Corporate Bonds
Highlights Corporate Spreads: The Fed’s dovish pivot prolongs the period of time before the yield curve inverts, thus extending the window for corporate bond outperformance. Investors should remain overweight corporate bonds, with a preference for securities rated Baa and below, where spreads remain wide relative to our fair value estimates. Yield Curve: Investors should barbell their U.S. bond portfolios, favoring long-maturity (> 10 years) and short-maturity (< 2 years) securities while avoiding the 5-year and 7-year notes. This positioning will boost average portfolio yield and will benefit from any future hawkish re-assessment of Fed policy. MBS: Lower mortgage rates have led to a jump in mortgage refinancings and wider MBS spreads. However, MBS spreads remain quite low compared to history. Maintain a neutral allocation to MBS in U.S. bond portfolios. Feature Last December, we laid out our key fixed income themes for 2019 in a Special Report.1 In that report we also introduced a framework for splitting the economic cycle into three phases based on the slope of the yield curve. Specifically, we use the 3-year/10-year Treasury slope to divide each cycle into the following three phases:2 Phase 1 runs from the end of the last recession until the 3/10 slope flattens to below 50 bps. Phase 2 encompasses the period when the 3/10 slope is between 0 bps and 50 bps. Phase 3 begins after the 3/10 slope inverts and ends at the start of the next recession. Clearly, as is illustrated in Chart 1, we are smack dab in the middle of a Phase 2 environment. This has implications for how we should think about positioning a U.S. bond portfolio. Chart 1Firmly In Phase 2 What Makes The Middle Phase Awkward? Table 1 shows annualized excess returns for Treasuries and corporate bonds (both investment grade and high-yield) in each phase of every cycle stretching back to the mid-1970s. Treasury excess returns are calculated relative to cash, as a proxy for the returns from taking duration risk. Corporate excess returns are relative to a duration-matched position in Treasury securities. Table 1Bond Performance In Different Yield Curve Regimes A look at Table 1 reveals why we call Phase 2 the “awkward” middle phase of the cycle. The excess returns earned from taking both duration and corporate spread risk tend to be underwhelming. On duration, we observe that in three of the four complete cycles in our sample, Treasury excess returns are lowest in Phase 2. This lines up well with intuition. The flatter yield curve means that Treasuries offer a lower term premium in Phase 2 than in Phase 1. Meanwhile, Phase 3 periods tend to coincide with rapid Fed rate cuts, and thus large capital gains. Phase 2 periods, in contrast, often contain Fed tightening cycles. On corporate credit, we observe that excess returns tend to be lower in Phase 2 than in Phase 1, but are usually still positive. Returns tend not to turn consistently negative until after the 3/10 slope inverts and we enter Phase 3. Overall, if we know nothing other than that we are in Phase 2 of the cycle, our results suggest that we should take less duration risk in our portfolio than in Phases 1 or 3. Overall, if we know nothing other than that we are in Phase 2 of the cycle, our results suggest that we should take less duration risk in our portfolio than in Phases 1 or 3. The results also suggest that we should prefer corporate credit over Treasuries, though to a lesser extent than in Phase 1. What Makes The Middle Phase Long? In last December’s Special Report, we argued that the U.S. economy would remain in a Phase 2 environment for a long time, at least until late 2019. Our reasoning was that, in the absence of inflationary pressures, the Fed would be reluctant to tighten policy enough to invert the 3/10 curve. The Fed’s recent dovish pivot, and the resultant steepening of the curve (see Chart 1), only prolongs the current Phase 2 environment. We now think it will be well into 2020, and possibly later, before the 3/10 slope inverts and the economy enters Phase 3. One obvious investment implication of an extended Phase 2 environment is that we should remain overweight corporate bonds relative to duration-matched Treasuries. However, we also need to consider valuation before drawing too firm of a conclusion. Charts 2A and 2B show spreads for each corporate credit tier, encompassing both investment grade and high-yield, along with our spread targets. The spread targets are the median levels observed in prior Phase 2 environments, adjusted for changes in the average duration of the bond indexes over time.3 The charts reveal that Aaa-rated bonds already look expensive, while Aa and A-rated bonds are close to fairly valued. Baa-rated bonds are 13 bps cheap relative to our target, while the high-yield credit tiers offer significantly more value. Chart 2AInvestment Grade Spread Targets Chart 2BHigh-Yield Spread Targets As discussed in last week’s report, the Fed’s dovish pivot will cause corporate spreads to tighten in the near-term, but it will take longer before Treasury yields respond by moving higher.4 For Treasury yields to move higher, investors must first become convinced that the Fed’s reflationary efforts are translating into stronger global economic growth. Ultimately, we expect this will occur in the second half of this year and Treasury yields will be higher 12 months from now, as the Fed will fail to deliver the 92 bps of rate cuts that are currently priced. The flat yield curve means that the yield give-up is small, and we expect global growth to improve in the second half of the year. Bottom Line: The Fed’s dovish pivot prolongs the period of time before the yield curve inverts, thus extending the window for corporate bond outperformance. Investors should remain overweight corporate bonds, with a preference for securities rated Baa and below, where spreads remain wide relative to our fair value estimates. Investors should also keep portfolio duration low. The flat yield curve means that the yield give-up is small, and we expect global growth to improve in the second half of the year. Barbell Your Portfolio Chart 3Barbell Your Portfolio For those unwilling or unable to deviate portfolio duration significantly from benchmark, there is another way to bet on the Fed delivering fewer cuts than are currently priced into the market. Investors can run a barbelled portfolio, favoring short-maturity (< 2 years) and long-maturity (> 10 years) securities, while avoiding the belly (5-year/7-year) of the curve. This sort of positioning has a few advantages. First, since the financial crisis, the yield curve has tended to steepen out to the 5-year/7-year point and flatten beyond that point whenever our 12-month Fed Funds Discounter rises (Chart 3). Conversely, whenever the market prices in more cuts/fewer hikes and our discounter falls, the yield curve has flattened out to the 5-year/7-year maturity point and steepened beyond that point. This correlation has been very consistent during the past few years, and continued to hold during the most recent decline in rate expectations. Notice that the 5-year yield has fallen by more than either the 2-year or 10-year yields since our Discounter's early-November peak (Table 2). Table 2The Belly Of The Curve Is Most Sensitive To Rate Expectations The upshot is that, if rate expectations rise during the next 12 months, as we expect, the 5-year and 7-year notes will endure the most damage. The second reason why a barbelled portfolio makes sense is that valuation is very attractive. Chart 4 shows that the 5-year yield is below the yield on a duration-matched 2/10 barbell. It also shows that this 2/5/10 butterfly spread is very low relative to our model’s fair value.5 Chart 42/10 Barbell Is Attractive Versus 5-Year Bullet We run similar fair value models for every possible bullet/barbell combination along the yield curve, and barbells appear universally cheap (see Appendix). Bottom Line: Investors should barbell their U.S. bond portfolios, favoring long-maturity (> 10 years) and short-maturity (< 2 years) securities while avoiding the 5-year and 7-year notes. This positioning will boost average portfolio yield and will benefit from any future hawkish re-assessment of Fed policy. MBS & Housing: The Implications Of Lower Mortgage Rates Alongside bond yields, mortgage rates have fallen sharply during the past few months, a trend that has important implications for both MBS spreads and future housing data. We consider the outlook for both. MBS Spreads Lower mortgage rates encourage homeowners to refinance their loans, and any increase in refinancing activity puts upward pressure on MBS spreads. Not surprisingly, as mortgage rates have declined we have seen a jump in the MBA Refinance Index and a widening of nominal MBS spreads (Chart 5). Chart 5MBS Spreads Still Historically Tight While spreads have widened somewhat, they remain low compared to history (Chart 5, top panel). As such, we do not see a compelling buying opportunity in MBS. This is especially true relative to corporate credit where spreads are more attractive. Chart 6Limited Upside For Refis With the mortgage rate now below 4%, our rough calculation suggests that approximately 44% of the Bloomberg Barclays Conventional 30-year MBS index is refinanceable. A regression of the MBA Refi Index versus the refinanceable share suggests a fair value of 2014 for the Refi Index, slightly above its actual level of 1950 (Chart 6). We also calculate that a further drop in the mortgage rate to below 3.5%, where it troughed in mid-2016, would increase the refinanceable share to 77%. Our regression translates this 77% share to a level of 3309 on the Refi Index. It should be noted that when the refinanceable share rose to 77% in 2016, the MBA Refi Index peaked at 2870. This means that our simple regression analysis probably overstates the surge in refis that would occur if mortgage rates fell another 50 bps. In addition, we think it’s unlikely that mortgage rates will actually fall back to 3.5%, as they did in 2016, and as such, we are hesitant to position for further MBS spread widening. The improvement in housing actitivty is not uniform across all indicators. We recommend maintaining a neutral allocation to MBS for now. If mortgage rates drop and spreads widen further in the near-term, then a buying opportunity may present itself. Housing Activity Chart 7Housing Activity: A Mixed Picture The drop in mortgage rates will also have a significant impact on housing activity data. This is important because, as we have demonstrated in prior reports, housing activity data – particularly single-family housing starts and new homes sales – are reliable indicators of U.S. recessions and interest rates.6 By all measures, housing activity weakened significantly as mortgage rates surged in 2018. But it has improved somewhat now that mortgage rates have declined. However, the improvement is not uniform across all indicators (Chart 7): New home sales jumped sharply early this year, then fell back more recently. The current trend is neutral, with the latest monthly print very close to the 12-month moving average (Chart 7, top panel). Housing starts and permits are both trending below their respective 12-month moving averages, though by less than in 2018 (Chart 7, panel 2 & 3). Existing home sales have popped, and are now exerting upward pressure on the 12-month average (Chart 7, panel 4). Likewise for mortgage purchase applications (Chart 7, panel 5). Homebuilders also report that lower mortgage rates have led to a jump in sales activity (Chart 7, bottom panel). With mortgage rates still low, the tentative rebound in housing activity data should continue in the coming months. Looking further out, we see significantly more upside in single-family housing starts and new home sales as builders shift construction toward lower-priced properties. The Bifurcated Housing Market Beyond the large swings in mortgage rates, another trend has significantly influenced housing activity in recent years. For the past few years, homebuilders have focused their attention on higher priced homes, and that segment of the market now looks oversupplied. Data from the American Enterprise Institute Housing Center show that the recent deceleration in home prices has been driven by falling prices for the most expensive homes. Homes in the lowest price tier have seen prices accelerate (Chart 8).7 The divergence is also evident in the supply data. New home inventories are roughly consistent with average historical levels, while existing home inventories are incredibly low (Chart 9). In fact, new home inventories now represent 6.4 months of demand while existing home inventories represent 4.3 months of demand (Chart 9, panel 3). Such a wide divergence is historically rare. Chart 8An Oversupply Of High ##br##Priced Homes... Chart 9...And An Undersupply Of Low Priced Homes The divergence between an oversupply of new homes and an undersupply of existing homes is a result of new construction having focused on higher priced homes in recent years. The median price for a new home used to be only slightly above the median price for an existing home, but the difference shot up to above 75k during the past few years (Chart 9, bottom panel). More recently, the price differential between new and existing homes has started to fall, as builders are starting to recognize that the greater growth opportunity lies at the low-end of the market where demand is strong relative to supply. As this supply-side adjustment plays out, it will provide an additional boost to new homes sales and housing starts going forward. Appendix 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 3 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 3Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of June 27, 2019) Table 4 scales the raw residuals in Table 3 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 4Butterfly Strategy Valuation: Standardized Residuals (As of June 27 2019) Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 We use the 3/10 Treasury slope in place of the more commonly referenced 2/10 slope because it is a close proxy that provides an additional 14 years of historical data. 3 For more 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 4 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 5 For more details on our yield curve models please see U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 7 Low-tier homes are those in the bottom 40% of the price distribution in each metro area. High-tier homes are those that are both in the top 20% of the price distribution and exceed the GSE loan limit by more than 25%. For further details: http://www.aei.org/wp-content/uploads/2019/06/HPA_market_conditions_report_June_2019.pdf Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Central banks globally have turned dovish, with the Fed virtually promising to cut rates in July. But this will be an “insurance” cut, like 1995 and 1998, not the beginning of a pre-recessionary easing cycle. The global expansion remains intact, with the fundamental drivers of U.S. consumption robust and China likely to ramp up its credit stimulus over the coming months. The Fed will cut once or twice, but not four times over the next 10 months as the futures markets imply. Underlying U.S. inflation – properly measured – is trending higher to above 2%. U.S. GDP growth this year will be around 2.5%. Inflation expectations will move higher as the crude oil price rises. Unemployment is at a 50-year low and the U.S. stock market at an historical peak. These factors suggest bond yields are more likely to rise than fall from current levels. The upside for U.S. equities is limited, but earnings growth should be better than the 3% the bottom-up consensus expects. The key for allocation will be when to shift in the second half into higher-beta China-related plays, such as Europe and Emerging Markets. For now, we remain overweight the lower-beta U.S. equity market, neutral on credit, and underweight government bonds. To hedge against the positive impact of China stimulus, we raise Australia to neutral, and re-emphasize our overweights on the Industrials and Energy sectors. Feature Overview Precautionary Dovishness – Or Looming Recession? Recommendations Central banks everywhere have taken a decidedly dovish turn in recent weeks. June’s FOMC statement confirmed that “uncertainties about the outlook have increased….[We] will act as appropriate to sustain the expansion,” hinting broadly at a rate cut in July. The Bank of Japan’s Kuroda said he would “take additional easing action without hesitation,” and hinted at a Modern Monetary Theory-style combination of fiscal and monetary policy. European Central Bank President Draghi mentioned the possibility of restarting asset purchases. There are two possible explanations. Either the global economy is heading into recession, and central banks are preparing for a full-blown easing cycle. Or these are “insurance” cuts aimed at prolonging the expansion, as happened in 1995 and 1998, or similar to when the Fed went on hold for 12 months in 2016 (Chart 1). Our view is that it is most likely the latter. The reason for this is that the main drivers of the global economy, U.S. consumption ($14 trillion) and the Chinese economy ($13 trillion) are likely to be strong over the next 12 months. U.S. wage growth continues to accelerate, consumer sentiment is close to a 50-year high, and the savings rate is elevated (Chart 2); as a result core U.S. retail sales have begun to pick up momentum in recent months (Chart 3). Unless something exogenous severely damages consumer optimism, it is hard to see how the U.S. can go into recession in the near future, considering that consumption is 70% of GDP. Moreover, despite weaknesses in the manufacturing sector – infected by the China-led slowdown in the rest of the world – U.S. service sector growth and the labor market remain solid. This resembles 1998 and 2016, but is different from the pre-recessionary environments of 2000 and 2007 (Chart 4). There is also no sign on the horizon of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation (Chart 5). Chart 1Insurance Cuts, Or Full Easing Cycle? Chart 2Consumption Fundamentals Are Strong... Chart 3...Leading To Rebound In Retail Sales Chart 4Manufacturing Weak, But Services Holding Up Chart 5No Signs Of Usual Recession Triggers China’s efforts to reflate via credit creation have been somewhat half-hearted since the start of the year. Investment by state-owned companies has picked up, but the private sector has been spooked by the risk of a trade war and has slowed capex (Chart 6). China may have hesitated from full-blown stimulus because the authorities in April were confident of a successful outcome to trade talks with the U.S., and a bit concerned that the liquidity was going into speculation rather than the real economy. But we see little reason why they will not open the taps fully if growth remains sluggish and trade tensions heighten.1 Chinese credit creation clearly has a major impact on many components of global growth – in particular European exports, Emerging Markets earnings, and commodity prices – but the impact often takes 6-12 months to come through (Chart 7). A key question is when investors should position for this to happen. We think this decision is a little premature now, but will be a key call for the second half of the year. Chart 6China's Half-Hearted Reflation Chart 7China Credit Growth Affects The World Chart 8Fed Won't Cut As Much As Market Wants... The Fed has so clearly signaled rate cuts that we see it cutting by perhaps 50 basis points over the next few months (maybe all in one go in July if it wants to “shock and awe” the market). But the futures market is pricing in four 25 bps cuts by April next year. With GDP growth likely to be around 2.5% this year, unemployment at a 50-year low, trend inflation above 2%,2 and the stock market at an historical high, we find this improbable. Two cuts would be similar to what happened in 1995, 1998 and (to a degree) 2016 (Chart 8). In this environment, we think it likely that equities will outperform bonds over the next 12 months. When the Fed cuts by less than the market is expecting, long-term rates tend to rise (Chart 9). BCA’s U.S. bond strategists have shown that after mid-cycle rate cuts, yields typically rise: by 59 bps in 1995-6, 58 bps in 1998, and 19 bps in 2002.3 A combination of rising inflation, stronger growth ex-U.S., a less dovish Fed that the market expects, and a rising oil price (which will push up inflation expectations) makes it unlikely – absent an outright recession – that global risk-free yields will fall much below current levels. Moreover, June’s BOA Merrill Lynch survey cited long government bonds as the most crowded trade at the moment, and surveys of investor positioning suggest duration among active investors is as long as at any time since the Global Financial Crisis (Chart 10). Chart 9...So Bond Yields Are Likely To Rise Chart 10Investors Betting On Further Rate Decline The outlook for U.S. equities is not that exciting. Valuations are not cheap (with forward PE of 16.5x), but earnings should be revised up from the currently very cautious level: the bottom-up consensus forecasts S&P 500 EPS growth at only 3% in 2019 (and -3% YoY in Q2). We have sympathy for the view that there are three put options that will prop up stock prices in the event of external shocks: the Fed put, the Xi put, and the Trump put. Relating to the last of these, it is notable that President Trump tends to turn more aggressive in trade talks with China whenever the U.S. stock market is strong, but more conciliatory when it falls (Chart 11). For now, therefore, we remain overweight U.S. equities, as a lower beta way to play an environment that continues to be positive – but uncertain – for stocks. But we continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Chart 11Trump Turns Softer When Market Falls Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com What Our Clients Are Asking Chart 12Temporary Forces Drove Inflation Downturn Why Is Inflation So Low? After reaching 2% in July 2018, U.S. core PCE currently stands at 1.6%, close to 18 month lows. This plunge in inflation, along with increased worries about the trade war and continued economic weakness, has led the market to believe that the Fed Funds Rate is currently above the neutral rate, and that several rate cuts are warranted in order to move policy away from restrictive territory. We believe that the recent bout of low inflation is temporary. The main contributor to the fall in core PCE has been financial services prices, which shaved off up to 40 basis points from core PCE (Chart 12, panel 1). However, assets under management are a big determinant of financial services prices, making this measure very sensitive to the stock market (panel 2). Therefore, we expect this component of core PCE to stabilize as equity prices continue to rise. The effect of higher equity prices, and the stabilization of other goods that were affected by the slowdown of global growth in late 2018 and early 2019, may already have started to push inflation higher. Month-on-month core PCE grew at an annualized rate of 3% in April, the highest pace since the end of 2017. Meanwhile, trimmed mean PCE, a measure that has historically been a more stable and reliable gauge of inflationary pressures, is at a near seven-year high (panel 3). The above implies that the market might be overestimating how much the Fed is going to ease. We believe that the Fed will likely cut once this year to soothe the pain caused by the trade war on financial markets. However, with unemployment at 50-year lows, and inflation set to rise again, the Fed is unlikely to deliver the 92 basis points of cuts currently priced by the OIS curve for the next 12 months. This implies that investors should continue to underweight bonds. Chart 13Turning On The Taps Will China Really Ramp Up Its Stimulus? The direction of markets over the next 12 months (a bottoming of euro area and Emerging Markets growth, commodity prices, the direction of the USD) are highly dependent on whether China further increases monetary stimulus in the event of a breakdown in trade negotiations with the U.S. But we hear much skepticism from clients: aren’t the Chinese authorities, rather, focused on reducing debt and clamping down on shadow banking? Aren’t they worried that liquidity will simply flow into speculation and have little impact on the real economy? Now the government has someone to blame for a slowdown (President Trump), won’t they use that as an excuse – and, to that end, are preparing the population for a period of pain by quoting as analogies the Long March in the 1930s and the Korea War (when China ground down U.S. willingness to prolong the conflict)? We think it unlikely that the Chinese government would be prepared to allow growth to slump. Every time in the past 10 years that growth has slowed (with, for example, the manufacturing PMI falling significantly below 50) they have always accelerated credit growth – on the basis of the worst-case scenario (Chart 13, panel 1). Why would they react differently this time, particularly since 2019 is a politically sensitive year, with the 70th anniversary of the founding of the People’s Republic in October and several other important anniversaries? Moreover, the government is slipping behind in its target to double per capita income in the 10 years to end-2020 (panel 2). GDP growth needs to be 6.5-7% over the next 18 months to achieve the target. The government’s biggest worry is employment, where prospects are slipping rapidly (panel 3). This also makes it difficult for the authorities to retaliate against U.S. companies that have large operations, such as Apple or General Motors, since such measures would hurt their Chinese employees. Besides a significant revaluation of the RMB (which we think likely), China has few cards to play in the event of a full-blown trade war other than fully turning on the liquidity tap again. Aren’t There Signs Of Bubbliness In Equity Markets? Clients have asked whether the current market environment has been showing any classic signs of euphoria. These usually appear with lots of initial public offerings (IPO), irrational M&A activity, and excess investor optimism. The IPO market has some similarities to the years leading up to the dot-com bubble, but it is important to look below the surface. The percentage of IPOs with negative earnings in 2018 was similar to the previous peak in 1999. However, the average first-day return of IPOs in 2019, while still above the historical average, has been much lower than that during the dot-com bubble period (Chart 14, panel 1). There is also a difference in the composition of firms going public. There are now many IPOs for biotech firms that have heavily invested in R&D, and so have relatively low sales currently but await a breakthrough in their products; by their nature, these are loss-making (panel 2). Cross-sector, unrelated M&A activity has also often been a sign of bubble peaks. It is a consequence of firms stretching to find inorganic growth late in the cycle. Such deals are characterized by high deal premiums, and are usually conducted through stock purchases rather than in cash. The current average deal premium is below its historical average (panel 3). Additionally, 2018 and 2019-to-date M&A deals conducted using cash represented 60% and 90% of the total respectively, compared to only 17% between 1996 and 2000. Investor sentiment is also moderately pessimistic despite the rally in the S&P 500 since the beginning of the year (panel 4). This caution suggests that investors are fearful of the risk of recession rather than overly positive about market prospects, despite the U.S. market being at an historical high. Given the above, we do not see any signals of the sort of euphoria and bubbliness that typically accompanies stock market tops. Will Japan Benefit From Chinese Reflation? Japan has been one of the worst-performing developed equity markets since March 2009, when global equities hit their post-crisis bottom in both USD (Chart 15) and local currency terms. Now with increasing market confidence in China’s reflationary policies, clients are asking if Japan is a good China play given its close ties with the Chinese economy. Our answer is No. Chart 16Downgrade Japan To Underweight It’s true that Japanese equities did respond to past Chinese reflationary efforts, but the outperformances were muted and short-lived (Chart 16, panel 1). Even though Japanese exports to China will benefit from Chinese reflationary policy (panel 5), MSCI Japan index earnings growth does not have strong correlation with Japanese exports to China, as shown in panel 4. This is not surprising given that exports to China account for only about 3% of nominal GDP in Japan (compared to almost 6% for Australia, for example). The MSCI Japan index is dominated by Industrials (21%) and Consumer Discretionary (18%). Financials, Info Tech, Communication Services and Healthcare each accounts for about 8-10%. Other than the Communication Services sector, all other major sectors in Japan have underperformed their global peers since the Global Financial Crisis (panels 2 and 3). The key culprit for such poor performance is Japan’s structural deflationary environment. Wage growth has been poor despite a tight labor market. This October’s consumption tax increase will put further downward pressure on domestic consumers. There is no sign of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation. As such, we are downgrading Japan to a slight underweight in order to close our underweight in Australia (see page 16). This also aligns our recommendation with the output from our DM Country Allocation Quant Model, which has structurally underweighted Japan since its inception in January 2016. Global Economy Chart 17Is Consumption Enough To Prop Up U.S. Growth? Overview: The tight monetary policy of last year (with the Fed raising rates and China slowing credit growth) has caused a slowdown in the global manufacturing sector, which is now threatening to damage worldwide consumption and the relatively closed U.S. economy too. The key to a rebound will be whether China ramps up the monetary stimulus it began in January but which has so far been rather half-hearted. Meanwhile, central banks everywhere are moving to cut rates as an “insurance” against further slowdown. U.S.: Growth data has been mixed in recent months. The manufacturing sector has been affected by the slowdown in EM and Europe, with the manufacturing ISM falling to 52.1 in May and threatening to dip below 50 (Chart 17, panel 2). However, consumption remains resilient, with no signs of stress in the labor market, average hourly earnings growing at 3.1% year-on-year, and consumer confidence at a high level. As a result, retail sales surprised to the upside in May, growing 3.2% YoY. The trade war may be having some negative impact on business sentiment, however, with capex intentions and durable goods orders weakening in recent months. Euro Area: Current conditions in manufacturing continue to look dire. The manufacturing PMI is below 50 and continues to decline (Chart 18, panel 1). In export-focused markets like Germany, the situation looks even worse: Germany’s manufacturing PMI is at 45.4, and expectations as measured by the ZEW survey have deteriorated again recently. Solid wage growth and some positive fiscal thrust (in Italy, France, and even Germany) have kept consumption stable, but the recent tick-up in German unemployment raises the question of how sustainable this is. Recovery will be dependent on Chinese stimulus triggering a rebound in global trade. Chart 18Few Signs Of Recovery In Global Ex-U.S. Growth Japan: The slowdown in China continues to depress industrial production and leading indicators (panel 2). But maybe the first “green shoots” are appearing thanks to China’s stimulus: in April, manufacturing orders rose by 16.3% month-on-month, compared to -11.4% in March. Nonetheless, consumption looks vulnerable, with wage growth negative YoY each month so far this year, and the consumption tax rise in October likely to hit consumption further. The Bank of Japan’s six-year campaign of maximum monetary easing is having little effect, with core core inflation stuck at 0.5% YoY, despite a small pickup in recent months – no doubt because the easy monetary policy has been offset by a steady tightening of fiscal policy. Emerging Markets: China’s growth has slipped since the pickup in February and March caused by a sharp increase in credit creation. Seemingly, the authorities became more confident about a trade agreement with the U.S., and worried about how much of the extra credit was going into speculation, rather than the real economy. The manufacturing PMI, having jumped to almost 51 in March, has slipped back to 50.2. A breakdown of trade talks would undoubtedly force the government to inject more liquidity. Elsewhere in EM, growth has generally been weak, because of the softness in Chinese demand. In Q1, GDP growth was -3.2% QoQ annualized in South Africa, -1.7% in Korea, and -0.8% in both Brazil and Mexico. Only less China-sensitive markets such as Russia (3.3%) and India (6.5%) held up. Interest rates: U.S. inflation has softened on the surface, with the core PCE measure slipping to 1.6% in April. However, some of the softness was driven by transitory factors, notably the decline in financial advisor fees (which tend to move in line with the stock market) which deducted 0.5 points from core PCE inflation. A less volatile measure, the trimmed mean PCE deflator, however, continues to trend up and is above the Fed’s 2% target. Partly because of the weaker historical inflation data, inflation expectations have also fallen (panel 4). As a result, central banks everywhere have become more dovish, with the Australian and New Zealand reserve banks cutting rates and the Fed and ECB raising the possibility they may ease too. The consequence has been a big fall in 10-year government bonds yields: in the U.S. to only 2% from 3.1% as recently as last September. Global Equities Chart 19Worrisome Earnings Prospects Remain Cautiously Optimistic, Adding Another China Hedge: Global equities managed to eke out a small gain of 3.3% in Q2 despite a sharp loss of 5.9% in May. Within equities, our defensive country allocation worked well as DM equities outperformed EM by 2.9% in Q2. Our cyclical tilt in global sector positioning, however, did not pan out, largely due to the 2% underperformance in global Energy as the oil price dropped by 2% in Q2. Going forward, BCA’s House View remains that global economic growth will pick up sometime in the second half thanks to accommodative monetary policies globally and the increasing likelihood of a large stimulus from China to counter the negative effect from trade tensions. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. The “optimistic” side of our allocation is reflected in two aspects: 1) overweight equities vs. bonds at the asset class level; and 2) overweight cyclicals vs. defensives at the global sector level. However, corporate profit margins are rolling over and earnings growth revisions have been negative (Chart 19). Therefore, the “cautious” side of our allocation remains a defensive country allocation, reflected by overweighting DM vs. EM. Our macro view hinges largely on what happens to China. There is an increasing likelihood that China may be on a reflationary path to stimulate economic growth. We upgraded global Industrials in March to hedge against China’s re-acceleration. Now we upgrade Australia to neutral from a long-term underweight, by downgrading Japan to a slight underweight from neutral, because Australia will benefit more from China’s reflationary policies (see next page). Chart 20Australian Equities: Close The Underweight Upgrade Australian Equities To Neutral The relative performance of MSCI Australian equities to global equities has been closely correlated with the CRB metal price most of the time. Since the end of 2015, however, the CRB metals index has increased by more than 40%, yet Australian equities did not outperform (Chart 20, panel 1). Why? The MSCI Australian index is concentrated in Financials (mostly banks) and Materials (mostly mining), as shown in panel 2. Aussie Materials have outperformed their global peers, but the banks have not (panel 3). The banks are a major source of financing for the mining companies (hence the positive correlation with metal prices). They are also the source of financing for the Aussie housing markets, which have weighed down on the banks’ performance over the past few years due to concerns about stretched valuations. We have been structurally underweight Australian equities because of our unfavorable view on industrial commodities, and also our concerns on the Australian housing market and the problems of the banks. This has served us well, as Australian equities have done poorly relative to the global aggregate since late 2012. Now interest rates in Australia have come down significantly. Lower mortgage rates should help stabilize house prices, which suffered in Q1 their worst year-on-year decline, 7.7%, in over three decades. Australian equity earnings growth is still slowing relative to the global earnings, but the speed of slowing down has decreased significantly. With 6% of GDP coming from exports to China, Aussie profit growth should benefit from reflationary policies from China (panel 4). Relative valuation, however, is not cheap (panel 5). All considered, we are closing our underweight in Australian equities as another hedge against a Chinese-led re-acceleration in economic growth. This is financed by downgrading Japan to a slight underweight (for more on Japan, see What Our Clients Are Asking, on page 11). Government Bonds Chart 21Limited Downside In Yields Maintain Slight Underweight On Duration: After the Fed signaled at its June meeting that rates cuts were likely on the way, the U.S. 10-year Treasury yield dropped to 1.97% overnight on June 20, the lowest since November 2016. Overall, the 10-year yield dropped by 40 bps in Q2 to end the quarter at 2%. BCA’s Fed Monitor is now indicating that easier monetary policy is required. But that is already more than discounted in the 92 bps of rate cuts over the next 12 months priced in at the front end of the yield curve, and by the current low level of Treasury yields. (Chart 21). We see the likelihood of one or two “insurance” cuts by the Fed, but the current environment (with a record-high stock market, tight corporate spreads, 50-year low unemployment rate, and 2019 GDP on track to reach 2.5%) is not compatible with a full-out cutting campaign. In addition, the latest Merrill Lynch survey indicated that long duration is the most crowded global trade. Given BCA’s House View that the U.S. economy is not heading into a recession but rather experiencing a manufacturing slowdown mainly due to external shocks, the path of least resistance for Treasury yields is higher rather than lower. Investors should maintain a slight underweight on duration over the next 9-12 months. Chart 22Favor Linkers Over Nominal Bonds Favor Linkers Vs. Nominal Bonds: Global inflation expectations have dropped anew in the second quarter, with the 10-year CPI swap rate now sitting at 1.55%, 41 bps lower than its 2018 high of 1.96%. However, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. BCA’s Commodity & Energy Strategy service revised down its 2019 Brent crude forecast to an average of US$73 per barrel from US$75, but this implies an average of US$79 in H2. (Chart 22). This would cause a significant rise in inflation expectations in the second half, supporting our preference for inflation-linked over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds. Corporate Bonds Chart 23Profit Growth Should Still Outpace Debt Growth We turned cyclically overweight on credit within a fixed-income portfolio in February. Since then, corporate bonds have produced 120 basis points of excess return over duration-matched Treasuries. We believe this bullish stance on credit will continue to pay dividends. The global leading economic indicators have started to stabilize while multiple credit impulses have started to perk up all over the world. Historically, improving global growth has been positive for corporate bonds (Chart 23, panel 1). A valid concern is the deceleration in profit growth in the U.S., as the yearly growth of pre-tax profits has fallen from 15% in 2018 Q4 to 7% in the first quarter of this year. In general, corporate bonds suffer when profit growth lags debt growth, as defaults tends to rise in this environment. Is this scenario likely over the coming year? We do not believe so. While weak global growth at the end of 2018 and beginning of 2019 is likely to weigh on revenues, the current contraction in unit labor costs should bolster profit margins and keep profit growth robust (panel 2). Additionally, the Fed’s Senior Loan Officer Survey shows that C&I loan demand has decreased significantly this year, suggesting that the pace of U.S. corporate debt growth is set to slow (panel 3). How long will we remain overweight? We expect that the Federal Reserve will do little to no tightening over the next 12 months. This will open a window for credit to outperform Treasuries in a fixed-income portfolio. We have also reduced our double underweight in EM debt, since an acceleration of Chinese monetary stimulus would be positive for this asset class. Commodities Chart 24Watch Oil And Be Wary Of Gold Energy (Overweight): Supply/demand fundamentals continue to be the main driver of crude oil prices. However, it seems as though the market is discounting something else. President Trump’s tweets, OPEC+ coalition statements, and concerns about future demand growth are contributing to price swings (Chart 24, panel 1). According to the Oxford Institute for Energy Studies, weak demand has reduced oil prices by $2/barrel this year. That should be offset, however, by a much larger contribution from supply cuts, speculative demand, and a deteriorating geopolitical environment. We see crude prices tilted to the upside, as OPEC’s ability to offset any supply disruptions (besides Iran and Venezuela) is limited (panel 2). We expect Brent to average $73 in 2019 and $75 in 2020. Industrial Metals (Neutral): A stronger USD accompanied by weakening global growth since 2018 has put downward pressure on industrial metal prices, which are down about 20% since January 2018. However, we now have renewed belief that the Chinese authorities will counter with a reflationary response though credit and fiscal stimulus. That should push industrial metal prices higher over the coming 12 months (panel 3). Precious Metals (Neutral): Allocators to gold are benefiting from the current environment of rising geopolitical risk, dovish central banks, a weaker USD, and the market’s flight to safety. Escalated trade tensions, falling global yields, and lower growth prospects are some of the factors that have supported the bullion’s 18% return since its September 2018 low. Until evidence of a bottom in global growth emerges, we expect the copper-to-gold ratio – another barometer for global growth – to continue falling (panel 4). The months ahead could see a correction, as investors take profits with gold in overbought territory. Nevertheless, we continue to recommend gold as both an inflation hedge as well as against any uncertain escalated political tensions. Currencies Chart 25Stronger Global Growth Will Weigh On The Dollar U.S. dollar: The trade-weighted dollar has been flat since we lowered our recommendation from positive to neutral in April. We expect that the Fed will cut rates at least once this year, easing financial conditions, and boosting economic activity. This will eventually prove negative for the dollar. However as long as the global economy is weak the greenback should hold up. Stay neutral for now. Euro: Since we turned bullish on the euro in April, EUR/USD has appreciated by 1.5%. Overall, we continue to be bullish on EUR/USD on a cyclical timeframe. Forward rate expectations continue to be near 2014 lows, suggesting that there is little room for U.S. monetary policy to tighten further vis-à-vis euro area monetary policy, creating a floor under the euro (Chart 25, panel 1). EM Currencies: We continue to be negative on emerging market currencies. However, some indicators suggest that Chinese weakness, the main engine behind the EM currency bear market might be reaching its end. Chinese marginal propensity to spend (proxied by M1 growth relative to M2 growth), has bottomed and seems to have stabilized (panel 2). The bond market has taken note of this development, as Chinese yields are now rising relative to U.S. ones (panel 3). Historically, both of these developments have resulted in a rally for emerging market currencies. Thus, while we expect the bear market to continue for the time being, the pace of decline is likely to ease, making EM currencies an attractive buy by the end of the year. Accordingly, we are reducing our underweight in EM currencies from double underweight to a smaller underweight position. Alternatives Return Enhancers: Hedge funds historically display a negative correlation with global growth momentum. Despite growth slowing over the past year, hedge funds underperformed the overall GAA Alternatives Index as well as private equity. Hedge funds usually outperform other risky alternatives during recessions or periods of high credit market stress. Credit spreads have been slow to rise in response to the slowing economy and worsening political environment. A pickup in spreads should support hedge fund outperformance (Chart 26, panel 2). Inflation Hedges: As we approach the end of the cycle, we continue to recommend investors reduce their real estate exposure and increase allocations towards commodity futures. Our May 2019 Special Report4 analyzed how different asset classes perform in periods of rising inflation. Our expectation is that inflation will pick up by the end of the year. An allocation to commodity futures, particularly energy, historically achieved excess returns of nearly 40% during periods of mild inflation (panel 3). Volatility Dampeners: Realized volatility in the catastrophe bond market is generally low. In fact, absent any catastrophe losses, catastrophe bonds provide stable returns, with volatility that is comparable to global bonds (panel 4). In a December 2017 Special Report,5 we tested for how the inclusion of catastrophe bonds in a traditional 60/40 equity-bond portfolio would have impacted portfolio risk-return characteristics. Replacing global equities with catastrophe bonds reduced annualized volatility by more than 1.5%. Risks To Our View Chart 27What Risk Of Recession? Our main scenario is sanguine on global growth, which means we argue that bond yields will not fall much below current levels. The risks to this view are mostly to the downside. There could be a full-blown recession. Most likely this would be caused either by China failing to do stimulus, or by U.S. rates being more restrictive than the Fed believes. Both of these explanations seem implausible. As we argue elsewhere, we think it unlikely that China would simply allow growth to slow without reacting with monetary and fiscal stimulus. If current Fed policy is too tight for the economy to withstand, it would imply that the neutral rate of interest is zero or below, something that seems improbable given how strong U.S. growth has been despite rising rates. Formal models of recession do not indicate an elevated risk currently (Chart 27). We continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Even if growth is as strong as we forecast, is there a possibility that bond yields fall further. This could come about – for a while, at least – if the Fed is aggressively dovish, oil prices fall (perhaps because of a positive supply shock), inflation softens further, and global growth remains sluggish. Absent a recession, we find those outcomes unlikely. The copper-to-gold ratio has been a good indicator of U.S. bond yields (Chart 28). It suggests that, at 2%, the 10-year Treasury yield has slightly overshot. In fact, in June copper prices started to rebound, as the market began to price in growing Chinese demand. Chart 28Can Bond Yields Fall Any Further? Chart 29Are Analysts Right To Be So Gloomy? For U.S. equities to rise much further, multiple expansion will not be enough; the earnings outlook needs to improve. Analysts are still cautious with their bottom-up forecasts, expecting only 3% EPS growth for the S&P500 this year (Chart 29). This seems easy to beat. But a combination of further dollar strength, worsening trade war, further slowdown in Europe and Emerging Markets, and higher U.S. wages would put it at risk. Footnotes 1 Please see What Our Clients Are Asking on page 9 of this Quarterly for further discussion on why we are confident China will ramp up stimulus if necessary. 2 Trimmed Mean PCE inflation, a better indicator of underlying inflation than the Core PCE deflator, is above 2%. Please see What Our Clients Are Asking on page 8 of this Quarterly for details. 3 Please see U.S. Bond Strategy Weekly Report, “Track Records,” dated June 18, available at usb.bcaresearch.com. 4 Please see Global Asset Allocation Special Report “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report “A Primer On Catastrophe Bonds,” dated December 12, 2017 available at gaa.bcaresearch.com GAA Asset Allocation
The upshot is that while the Fed’s dovish pivot will take some time to translate into stronger global growth and higher Treasury yields (see previous Insight), it will provide an immediate boost to excess corporate bond returns. Our U.S. Bond Strategy…
Highlights Fed: The Fed will cut rates in July, and possibly once more this year. This extra stimulus will help boost global growth in the second half of 2019. Credit: With inflation expectations low, the Fed will not risk upsetting financial markets by striking a hawkish tone. This will be a boon for corporate bonds. We no longer advocate a cautious near-term allocation to corporate credit. Spreads have likely peaked. Duration: The economic environment bears a greater resemblance to prior mid-cycle slowdowns than to prior pre-recession periods. As such, the Fed will not deliver more than the 89 basis points of rate cuts that are already discounted for the next 12 months. Maintain below-benchmark portfolio duration. Feature More Houdini Than Bullwinkle When Fed Chair Jay Powell reached into his hat at last week’s FOMC meeting, most – including us – thought he might emerge looking like Bullwinkle the cartoon moose.1 Instead, he pulled a rabbit, delivering a dovish surprise to markets that already expected a lot. The yield curve was discounting 80 basis points of rate cuts over the next 12 months heading into last Wednesday’s announcement. Then, the Fed’s statement and Powell’s press conference pushed our 12-month discounter all the way down to -94 bps (Chart 1). The 10-year Treasury yield also dropped 8 bps post-FOMC, while the 2-year yield fell a whopping 14 bps. The Fed will go to great lengths to signal that monetary conditions remain accommodative. The Fed communicated its dovish pivot through both the post-meeting statement and its interest rate projections. In the post-meeting statement, the Fed replaced its pledge to be “patient” with a promise to “act as appropriate to sustain the expansion”. A re-phrasing that is clearly designed to signal a rate cut in July. FOMC participants also revised their interest rate projections sharply lower (Chart 2). In March, 11 out of 17 participants expected the Fed to stay on hold for the balance of 2019, while 4 participants called for one rate hike and 2 called for two rate hikes. Now, 8 out of 17 participants continue to expect a steady fed funds rate, but 7 are calling for two rate cuts this year. Only one participant is still looking for a 2019 hike. Chart 1A Dovish Magic Show Chart 2Dots Revised Lower In his press conference, Chair Powell explicitly linked the Fed’s dovish pivot to “trade developments” and “concerns about global growth”. Bond investors will undoubtedly heed this message, and Treasury yields will be extra sensitive to any trade-related news that comes out of this weekend’s G20 summit, as well as to any fluctuations in the global growth data (see section titled “No PMI Recovery Yet” below). Ultimately, our baseline expectation is that there will be enough progress in trade negotiations at the G20 summit to keep the U.S. from imposing a further $300 billion in tariffs on Chinese imports. However, an all-encompassing deal, which rolls back existing tariffs, is not in the cards. Table 1Fed Funds Futures: What's Priced In? But even such a muddle-though scenario, when combined with a Fed rate cut in July and continued credit easing out of China, will be sufficient to support global growth in the second half of this year. This will prevent the Fed from delivering the 79 bps of rate cuts that are priced-in for between now and next February (Table 1). We remain short the February 2020 fed funds futures contract. And Now Here’s Something We Hope You’ll Really Like Our main takeaway from the FOMC meeting is that the Fed will go to great lengths to signal that monetary conditions remain accommodative. We posited back in March that the new battleground for monetary policy is between inflation expectations and financial conditions.2 That is, the Fed will only move to a restrictive policy stance in response to above-target inflation expectations or “bubbly” financial asset prices. While the Fed’s reflationary efforts will cause corporate bond spreads to tighten in the coming months, they will not immediately translate into a higher 10-year Treasury yield. At present, long-maturity TIPS breakeven inflation rates remain well below target levels and financial markets are far from “bubbly” (Chart 3): The Financial Conditions component of our Fed Monitor is close to neutral (Chart 3, panel 2). The S&P 500 12-month forward P/E ratio has rebounded this year, but is not close to the highs seen in late-2017/early-2018 (Chart 3, panel 3). The GZ measure of the excess premium in corporate bond spreads after accounting for expected default losses is low, but above where it traded throughout most of the 2000s (Chart 3, bottom panel). The upshot is that the Fed will continue to act as a tailwind for risk assets, and we therefore remove our prior recommendation to stay cautious on credit spreads in the near-term. It is now likely that credit spreads have peaked, a message confirmed by our list of “peak credit spread” indicators (Chart 4): Chart 3No Rush For Fed To Tighten Chart 4Credit Spreads Have Likely Peaked The price of gold has decisively broken-out to the upside, a sign that the market views monetary policy as reflationary (Chart 4, panel 2). Such a breakout has preceded the last two peaks in corporate bond spreads. The dollar’s uptrend has abated, signaling that the market views U.S. monetary policy as less out of step with the rest of the world (Chart 4, panel 3). Global industrial mining stocks have rebounded (Chart 4, panel 4). The CRB Raw Industrials index is the sole holdout (Chart 4, bottom panel). A rebound in this index would confirm our intuition that credit spreads have peaked. Chart 5Waiting For Improving Global Growth While the Fed’s reflationary efforts will cause corporate bond spreads to tighten in the coming months, they will not immediately translate into a higher 10-year Treasury yield. The ratio between the CRB Raw Industrials index and Gold correlates very tightly with the 10-year yield, and it continues to plummet (Chart 5). The CRB/Gold ratio will only rise when gains in the CRB index start to outpace gains in Gold. In other words, the Fed’s reflationary policy stance needs to translate into an improving global growth outlook. This could take a few months, though we ultimately continue to think that Treasury yields will be higher on a 6-12 month horizon. As explained in the next section, as long as the U.S. economy avoids recession, mid-cycle rate cuts tend to be followed by higher Treasury yields. A History Of Rate Cuts Part 2 In last week’s report we looked at every Fed rate cut since 1995 and showed how the 10-year Treasury yield reacted during the subsequent 21-day, 65-day, 130-day and 261-day periods.3 Our main conclusion was that the 10-year Treasury yield tended to rise following mid-cycle rate cuts, such as those that occurred in 1995-98 and 2003, and decline following rate cuts that led into a U.S. recession. For reference, we have attached last week’s analysis as an Appendix to this report, along with a new table showing how the Bloomberg Barclays Treasury Master index performed relative to cash following each post-1995 rate cut. The 2/10 Treasury slope tends to steepen quite sharply in the immediate aftermath of a mid-cycle rate cut, before starting to flatten after a few months have passed. This week, we delve a little deeper and look at the market’s interest rate expectations around each prior cut, and also at how the 2/10 Treasury slope responded in each case. Rate Expectations At The Time Of Fed Rate Cuts Table 2 shows the 12-month change in the fed funds rate that the market was discounting prior to each Fed rate cut announcement since 1995. It also shows the actual change in the fed funds rate that occurred over the subsequent 12-month period, and the difference between what occurred and what was expected – the 12-month fed funds surprise. Table 2A History Of Rate Cuts: Rate Expectations According to our Golden Rule of Bond Investing, a dovish surprise (actual change < expectations) should coincide with a falling 10-year Treasury yield, and a hawkish surprise (actual change > expectations) should coincide with a rising 10-year yield.4 The table shows that this indeed occurred in 26 out of 29 episodes. As was the case last week, the mid-1990s rate cuts immediately capture our attention. We have previously noted the resemblance between today’s economic environment and that of the mid-1990s.5 It’s interesting that the market is currently priced for a similar number of rate cuts as at that time. Once again, we expect those expectations will be disappointed. The Global Manufacturing PMI is the measure of global growth that lines up best with the 10-year Treasury yield. Yield Curve: Steeper Now = Flatter Later Another interesting trend is that the 2/10 Treasury slope steepened dramatically in the run-up to, and following, last week’s FOMC meeting. It is now back up to 29 bps after having troughed at 11 bps near the end of last year (Chart 6). It is also worth noting that the 2/10 Treasury slope has yet to invert this cycle. Such an inversion has occurred prior to every U.S. recession since at least 1960. Table 3 shows how the 2/10 Treasury slope has responded to Fed rate cuts in the past, and it reveals an interesting pattern. The slope tends to steepen quite sharply in the immediate aftermath of a mid-cycle rate cut, before starting to flatten after a few months have passed. The 2003 episode is a prime example. The 2/10 slope steepened by 62 bps in the month following the rate cut, but a year later it was 14 bps below where it started. Chart 6The Fed Steepens The Curve Table 3A History Of Rate Cuts: 2/10 Treasury Slope In contrast, the 2/10 steepening that immediately follows a “pre-recession” rate cut tends to be milder, but the steepening then accelerates as time passes and the Fed eases further. The observed yield curve patterns line up well with theory. We would expect rapid curve steepening immediately following a mid-cycle rate cut, as the market prices in a quick return to tighter policy settings. Then, the curve should eventually flatten as the Fed reverses its initial cuts. In contrast, a rate cut that precedes a recession should not lead to much initial steepening, because the market would not be expecting a quick recovery. The steepening would then accelerate as more rate cuts are eventually delivered. The fact that the 2/10 slope has steepened a lot in recent weeks is another datapoint in favor of “mid-cycle” rather than “pre-recession” market behavior. No PMI Recovery Yet We remain confident that the combination of a July Fed rate cut and Chinese credit stimulus will put a floor under global growth in the second half of the year. However, no such global growth rebound is yet evident in the crucial manufacturing PMI data. The Global Manufacturing PMI is the measure of global growth that lines up best with the 10-year Treasury yield, and it remains in a free-fall, even breaking below the 50 boom/bust line in May (Chart 7). Flash PMI data paint an equally dim picture for June: The Euro Area Manufacturing PMI is expected to tick up in June, but only to 47.8 from 47.7 in May (Chart 7, panel 2). The U.S. Manufacturing PMI is expected to fall to 50.1 in June, from 50.5 in May (Chart 7, panel 3). The Japanese Manufacturing PMI is expected to fall to 49.5 in June, from 49.8 in May (Chart 7, bottom panel). There is no Flash PMI data for China, but the Chinese index stood at 50.2 in May, only a hair above the 50 boom/bust line. On the bright side, financial markets are starting to price-in the beginnings of a reflation trade. Gold is rallying strongly, as we noted above, and an index of high-beta currency pairs (RUB/USD, ZAR/USD and BRL/USD) is off its lows. Both of these moves signal that the policy backdrop is becoming more supportive, and both have led upswings in the Global Manufacturing PMI in the past (Chart 8). Chart 7No Rebound In Sight Yet... Chart 8...But Financial Markets Are Already Looking Ahead Bottom Line: Treasury yields will probably need to see a rebound in the Global Manufacturing PMI before moving higher, but a few reflationary indicators suggest that such a rebound will occur in the second half of the year. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Appendix Table 4A History Of Rate Cuts: 10-Year Treasury Yield Table 5A History Of Rate Cuts: Treasury Excess Returns Footnotes 1 https://www.youtube.com/watch?v=kx3sOqW5zj4 2 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Track Records”, dated June 18, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Tracking The Mid-1990s”, dated June 11, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights June FOMC Meeting: To appease markets, the Fed will at least have to signal that it stands ready to cut rates in July. While this is possible, there is a significant risk that the committee fails to deliver. We continue to advocate a cautious approach to corporate credit spreads in the near-term (0-3 months). Rate Cuts: The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. With a U.S. recession still far off, we see a good chance that Treasury yields will rise during the next 6-12 months, even if the Fed lowers rates in June or July. Treasury Yields: Yields have fallen a lot since the beginning of November, but the move isn't terribly anomalous relative to history. We use statistics to place recent price action in its appropriate historical context. Feature The Fed This Week Chart 1Credit Spreads At Risk Tomorrow’s FOMC meeting is the main event in financial markets this week, with investors of all stripes eager to learn whether the Fed will deliver on the rate cut expectations that have already been priced into bond yields. As we’ve written in prior reports, our immediate concern is that the Fed may not sound dovish enough to appease markets, leading to further near-term widening in corporate bond spreads.1 Corporate bond excess returns have far outpaced commodity prices of late (Chart 1), leaving the sector vulnerable to any hawkish surprise. What’s Priced In, And Can The Fed Deliver? How dovish must the Fed be to prevent a sell-off in corporate credit? A look at current fed funds futures pricing shows that the market is looking for nearly three 25 basis point rate cuts spread over the next six FOMC meetings (Table 1). Roughly, the market expects one rate cut at either the June or July meeting, a second rate cut in either September or October, and a third rate cut in either December or January. To appease markets, the Fed will at least have to revise its 2019 funds rate projections down and signal that it stands ready to cut rates in July (Chart 2). While this is possible, there is a significant risk that the committee fails to deliver. We continue to advocate a cautious approach to corporate credit markets in the near-term (0-3 months). Table 1Fed Funds Futures: What's Priced In? Chart 2Watch For Dot Plot Revisions Fed Rate Cuts: A Track Record While we are cautious on corporate spreads in the near-term, we are also not willing to chase Treasury yields lower from current levels. Our view is that while the Fed might deliver a rate cut at one of the next few meetings, it is unlikely to lower rates by more than the 84 bps that are priced into the yield curve for the next 12 months. Ultimately, we expect Treasury yields to be higher on a 6-12 month horizon, even if the Fed cuts rates during the next few months. In response to this outlook, a few clients have asked whether it is possible for Treasury yields to rise so soon after a Fed rate cut. While we see no theoretical reason why it shouldn't be possible, it is always a good idea to stress test a theory against the historical track record. We therefore compiled a list of every Fed rate cut since 1995, and looked at how the 10-year Treasury yield reacted to each event. The results are displayed in Tables 2A-2D. Table 2A shows the rate cuts that the Fed delivered in the mid-1990s, in response to persistently low U.S. inflation and slowing growth in the rest of the world. At the time, overall U.S. economic growth was quite solid and the U.S. economy didn’t fall into recession until 2001. The divergence between relatively strong U.S. economic growth and slower growth in the rest of the world makes the period look very similar to today, and we have long argued that the current cycle should be viewed in the context of the mid-1990s.2 Table 2A reveals that, on average, the 10-year Treasury yield tended to rise in the months following a rate cut, often even in the first 21 days. The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. Table 2C shows the rate cuts that were delivered during the economic recovery of the mid-2000s, and it paints a similar picture as Table 2A. In particular, the 10-year Treasury yield rose dramatically following the 2003 rate cut, and the Fed actually started to hike interest rates almost exactly one year after the 2003 cut. Tables 2B & 2D show the rate cuts that led into the 2001 and 2008 recessions. Not surprisingly, yields were much more likely to fall after the Fed cut rates in those episodes. Bottom Line: The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. The yield is much more likely to fall if the cut occurs in the run-up to a recession. With a U.S. recession still far off, we see a good chance that Treasury yields will rise during the next 6-12 months, even if the Fed lowers rates at one of the next few FOMC meetings. Treasury Yield Moves: A Track Record In recent weeks a BCA client who had been shaking his head at the large drop in Treasury yields reached out to see if we could put the recent moves in historical context. Specifically, he wondered how often such large yield moves have occurred in the past, and whether there is a tendency for moves of this magnitude to mean-revert. Our U.S. Investment Strategy team took a stab at answering these questions. The below analysis first appeared in last week's U.S. Investment Strategy report, but is re-printed here for the interest of U.S. bond clients.3 The ongoing decline in bond yields has felt like a big deal in real time, but it isn’t historically. The sharp decline in the 10-year Treasury yield that began in early November can be viewed as three separate declines (Chart 3). In the first, the 10-year yield fell by 68 basis points (“bps”) over a span of 37 trading days. After retracing a third of the decline over the next 11 sessions, it slid by another 40 bps over 48 days. Following a one-half retracement over the ensuing 13 days, it shed 53 basis points in 32 days, capped off by a 36-bps decline across the final eight sessions (Table 3). Chart 3The Path To 2.07% Table 3A Lower 10-Year Treasury Yield In Three Steps Using the daily 10-year Treasury yield series beginning in 1962, we compared the individual yield declines for prior 37-, 48- and 32-day periods, as well as for the aggregate 141-day session spanning the entire stretch from the November 8th peak to the June 3rd trough. We also looked at the May 21st to June 3rd crescendo relative to past eight-day segments. The standardized moves range from three-quarters of a standard deviation below the mean for the 48-day middle leg to 1.5 and 1.8 for the 37- and 8-day moves, respectively (Table 4). All in all, the entire move grades out to 1.3 standard deviations below the mean – a somewhat unusual move, but nothing too special. Table 4Standardized Values Of Nominal 10-Year Treasury Yield Declines The current decline’s relative stature is undermined by the wild volatility of the late ‘70s and early ‘80s, when bond yields and annual inflation reached double-digit levels (Chart 4). To try to place the current episode on a more equal framework, we also calculated standardized moves in real (inflation-adjusted) yields. On a real basis, however, the current moves made even less of a splash. The 8-day decline (z-score = -1.2) was the only component that was more than a standard deviation from the mean, and the overall move amounted to just 0.7 standard deviations below the mean (Chart 5). Chart 4No Historical Anomaly In The Current Market Chart 5Little Impact In Terms Of Real Yields We are familiar with the electronic financial media’s increasingly popular convention of stating daily yield moves in proportion to the previous day’s closing yield.4 That convention has the advantage of fitting snugly aside stock price quotes on TV and computer screens, but it is ultimately nonsensical. The proportional change in a bond’s yield relative to its starting yield doesn’t come close to approximating the change in the value of that bond. Comparing proportional changes in bond yields across timeframes would be a way of putting today’s yield moves on a more equal footing with yield moves in the high-inflation, high-coupon era of the late seventies and early eighties, but it conveys no practical information. The standardized moves in real yields and Treasury index returns haven’t been a big deal. Our next steps were instead to compare Treasury total returns and the change in the slope of the yield curve to past flattening and steepening episodes. The moves here were also unavailing over both seven- and one-month periods, as the high-coupon ‘70s and ‘80s still dominated (Chart 6). In terms of the change in the 10-year Treasury yield, both nominal and real; Treasury index total returns; and the slope of the yield curve (3-month rate to 10-year yield), both the aggregate move since last October and its three component moves have amounted to one-standard-deviation events. They would only have had about a one-in-six chance of occurring randomly in a normally distributed population, but they do not represent unsustainable moves that cry out to be reversed. Chart 6Little Impact In Terms Of Treasury Total Returns, ... Digging a little deeper to consider total returns across different regions of the yield curve, we do find one apparent anomaly at the long end of the curve. The long Treasury index has outperformed the intermediate Treasury index by a two-standard-deviation margin over both a seven-month and a one-month timeframe (Chart 7). On a standalone basis, the long Treasury index has beaten the seven-month mean return by one-and-a-half standard deviations, and the one-month mean return by two standard deviations (Chart 8). The two-standard-deviation results would only be expected to occur one out of forty times, and thereby validate our client’s sense that something has been going on. Chart 7... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... Chart 8... And Long-Maturity Returns Have Been Elevated The margin by which long-maturity Treasuries have outperformed intermediate-maturity Treasuries is unusual, and history suggests it will be partially unwound over the next six to twelve months. Moving on to the second part of his inquiry, we reviewed the standalone performance of the long Treasury index, and the relative long-versus-intermediate performance, over subsequent six- and twelve-month periods. We focused our analysis on instances when historical z-scores were greater than or equal to their current levels to try to determine if we should expect current performance to reverse and, if so, how sharply. On a standalone basis, long Treasury index performance has gently reverted to the mean over the subsequent six and twelve months, posting returns over those periods within +/- 0.2 standard deviations of its long-run average (Table 5). Table 5Standardized Values Of Future Long-Maturity Treasury Index Returns Outlying relative long-versus-intermediate performance like we’ve witnessed over the last seven months has reversed more convincingly. The long Treasury index has underperformed its intermediate-maturity counterpart over six and twelve months when its z-scores were greater than or equal to their current levels over a seven- and one-month basis, falling roughly 0.5 standard deviations below the mean (Table 6). The future does not have to resemble the past, especially over small sample sizes, but relative long-end underperformance would accord with our constructive view of the U.S. economy. Table 6Standardized Values Of Future Difference Between Long- And Intermediate-Maturity Treasury Index Returns Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Tracking The Mid-1990s”, dated June 11, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Investment Strategy Weekly Report, “Context”, dated June 10, 2019, available at usis.bcaresearch.com 4 If a bond yielding 3% at Friday’s close ends Monday’s session with a yield of 2.94%, 6 bps lower, its yield is shown as having declined 2% on the day (-.0006/.03 = -2%). Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Fed: The large divergence between Treasury yields and risk assets means that the Fed will almost certainly cut rates during the next few months. The only question is whether a large sell-off in risk assets will be required to force the Fed’s capitulation. Maintain a cautious near-term (0-3 month) allocation to corporate credit. Duration: The economic data and shape of the yield curve do not suggest that the economy is heading into recession. Rather, they suggest that the economy is experiencing an external shock – akin to 1998 or 2015/16 – that can be offset by a relatively minor pivot in Fed policy. Investors should keep portfolio duration low. Corporate Balance Sheets: Growth rates for both corporate profits and debt should settle into the mid-single digits during the next few quarters. This will keep gross leverage and the default rate roughly stable. A sustained period of negative profit growth and tighter C&I lending standards would challenge this outlook. Feature Chart 1Markets Taking The Rate Cut For Granted Markets aren’t begging for a rate cut. Rather, they are behaving as though one has already occurred. This sort of set-up could lead to wider credit spreads and lower equity prices in the near-term. To elaborate, notice that the S&P 500 is only 3% off its late-2018 peak, but is down an alarming 8% relative to the Bloomberg Barclays Treasury Master Index. Meanwhile, the 10-year Treasury yield had fallen all the way to 2.06% as we went to press last Friday (Chart 1, bottom panel). The overall message from financial markets is that investors expect the Fed to cut rates very soon, but also think that a small number of cuts will be enough to forestall recession and keep risk assets supported. As we see it, the divergence between risk assets and Treasuries makes a rate cut during the next few months a near certainty. If the Fed does not appear sufficiently dovish at next week’s FOMC meeting, then risk assets will sell off. The resulting tightening of financial conditions will then force the Fed’s hand, leading to a rate cut in July or September. The alternative is that the Fed tries to get ahead of market sentiment by delivering a rate cut next week, even if such a move is not easily justified by the economic data. A New Trade In last week’s report, we recommended adding a fed funds futures calendar spread trade to take advantage of these near-term policy moves (Chart 2).1 Specifically, we advised investors to go long the August 2019 fed funds futures contract and short the February 2020 contract. Chart 2Exit Long Aug 2019 / Stay Short Feb 2020 We recommended buying the August 2019 fed funds futures contract to hedge the risk that the Fed tries to get ahead of market sentiment by cutting rates in June or July. As of last week, this contract would have earned a positive return in a scenario where the Fed delivered one 25 basis point rate cut in either June or July, and a negative return in a scenario where rates are unchanged. But as of last Friday, the contract’s risk/reward profile had shifted dramatically. The contract is now priced for a loss in both the “one rate cut” and “no rate cut” scenarios. We therefore exit our long position in the August 2019 fed funds futures contract for a gain of 8 bps. . The second leg of our proposed trade was to short the February 2020 fed funds futures contract. This remains an excellent bet. As of last Friday, a short position in the February 2020 contract will earn a positive return as long as three or fewer rate cuts occur between now and next February (Chart 2, bottom panel). In last week’s report, we recommended adding a fed funds futures calendar spread trade to take advantage of these near-term policy moves. Table 1 displays the expected returns from our proposed spread trade (long Aug 2019/short Feb 2020) as of last Friday, the most recent pricing available at the time of publication. Because of the rapid gains in the August 2019 contract price, an outright short position in the February 2020 contract now dominates the expected returns from the calendar spread trade in all likely scenarios. We therefore advise investors to exit the long position in the August 2019 contract, but to remain short the February 2020 contract. Table 1Expected Returns From Long Aug 2019 / Short Feb 2020 Fed Funds Futures Calendar Spread Trade Bottom Line: The large divergence between Treasury yields and risk assets means that the Fed will almost certainly cut rates during the next few months. The only question is whether a large sell-off in risk assets will be required to force the Fed’s capitulation. We advise near-term caution on credit spreads. While a near-term rate cut is likely, we also doubt that the Fed will deliver more than the 76 bps of rate cuts priced into the curve for the next 12 months. We therefore recommend that investors keep portfolio duration low and maintain a short position in the February 2020 fed funds futures contract. More 1998 Than 2001 In the last section we reiterated our view that the Fed will deliver fewer than the 76 bps of rate cuts that are priced into the yield curve for the next 12 months. Our main justification is that such a large number of rate cuts will only occur if the economy enters recession. At present, the pre-conditions for an economic recession are simply not in place. Rather, the economy is experiencing an external shock – akin to 2015/16 and 1998 – that will require only a modest shift in Fed policy. In other words, if we use the mid-1990s cycle as a roadmap, today looks much more like 1998 than 2001. The divergence between manufacturing and services PMIs is exactly what occurred in 1998 and 2015/16. In a recent Special Report, we observed that every single post-WWII recession was preceded by either high inflation or rapid private debt growth (Chart 3).2 At present, inflation is muted and private debt growth is low. The economy is unlikely to experience a recession if there hasn’t been a prior build-up of excess demand. Chart 3Private Debt Growth, High Inflation & Recessions Second, economic indicators are much more consistent with the 2015/16 and 1998 episodes than with “pre-recession” conditions. The ISM Manufacturing PMI has fallen sharply, though it remains above 50, but the ISM Non-Manufacturing PMI looks much healthier. This divergence between manufacturing and services is exactly what occurred in 1998 and 2015/16 (Chart 4). It is consistent with a shock to global demand and trade that has relatively little impact on the U.S. consumer and the domestic economy’s large service sector. Chart 4Divergence Between Services And Manufacturing Granted, the PMIs compiled by Markit do not mirror the divergence between the ISM Manufacturing and Non-Manufacturing surveys. In fact, the Markit Services PMI has dropped sharply alongside its manufacturing counterpart (Chart 5). However, the Markit surveys also showed no divergence between manufacturing and services in 2015/16 and have no available data for 1998. We are therefore inclined to downplay the weakness in the Markit Services PMI for the time being. Chart 5MARKIT PMIs Third, employment growth usually starts to slow at least one year before the economy heads into recession. But it showed relatively little weakness in 1998 and 2015/16 (Chart 4, bottom panel). If May’s downbeat payrolls number turns out to be the start of a trend, then we will have to reconsider our view. But for now, even after last week’s report, employment growth remains solid. Finally, not only do the economic data suggest an episode similar to 1998 and 2015/16, but the slope of the yield curve does as well. While many have focused on the inversion of the 3-month/10-year Treasury slope, the 2-year/10-year slope remains above zero, and has indeed steepened in recent weeks. A more comprehensive look at the entire yield curve, adjusting for changes in the overall level of yields, shows that it looks very similar to the yield curve seen just ahead of the first 1998 rate cut. In contrast, the yield curve seen just before the first 2001 rate cut was more heavily inverted at the front-end, and long-dated yields priced-in much less of a rebound (Charts 6A & 6B). Bottom Line: The economic data and shape of the yield curve do not suggest that the economy is heading into recession. Rather, they suggest that the economy is experiencing an external shock – akin to 1998 or 2015/16 – that can be offset by a relatively minor pivot in Fed policy. Investors should keep portfolio duration low on the view that the Fed will cut rates by less than 76 bps during the next 12 months. Corporate Health Update Chart 7Weak Profit Growth In Q1 The full slate of first quarter corporate balance sheet data have now been released, and as expected, corporate profit growth cooled significantly compared to the rapid gains seen in 2018. As a result, our Corporate Health Monitor – an equal-weighted composite of six important financial ratios – ceased its recent improvement and jumped firmly back into “deteriorating health” territory (Chart 7). Our preferred measure of pre-tax profits contracted at an annualized rate of 17% in Q1, dragging the year-over-year growth rate down to 7%, from 15% in 2018 Q4 (Chart 7, bottom panel). The crucial relationship for corporate bond investors is between pre-tax profit growth and debt growth. If profit growth exceeds debt growth, then gross leverage will decline over time taking the default rate with it. Conversely, defaults tend to rise whenever profit growth fails to keep pace with debt growth.3 Corporate debt has been growing at an annualized pace of about 6-8%. This means that profit growth would have to slow to below those levels for us to become concerned about an increase in defaults. This could occur for the next quarter or two, as the weak global growth environment weighs on revenues (Chart 8). But our Profit Margin Proxy – corporate selling prices less unit labor costs – is in a strong uptrend, suggesting that the weakness may not be that dire. The crucial relationship for corporate bond investors is between pre-tax profit growth and debt growth. There is also some reason to think that corporate debt growth might slow during the next few quarters. According to the Fed’s Senior Loan Officer Survey, C&I loan demand has weakened significantly in recent months, while lending standards remain approximately unchanged. Historically, it is extremely rare for loan demand to weaken without a simultaneous tightening in bank lending standards (Chart 9). However, if the current unusual situation were to persist, it would be quite positive from the perspective of corporate balance sheet health. It would suggest that firms are adding less debt to balance sheets, even though banks continue to make credit readily available. Chart 8Profit Margins Still Strong Chart 9Is Corporate Sector On A Debt Diet? Bottom Line: Growth rates for both corporate profits and debt should settle into the mid-single digits during the next few quarters. This will keep gross leverage and the default rate roughly stable. A sustained period of negative profit growth and tighter C&I lending standards would challenge this outlook. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, “When Expectations Are Self-Fulfilling”, dated June 4, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy/Global Fixed Income Strategy Special Report, “The Risk From Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The May official PMI shows that manufacturing in China will slow over the coming year unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. The divergence between H-shares and both A-shares and the domestic fixed-income market suggests that China’s domestic financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. We agree that such a response will occur over the coming 6-12 months, and would recommend that investors stay overweight Chinese equities within a global equity portfolio over that time horizon. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, April’s activity data provided early evidence that the trajectory of the economy was beginning to turn prior to the breakdown in U.S./China trade talks, in response to a meaningful credit improvement in Q1. The May Caixin manufacturing PMI was stable, but the official PMI fell and the experience of last year clearly shows that manufacturing in China will slow over the coming year unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. Assuming that the Trump administration follows through with its threat, investors are likely to see a repeat of last year’s perversely positive effects of tariff frontrunning on the Chinese trade data over the next few months; this should be viewed as confirmation of an impending collapse in trade activity, rather than a sign that the underlying trade situation is improving. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, the most notable development is the contrast between the relative performance of investable Chinese stocks on the one hand, and domestic equities and the Chinese fixed-income market on the other. The recent performance of investable stocks confirms that they have been driven nearly exclusively by trade war developments for the better part of the past year, whereas the somewhat better relative performance of A-shares and the calm in the government bond, corporate bond, and sovereign CDS markets suggests that China’s domestic financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. We agree that such a response will occur over the coming 6-12 months, and would recommend that investors stay overweight Chinese equities within a global equity portfolio over that time horizon. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock Both Bloomberg’s and our alternative calculation of the Li Keqiang index (LKI) rose in April, albeit only fractionally in the case of the latter. Still, as we noted in last week’s report,1 the Q1 rebound in credit appears to have halted the decline in investment-relevant Chinese economic activity (Chart 1). This suggests that the trajectory of the economy was beginning to change in April prior to the breakdown in U.S./China trade talks, implying that an aggressively stimulative response from Chinese authorities to counter a full 25% tariff scenario has good odds of succeeding. This supports our cyclically overweight stance towards Chinese stocks. Our leading indicator for the LKI declined slightly in April, but remains in a very modest uptrend. The gap between accelerating credit growth and the sluggishness of our leading indicator is explained by the fact that growth in Chinese M2 and M3 has been slow to rise. A weaker-than-expected recovery in Chinese economic activity is much more likely if money growth remains weak, but we cannot reasonably envision an outcome where credit growth continues to trend higher and growth in the money supply does not meaningfully accelerate. The incoming Chinese housing data continues to provide conflicting signals. The annual change of the PBOC’s pledged supplementary lending injections declined further in April, which since 2015 has done an excellent job explaining weak housing demand. However, both floor space started and sold picked up in April (Chart 2), and house price growth remained steady despite a significant decline in the breadth of house price appreciation across 70 cities. Policymakers are likely to allow aggregate credit growth to accelerate significantly over the coming 6-12 months in order to counter the deflationary impact of a trade war with the U.S., but our sense is that policymakers will then refocus their financial stability efforts on the household sector (i.e. they will work to prevent another significant reacceleration in household debt growth). Given this, we continue to expect that housing demand will remain weak, although we will be closely watching floor space sold over the coming few months. The new export orders component of the official manufacturing PMI is signaling an external outlook that is as negative as the 2015/2016 episode. The May official manufacturing PMI fell back into contractionary territory, led by a very significant decline in the new export orders component (Chart 3). The Caixin manufacturing PMI was stable, but the outlook for manufacturing in China is clearly negative unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. Investors are likely to see a repeat of last year’s perversely positive effects of tariff frontrunning on the Chinese trade data over the next few months; this should be viewed as confirmation of an impending collapse in trade activity, rather than a sign that the underlying trade situation is improving. Chart 2Surprising Resilience In China's Housing Market (For Now) Chart 3A Clearly Negative Outlook For Manufacturing There has been a sharp contrast in the behavior of the Chinese investable and domestic equity markets over the past month, which in our view confirms that the former has been driven nearly exclusively by trade war developments for the better part of the past year. Chart 4 shows that the relative performance of investable stocks (versus global) has nearly fallen back to its late-October low, whereas A-shares technically remain in an uptrend despite having sold off. Some investors have attributed the relative support of A-shares to aggressive buying by the “national team”, state-related financial market participants that the government has relied on since 2015 to manage volatility in the domestic equity market. Chart 4Are A-Shares Acting More Rationally Than The Investable Market? However, it is also possible that the A-share market is acting more rationally than the investable market, by focusing on the possibility of a major reflationary response to the Trump tariffs. This contrast in behavior between the investable and domestic markets was also observed pre- and post-February 15th, when the January credit data was released. Prior to this point, the A-share market was (rightly) not confirming the relative uptrend in investable stocks; following February 15th, A-shares exploded higher in response to tangible evidence that a upcycle in credit had arrived. If it is true that the A-share market is better reflecting the prospect of a reflationary response from Chinese policymakers, the relative performance trend for domestic stocks supports our decision to remain cyclically overweight Chinese stocks versus the global benchmark. Chinese utilities and consumer staples have outperformed in both the investable and domestic equity markets over the past month, which is not surprising given that these sectors typically outperform during risk-off phases. Within the investable market, the sharp underperformance of the BAT (Baidu, Alibaba, and Tencent) stocks has been the most interesting (Chart 5). To the extent that the selloff in BAT stocks reflects trade war retaliation risk (through, for example, delisting from U.S. exchanges), then the selloff is rational. But the fact that Tencent (which also trades in Hong Kong) has also declined so sharply suggests that investors are blanket selling Chinese technology-related stocks out of concern that the sector will be heavily implicated by punitive action from the Trump administration. The BAT stocks are domestically oriented, meaning that “Huawei risk” appears to be minimal. Chart 5A Potential (Future) Opportunity In The BAT Stocks Beyond the near-term risk from deteriorating sentiment, the selloff in BAT stocks may present a cyclical opportunity for investors. Unlike Huawei, whose export-oriented business model relied on the U.S. as part of its supply chain, Alibaba and Tencent are largely domestically-driven businesses whose earnings will depend mostly on the outlook for Chinese consumer spending. We agree that reflationary efforts by Chinese policymakers will attempt to avoid stoking a significant acceleration in residential mortgage credit, but it is difficult to envision a scenario in which China stimulates aggressively and consumer spending growth does not accelerate. As such, investors should closely watch the performance of BAT stocks in response to reflationary announcements and developments on the credit front; we would strongly consider an outright long stance favoring BAT stocks if a technical breakout occurs alongside the release of data that is consistent with a significant improvement in the macro outlook. There has been little movement in the Chinese government bond market over the past month, with the Chinese 10-year government bond yield having fallen merely 10 basis points since late-April. This is in contrast to what has occurred in the U.S., with yields on 10-year Treasurys having come in roughly three times as much over the past month (Chart 6). The relative calm in the Chinese government bond market is echoed by the relative 5-year CDS spread between China and Germany, a component of our BCA Market-Based China Growth Indicator. While the spread has certainly moved higher in response to the breakdown in trade talks and President Trump’s full imposition of tariffs on the second tranche of imports from China, it remains below its 2018 average and well below levels that prevailed in 2015 and 2016 (Chart 7). Similarly, Chinese onshore corporate bond spreads have not reacted negatively to the resumption in the trade war, with the spread on the aggregate ChinaBond Onshore Corporate Bond Index up one basis point over the past month. Taken together with the relative performance of A-shares as well as Charts 6 and 7 we see this as evidence that China’s financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. Chart 6Relative Calm In China's Fixed-Income Market Chart 7China's Sovereign CDS Spread Is Rising, But The Level Remains Low A decline in the RMB is necessary to stabilize China’s economy (and is thus reflationary), but global investors will not act like it is until the economy visibly improves. Global financial market commentary on the RMB has been focused almost exclusively over the past month on the USD-CNY exchange rate, but Chart 8 shows that the decline in the currency has been broad-based. The RMB has fallen roughly 1.4% versus the euro over the past month, and over 2% versus an equally-weighted basket of Asian currencies. We highlighted in our May 15 Weekly Report that a 25% increase in tariffs affecting all U.S.-China trade would cause economic conditions in China to deteriorate to 2015/2016-like levels, and that currency depreciation was essential in order to generate a 2015/2016-magnitude policy response.2 However, to the extent that the decline in the RMB will contribute to a period of greater volatility in the global foreign exchange market, China-related assets are not likely to respond positively to this form of stimulus until “hard” activity data clearly shows a meaningful rise. Chart 8The RMB Has Declined Against Everything, Not Just The Dollar Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “Waiting For The Pain”, dated May 29, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, “Simple Arithmetic”, dated May 15, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Chart 1Bond Rally Supports Stocks Financial markets are pricing-in an intensifying global growth slowdown, but not all assets are responding equally. U.S. Treasuries have rallied strongly, while equities and credit spreads remain resilient. Case in point, the S&P 500 is only 5.9% off its Q3 highs in absolute terms, but is down 11.3% versus bonds (Chart 1). The markets are pricing-in that the Fed will react to slower growth by cutting rates and that easier Fed policy will keep risk assets supported. But consider what will happen if, at the June FOMC meeting, the Fed doesn’t seem as eager to cut rates as the market would like. The perception of less monetary support could prompt a sharp sell-off in equities and credit spreads. That tightening of financial conditions could then be enough to force the Fed’s hand, ultimately leading to the rate cut that the market has already come to expect. The odds of the above scenario are rising by the day, especially since the President’s decision to expand the trade war to Mexico. We recommend a cautious near-term (0-3 month) stance on credit spreads as a hedge against this mounting risk. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 139 basis points in May, dragging year-to-date excess returns down to +221 bps. As we noted in last week’s report, corporate bond spreads have not responded as aggressively as some other assets – commodities and Treasuries – to the escalating trade war and the deteriorating global growth data.1 This leaves the sector vulnerable to a near-term sell-off, especially if the Fed doesn’t validate the market’s dovish expectations at this month’s FOMC meeting. We advise investors to hedge their exposure to credit spreads on a 0-3 month horizon. Beyond that, assuming that the U.S. government’s tariff announcements eventually reach a plateau, the outlook for corporate bond excess returns is positive on a 6-12 month investment horizon. Spreads are comfortably above levels typically seen at this stage of the economic cycle (Chart 2) and, tariffs aside, the U.S. economy is growing at a reasonable clip. As for balance sheets, corporate profit growth contracted in the first quarter, dragging the year-over-year growth rate down to 7%. That is roughly equivalent to the trend rate in corporate debt growth, meaning that if profit growth stabilizes near that level our measure of gross leverage will stay flat (panel 4). We are also keeping a close eye on C&I lending standards. While the most recent data showed an easing in Q1, the continued contraction in loan demand poses a risk (bottom panel). High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 250 basis points in May, dragging year-to-date excess returns down to +443 bps. As with investment grade corporates, the risk of near-term spread widening is high. We noted in last week’s report that excess junk returns versus Treasuries outpaced the CRB Raw Industrials index by 9% during the past 12 months, a historically wide divergence that is bound to fade.2 Looking further out, high-yield bonds still look like a good bet on a 6-12 month investment horizon. Spreads are comfortably above typical levels from past cycles and the excess spread available in the junk index after accounting for expected default losses has risen to 325 bps, well above its historical average (Chart 3). Assuming historically average excess compensation and a 50% recovery rate, current junk spreads discount an expected 12-month default rate of 3.1%. This is well above the Moody’s baseline projection of 1.5% and even above the 2.7% default rate seen during the past 12 months. The spread-implied default rate should be easy to beat, though a persistent increase in job cut announcements could pose a risk (bottom panel). MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in May, dragging year-to-date excess returns down to -13 bps. The conventional 30-year zero-volatility spread widened 6 bps on the month, the combination of a 4 bps widening in the option-adjusted spread (OAS) and a 2 bps increase in the compensation for prepayment risk (option cost). At 49 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains slightly below its pre-crisis mean (Chart 4). Nonetheless, we see high odds that the MBS/Treasury basis will contract going forward. Falling mortgage rates and an uptick in refinancing activity led to the recent widening in MBS spreads. But with the housing activity data showing signs of improvement, we anticipate that mortgage rates are close to a trough and that refis will soon peak (panel 2). If the “risk off” sentiment in financial markets prevails in the near-term, then MBS will outperform corporate credit. But expected 6-12 month excess returns remain higher for corporate bonds than for MBS. We therefore maintain only a neutral allocation to MBS, despite increasingly attractive valuations. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to +107 bps. Sovereign debt underperformed duration-equivalent Treasuries by 205 bps on the month, dragging year-to-date excess returns down to +206 bps. Local Authorities outperformed the Treasury benchmark by 11 bps, bringing year-to-date excess returns up to +219 bps. Meanwhile, Foreign Agencies underperformed by 61 bps, dragging year-to-date excess returns down to +130 bps. Domestic Agencies underperformed by 1 bp in May, bringing year-to-date excess returns up to +28 bps. Supranationals outperformed by 4 bps on the month, bringing year-to-date excess returns up to +27 bps. Sovereign debt remains expensive relative to equivalently rated U.S. corporate credit (Chart 5), and the dollar’s relentless march higher presents a further headwind for the sector. We continue to recommend an underweight allocation. Previously, we made an exception for Mexican sovereign bonds, which trade cheap relative to U.S. corporates (bottom panel). However, with the U.S. government now threatening tariffs on imported Mexican goods, the peso will likely see heightened volatility in the coming months. We recommend standing aside on Mexican sovereigns for the time being. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 75 basis points in May, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 1% in May, and currently sits at 80% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, but close to the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) have outperformed short-dated munis (2-year and 5-year) by a wide margin since the beginning of the year, but long-end yield ratios remain relatively attractive. 20-year and 30-year Aaa-rated municipal bonds are particularly alluring. Yield ratios for those bonds remain above their pre-crisis averages, whereas 10-year, 5-year and 2-year Aaa yield ratios are close to one standard deviation below their respective pre-crisis means. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.3 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in May, with yields falling by more than 30 basis points for all maturities beyond 1 year. The 2/10 Treasury slope flattened 5 bps on the month and currently sits at 19 bps. The 5/30 slope was unchanged on the month and currently sits at 65 bps (Chart 7). The belly (5-year/7-year) of the curve looks particularly expensive relative to the wings (see Appendix B) and we continue to recommend a barbell curve positioning: Investors should overweight the long and short ends of the curve and avoid the belly.4 Further, this week we recommend an additional fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract. The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if 3 or more rate cuts occur between now and then. We would expect our spread trade to return +48 bps in a scenario where the Fed keeps rates flat until next March and +23 bps in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 116 basis points in May, dragging year-to-date excess returns down to +39 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.74%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps on the month and currently sits at 1.90%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.5 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 3% (annualized) clip in April, but has only risen 1.6% during the past year. 12-month trimmed mean PCE inflation has been higher, and actually just moved above the Fed’s target following last week’s April data release (Chart 8). In last week’s report we noted that core PCE inflation has a track record of converging toward the trimmed mean.6 As such, we recommend that investors remain overweight TIPS versus nominal Treasuries in U.S. bond portfolios. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +64 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and actually hit a new all-time low of 26 bps in mid-May, before settling at 28 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in May, bringing year-to-date excess returns up to +195 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 69 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst waning demand (bottom panel) and decelerating prices (panel 3). However, CMBS still offer reasonable compensation for this risk. Especially compared to other similarly-rated fixed income sectors.7 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in May, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread widened 3 bps on the month and currently sits at 51 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread product. An overweight allocation to this defensive 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 75 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. 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 Valuation 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 Valuation: Raw Residuals In Basis Points (As of May 31, 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 May 31, 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 +56 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 56 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. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. 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, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 4 We have specifically been recommending a position short the 7-year bullet and long a duration-matched 2/30 barbell. 5 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Please note that analysis on India is published below. Highlights This report reviews several financial market-based indicators and price signals from various corners of global markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these indicators and price actions is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities, and EM assets are all at risk of plunging. Beware of reigning complacency in EM sovereign and corporate credit markets. Various indicators point to wider EM credit spreads. Feature EM risk assets appear to be on the brink of a breakdown. This week we review various market-based indicators that are telegraphing a relapse in both EM risk assets and commodities. The relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months. As always, we monitor economic data extremely closely. However, one cannot rely solely on economic data to predict directional changes in financial markets. Turning points of economic indicators and data often lag those of financial markets. In fact, one can make reliable economic forecasts based on the performance of financial markets. For example, the relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months (Chart I-1). Chart I-1EM Stocks Signal No Improvement In Global Industrial Cycle Over the years, we have devised and tracked several market-based indicators that have a good track record of identifying trends in EM risk assets. In addition, we constantly monitor price signals from various corners of financial markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these market-based indicators is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities and EM are all at risk of plunging. Our Reflation Indicator Our Reflation Indicator is calculated as an equal-weighted average of the London Industrial Metals Price Index (LMEX), platinum prices and U.S. lumber prices. The LMEX index is used as a proxy for Chinese growth, while U.S. lumber prices reflect cyclical growth conditions in the American economy. We use platinum prices as a global reflation proxy; this semi-precious metal is sensitive to the global industrial cycle in addition to benefitting from easy U.S. dollar liquidity. The Reflation Indicator has failed to advance above its long-term moving average and has broken down. Chart I-2Our Reflation Indicator Presages No Reflation Chart I-2 illustrates that the Reflation Indicator has failed to advance above its long-term moving average and has broken down. Typically, such a technical profile is worrisome and is often followed by a significant drop. In addition, the Reflation Indicator rolled over at its previous highs last year, another bearish technical signal. Investors should heed signals from this indicator as it correlates well with EM share prices in U.S. dollar terms as well as EM sovereign and corporate credit spreads (Chart I-3). EM credit spreads are shown inverted in the middle and bottom panels. An examination of the individual components of the Reflation Indicator reveals the following: Industrial metals prices in general and copper prices in particular have formed a classic head-and-shoulders pattern (Chart I-4, top panel). As and when the neckline of this pattern is broken, a major downward gap is likely to ensue. Platinum prices have reverted from their key technical resistance levels (Chart I-4, middle panel). This constitutes a bearish technical configuration, and odds are that platinum prices will be in freefall. Finally, lumber prices have failed to punch above their 200-day moving average and have broken below their 3-year moving average (Chart I-4, bottom panel). Chart I-3Reflation Indicator And EM Chart I-4Beware Of Breakdowns In Commodities Prices These technical signals are in accordance with our qualitative assessment of global growth conditions. The global industrial cycle remains very weak, and a recovery is not yet imminent. Meanwhile, the U.S. is the least exposed to the ongoing global trade recession because manufacturing and exports each represent only about 12% of the U.S. economy. Remarkably, economic weakness in Asian export-dependent economies has so far been driven by retrenching demand in China – not the U.S. As Chart I-5 reveals, aggregate exports to China from Korea, Japan, Taiwan and Singapore were still contracting at a 9% pace in April from a year ago, while their shipments to the U.S. grew at a respectable 7% rate. Chart I-5Asian Exports To China And To U.S Chart I-6Global Steel And Energy Stocks Are Breaking Down Commodities: Hanging By A Thread? Some commodity-related markets are also exhibiting configurations that are consistent with a breakdown. Specifically: Global steel stocks as well as oil and gas share prices have formed a head-and-shoulders pattern, and are breaking below their necklines (Chart I-6). Such a technical configuration foreshadows major downside. Shares of Glencore – a major player in the commodities space – have dropped below their three-year moving average which has served as a support a couple of times in recent years (Chart I-7). Crucially, this stock has also exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads U.S. manufacturing cycles, and has formed a similar configuration to Glencore’s (Chart I-8). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Chart I-7A Head-And-Shoulders Pattern In Glencore Stock... Chart I-8...And In Kennametal (High-Beta U.S. Industrial Stock) Finally, three-year forward oil prices are breaking below their three-year moving averages (Chart I-9). A drop below this technical support will probably mark a major downleg in crude prices. Bottom Line: Commodities and related equity sectors appear vulnerable to the downside. Meanwhile, the U.S. dollar is exhibiting a bullish technical pattern and will likely grind higher, as we discussed in last week’s report titled, The RMB: Depreciation Time? (Chart I-10). Chart I-9Forward Oil Prices Are Much Weaker Than Spot Chart I-10The U.S. Dollar Is Heading Higher EM Equities: A Make-It-Or-Break-It Moment Chart I-11EM Stock Indexes: Sitting On Edge Of A Cliff The MSCI EM Overall Equity Index is at an important technical support level (Chart I-11, top panel). If this support is violated, a major downleg will likely ensue. In addition to the above indicators, the following observations also suggest that this support level will be broken and that a gap-down phase will transpire. Both the EM small-cap and equal-weighted equity indexes have been unable to advance above their respective three-year moving averages and are now breaking down (Chart I-11, middle and bottom panels). This could be a precursor for the overall EM stock index to tumble through defense lines, and drop well below its December lows. Our Risk-On/Safe-Haven Currency ratio also points to lower EM share prices (Chart I-12). This indicator is constructed using relative total returns of commodity related (cyclical) currencies such as the AUD, NZD, CAD, BRL, CLP and ZAR against safe-haven currencies such as the JPY and CHF. Importantly, as with EM stocks, this market-based indicator has failed to break above highs reached over the past 10 years. This is in spite of negative interest rates in both Japan and Switzerland that have eroded the latter’s total returns in local currency terms. This ratio has also formed a head-and-shoulders pattern, and may be on the edge of breaking below its neckline. A move lower will spell trouble for EM financial markets. EM corporate profits are shrinking in U.S. dollar terms, and the pace of contraction will continue to deepen through the end of the year. The U.S.-China confrontation is not the only reason behind the EM selloff. In fact, the EM equity rebound early this year was not supported by improving profits. Not surprisingly, the EM equity rebound has quickly faded as investor sentiment deteriorated in response to rising trade tensions. Global semiconductor share prices have made a double top and are falling sharply. Importantly, prices for semiconductors (DRAM and NAND) have not recovered since early this year. The ongoing downdraft in the global semiconductor industry will continue to weigh on the emerging Asian Equity Index. Finally, the relative performance of emerging Asian equities versus DM ones has retreated from its major resistance level (Chart I-13). Odds are that it will break below its recent lows. Chart I-12Risk-On/Safe-Haven Currency Ratio And EM Equities Chart I-13Emerging Asian Stocks Versus Developed Markets Bottom Line: EM share prices are sitting on the edge of a cliff. Further weakness will likely lead to investor capitulation and a major selloff. EM Credit Markets: Reigning Complacency? One asset class in the EM space that has so far held up relatively well is sovereign and especially corporate credit. EM sovereign bonds’ excess returns correlate with EM currencies and industrial metals prices, as shown in Chart I-14. So far, material EM currency depreciation and a drop in industrial metals prices have generated only a mild selloff in EM sovereign credit. Lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Excess returns on EM corporate bonds track the global business cycle closely (Chart I-15). The current divergence between EM corporates’ excess returns and the global manufacturing PMI is unprecedented. Chart I-14EM Sovereign Credit Market Is Complacent... Chart I-15...As Is EM Corporate Credit Market Our expectation that EM credit spreads will widen is not contingent on a massive default cycle unravelling across the EM credit space. However, lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Chart I-16 illustrates that swings in cash flow from operations (CFO) among EM ex-financials and technology companies correlate with other global business cycle indicators such as Germany’s IFO manufacturing index. Chart I-16EM Corporate Cash Flow Fluctuates With Global Manufacturing Cycle Chart I-17EM Corporate Spreads Are Too Narrow Given Their Financial Health The lingering weakness in the global business cycle will likely lead to shrinking CFOs among EM companies, and hence warrants wider corporate credit spreads. Concerning valuations, EM corporate bonds are not cheap at all when their fundamentals are taken into account. Chart I-17 demonstrates two vital debt-servicing ratios for EM ex-financials and technology companies: interest expense-to-CFO and net debt-to-CFO. Both measures have improved only marginally in recent years, yet corporate spreads are not far from their all-time lows (Chart I-17, bottom panel). We are aware that with DM bond yields at very low levels - and in many cases even negative - the appeal of EM credit markets has risen. We are also cognizant that some investors are expecting to hold these bonds to maturity and earn a reasonable yield. Such a strategy has largely paid off in recent years. Nevertheless, if the selloff in EM financial markets escalates – as we expect – EM credit markets will be hit hard as well. To this end, it makes sense to step aside and wait for a better entry point. For dedicated fixed-income portfolios, we continue to recommend underweighting EM sovereign and corporate credit versus U.S. investment-grade credit. Finally, to identify relative value within EM sovereign credit spreads, we plot, each country’s foreign debt obligations as a share of annual exports on the X axis against sovereign spreads on the Y axis (Chart I-18). This scatter plot reveals that Russia and Mexico offer the best relative value in the EM sovereign space. As such, we are reiterating our high-conviction overweight position in these sovereign credit markets as well as in Hungary, Poland, Chile and Colombia. South Africa and Brazil appear attractive as well, but we are underweight these two sovereign credits. The basis for our pessimistic outlook is due to the unsustainable public debt dynamics in these two countries, as we discussed in our Special Report from April 23. Other underweights within the EM sovereign credit space include Indonesia, the Philippines, Malaysia, Turkey and Argentina. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com India: How Sustainable Is A 2.0 Modi Rally? Prime Minister Narendra Modi, and his party – the Bharatiya Janata Party – have won a strong majority in the Indian general election this month. Indian stocks surged in the past month as evidence was emerging that Modi was in the lead. Chart II-1Facing Resistance? Yet this Modi 2.0 rally is unlikely to last for too long. First, as EM stocks continue selling off, Indian share prices will not defy gravity and will fall in absolute terms. Interestingly, the Indian stock market has hit its previous highs – levels at which it failed to break above in the past 12 years (Chart II-1, top panel). We expect this resistance line to hold this time around too. Likewise, we are still reluctant to upgrade this bourse on a relative basis as it has reached its previous highs. This level will likely prove to be a hindrance, at least for the time being (Chart II-1, bottom panel). The basis for betting against a break out in Indian equity prices in both absolute terms and relative to the EM benchmark over the next couple of months is because of the following: Domestic Growth Weakness: India’s domestic growth has been decelerating sharply. The top two panels of Chart II-2 illustrate that manufacturing and intermediate goods production as well as capital goods production growth are all either contracting or on the verge of shrinking. Similarly, domestic orders-to-inventories ratio for businesses is pointing to a further growth slump according to a survey conducted by Dun & Bradstreet (Chart II-2, bottom panel). Furthermore, sales growth of all types of vehicles are either contracting or have stalled (Chart II-3). Chart II-2Business Cycle Is Weak Chart II-3Domestic Demand Is Fragile Regarding the financial sector, Indian banks – encouraged by a more permissive and forbearing central bank on the recognition of non-performing loans – have recently lowered provisions to boost their earnings (Chart II-4). Share prices should not normally react to such accounting changes. Banks either do carry these NPLs or do not. Therefore, the stock price of a bank should not fluctuate much if a central bank is forcing it to recognize those NPLs or if the latter is relaxing recognition and provisioning standards. Chart II-4Less Provisions = More Paper Profit Chart II-5Very Weak Equity Breadth In brief, we are skeptical about the sustainability of the current rally in bank share prices based on the relaxation of some accounting rules. Unfavorable Technicals & Valuations: Technicals for India’s stock market are precarious. Participation in this rally has been very slim. Indian small cap stocks have not rallied much, lagging dramatically behind large-cap stocks (Chart II-5, top panel). Our proxy for market breadth – the ratio of equal-weighted stocks to market-cap weighted stocks – has also been deteriorating and is sending a very bearish signal for the overall stock market (Chart II-5, bottom panel). Finally, the Indian stock market is overbought and vulnerable to a general selloff in EM stocks. Namely, foreign investors have rushed into Indian equities as of late. This raises the risk of a pullout as foreign investors become disappointed by India’s dismal corporate earnings and outflows from EM funds leads them to pare their holdings. As for valuations, the Indian stock market is still quite expensive both in absolute and relative terms. Oil Prices: Although oil prices will likely drop,1 Indian stocks could still underperform the EM equity benchmark in the near term. Chart II-6India Versus EM & Oil Prices The rationale for this is that Indian equities have brushed off the rise in oil prices since the beginning of the year and outperformed the majority of other EM bourses (Chart II-6). By extension, Indian equities could ignore lower oil prices for a while and underperform the EM benchmark in the near term. Beyond near term underperformance, however, India will likely resume its outperformance. First, sustainably lower oil prices will begin to help the Indian stock market later this year. Second, the growth impact of ongoing fiscal and monetary easing will become visible toward the end of this year. Meanwhile, food prices are starting to pickup and this will support rural income and spending. Finally, the Indian economy is much less vulnerable to a slowdown in global trade because Indian exports make only 13% of the country's GDP. Bottom Line: We are maintaining our underweight stance in Indian equities for tactical considerations, but are putting this bourse on an upgrade watch-list. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes 1 The view on commodities of BCA’s Emerging Markets Strategy service is different from BCA’s house view due to the difference on the view on the global business cycle and Chinese demand. Equity Recommendations Fixed-Income, Credit And Currency Recommendations