard any dollars they access in order to repay their liabilities instead of using these greenbacks to finance economic transactions. As Chart I-3 shows this problem is particularly acute today: relative to EM GDP and various measures of U.S. money supply, EM dollar debt stands at record highs, highlighting deep vulnerabilities if liquidity conditions deteriorate. Chart I-3The Sensitivity To Dollar Liquidity Stems From The Large Stock Of Dollar Debt The problem extends beyond the capacity of the U.S. economy to generate deposits in excess of non-bank liabilities. Despite a meaningful slowdown in non-U.S. industrial production, official reserves are contracting relative to global industrial activity (Chart I-4). This further suggests that the global economy is experiencing some form of liquidity crunch, where the growth of monetary aggregates is insufficient to support economic activity. This is a deflationary environment. Chart I-4High-Powered Money Lagging Sagging Activity Another factor is at play: We have often argued in these pages that carry trades are a key component of global liquidity, as they allocate funds from economies where savings are excessive (i.e. borrowing in funding currencies) to economies that need those savings to generate growth (i.e. carry currencies).1 This is why the performance of high-octane carry trades is often a very reliable leading indicator of global economic activity. However, as Chart I-5 demonstrates, EM carry trades funded in yen continue to perform execrably, a poor signal for global liquidity and growth. Chart I-5Underperforming Carry Trades Add To The Global Liquidity Woes The impact of the deterioration in dollar liquidity, in FX reserves growth and in carry trade liquidity is evident in EM monetary aggregates. EM M1 growth has sharply decelerated. Since decelerating EM money supply presages weaker growth, it also points to stronger counter cyclical currencies like the dollar and the yen, especially against the very growth-sensitive commodity currencies (Chart I-6). The dollar bull market is unlikely to be over this year. Chart I-6Ominious Signal From EM Money Supply This risk is reinforced by the tight inverse correlation between the dollar and U.S. commercial banks’ liquidity. When U.S. banks curtail their holdings of securities, a key source of dollar liquidity in international markets, a dollar rally follows (Chart I-7). Not only does last year’s fall in securities in bank assets point to a firming greenback, but if banks also expand their loan books they will also further curtail their securities holdings. Chart I-7Contracting Liquidity On U.S. Commercial Banks Balance Sheets Support The Dollar The much-higher real rates offered by U.S. Treasurys relative to other DM bonds magnifies these dollar positive trends (Chart I-8). Hence, not only will global growth and money quantity considerations prove tailwinds for the greenback, but so will more well-known drivers of exchange rates. Chart I-8Real Rates Differentials Still Favor The Dollar Bottom Line: The deterioration in global liquidity conditions continues to argue in favor of the dollar. Since U.S. credit growth is still managing to accelerate, the Fed is unlikely to pause on the rate-hike front for too long, implying that excess dollars will further vanish from the international financial system. Consequently, global monetary conditions will tighten again, and global growth has not hit its nadir this cycle. On a 9 to 12 month basis, the dollar will benefit in this environment, especially against cyclical commodity currencies. How Fast Can Investors Price In Bad News? Due to the tightening in global liquidity conditions, global growth has suffered. However, the global and U.S. stock-to-bond ratios, two financial market metrics finely tuned to global economic gyrations, have already fallen in line with our Global Economic and Financial Diffusion Index that tallies the improvement and deterioration among more than 100 key global variables (Chart I-9). This implies that asset prices already reflect much of the deterioration in the economic outlook. Chart I-9The Global Economy Is Soft, But Financial Markets Already Reflect This Reality The problem for bears is that economic cycles rarely play out in a straight line. Now that asset prices are incorporating poor expectations, any positive surprises, even if modest, could lift asset prices. And there is room for improvement in global economic surprises (Chart I-10), particularly as Sino-U.S. trade relations are improving, global financial conditions are easing and China is trying to manage its slowdown. In fact, China’s fiscal and monetary stimulus already points to a rebound in growth-sensitive currencies, and to a correction in the dollar (Chart I-11). Chart I-10Scope For A Rebound In Economic Surprises Chart I-11Chinese Reflation Points To A Dollar Correction, Even If Only A Small One EM breadth confirms this message. Chart I-12 shows that the breadth of EM equities has not been this poor since early 2009. However, it has begun to rebound. Rebounds in EM breadth from such levels are historically associated with a weaker dollar, stronger commodity currencies and a weaker yen. Chart I-12Deep Oversold Conditions In EM Stocks Further Support The Case For A Dollar Correction Flows paint a similar picture. Global investors tend to buy Japanese bonds when global growth conditions deteriorate. Foreigners buying of Japanese fixed-income products now stands near record levels – something normally witnessed when credit spreads widen. However, positive economic surprises and the recent easing in global financial conditions suggest that these flows will reverse. When they do, the dollar will suffer (Chart I-13) and very pro-cyclical pairs like AUD/JPY will appreciate, even if only temporarily. Chart I-13Elevated Flows Into Japanese Bonds Suggest Overdone Pessimism, And Scope For A Dollar Correction It’s not just the commodity currencies that have upside: so does the euro. German bunds’ hedged yields have been rising relative to the U.S., which in recent years has often led to a rally in EUR/USD (Chart I-14). Chart I-14European Hedged Yields Imply A Euro Rebound How deep will this dollar down leg be? Our Intermediate-Term Timing Model suggests that the greenback’s weakness is likely to be limited. The dollar already trades below our fair-value estimate, but during corrective episodes it tends to trough at a 5% discount, implying that the DXY at 93 is a buy (Chart I-15). The euro, the dollar’s mirror image, could rebound to a roughly 5% overvaluation, implying that a countertrend move to 1.17-1.18 is also likely. Finally, the CAD may be able to rebound to USD/CAD 1.27. Chart I-15Gauging The Extent Of The Countertrend Moves At these levels, we would expect the countertrend moves to end. Ultimately, the aforementioned deterioration in global liquidity conditions means that positive surprises are likely to be transitory phenomena. Moreover, we doubt that Chinese stimulus, a key catalyst for a weaker dollar, will be very deep. Ultimately, our view remains that China is only trying to prevent a collapse of its economy and Beijing is extremely reluctant to stimulate enough to generate yet another boom – something needed to genuinely boost global growth if the Fed resumes its tightening campaign. Finally, while a trade deal between China and the U.S. is likely, investors should not get overly exuberant on its ramifications. Disagreements over intellectual property transfers will not be resolved anytime soon, and China remains the U.S.’s largest geopolitical challenger. Bottom Line: Global liquidity conditions may have deteriorated, suggesting a trough in global growth is not yet in the cards, but slowdowns do not evolve in straight lines. This means that oversold risk assets are likely to respond well to positive economic surprises. As a result, the countercyclical dollar will correct, probably to 93. The commodity currency complex should be the main beneficiary of this move, with downside in USD/CAD to 1.27. The euro could rebound toward 1.17-1.18. Buy NOK/SEK In June 29th, we closed our long NOK/SEK trade, expecting corrective action in this cross. A serious selloff ensued, and we are now buying this pair again.2 First, NOK/SEK is very sensitive to oil prices (Chart I-16), and BCA’s Commodity and Energy service anticipates a rebound in oil prices this year on the back of tightening supply conditions. Chart I-16BCA's Oil View Points To A NOK/SEK Rebound Second, the Norwegian economy is outperforming Sweden’s. As Chart I-17 shows, the Norwegian LEI continues to rise relative to Sweden’s, which historically implies a much stronger NOK/SEK. Beyond the LEIs, Norway’s PMIs and economic surprises have not only rebounded, but are also outpacing Sweden’s equivalent metrics. The Norwegian consumer is also participating in the good times. The three-month moving average of employment growth, retail sales and consumer confidence are stronger in Norway than in Sweden. Chart I-17Norwegian Growth Is Superior To Sweden's Third, after a long period of underperformance, Norwegian core inflation stands above that of Sweden, pointing to a potentially more hawkish Norges Bank than Riksbank. Fourth, NOK/SEK trades at a 5% discount to its fair value implied by our Intermediate-Term Timing model. Historically, a rebound in this cross follows such discounts Chart I-18). Chart I-18The ITTM Highlights An Attractive Entry Point To Buy NOK/SEK Finally, NOK/SEK is at a technically attractive spot. Our momentum oscillator shows deeply oversold conditions in the pair (Chart I-19). However, momentum has begun to roll over, suggesting that a reversal of those oversold conditions is starting. Moreover, the uptrend that began in the first quarter of 2016 has been confirmed. Had NOK/SEK not rebounded from where it did, that uptrend would have been seriously challenged, with potential greater downside ahead. Chart I-19Favorable Technical Setup To Buy NOK/SEK Bottom Line: We are re-opening our long NOK/SEK trade. We avoided the serious correction in this pair at the end of last year, but rebounding oil prices, an outperforming Norwegian economy, a potentially more-hawkish Norges Bank, a favorable valuation backdrop and positive technical developments argue in favor of buying this cross. Set a stop at 1.037 and a target at 1.120. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In the Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017. Both are available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "What Is Good For China Doesn’t Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Capacity utilization outperformed expectations, coming in at 78.7%. However, the Michigan Consumer Sentiment Index surprised to the downside, coming in at 90.7. Finally, existing home sales month-on-month grow also surprised negatively, coming in at 4.99 million. DXY has risen 0.2% this week. While we believe that DXY could experience some weakness in the next couple of months, we remain bullish on the DXY on a cyclical basis, as the strength in the U.S. economy will prompt the Fed to deliver more rate hikes than expected by market participants. Moreover, the sharp focus of Chinese policymakers on limiting indebtedness should continue to put downward pressure on global growth, helping the dollar in the process. Report Links: So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro has been negative: Both headline and core inflation came in line with expectations, coming in at 1.6% and 1% respectively. However, Markit Services PMI underperformed expectations, coming in at 50.8. Moreover, the Markit Manufacturing PMI also surprised negatively, coming in at 50.7. EUR/USD fell 0.4% this week. Thursday, ECB President Mario Draghi highlighted that downside risks to the European economy are building up. Overall, we agree with his assessment, and thus remain bearish on the euro on a cyclical basis. We believe that the Fed will eventually raise rates more than the market expects, widening the rate differentials between Europe and the U.S, which will hurt EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Import growth underperformed expectations, coming in at 1.9%. Moreover, driven by weak shipments to China, export growth also surprised to the downside, coming in at a 3.8% contraction. USD/JPY fell 0.1% this week. We remain bearish on the yen on a short-term basis, as the recent easing in global financial conditions and the improvement in sentiment towards risk assets will likely weigh on safe havens like the yen. Moreover, we believe that bond yields will start rising again. In light of the positive relationship between yields and USD/JPY, we remain bullish on this cross. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales yearly growth and retail sales excluding fuel yearly growth underperformed expectations, coming in at 3% and 2.6%, respectively. Moreover, the claimant count change also surprised to the downside, coming in at 20.8 thousand. However, average hourly earnings growth also outperformed, coming in at 3.4%. GBP/USD has rose 1.5% this week, lifted by motion by MPs to delay the implementation of Article 50, and news that Jeremy Corbyn may be moving more clearly in favor of a new referendum if Labour takes hold of Westminster. We are closing our short EUR/GBP trade today, after reaching our target of 0.87. At this point, we think that plenty of good news have been discounted by the pound. While it is true that GBP could go up on the back of positive political developments, we believe that the risk reward ratio of selling EUR/GBP is not as attractive anymore, especially if EUR/USD can rebound. That being said, we remain bullish on cable on a long-term basis due to its cheap valuation. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in the Australia has been mixed: The participation rate surprised to the downside, coming in at 65.6%. However, the unemployment rate surprised positively, coming in at 5%. Moreover, the change in employment also outperformed expectations, coming in at 21.6 thousand, however, this improvement was driven by part-time positions, not full-time ones. AUD/USD has fallen by 1% this week. We remain bearish on the AUD versus the USD on a cyclical basis given that we expect that Chinese authorities will remain reluctant to over-stimulate their economy while global dollar liquidity deteriorates. Thus, in light of the tight economic links between Australia and Chinese industrial activity, the Australian economy is likely to suffer, dragging the AUD down in the process. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The Q4 New Zealand inflation on a year–over-year basis remains at 1.9%, slightly surprised to the upside. December business NZ PMI has increased to 55.1. December credit card spending year over year growth dropped to 4.5%. NZD/USD appreciated by 0.3% this week. On a structural basis, we are negative on the kiwi. The new government is looking to lower immigration, and implement an unemployment mandate. Both of these developments would likely lower the neutral rate of interest for the RBNZ, which would imply a lower NZD/USD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Consumer price index year over year growth in December surprised to the upside, coming in at 2.0%. Core inflation year over year measure also increased to 1.7%, from the previous 1.5%. Retail sales in November month on month growth is lower than expected, dropping to -0.9% from the previous 0.2% in October. Year-on-year growth hit levels not seen since 2012. USD/CAD is now trading above 1.3354, after a small rebound by 0.5% this week following weak data releases. We are bearish on Canadian dollar in the long run, but are bullish on a tactical basis. Financial condition will stay easy, as suggested by Stephen S. Poloz’s interview with Bloomberg this Wednesday. Given the recent trade tensions, housing market and oil price plunge, there is less urgency for BoC to push for higher rate at this moment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen 0.3% this week. We are bullish on this cross, given that the surge of the franc against the euro has caused a significant slowdown in Swiss inflation. The strong relationship between inflation and the currency means that any additional currency strength could severely impair the central bank’s objective of achieving 2% inflation. The SNB is very well aware of this developments, which means that it will likely intervene in the currency market in order to put a floor on EUR/CHF. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Norges Bank kept the key interest rate unchanged at 0.75%. Overall, we remain bullish on USD/NOK on a cyclical basis, given that this cross is very sensitive to real rate differentials. We expect the Fed to continue hiking rates this year at a faster pace than the Norges Bank, a development which will widen rate differentials and provide a tailwind for USD/NOK. That being said, we are positive on NOK/SEK. Not only is this cross attractive from a technical perspective, but also the expected rise in oil prices should help the Norwegian economy outperform the Swedish one. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by 0.6% this week. We are bullish on the krona on a long-term basis, as we believe that the Riksbank’s monetary policy is too accommodative considering the strong inflationary pressures brewing in the Scandinavian country. The cyclical outlook for the SEK remains poor, as the krona displays the highest sensitivity to the dollar’s strength of any G10 currencies. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Five reasons underpin our currency strategists’ cautious tactical view: First, the dollar - a momentum currency - is currently over-owned. Both net speculative positions in the dollar and sentiment toward the DXY are near bullish extremes suggesting the…