Financial Markets
Highlights All the steps in the earnings dance are well known: Company management teams guide Wall Street analysts to lower their expectations in the weeks leading up to the beginning of earnings season, and their companies’ results then comfortably clear the lowered bar. Given the lack of true suspense, the S&P 500 largely ignores quarterly results: In the near term, moves in the S&P 500 have little to no relationship with either earnings growth or the magnitude of earnings beats. Over time, however, index prices and earnings move together: If earnings multiples mean-revert, earnings and prices have to converge over the long run. The equity bull market isn’t finished yet: The monetary policy backdrop will support earnings growth well into 2021, though it will not promote multiple expansion for much more than a year. Feature Chart 1We've Seen This Movie Before Taking a turn chairing BCA’s daily meeting last week, we duly updated our colleagues on the progress of earnings season. At the time, over 75% of the S&P 500’s constituents had reported, and the index was on its way to surpassing consensus analyst expectations by a few percentage points. We then showed charts tracking the course of expectations across each of this year’s three quarters to show that the “surprise” wasn’t actually very surprising (Chart 1). We included the charts to add a bit of levity, but a fellow strategist asked an incisive question: If earnings season follows the same pattern every quarter, why pay attention to it at all? Earnings season surely has its elements of Kabuki theater, but earnings are the fundamental basis for purchasing an ownership stake in a company. A share of stock is a claim on a company’s aggregate future earnings. To the extent that quarterly earnings reports provide a window into the trajectory of a company’s future earnings path, they contain relevant information about the fair value of its shares. Quarterly earnings offer more insight at the individual stock level than at the index level, as individual stocks are subject to idiosyncratic factors, while index earnings tend to reflect overall economic performance, and we therefore view them as a check on the other real-time indicators we examine to gauge the health of the economy. A review of how S&P 500 prices interact with S&P 500 earnings suggests that earnings have little to no impact on near-term index performance. They do move together in the long term, though, as they must if earnings multiples are a mean-reverting series. In the near term, when multiples are oscillating, anticipating stock market moves is a function of anticipating earnings growth and swings in multiples, which move independently of one another. The fed funds rate cycle has historically provided a good high-level guide to earnings and multiples trends. S&P 500 Performance During Earnings Season To test the S&P 500’s sensitivity to earnings surprises, we dug through weekly earnings updates going back to the beginning of 2012 (4Q11 earnings season) to compare expected index earnings per share (EPS) with reported index EPS.1 I/B/E/S has long been recognized as the earnings-estimates authority, so we use its estimates in conjunction with its compilation of reported earnings to ensure our analysis really is apples-for-apples.2 We track S&P 500 performance in three-month segments, beginning with the Monday following the second Friday of the new quarter, since that is the week that the banks typically get earnings season rolling. Earnings beats are stable and predictable, but the S&P 500's reaction to them is anything but. The empirical record over the last 31 quarters supports our colleague’s intuition. Over the 13 weeks following the major banks’ releases, S&P 500 performance exhibits no consistent link with earnings surprises (Chart 2). The best-fit line through a simple scatterplot shows that the relationship, such as it is, has been inverse and weak (Chart 3). The link with the year-over-year change in S&P 500 earnings is even weaker (Charts 4 and 5). Chart 2Earnings Surprises Don't Move The S&P 500 … Chart 3… Which Is Slightly Negatively Correlated With Them Chart 4Earnings Growth Doesn't Move The S&P 500 … Chart 5… Which Has No Short-Term Relationship With It Earnings data support our colleague’s contention that earnings season, at least as it relates to expectations, is something of a charade. Companies, which heavily influence analyst estimates with their guidance, have beaten expectations every quarter for at least eight years. As Charts 2 and 3 show, earnings beat expectations by an average of 3.7%, nearly the midpoint of the 1-6% range. The S&P 500 shouldn’t be expected to react to “surprises” that are more or less pre-ordained. Bottom Line: Earnings season has no observable impact on the S&P 500. Earnings attract a lot of attention, but they do not influence index-level performance in the near term. The S&P 500 And Earnings Over Longer Periods Anything can happen over short periods, but stock prices have to track earnings over the long term. If the idea that an ownership share represents a proportional stake in company earnings is too abstract, consider the equity equation. Equity prices, P, can be viewed as the product of earnings, E, and the multiple investors are willing to pay for each dollar of earnings, P/E. P = E * (P/E) The market P/E ratio is subject to mean reversion, making changes in earnings the key long-term driver of S&P 500 performance. Since 1966, the S&P 500 index (Chart 6, top panel) has appreciated at the same rate as its trailing four-quarter operating earnings (Chart 6, middle panel), given that its trailing multiple is not far from where it started (Chart 6, bottom panel). Growth in forward earnings expectations (Chart 7, middle panel) has lagged S&P 500 growth (Chart 7, top panel) since expectations data began to be compiled in 1979 because the forward multiple has more than doubled from late ‘70s trough levels (Chart 7, bottom panel). In any extended period not bookended by an outlier multiple, however, one should expect S&P 500 appreciation to track earnings estimate growth. Chart 6S&P 500 Earnings And Prices Will Converge Over Time ... Chart 7... As Long As The Starting Or Ending Multiple Isn't An Outlier Bottom Line: Stock price gains and earnings growth will converge over the long run as long as the earnings multiple mean-reverts. Earnings do matter in the long run. Where Do We Go From Here? There are several earnings growth models within BCA. Like all regression models, they often work well in stretches, but are susceptible to unanticipated inflections and changes in correlations. Since the crisis, the difference between year-over-year growth in industrial production and year-over-year growth in the money supply has aligned closely with earnings growth (Chart 8). If we (and global equity markets) are correct in sniffing out a bottoming in global manufacturing activity, and loan growth is unlikely to accelerate much as banks are pulling in their horns in commercial real estate and selected consumer categories, earnings growth could pull out of its funk. Chart 8Earnings Growth Will Revive Once Global Manufacturing Pressure Abates We have found that earnings growth and multiple re-rating or de-rating is reliably influenced by the monetary policy backdrop. While the level of the fed funds rate goes a long way to explaining overall index moves, earnings growth and multiple expansion/compression are a function of its direction. Broadly, forward estimates grow at a rapid rate when the Fed is hiking rates (the economy is expanding) and slump when it’s cutting them (the economy needs a hand). Forward multiples are the mirror image of earnings estimates, contracting when the Fed is hiking and expanding at a robust clip when the Fed is cutting. Earnings grow at a rapid clip when the Fed is leaning against a too-strong economy, but they slump when the Fed is trying to nurse it back to health. Viewed through the lens of the fed funds rate cycle (Figure 1), policy had been in Phase I from December 2015, when the Fed began hiking rates, until the end of July, when the Fed began cutting, transitioning into Phase IV. Phase IV has been characterized by solid multiple expansion and, ex-2008-9, decent earnings growth. It will remain in force until the Fed returns to hiking rates, which we do not expect until the second half of 2020 at the earliest. Once the Fed does resume hiking, it will likely take some time for it to raise the fed funds rate above its equilibrium level (Phase II). Figure 1The Fed Funds Rate Cycle Our base case is that the Fed will not turn restrictive until 2021. Easy monetary policy is a tailwind for earnings growth, which remains strong in Phase II, so we expect that earnings growth will shake loose of 2019’s doldrums across the next two years. Stocks should benefit from re-rating until the Fed resumes hiking rates (Phase I), cutting off multiple expansion. They will de-rate once monetary policy becomes restrictive (Phase II), as it must once the Fed perceives a need to cool the economy. The bottom line is that the monetary policy backdrop should be earnings-friendly well into 2021, even if multiple expansion isn’t likely to persist beyond the next nine to twelve months. Investment Implications Investors should not look to quarterly earnings reports to inform asset allocation decisions. Quarterly releases may be telling for individual companies’ longer-run profit potential, but they do not shed much light on the S&P 500’s future earnings. The long-run index earnings profile is much more likely to be influenced by broad themes than real-time data points. We devote our focus to the cyclical forces affecting asset-class-level returns, and find that the monetary policy cycle offers useful insight into future moves in earnings and multiples. The Fed's dovish pivot will help keep the expansion going, ... That insight is favorable for equities, and for spread product as well. We are in the latter stages of both the business cycle and the credit cycle, but new injections of monetary accommodation and the postponement of the shift to restrictive monetary policy settings will extend the longevity of the expansion and the period over which credit generates positive excess returns. Investors have different objectives and risk tolerances, but we think all of them should remain at least equal weight equities in balanced portfolios, and overweight spread product (and underweight Treasuries) within fixed-income sleeves. It is too soon to de-risk investment portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 All data cited in this section comes from Refinitiv’s (formerly Thomson Reuters’) This Week in Earnings publication. 2 Earnings estimates compiled by other vendors may differ from I/B/E/S estimates, and other measures of reported earnings, like Standard & Poor’s, regularly diverge from I/B/E/S’.
Highlights The correlation between oil and petrocurrencies has shifted in recent years. It no longer makes sense going long petrocurrencies versus the US dollar blindly. One of the reasons has been the impressive and prominent output from US shale. We are currently long a basket of petrocurrencies versus the euro, but intend to shift this trade towards a short USD position on more visible signs of a breakdown in the US dollar. Go short CAD/NOK for a trade. Feature Chart I-1Oil And Petrocurrencies Have Diverged Since the middle of the last decade, one of the most perplexing disconnects has been the divergence between the price of oil and the performance of petrocurrencies. From the 2016 bottom, oil prices more than doubled, but the petrocurrency basket has underperformed by a whopping 110% versus the US dollar. This has been a very perplexing result that has surprised many investors on what was traditionally a very sound correlation (Chart I-1). In general, an increase in oil prices usually implies rising terms of trade, which should increase the fair value of a currency. Throughout our modeling exercises, terms of trade were uncovered as what mattered the most for commodity currencies in general, and petrocurrencies in particular. In theory, this makes sense, given the improvement in balance-of-payment dynamics (that tend to be observed with a lag) and the ability for increased government spending, allowing a resident central bank to tighten monetary policy. In the case of Canada and Norway, petroleum represents over 20% and 50% of total exports. For Saudi Arabia, Iran or Venezuela, this number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast, but it has now become a necessary but not sufficient condition. Oil Demand Should Recover We agree with our commodity strategists that the outlook for oil prices is to the upside. Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a manufacturing recession. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt (Chart I-2). Chart I-2Oil Demand Has Been Weak Part of the slowdown in global demand is being reflected through elevated inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-3). Chinese oil imports continue to hold up well, and should easier financial conditions put a floor on the manufacturing cycle, overall consumption will follow suit (Chart I-4). Chart I-3Oil Inventories Are Elevated Chart I-4China Oil Imports Holding Up The increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity is only at 2%. This means that any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints – especially in the face of OPEC production discipline. Second, unplanned outages wiped out about 1.5% of supply in 2018, and should this occur again as oil demand recovers, it will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-5Opec Spare Capacity Is Low Bottom Line: A recovery in the global manufacturing sector will help revive oil demand. This should be positive for oil prices in general. A Necessary But Not Sufficient Condition Rising oil prices are bullish for petrocurrencies, but being long versus the US dollar is no longer an appropriate strategy. This is because the landscape for oil production is rapidly shifting, with the US shale revolution grabbing market share from both OPEC and non-OPEC members. As the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces almost 15% of global crude, having grabbed market share from many other countries. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-6). Chart I-6US Has Grabbed Oil Production Market Share This explains why the positive correlation between petrocurrencies and oil has been gradually eroded as the US economy has become less and less of an oil importer. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Meanwhile, falling production in Iran, Venezuela, and even Angola has been a net boon for US production and the dollar. In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-7). Since then, that correlation has fallen from around 0.9 to around 0.2. At the same time, the DXY dollar index is on its way to becoming positively correlated with oil as the US becomes a net energy exporter. Chart I-7Falling Correlation Between Petrocurrencies And The US Dollar Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Oil Consumers Versus Producers Our strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar downleg. We are long an oil currency basket versus the euro, but intend to make the switch once our momentum indicators for the dollar decisively break lower. With bond yields having already made a powerful downward adjustment, the valve for financial conditions to get any looser could easily be via the US dollar (Chart I-8). A loss of global market share has hurt the oil sensitivity of many petrocurrencies. The second strategy is to be long a basket of oil producers versus oil consumers. Chart I-9 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. It is also notable that the correlation has strengthened as that between petrocurrencies and the US dollar has weakened. Chart I-8The Dollar As An Arbiter Of Growth Chart I-9Buy Oil Producers Versus Oil Consumers Sell CAD/NOK The Norges Bank has been quite hawkish in spite of the dovish tilt by most other central banks. As such, the underperformance of the Norwegian krone, especially versus the euro, has been quite perplexing in the face of diverging monetary policies (Chart I-10). Our bias is that speculators have been using the thinly traded krone to play USD upside, but that momentum is now fading. The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence, and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher. A weak exchange rate will also anchor inflation expectations (Chart I-11). Chart I-10Diverging Monetary ##br##Policies Chart I-11A Weak Exchange Rate Will Anchor Inflation Expectations Higher The underperformance of the Norwegian krone has mirrored that of global oil and gas stocks. Perhaps sentiment towards the environment and climate change has been pushing investor flows out of these markets, but given the central role oil plays in the global economy, we may have reached the point of capitulation (Chart I-12). Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts. Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts (Chart I-13). The CAD/NOK briefly punched through the 7.1 level in October but is now seeing a powerful reversal. Our intermediate-term indicators also suggest the next move is likely lower. The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate (Chart I-14) Chart I-12ESG And Global Divestments Chart I-13NOK Will Outperform CAD (I) Chart I-14NOK Will Outperform CAD (II) Bottom Line: Go short CAD/NOK for a trade, but more aggressive investors should begin accumulating long NOK positions versus the US dollar outright. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been strong: The labor market remains tight: nonfarm payrolls increased by 128K in October, well above expectations of 89K. Average hourly earnings continue to grow by 3% year-on-year. Unit labor costs grew by 3.6% year-on-year in Q3. The ISM manufacturing PMI increased to 48.3 from 47.8 in October. The non-manufacturing PMI soared to 54.7 from 52.6 in October, well above expectations. The trade balance narrowed by $2.5 billion to $52.5 billion in September. The DXY index appreciated by 0.8% this week. ISM PMI data points to improvements in both manufacturing and services sectors, mainly supported by production, new orders, and the employment components. It will be interesting to monitor if this signals an improvement in the global manufacturing cycle, or is a US-centric issue. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The Markit manufacturing PMI slightly increased to 45.9 from 45.7 in October. The services PMI also improved to 52.2 from 51.8. The Sentix confidence index increased to -4.5 from -16.8 in November. Retail sales grew by 3.1% year-on-year in September, an improvement from the 2.7% yearly growth rate in the previous month. EUR/USD fell by 0.8% this week. On Monday, Christine Lagarde, the former managing director of the IMF, gave her first speech as the new ECB president where she urged Europe to overcome self-doubt, aiming to boost investor and business confidence in the euro area. However, no comments were given regarding ECB monetary policy. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Vehicle sales shrank by 26.4% year-on-year in October. The monetary base grew by 3.1% year-on-year in October. The services PMI plunged to 49.7 from 52.8 in October. The Japanese yen depreciated by 1% against the US dollar this week. We remain short USD/JPY given global economic uncertainties and domestic deflationary tailwinds. Should the global economy pick up early next year, the yen could still remain bid against the USD, allowing investors time to rotate their short USD/JPY bets. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased to 49.6 from 48.3 in October. Services PMI increased to 50 from 49.5 in October. Retail sales increased by 0.1% year-on-year in October, compared to a contraction of 1.7% in the previous month. Halifax house prices grew by 0.9% year-on-year in October. GBP/USD depreciated by 1% this week. On Thursday, the BoE decided to leave its interest rate unchanged at the current level of 0.75%. However, unlike a unanimous decision as in previous policy meetings this year, two BoE officials unexpectedly voted to lower interest rates amid signs of deeper economic slowdown and entrenched Brexit chaos. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Retail sales grew modestly by 0.2% month-on-month in September. The Commonwealth composite PMI fell slightly to 50 from 50.7 in October. The services PMI also fell to 50.1 from 50.8. The trade balance increased by A$1.3 billion to A$7.2 billion in September. Both exports and imports grew by 3% month-on-month in September. The Australian dollar has been volatile against the US dollar, but returned flat this week. The RBA has left its interest rate unchanged this Monday, as widely expected. We remain positive on the Australian dollar and went long AUD/CAD last week, which is currently 0.3% in the money. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: The participation rate increased marginally to 70.4% from a downward-revised 70.3% in Q3. The labor cost index increased by 2.3% year-on-year in Q3. The unemployment rate however, climbed to 4.2% from 3.9%, higher than expectations of a rise to 4.1%. The kiwi fell by 1.4% against the US dollar, making it the worst performing G-10 currency this week. Despite the rise of the unemployment rate in Q3, the under-utilization rate, a broad measure of labor market spare capacity has fallen to the lowest level in over 11 years, as suggested by the manager of Statistics New Zealand, Paul Pascoe. That said, we remain underweight the kiwi given it will likely lag other commodity currencies in a global growth upswing. We will change this view if New Zealand terms of trade start to inflect meaningfully higher. Stay with our long AUD/NZD and SEK/NZD positions. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The Markit manufacturing PMI was little changed at 51.2 in October. The trade deficit narrowed marginally from C$1.24 billion to C$0.98 billion in September. Exports and imports both fell in September. Ivey PMI fell to 48.2 from 48.7 in October. USD/CAD increased by 0.3% this week. The recent uptick in oil prices support the Canadian dollar, but the loonie will likely underperform other petrocurrencies. We remain bullish on the oil prices, however, spreads will likely continue to move against the Western Canadian Select blend. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline CPI fell below 0 at -0.3% year-on-year for the first time over the past 3 years in October. On a month-on-month basis, it contracted by 0.2%. Real retail sales grew by 0.9% year-on-year in September. PMI improved to 49.4 from 44.6 in October. FX reserves were little changed at CHF 779 billion in October. The Swiss franc fell by 0.9% against the US dollar this week. Faced with deflationary pressures, the SNB will likely to use its currency as a weapon to stimulate the economy and exit deflation. This will favor long EUR/CHF positions. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Industrial production contracted by 8.1% year-on-year in September, mainly caused by the slowdown in extraction and related services. On the positive side, manufacturing output grew by 2.9% year-on-year. The manufacturing output of ships, boats, and oil platforms in particular, grew by 26.2% year-on-year in September. The Norwegian krone appreciated by 0.3% against the US dollar this week, despite the broad dollar strength. The WTI crude oil price increased by nearly 6% this week, which is a tailwind for petrocurrencies. We maintain a pro-cyclical stance and expect oil prices to increase further. The global growth recovery and a weaker US dollar should all boost the oil demand, and lift the Norwegian krone. Please refer to our front section this week for more detailed analysis on the NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: The manufacturing PMI fell marginally to 46 from 46.3 in October. Industrial production growth slowed to 0.9% from 2.1% year-on-year in September. Manufacturing new orders contracted by 1.5% year-on-year in September. The Swedish krona has been flat against the USD this week. The PMI components of new orders, industrial production, and employment all continued to fall. On the positive side, the export component increased marginally. We expect the cheap krona to help improve the trade dynamics in Sweden and put a floor under the krona. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights Please note that we will publish a Special Report on the Asian semiconductors cycle on Monday November 11. The risk to our negative stance on EM stocks is that DM share prices will continue advancing, pulling EM equities higher. If the MSCI EM Equity Index breaks decisively above our stop buy level instituted two weeks ago, we will reverse our stance on the absolute performance of EM. Nevertheless, we assign high odds that EM share prices will underperform DM even in a global equity rally. Hence, we are not changing our underweight recommendation on EM within a global equity portfolio. In the 2012-14 period, EM stocks underperformed their DM counterparts despite the global equity rally. Feature Chart I-1China: A Tale Of Two Manufacturing PMIs In our October 24 weekly report, we instituted a buy stop on the MSCI EM Equity Index at 1,075. The index is currently flirting with this level. If EM stocks break decisively above this level, our buy stop will be triggered. Such a technical breakout will signify that this EM equity rally will likely be sustained in the medium term, and that investors should play it. What would be the rationale behind this rally? Is it the rise in China’s Caixin manufacturing PMI or an imminent trade deal between the U.S. and China? Or is it a recovery in the global business cycle? The top panel of Chart I-1 shows that China’s Caixin and NBS manufacturing PMIs have decoupled. The Caixin PMI is compiled through a survey of about 500 companies, while the NBS measure is based on about 3000 companies. Neither one appears to have a consistently better track record than the other. For this reason, to tackle the issues of excessive volatility and false signals from both measures, we prefer to look at their average. The bottom panel of Chart I-1 illustrates the average of the two. The takeaway is that China’s manufacturing PMI has indeed improved, but only modestly. Further, non-manufacturing PMI – also the average of the Caixin and the NBS figures – has dropped to 2015 lows (Chart I-2). Hence, Chinese PMIs are not sending an unequivocal message that the mainland economy is recovering. Chart I-2China: Non-Manufacturing PMI Is At Its 2015 Low On one hand, the business cycle in China as well as global trade and manufacturing have not yet improved. On the other, share prices often lead markets, and waiting for economic data often results in missing the turning points. In this week’s report, we present both the bullish market signals and the lack of evidence of an economic recovery in China/EM, global trade and manufacturing. Finally, we elaborate why an enduring global equity rally does not always lead to EM equity relative outperformance versus DM. Bullish Market Signals… The motive for our buy stop on the EM Equity Index is the number of bullish market signals that currently suggest the global equity rally could be sustainable, and hence playable. First, DM share prices have been trading well – equity market actions in the U.S., Europe and Japan have been characteristic of a bull market since early October. Specifically, companies that have missed analysts’ earnings estimates have seen their share prices do quite well, often rising markedly in the days following their earnings announcements. Share prices of companies that have beaten analysts’ expectations have literally surged. This is typical of a genuine bull market. Technical patterns are also positive for U.S. equities. U.S. small caps, S&P 500 high-beta stocks and FAANG share prices have all bounced from major support levels. Second, technical patterns are also positive for U.S. equities. U.S. small caps, S&P 500 high-beta stocks and FAANG share prices have all bounced from major support levels and are attempting to break out (Chart I-3). Finally, the U.S. stock-to-bond ratio has also failed to break below one of its long-term moving averages and has rebounded (Chart I-4). When a 200-day or long-term moving average holds, it often marks a major reversal. Chart I-3Bullish Patterns In U.S. Equities Chart I-4A Bull Market In U.S. Stocks-To-Bonds Ratio All these signals imply a bullish trajectory for U.S. and other DM share prices. At the current juncture, we are giving the benefit of the doubt to the market and ready to reverse our stance on EM performance in absolute terms when our buy stop is triggered. Apart from these technical signals and market actions, U.S. economic fundamentals remain healthy. In particular, U.S. households have decent balance sheets, their income and spending growth is quite robust, the banking system is healthy, and nationwide property markets are picking up following a soft spot early this year. Although American manufacturing and capital spending have been weak, these relapses primarily reflect negative demand from the rest of the world and business confidence deterioration due to the U.S.-China trade confrontation. The latter will be partially reversed by the forthcoming U.S.-China trade deal. Chart I-5China Not U.S. Drives EM Profits Cycles At the same time, there is a lack of meaningful green shoots in global trade and manufacturing (we discuss this in more detail below). Altogether, one can explain this equity rally as being driven by subsiding fears of a U.S. recession, Federal Reserve easing and the improvement on the U.S.-China trade front. That said, our negative view on EM has not been contingent on a U.S. recession, Fed policy or the U.S.-China trade confrontation. As such, improvements on these fronts do not constitute sufficient basis for us to change our fundamental stance on EM. The empirical evidence that U.S. growth is not driving EM growth in general and EM corporate profitability in particular emanates from the following: U.S. imports and EM corporate earnings cycles have not been correlated since 2011 (Chart I-5, top panel). EM earnings-per-share cycles have instead been driven by Chinese imports since 2009 (Chart I-5, bottom panel). Hence, it is China’s domestic demand that drives broader EM profit cycles. As we elaborate below, there is little evidence of improvement in the mainland’s business cycle, its imports, and commodities prices. Bottom Line: There are numerous bullish signals from DM equity markets. The risk to our negative stance on EM is as follows: If DM share prices continue to rally, they will drag EM stocks and other risk assets higher. …But Global Growth Has Not Yet Improved Chart I-6No Clear Bullish Signal From Currency Markets Several key financial market signals, as well as soft and hard data, are not yet indicating that a recovery is already underway in global trade and manufacturing. Nor do they point to an improvement in China/EM economies. Our Risk-On/Safe-Haven currency ratio1 has rebounded but has not yet broken above its neckline (Chart I-6, top panel). This indicator had formed a classic head-and-shoulders pattern before breaking down. The jury is still out on whether the recent rebound is a false start or the beginning of a cyclical advance. We put a lot of emphasis on this indicator because (1) it is very strongly correlated with EM share prices, (2) it captures both risk-on and risk-off periods in global financial markets, (3) it leads the global business cycle, and (4) it is agnostic to the U.S. dollar’s trend. In a similar vein, the broad trade-weighted U.S. dollar has weakened but has not yet broken through key moving averages to conclude that it has definitively entered a bear market. With the exception of China’s Caixin manufacturing PMI, there are few green shoots in global manufacturing. Manufacturing PMIs in Japan, Korea, Singapore and Taiwan are all still below the 50 boom-bust line (Chart I-7, top and middle panels). Meanwhile, manufacturing PMIs in the ASEAN region have plunged (Chart I-7, bottom panel). Critically, EM per-share earnings are contracting at a rate of 10% from a year ago. Notably, the leading indicators for EM corporate profits – China’s domestic orders of 5,000 industrial companies and narrow money (M1) growth – signal a tentative bottoming of EM corporate profit growth only in early 2020 (Chart I-8). Chart I-7Outside China, Asian Manufacturing PMIs Are Weak Chart I-8Leading Indicators For EM EPS Growth In the majority of developing economies, corporate per-share earnings are contracting or stagnating in local currency terms (Chart I-9). Our Risk-On/Safe-Haven currency ratio has rebounded but has not yet broken above its neckline. “Hard” economic data out of EM/China and global trade remain downbeat as well. For example, Chinese construction activity and capital goods imports as well as Japanese foreign machine tool orders are all shrinking at double-digit rates from a year ago (Chart I-10, top and middle panels). Korea’s October exports contracted by 15% from a year earlier (Chart I-10, bottom panel). Chart I-9Individual EM Country EPS In Local Currency Terms Chart I-10China Capex And Global Trade: Double Digit Contraction Finally, the import sub-component of China’s NBS manufacturing PMI remains well below the 50 boom-bust line. Chinese demand is of paramount importance for industrial metals. China accounts for 50% of industrial metals demand, while the U.S. accounts for only about 7%. The very subdued bounce in commodities in general and industrial metals prices in particular, are confirming a lack of recovery in Chinese intake of raw materials (Chart I-11). EM share prices, including emerging Asian stocks, have the highest correlation with global materials stocks (Chart I-12). The rationale for this tight relationship between emerging Asian equities and commodities is that both are leveraged to the Chinese business cycle, as we discussed in our recent report, EM: Perceptions Versus Reality. It is difficult to envision EM share prices staging a cyclical bull market when commodities prices are flat to down. Chart I-11Chinese Imports PMI And Industrial Metals Chart I-12Emerging Asian Stocks And Global Materials: Moving In Tandem Bottom Line: The key variables driving EM share prices are China’s credit and business cycles, its imports and global trade. There are few green shoots in China/EM business cycles and global trade. This is why we believe even if this global equity rally is sustained, EM equities will underperform DM ones. We elaborate on this below. Can EM Underperform DM In A Bull Market? Chart I-132012-14: EM Underperformed During Global Bull Market BCA’s Emerging Markets Strategy team’s view on global equity allocation is as follows: Even if DM equities enter a sustainable bull market, odds are that EM stocks will underperform. This scenario will likely resemble the 2012-14 episode that was characterized by the following: DM share prices were in a strong bull market following the European credit crisis and the global markets selloff in 2011 (Chart I-13, top panel). Global trade and manufacturing bottomed in late 2012 and accelerated in 2013 (Chart I-13, third panel). Yet, this global trade and manufacturing improvement did little to support EM share prices, currencies and commodities prices. In 2012-14, EM equities were range-bound in absolute terms and significantly underperformed their DM peers (Chart I-13, second panel). In short, EM stocks were low beta relative to global stocks during that period. Besides, commodities prices were falling and EM currencies were depreciating versus the U.S. dollar (Chart I-13, bottom panel). The cause of such poor EM performance was two-fold: First, the recovery in China’s business cycle and its imports was tame. Second, many EM economies were suffering from poor domestic fundamentals following the 2009-2011 credit and cheap money booms. We expect any growth improvement in China to be muted, resembling the 2012 growth stabilization rather than the 2016 recovery. The top panel of Chart I-14 illustrates that China’s manufacturing PMI oscillated between 48 and 52 in 2012-2014 when the global manufacturing cycle rebounded and DM growth improved. This occurred despite China’s large stimulus in 2012 (Chart I-14, bottom panel). Chart I-14Chinese PMI And Credit And Fiscal Stimulus In line with the subdued recovery in China’s business cycle at the time, EM corporate profits did not recover much in the 2012-2014 period (please refer to Chart I-8 on page 7). We expect EM currencies to depreciate versus the U.S. dollar even if global share prices continue rallying. This will resemble the 2012-14 scenario. Notably, EM equity underperformance versus DM escalated in the spring of 2013 during the Fed’s Taper Tantrum when EM currencies plunged and EM fixed-income markets sold off. Yet, the Fed’s Taper Tantrum was not the only reason for EM currency depreciation. As demonstrated in the bottom panel of Chart I-13 on page 10, EM ex-China currencies’ total return was strongly correlated with commodities prices. Currently, many EM countries do not suffer from the same malaises they did in 2012-14, namely, high inflation and large current account deficits. On the contrary, very low nominal growth, i.e., enduring deflationary pressures, is the foremost problem in many EM countries such as India, Indonesia, Malaysia, Korea, Brazil, Mexico and Russia. These deflationary pressures are due to very sluggish domestic demand, weak/unhealthy banking systems and falling commodities prices. This backdrop indicates that these economies are not in a position to withstand either higher global borrowing costs or lower commodities prices. Their currencies will depreciate with either higher global bond yields or falling commodities prices. Even if DM equities enter a sustainable bull market, odds are that EM stocks will underperform. Hence, a scenario of firming U.S. and European demand – which would warrant higher bond yields – amid still weak Chinese growth – which would push commodities prices lower – would be very negative for EM currencies. Chart I-15Outperformance By Euro Area And Value Stocks Does Not Always Herald EM Outperformance Chart I-16EM Vs. DM: Relative Share Prices Are Tracking Relative EPS Finally, EM stocks’ relative performance versus global stocks does not always coincide with the relative performance of euro area or value stocks (Chart I-15). This entails that outperformance by euro area and global value stocks does not always herald EM outperformance versus the global equity benchmark. Bottom Line: Regardless the direction of global share prices, we expect EM stocks to underperform DM equities in the next several months. Relative equity performance is driven by relative EPS trends, as illustrated in Chart I-16. The corporate earnings outlook is worse in EM than in the U.S., euro area and Japan. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Global: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US: The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out. Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. Canada: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves. Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. Feature After knocking on the door several times in recent weeks, global equity markets are finally enjoying a true breakout. In the U.S., the S&P 500 is setting new all-time highs on a daily basis, while equities in Europe and emerging markets (EM) are also registering solid gains. There is no conflicting signal from global corporate credit markets where spreads remain stable, or from the volatility space with measures like the US VIX index hovering near the 2019 lows. Chart Of The WeekThings Are Looking Up Despite this positive price action, many remain skeptical that this “risk rally” is sustainable. Just last week, a headline in the Financial Times declared that the “U.S. stock market’s new highs baffles investors”. We find that reluctance to accept the equity market strength to be even more baffling, as the current macro backdrop is a perfect “sweet spot” for risk assets to do well. Global economic momentum is bottoming out, with improving leading indicators suggesting better days lie ahead for growth. A majority of central banks worldwide have eased monetary policy over the past several months, providing a more supportive liquidity backdrop for financial markets. The world’s most important central bank, the Federal Reserve, has delivered a cumulative -75bps of rate cuts since July, helping to cool off the US dollar, which is now flat on a year-over-year basis in trade-weighted terms (Chart Of The Week). A softening dollar is also often a signal that global growth is improving, as it indicates a shift in capital flows into more economically-sensitive non-U.S. markets like Europe and EM. Thus, a weaker greenback combined with better global growth prospects should help lift global bond yields by raising depressed inflation expectations (middle panel). The “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. Yet with policymakers worldwide still playing the stimulus game, fearful of persistent negative impacts on growth from the U.S.-China trade dispute and other political uncertainties, it will take a large and sustained increase in inflation expectations before there is any shift to a more hawkish global policy bias. This is critical for bond markets, as a much bigger move higher in global bond yields would require not just a pricing out of rate cut expectations, but the pricing in of future rate hikes. Such a repricing will not occur before there is clear evidence that global growth, broadly speaking, is accelerating for a sustained period and not just stabilizing in a few countries. The earliest we can envision such a hawkish shift for global monetary policy would be late in 2020, led by the Fed signaling a removal of some of the “insurance” rate cuts of 2019. Until that happens, the “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. The Art Of Analyzing Economic Data At Turning Points Typically, at turning points in the global growth cycle, there are always data available to support the arguments of both optimists and pessimists. That is certainly the case today, where so-called “hard” economic data that is reported with a lag (i.e. exports, durable goods orders) remains weak, but leading indicators are starting to improve. For example, the global manufacturing PMI data for October released last week shows the following (Chart 2): strong pickup in China, with the Caixin manufacturing PMI now up to 51.7; slight improvement in the US ISM manufacturing index, which rose from 47.8 to 48.3 in the month but remains below the 50 boom/bust line; bounce in the U.K. Markit manufacturing PMI index, rising from 48.3 to 49.6; the slightest of increases in the overall euro area Markit manufacturing PMI, from 45.7 to 45.9, still below the 50 line but showing marginal improvement in the critical German PMI; Continued weakness in the Japanese Markit manufacturing PMI, which fell to 48.4. The relative message from the PMIs fits with the signals sent from the OECD leading economic indicators (LEI) for those same countries, with the China LEI strengthening the most and the LEIs in Europe and Japan still struggling. The US is a mixed bag, with the ISM ticking up but the LEI languishing. There is, however, a sign of optimism in the export sub-index of the ISM manufacturing data. That measure surged nine points in October from 41.0 to 50.4, signaling a potential bottoming of the overall ISM index within the next three months (Chart 3). While the ISM exports index is volatile, the modest improvement seen in the export order series from the China manufacturing PMI over the past few months (bottom panel) suggests that there may be a more significant improvement in global trade activity brewing – as signaled by the improvement in our global LEI index. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Chart 2Global PMIs Are A Mixed Bag Chart 3Momentum Turning For The Trade Warriors? Bottom Line: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US Capital Spending Slowdown: Only A Cautious Pause Chart 4Rising Uncertainty? Or Just Slowing Profit Growth? For growth pessimists in the US, a modest boost to “soft” data like the ISM does not allay their concerns about a broadening US economic slowdown. The trade war with China and the global manufacturing recession have had a clear negative impact on business confidence when looking at measures like the Conference Board CEO survey. At the same time, US capital spending has contracted in real terms during the 2nd and 3rd quarter of 2019. A logical inference would be to say that uncertainty over the trade war has led to a reduction in capex. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Like the fading impact of the 2018 U.S. corporate tax cuts (that helped trigger a surge in after-tax earnings growth) and the squeeze on profit margins from higher labor costs. On a year-over-year basis, US profit growth has slowed from nearly 25% in 2018 to 1.8% in the 3rd quarter (a projection based on the 76% of S&P 500 companies that have already reported). The real non-residential investment spending category from the US GDP accounts has slowed alongside profits, from 6.8% to 1.3% on a year-over-year basis (Chart 4). At the same time, annual growth in US non-farm payrolls has slowed only modestly from 1.91% to 1.4%, with average hourly earnings growth falling from a 2019 peak of 3.4% to 3.0% in October. Given the tightness of the US labor market, with firms continuing to report difficulties in finding quality labor, it should come as no surprise that employment and wages have not slowed as much as capital spending, despite the sharp downturn in profit growth. Businesses that see their earnings getting squeezed will seek to protect profits by cutting back on investment and hiring activity. With a tight labor market, however, cutting capital spending is an easier and less costly decision than laying off workers, as it may be even harder to re-hire those employees if the economy starts to improve once again. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer. That can also be seen when breaking down the US non-residential investment data into its broad sub-components (Chart 5). On a contribution-to-growth basis, the only part of US investment spending that is outright contracting year-over-year is Structures. There is still modest positive annual growth in Equipment investment, although that did contract on a quarter-on-quarter basis in Q3/2019. The Intellectual Property Products category (which includes Software, in addition to Research & Development) continues to expand at a steady pace. Chart 5Slowing US Capex Focused On Structures Chart 6The Fed Has Dis-Inverted The UST Curve So similar to signals from global PMIs and LEIs, the U.S. capital spending and employment data are sending a mixed message about U.S. growth. Yes, capital spending has slowed but the bulk of the deceleration has come in the component where canceling or delaying investment plans is easiest – buildings and construction. It is not necessarily an indication that a deeper economic downturn is unfolding. Similar cutbacks in Structures investment, without a broader decline in overall capital spending, occurred in 2013 and 2015/16. During the past two U.S. recessions in 2001 and 2008, however, all categories of capital spending contracted. If we look at the breakdown of the contribution to US investment spending today, the backdrop looks more like those non-recessionary years. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer (Chart 6). The trade détente between the US and China will help boost depressed business confidence, especially with global growth already showing signs of bottoming out. This, along with a softer US dollar and some easing of wage pressures, will help put a floor underneath US corporate profit growth. Treasury yields have more upside from here, as markets are still priced for -25bps of Fed rate cuts over the next year that is unlikely to happen if the US economy rebounds, as we expect. Bottom Line: The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out. Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. The Bank Of Canada’s Newfound Caution Is Unwarranted Chart 7Canada Is A High-Beta Bond Market The Bank of Canada (BoC) has been one of the few central banks to resist the shift towards easier global monetary policy in 2019. This has resulted in Canadian government bonds trading at relatively wide yield spreads to other countries in the developed world, even as global growth has slowed in 2019 (Chart 7). With global growth now set to improve over the next 6-12 months, Canada’s historic status as a “high yield beta” bond market during periods of rising global yields suggests that Canadian government bonds should underperform in 2020. However, in the press conference following last week’s policy meeting, BoC Governor Stephen Poloz noted that the BoC was “mindful that the resilience of Canada’s economy will be increasingly tested as trade conflicts and uncertainty persist.” Poloz even revealed that an “insurance” rate cut was discussed at the policy meeting, although the BoC Governing Council decided against it. This is similar language to that parroted by the more dovish global central bankers over the past several months, raising the risk that Canada could be a lower-beta bond market if the Canadian economy falters. That outcome seems unlikely, given the indications of improving growth momentum, occurring alongside tight labor markets and stable inflation: The RBC/Markit Canadian manufacturing PMI has climbed from a trough of 49 in May to 51 in October, indicating that real GDP growth accelerated in Q3 (Chart 8, top panel); The BoC’s Autumn 2019 Business Outlook Survey (BoS) showed that an increasing share of firms are reporting labor shortages, coinciding with a sharp pickup in the annual growth rate of average weekly earnings to just over 4% (middle panel); Core inflation measures remain right at the midpoint of the BoC’s 1-3% target range, although breakeven inflation rates from Canadian Real Return Bonds remain closer to the bottom end of that range (bottom panel); After a long period of adjustment, house prices and housing activity are showing some signs of recovery in response to easier financial conditions, rising household incomes and improved affordability (Chart 9); Chart 8Resilience In Canadian Growth & Inflation Chart 9Canadian Housing Showing Improvement Canadian investment spending is set to pick up, as the Autumn 2019 BoS reported a modest improvement in overall business sentiment and an increase in capital spending plans with a growing number of firms facing capacity pressures (Chart 10). Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Chart 10Signs Of Life For Canadian Capex? Looking forward, reduced U.S.-China trade tensions should provide a boost to Canadian capex. Firms that had previously held off in the past few months due to the slowdown in the economy, caused partially by worries over global trade, will start to invest again. The BoC’s updated forecasts in the latest Monetary Policy Report released last week showed that the central bank expects Canadian exports to resume their expansion in 2020 – despite Governor Poloz’s stated concerns over global growth. Oil and gas exports are expected to improve as pipeline and rail capacity gradually expand, while consumer goods excluding automobiles should remain strong. Improvement in Chinese economic activity would provide a meaningful lift to Canadian exports, as Chinese imports from Canada are still contracting at a double-digit rate (Chart 11). More importantly, Canadian exports to the country’s largest trade partner, the US, have already stabilized and should accelerate as the US economy gains momentum in the next 6-12 months. As Governor Poloz mentioned during the press conference, the BoC's decisions are not going to be directly influenced by political events such as Prime Minister Justin Trudeau’s recent re-election. Yet the odds of Canadian fiscal stimulus have shot up after Trudeau could only secure a minority government in the Canadian Parliament. Any fiscal stimulus is starting from a healthier place with the budget deficit currently at only -1% of GDP and the net government debt-to-GDP ratio falling towards a low 40% level (Chart 12). Expected fiscal stimulus will provide an incremental boost to Canadian growth in 2020. Chart 11The Global Trade Slump Has Hurt Canada Chart 12Canada Can Afford A Fiscal Stimulus Net-net, the Canadian economy appears to be in good shape, with momentum starting to improve. Inflation remains close to the BoC target, with rising pressures stemming from a tight labor market. This is not a backdrop that would be conducive to an “insurance” rate cut in December or even in early 2020. Only -18bps of rate cuts over the next twelve months are discounted in the Canadian Overnight Index Swap (OIS) curve. Yet there is only a 16% chance of a -25bp cut expected at the December 2019 meeting, according to Bloomberg. In other words, the markets are not taking the threat of a BoC rate cut seriously – a view that we agree with. Chart 13Stay Neutral On Canadian Government Bonds We suspect that Governor Poloz’s comments about a potential BoC policy ease were more designed to take some steam out of the strengthening Canadian dollar (Chart 13), which was threatening a major breakout going into last week’s BoC meeting. We would be surprised if a rate cut was delivered at the December 2019 BoC meeting, but the dovish message sent last week does raise the possibility that the BoC could shock us. For now, we are choosing to stick with our neutral recommendation on Canadian government bonds, but we will re-evaluate after the December 4 BoC meeting. Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Bottom Line: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves. Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. A Brief Follow Up To Our US MBS Versus IG Corporates Recommendation Chart 14Spread Targets Reached - Downgrade US IG To Neutral In last week’s report, we made the case for raising allocations to US Agency MBS while reducing exposure to higher-quality US investment grade (IG) corporate credit.1 We implemented the trade in our model bond portfolio, lowering our recommended allocation to US IG and increasing the weighting to US Agency MBS. We now see a case for shifting to a formal strategic recommendation, upgrading US Agency MBS to overweight (a ranking of 4 out of 5 in the tables on page 14) and downgrading US IG to neutral (3 out of 5). The rationale for the shift is based on valuation. Our colleagues at BCA Research US Bond Strategy calculate spread targets for each credit tier within US IG (Aaa, Aa, A and Baa). The targets are determined using a methodology that ranks the option-adjusted spread (OAS) of the Bloomberg Barclays index for each credit tier relative to its history, while controlling for the “phase” of the economic cycle as determined by the slope of the US Treasury yield curve.2 The latest rally in IG has driven the OAS for all tiers below those targets, with the Baa tier looking less expensive than the others (Chart 14). As a result, we now advise only a neutral allocation to US IG corporates, with a preference for the Baa credit tier. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1Please see BCA Research Global Fixed Income Strategy Weekly Report, “Big Mo(mentum) Is Turning Positive”, dated Oct 29, 2019, available at gfis.bcaresearch.com 2For details on how those spread targets are determined, please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Chart 1The Fed Must Remain Dovish Many were quick to label last week’s FOMC decision a “hawkish cut”. This is somewhat true in the near-term. The Fed lowered rates by 25 basis points while signaling that it doesn’t expect to have to cut more. But this focus on the near-term rate path misses the big picture. In the post-meeting press conference, Chairman Powell mentioned inflation expectations several different times. At one point, he called them “central” to the Fed’s framework and said “we need them to be anchored at a level that’s consistent with our symmetric 2 percent inflation goal.” As of today, the 5-year/5-year forward TIPS breakeven inflation rate is 1.69%, well short of the 2.3%-2.5% range that is consistent with the Fed’s goal (Chart 1). The Fed will take care to maintain an accommodative policy stance until inflation expectations are re-anchored. This will provide strong support for risk assets, and we recommend overweight positions in spread product versus Treasuries. We also expect that global growth will improve enough in the coming months for the Fed to keep its promise to stand pat. With the market still priced for 29 bps of cuts during the next 12 months, investors should keep portfolio duration low. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in October, bringing year-to-date excess returns up to +429 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is elevated and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The Fed’s Senior Loan Officer survey shows that C&I lending standards tightened in Q3 (bottom panel). We expect the Fed’s accommodative stance to push standards back into “net easing” territory in Q4. But if standards continue to tighten, it could indicate that monetary conditions are not as accommodative as we think. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are now below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield performed in line with the duration-equivalent Treasury index in October, keeping year-to-date excess returns steady at +621 bps. The junk index’s option-adjusted spread (OAS) has been fairly stable for most of the year, but the sector has become increasingly attractive from a risk/reward perspective.3 This is because the index’s negatively convex nature has caused its average duration to fall alongside declining Treasury yields. Chart 3 shows that while the index OAS has been rangebound, the 12-month breakeven spread has widened considerably.4 In other words, while junk expected returns have been stable, those expected returns now come with considerably less risk. As a result, the junk index OAS looks increasingly attractive relative to our spread target.5 Specifically, we now view the junk index OAS as 141 bps cheap (panel 3). Falling index duration also explains the divergence between quality spreads and the index OAS. Many have observed that the spread differential between Caa and Ba-rated junk bonds has widened in recent months, while the overall index OAS has been stable (panel 4). However, the divergence evaporates when we look at 12-month breakeven spreads instead of OAS (bottom panel). MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +3 bps. The conventional 30-year zero-volatility spread widened 4 bps on the month, as a 5 bps widening of the option-adjusted spread (OAS) was partially offset by a 1 bp decline in option cost (i.e. the expected losses from prepayments). This week we recommend upgrading Agency MBS from neutral to overweight, and in particular, we recommend favoring Agency MBS over corporate bonds rated A or higher. We have three main reasons for this recommendation.6 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 53 bps. This is above its pre-crisis average (Chart 4), and only 4 bps below the spread offered by a Aa-rated corporate bond. All investment grade corporate bond credit tiers also look expensive relative to our spread targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most people have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 20 basis points in October, bringing year-to-date excess returns up to +183 bps. Sovereign debt outperformed duration-equivalent Treasuries by 38 bps on the month, bringing year-to-date excess returns up to +475 bps. Local Authorities outperformed the Treasury benchmark by 9 bps, bringing year-to-date excess returns up to +220 bps. Meanwhile, Foreign Agencies outperformed by 63 bps, bringing year-to-date excess returns up to +261 bps. Domestic Agencies underperformed by 2 bps in October, dragging year-to-date excess returns down to +40 bps. Supranationals underperformed by 8 bps on the month, dragging year-to-date excess returns down to +31 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to U.S. corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.7 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).8 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 7 basis points in October, dragging year-to-date excess returns down to -64 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell almost 2% in October, and currently sits at 85% (Chart 6). We recently upgraded municipal bonds from neutral to overweight.9 The decision was based on the fact that yield ratios had jumped significantly. Yield ratios continue to look attractive relative to average pre-crisis levels, especially at the long-end of the Aaa curve (panel 2). Specifically, 2-year and 5-year M/T yield ratios are close to average pre-crisis levels at 73% and 77%, respectively. Meanwhile, M/T yield ratios for longer maturities are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 86%, 94% and 97%, respectively. Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve steepened considerably in October, as short-dated yields came under downward pressure even as long-maturity yields edged higher. The 2/10 Treasury slope steepened 12 bps on the month, and currently sits at 17 bps. The 5/30 slope steepened 9 bps on the month, and currently sits at 66 bps (Chart 7). Last week’s report discussed the outlook for the 2/10 Treasury slope on a 6-12 month horizon.10 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 27 basis points in October, bringing year-to-date excess returns up to -64 bps. The 10-year TIPS breakeven inflation rate rose 1 bp on the month, and currently sits at 1.60%. The 5-year/5-year forward TIPS breakeven inflation rate fell 8 bps on the month, and currently sits at 1.69%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations is becoming increasingly stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.11 That being said, the 10-year TIPS breakeven rate is currently 32 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in October, dragging year-to-date excess returns down to +67 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month. It currently sits at 39 bps, 5 bps above its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive U.S. spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The same is true for the household interest expense ratio (panel 3). Senior loan officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in October, bringing year-to-date excess returns up to +233 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS was flat on the month. It currently sits at 73 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in October, bringing year-to-date excess returns up to +100 bps. The index option-adjusted spread was flat on the month, and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 29 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuations: Raw Residuals In Basis Points (As Of November 1, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 1, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 48 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 48 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 1, 2019) Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 4 The 12-month breakeven spread is the spread widening required to break even with a duration-matched position in Treasuries on a 12-month horizon. It can be approximated by OAS divided by duration. 5 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Two Themes and Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Highlights Portfolio Strategy Lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the time is ripe for an underweight stance in the S&P semi equipment index. The chip down cycle is far from over, leading global semi sales indicators remain downbeat and our semi profit growth model is waving a yellow flag, compelling us to put the S&P semiconductors index on downgrade alert. Recent Changes Downgrade the S&P semiconductor equipment index to underweight, today. Table 1 Feature The S&P 500 made fresh all-time highs last week, despite the ongoing profit contraction and a well telegraphed hawkish Fed interest rate cut. The “hope rally” continues and the longer it lasts defying sagging profit fundamentals, the larger the snapback will be in the ensuing months. We remain cautious awaiting a turn in our proprietary four-factor macro SPX earnings growth model and in the meantime our strategy is to sell this strength and raise dry powder. Worrisomely, Chart 1 shows that analysts have thrown in the towel and are downgrading SPX long-term profit growth expectations at a faster pace than in the aftermath of the dotcom bubble. Historically, the S&P 500 and its five-year forward EPS growth estimates are joined at the hip, and the current message is bearish for the broad equity market. Chart 1Will Sinking Profit Growth Expectations Pull Stocks Lower? Importantly, on the valuation front, in May of 2018 we first showed the SPX P/E/G ratio and at the time we accurately argued that “on this valuation measure the SPX appears cheap”.1 How times have changed since then. Following that trough, the P/E/G ratio has nearly doubled and is now sitting right at 1.5 or one standard deviation above the historical mean (we divide the 12-month forward price-to-earnings ratio by the long-term EPS growth rate using I/B/E/S data, second panel, Chart 2). We are clearly in overshoot territory and this valuation metric represents another yellow flag. Chart 2SPX P/E/G Ratio Is In Overshoot Territory Moving on to the bond market, what caught our attention was a recent WSJ article detailing how investors are no longer paying up to own the lowest quality paper and while overall junk spreads were coming in, at the bottom of the pit investors were shunning CCC rated junk bonds.2 What is interesting is that this lowest quality corner of the junk market has some excellent forward looking properties and tends to lead not only the overall junk market, but also equities. Chart 3 shows the CCC rated option adjusted spread (OAS) versus the overall high yield OAS on a year-over-year change basis on inverted scale. This measure of bond market stress is moving in the opposite direction of S&P 500 momentum and we expect stocks to converge lower to this junk bond market stress indicator (JBMSI). Chart 3Bond Market Not Buying Stock Market Euphoria This week we are downgrading a niche tech subgroup that has gone parabolic and updating another early-cyclical tech subindex. The overall corporate bond ratings migration data (defined as downgrades minus upgrades as a percent of total) corroborates the JBMSI message and warns that the steep divergence with stocks is unsustainable (corporate bond ratings migration data shown inverted, middle panel, Chart 4). Chart 4Unsustainable Divergences Similarly, the S&P 500’s net earnings revision ratio is also negative and before long it will exert downward pull on SPX momentum (bottom panel, Chart 4). Under such a backdrop, we continue to recommend investors avoid chasing the broad equity market higher and instead build up their cash coffers, at least until we get a definitive signal that the path of least resistance is higher for profits. This week we are downgrading a niche tech subgroup that has gone parabolic and updating another early-cyclical tech subindex. Sell The Semi Equipment Exuberance Tech stocks have been on a tear with the sector besting the SPX by over 40% since 2015. While such a breakneck pace is unsustainable, what is missing from this outperformance is relative forward earnings participation. In fact, tech profit expectations stalled versus the overall market in late-2018 and have not been able to keep up with relative share prices. In other words, the forward multiple has skyrocketed and is now trading at a 15% premium to the SPX, at a time when relative margins are sinking like a stone (Chart 5). Importantly, given that stock performance should follow profit performance we are perplexed by this dynamic with investors religiously bidding up the sector’s forward multiple. Tack on the recent news of a plunge in overall tech capex growth – especially excluding software – and the tech sector’s bleak profit outlook dims further (Chart 6). Worryingly, within the tech sector the semiconductor equipment space is even more puzzling. Chart 7 shows that relative forward profits are trailing relative share prices as investors have extrapolated the recent positive trade news far into the future. As a reminder this index has a 90% foreign sales exposure with roughly 30% of sales originating from China. As a result, the S&P semiconductor equipment forward P/E is just below the broad market, nearly doubling on a year-over-year basis (middle panel, Chart 7). Chart 5Mind The Gap Chart 6Even Tech Investment Is Cracking The last time we tried to lean against semi equipment exuberance on the back of deteriorating profit fundamentals was on July 8 when we downgraded this index to underweight. But, we were offside and thankfully our risk management metric (stop loss at -7%) limited our downside a mere ten days later. Chart 7Sell Semi Equipment Stocks Since then, relative share prices have skyrocketed by 40% and we now have more confidence to re-enter our position. Today we recommend a downgrade in the S&P semi equipment index to a below benchmark allocation. This is a speculative/tactical downgrade and thus we also set a trailing stop loss near the -10% relative return mark. While bulls would buy this breakout, we are sticking our heads out and recommend selling the strength and warn that the S&P semi equipment all-time highs look more like a mania, eerily similar to the dotcom bubble era (Chart 8). Chart 8Chip Equipment Mania The contracting ISM manufacturing survey signals that relative share price momentum running at a 60%/annum clip is unwarranted and bound to return to earth (second panel, Chart 9). The same holds true for relative forward profit and revenue growth expectations, especially given the ongoing contraction in global semi sales (third & bottom panels, Chart 9). This deficient demand for semis and therefore semi equipment manufacturers is also apparent in deflating DRAM prices, our industry pricing power proxy. Historically, relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy. Net earnings revisions have slingshot from extreme pessimism to extreme optimism during the past quarter and are vulnerable to disappointment (Chart 10). Chart 9To The Moon… Chart 10…And Back? Not only is the relative share price momentum running at the fastest clip in 19 years, but our proprietary Technical Indicator is also signaling that it is a good time to shun away from these hyper-cyclical tech stocks. The last three times our TI spiked to over one standard deviation above the historical mean, relative share prices corrected on average by 36% in the ensuing 12-18 months (Chart 11). While we are confident to downgrade this index to underweight, there is a risk to our bearish view. Were the U.S. dollar to depreciate definitively from current levels, then it would reflate the global economy and put this position offside. In fact, there are some green shoots in the emerging markets that are appearing, but in order for them to blossom further and not get nipped in the bud the trade-weighted U.S. dollar has to fall (Chart 12). Chart 11Time To Be Contrarian In sum, lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the time is ripe for an underweight stance in the S&P chip equipment index. Chart 12Risk To View: U.S. Dollar The Global Reflator Bottom Line: Downgrade the S&P semi equipment index to underweight, today with a stop loss at the -10% relative return mark. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. Is Semi Euphoria Warranted? Similar to the broad tech space and the S&P semiconductor equipment subgroup, semi producers are also showing signs of excess. Chart 13 shows that relative forward EPS are in a clear and steep downtrend with no end in sight, whereas relative share prices are near post GFC highs, pushing the semi forward P/E on a par with the SPX. While the relative margin squeeze in chip stocks has been a whopping 5%, semi forward margins are still projected to outpace overall market by an impressive 15% (bottom panel, Chart 13). Trailing semiconductor earnings are contracting and our newly created top-down chip profit growth model is sputtering, warning that more earnings pain lies ahead (semi pricing power, global exports and the greenback comprise our proprietary S&P semiconductors earnings model, Chart 14). While chip earnings season has been a mixed bag with INTC on the bullish side and TXN on the bearish camp, TXN’s CFO commentary really grabbed our attention musing that: “When there are tensions in trade and obstacles to trade, what do businesses do? They become more cautious. And they pull back. And we are at the very end of a long supply chain. And when the ones at the very front pull back, it becomes a traffic jam” (emphasis ours). Chart 13Falling Profits Should Exert Downward Pull On Stocks Chart 14BCA Chip Profit Growth Model Is Bearish Our global semi sales-to-inventories ratio is still contracting also warning that the path of least resistance is lower for chip profits (Chart 15). In other words, the inventory liquidation phase has just began and steep price concessions to rebalance the markets will continue to weigh on the sector’s profit prospects. With regard to chip final-demand, while 5G euphoria has gripped the sector, our proprietary global auto sales proxy and global capex indicator (using the IFO’s World Economic Survey dataset) underscore that the global chip down cycle is far from over (Chart 16). Chart 15Semi Down Cycle … Chart 16… Is Far… Netting it all out, the chip down cycle is ongoing and leading global semi sales indicators remain downbeat. Other macro variables confirm that semi end-demand remains feeble. The global manufacturing PMI is waning and our diffusion index is probing multi-year lows. Our in-house calculated Global ZEW survey is also heralding additional global semi sales weakness in the coming months as it is hovering near levels last hit during the Great Recession (middle panel, Chart 17). Chinese electronics imports remain in contractionary territory (bottom panel, Chart 17) and U.S. new orders for computers & electronic products are on the verge of contraction (not shown). Despite this souring backdrop, investors have given the semi industry the benefit of the doubt and are anticipating a swift final-demand recovery. Our indicators suggest otherwise, and we expect relative share prices to converge lower to still contracting relative profit and revenue estimates (Chart 18). Chart 17…From Over… Chart 18…But Investors Are Mesmerized Netting it all out, the chip down cycle is ongoing and leading global semi sales indicators remain downbeat. Moreover, our semi profit growth model is waving a yellow flag, compelling us to put the S&P semiconductors index on downgrade alert. Bottom Line: Stay on the sidelines in the S&P semiconductors index for now, remove the upgrade alert and put it on downgrade watch. Stay tuned. The ticker symbols for the stocks in this index are: BLBG – S5SECO – INTC, TXN, ADI, AMD, MXIM, XLNX, MCHP, NVDA, AVGO, QCOM, MU, SWKS, QRVO. Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1. Please see BCA U.S. Equity Strategy Report, “Resilient” dated May 14, 2018, available at uses.bcaresearch.com. 2. https://www.wsj.com/articles/wave-of-financial-stress-hits-low-rated-companies-11571736606 Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights Earnings season concerns will not materialize, … : The energy sector is suffering, but overall third-quarter S&P 500 earnings are comfortably beating consensus expectations and the bears’ worst-case-scenario handwringing. … but there are other snares that could trip up the economy: Business and consumer pessimism can become self-fulfilling, and a material worsening in U.S.-China relations could trigger a fresh wave of gloom. We examined past bull-market cycles for a sense of the rally’s vulnerability: Cycle-on-cycle analysis of economic activity, inflation pressures, earnings expectations and investor sentiment does not suggest that the end of the bull market is yet in sight. Feature Chart 1Just Enough Earnings Growth For A New High Earnings season will not short-circuit the equity rally. Nearly three-quarters of S&P 500 constituents have reported their third-quarter results, and while Friday’s releases from the oil majors erased modest year-over-year growth in index earnings per share, earnings have beaten expectations by 3 to 4%. That’s not much to write home about in an absolute sense, but financial assets are graded on a curve, and earnings are poised to beat projections of a 2-4% year-over-year decline for the third consecutive quarter. Flat-to-slightly-higher earnings (Chart 1, second panel), combined with two-plus points of multiple expansion since the beginning of the year (Chart 1, bottom panel), have allowed the S&P 500 to gain 20% year to date (Chart 1, top panel), recouping the ground lost in last year’s fourth-quarter swoon and powering the index to new all-time highs. Stocks are not cheap, but we find that valuation only matters at extremes. At about three-quarters of a standard deviation above the mean, the S&P 500 is hardly trading at an extreme valuation (Chart 2). As Chart 1 showed, the large-cap benchmark is simply back to the 17 multiple that has been its mean valuation over the last three years. Investors are not euphoric, and the S&P 500 is therefore not in danger of a sudden de-rating. Chart 2Stocks Aren't Cheap, But Valuation Is Not A Pressing Concern Very slightly higher earnings and a restored multiple explain how stocks have surpassed their previous high, but where do they go from here? The bull market may be long in the tooth, but it can continue as long as the conditions supporting its rise to date remain in place. Monetary policy is easy, there is no recession in sight, and global growth is poised to revive. If the U.S. and China can reach enough of a détente to prevent a recession-inducing free fall in business and/or consumer confidence, equities should resume bounding up the wall of worry. Equity bull markets explode out of the gate and sprint to the finish, with a lot of trotting and grazing in between. Our view isn’t new, however, and an earnings stumble was not a major consensus concern. U.S.-China relations appear to be moving in the right direction, but our Geopolitical Strategy team has repeatedly cautioned against expecting a quick or clear solution to the trade component of what projects to be a lengthy struggle for hegemony between the established economic superpower and the new kid on the block. For new insight into the remaining duration of the equity bull market, we examined the contours of past cycles. We compared today’s economic and market conditions to the conditions that have commonly prevailed in the waning days of the six complete S&P 500 bull markets of the last 50-plus years. On balance, it does not appear that the current bull market is nearing its expiration date. Ground Rules We define a bull market as a 20% trough-to-peak gain in S&P 500 closing prices, and a bear market as a 20% peak-to-trough closing-price decline. Since 1966, there have been seven bear markets, six completed bull markets, and the current bull market that is now over ten-and-a-half years old (Table 1). We have slightly tweaked our definitions from prior analyses, leaving out the S&P 500’s 19.9% peak-to-trough decline from July to October 1990, and excluding the 21% gain from late September 2001 to the beginning of January 2002, which was more of a dead-cat bounce than a true bull market. The completed bull markets in our sample span 8,400 trading days, or the equivalent of over 33 market years. Table 1Bear And Bull Markets, 1966-2019 Bull Markets End In Stampedes We have noted before that bull markets tend to sprint to the finish line. The six completed bull markets from 1966 have exhibited a pronounced pattern in which they only materially exceed their overall pace of gains in their first and last deciles (Chart 3). The first-decile performance is easy to explain: bull markets begin in despair, when investors largely lament their equity holdings, and have little interest in adding to them. Falling earnings expectations and low P/E multiples push stocks down, but set the stage for a rapid move higher once sellers become exhausted. Chart 3Bull Markets Sprint To The Finish Line Chart 4Could This Bull Have Ended So Quietly? The last decile’s surge seems to be the mirror image, powered by professional investors who’ve failed to participate in at least the latter stages of the advance and capitulate under the pressure of relative underperformance. They are joined by individuals who have turned green with envy at their co-workers’ and neighbors’ lusty tales of market conquest and jump into the market in an attempt to capture their share of the bounty. The buying pressure they produce is often accompanied by earnings expectations that extrapolate a favorable fundamental backdrop well into the future. The bull market ends when there are no more marginal buyers left to maintain the upward impulse, just as bear markets end when there are no more sellers to sustain downward pressure. The real economy is not running hot the way it typically does at the end of the cycle. If the bull market ended last Wednesday, when the S&P 500 made its record closing high of 3,046.77,1 this bull market will have quietly expired after thirteen months of bumping around a tight range (Chart 4). Bull markets typically burn out, rather than fade away, and it would be unusual if the current bull were to finish without a bang, while its failure to better its overall return in its last decile would be unprecedented (Chart 5). We project that the next recession will not begin until the second half of 2021 at the earliest, which would suggest the bull market will extend at least until the end of 2020. If the bull market were to last that long, the last year-plus of range-bound moseying would shift from the tenth to the ninth decile (Chart 6), preparing the ground for a characteristic closing surge. Chart 5Individual Bull Market Returns By Decile Chart 6A More Familiar Pattern (If The Bull Lasts Through 2020) Bottom Line: Ever since the mid-‘60s, the pace of returns has quickened in bull markets’ final stages. It would be unprecedented if the current bull market were to quietly peter out. Goldilocks Trumps John Henry Bull markets, like economic expansions, end once they can no longer be sustained. When investors begin to extrapolate that feverish activity will continue well into the future, stocks and the economy are primed for disappointment. The cycle analysis of real activity suggests that bull markets don’t typically meet their demise when the real economy is pushed to its maximum speed, but rather when it’s been operated at a level above the speed limit for an extended period. Historically, real GDP has swiftly accelerated after briefly contracting, cooled off over an extended period, and then powered to a new cycle high, from which it only slowly and slightly tapered off as the end of the bull market approached (Chart 7, top panel). Consumer spending has followed the same basic pattern (Chart 7, middle panel), accompanied by elevated and rising credit growth (Chart 7, bottom panel). Consumer spending is well below the average pace of past bull markets, as is credit growth, which has been roughly flat at a moderate pace for four years, falling well below the average bull market pace. The Fed isn't about to get in the economy's way any time soon. Capacity utilization has spent much of past bull markets at or above 80%, but has yet to approach that level in this cycle (Chart 8, top panel). The manufacturing inventory-to-sales ratio has similarly lagged the average level of past bull markets (Chart 8, middle panel), and elevated inventories do not appear to be a source of vulnerability. Housing is one of the most cyclical elements of the economy, and with housing starts lagging household formations, it is not at all overheated relative to past bull market cycles (Chart 8, bottom panel). Chart 7No Overheating In Real Activity (I) Chart 8No Overheating In Real Activity (II) Chart 9The Fed Will Lay Off Despite A Positive Output Gap Pressures that knock the economy off course aren’t entirely endogenous; inflation concerns can provoke the Fed to make a deliberate attempt to cool activity. Inflation is well below the average of past bull cycles (Chart 9, top panel), and the fact that it has not yet gotten enough traction to be threatening, here or abroad, would seem likely to keep the Fed from hiking rates until well into next year at the earliest. It takes a positive output gap (output exceeds capacity) to promote inflation pressures. Though the IMF estimates that the U.S. output gap has been positive for the last three years (Chart 9, middle panel), persistently soft inflation expectations will likely allow it to remain positive for longer without causing a problem. Real yields are also well below the level that has typically been associated with expiring bull markets (Chart 9, bottom panel). Bottom Line: Cyclical segments of the real economy do not show signs of overheating on their own, and low inflation will keep the Fed from stymying growth with tighter monetary policy until at least the second half of next year. Expectations Matter As we mentioned above, overly optimistic expectations can trip up a bull market. If the earnings bar is set too high, companies have an elevated probability of failing to reach it. P/E multiples are a mean-reverting series, and overly ambitious valuations make stocks vulnerable to an inevitable de-rating. Sentiment is also mean-reverting, and surveys shedding light on investors’ aggregate bullishness or bearishness are classic contrarian indicators. Chart 10Expectations Are Undemanding, But Multiples Are Elevated Earnings expectations have oscillated across the three bull market cycles for which they’ve been compiled, but have risen to double-digit levels at past S&P 500 peaks (Chart 10, top panel). After the immediate aftermath of the crisis, expectations in the current bull market have been muted relative to history, but multiples have been steadily rising over the last five years (Chart 10, bottom panel). Some of the multiple-related concern is relieved by our composite sentiment survey, which is as close to the bottom of its historical range as it has been to the top of the range at the onset of the previous two market peaks (Chart 11, bottom panel). Multiples are the only series in our review that is approaching a danger zone, and we will keep an eye on them. Chart 11... But Sentiment Is Not Soft Sentiment Is A Tailwind For Stocks Investment Implications Sentiment is a classic contrarian indicator. We took some comfort last week in Barron’s downbeat semi-annual Big Money poll, which jibes with the wariness we’ve sensed in the institutional investors we’ve met. There are credible reasons for concern, and while our base-case scenario is market friendly, this is not a time to load up on risk exposures. Until the skeptical show-me climate eases, big bets could be buffeted by volatility that may undermine an investor’s ability to maintain them. Volatility spikes will occur in spite of the Goldilocks economy. The October employment report showed that she is still alive and well. On the verge of a too-cold reading – the consensus expected a three-month moving average of 130,000 net payroll additions – a hearty October beat, along with significant upward revisions to August and September, produced a 176,000 three-month moving average, smack dab in just-right territory. In our base-case macro scenario, the economy will continue to produce trend growth, helped along by the lagged effect of easier monetary policy in the U.S. and much of the rest of the world. S&P 500 earnings will get a boost from a global ex-U.S. growth revival and the dollar softness that will accompany it. Credit performance will continue to be very good as investor constituencies needing yield, and other parties pressured by FOMO (fear of missing out), keep capital flowing into spread product. The equity bull market will remain intact, and investors should stay the risk-friendly course. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 As we were going to press on Friday, it appeared that a new high would be set around 3,060.