Energy
Highlights Portfolio Strategy Recession odds continue to tick higher, according to the NY Fed’s probability of recession model, at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. The souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. The global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Recent Changes Upgrade the S&P hypermarkets index to overweight, today. Initiate a long global gold miners/short S&P oil & gas exploration & production (E&P) pair trade, today Table 1 Feature Obsession with the Fed easing continues to trump all else, with the SPX piercing through the 3,000 mark to fresh all-time highs last week. However, it is unrealistic for the Fed to do all the heavy lifting for the equity market as we have argued recently (see Chart 3 from June 24),1 at a time when profit cracks are spreading rapidly. This should be cause for some trepidation. Since the Christmas Eve lows essentially all of the 26% return in equities is explained by valuation expansion. The forward P/E has recovered from 13.5 to nearly 17.2 (Chart 1). There is limited scope for further expansion as four interest rate cuts in the coming 12 months are already priced in lofty valuations. Now profits will have to do the heavy lifting. But on the eve of earnings season, more than half of the S&P 500 GICS1 sectors are forecast to have contracted profits last quarter, and three sectors could not lift revenue versus year ago comps, according to I/B/E/S data. Looking further out, there is a plethora of indicators that we highlighted last week that suggest that a profit recession is looming.2 Our sense is that once the euphoria around the looming Fed easing cycle settles, there will be a massive clash between perception and reality (Chart 2) that will likely propagate as a surge in volatility. Chart 1Multiple Expansion Explains All Of The SPX’s Return Chart 2Unsustainable Divergence This addiction to low rates has come at a great cost to the non-financial corporate sector. As a reminder, this segment of the economy is where the excesses are in the current cycle as we have been highlighting in recent research.3 Using stock market related data for the non-financial ex-tech universe, net debt has increased by 70% to $4.2tn over the past five years, but cash flow has only grown 18% to $1.7tn. As a result, net debt-to-EBITDA has spiked from 1.7 to 2.5, an all-time high (Chart 3). While stocks are at all-time highs (top panel, Chart 3), the debt-saddled non-financials ex-tech universe will likely exert substantial downward pressure to these equities in the coming months (Chart 4). Chart 3Balance Sheet Degrading Chart 4Something’s Got To Give Moving on to the labor market, we recently noticed an interesting behavior between the unemployment rate and wage inflation since the early-1990s recession: a repulsive magnet-type property exists where like magnetic poles repel each other (middle panel, Chart 5). In other words, every time the falling unemployment rate has kissed off accelerating wage growth, a steep reversal ensued at the onset of recession during the previous three cycles. A repeat may be already taking place, as average hourly earnings (AHE) growth has been stuck in the mud since peaking in December 2018. Importantly, the AHE impulse is quickly losing steam and every time the Fed embarks on an aggressive easing cycle it typically marks the end of wage inflation (bottom panel, Chart 5). Chart 5Beware Of Repulsion Chart 6Waiting For Growth Meanwhile, BCA’s global manufacturing PMI diffusion index has cratered to below 40% (middle panel, Chart 6). Neither the G7 nor the EM aggregate PMIs are above the boom/bust line (top panel, Chart 6). Our breakdown of the Leading Economic Indicators into G7 and EM14 also signals that global growth is hard to come by, albeit EMs are showing some early signs of a trough (bottom panel, Chart 6). As the early-May announced increase in Chinese tariffs begin to take a toll, we doubt global growth can have a sustainable recovery for the rest of 2019, despite Chinese credit growth picking up. Now, even Japan and Korea are fighting it out and are erecting barriers to trade, dealing a further blow to these economically hyper-sensitive export-oriented economies. Netting it all out, the odds of recession by mid-2020 continue to tick higher according to the NY Fed’s model (NY Fed’s probability of recession shown inverted, top panel, Chart 5) at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. This week we are upgrading a consumer staples subgroup to overweight and initiating an intra-commodity market neutral trade. Time To Buy The Hype The tide is shifting and we are upgrading the S&P hypermarkets index to an above benchmark allocation. While valuations are stretched, trading at a 50% premium to the overall market on a 12-month forward P/E basis (not shown), our thesis is that these Big Box retailers will grow into their pricey valuations in the coming months. The macro landscape is aligned perfectly with these defensive retailers. Consumer confidence has been falling all year long and now cracks are spreading to the labor market (confidence shown inverted, top panel, Chart 7). ADP small business payrolls declined for the second month in a row. Similarly, the NFIB survey shows that small business hiring plans are cooling (hiring plans shown inverted, middle panel, Chart 7). As a reminder, 2/3 of all new hiring typically occurs in the small and medium enterprise space. In the residential real estate market, the drop in interest rates that is now in its eighth month has yet to be felt, and house price inflation has ground to a halt. Historically, Costco membership growth has been inversely correlated with house prices (house price inflation shown inverted, bottom panel, Chart 7). Chart 7Deteriorating Macro Backdrop … Chart 8…Is A Boon To Hypermarkets… Chart 8 shows three additional macro variables that signal brighter times ahead for the relative share price ratio. The drubbing in the 10-year U.S. treasury yield reflects a souring macro backdrop, melting inflation and a steep fall in U.S. economic data surprises. The ISM manufacturing index that continues to decelerate and is now closing in on the boom/bust line corroborates the bond market’s grim message. Tack on the Fed’s expected four cuts in the coming 12 months, and factors are falling into place for a durable rally in relative share prices. This disinflationary backdrop along with the Fed’s looming easing interest rate cycle have put a solid bid under gold prices. Hypermarket equities and bullion traditionally move in lockstep, and the current message is to expect more gains in the former (top panel, Chart 9). On the trade front specifically, these Big Box retailers do source consumer goods from China, but up to now these imports have been nearly immune to the U.S./China trade dispute as prices have been deflating (import prices shown inverted, bottom panel, Chart 9). However, this does pose a risk going forward and we will be closely monitoring it for two reasons: First, because downward pressures may intensify on the greenback and second, President Trump may impose additional tariffs, both of which are negative for industry pricing power. Chart 9Profit Margins… Chart 10…Will Likely Expand Meanwhile, industry demand is on the rise and will likely offset the potential trade and U.S. dollar induced margin pressures. Hypermarket retail sales are climbing at a healthy clip outpacing overall retail sales (bottom panel, Chart 10). Already non-discretionary retail sales are outshining discretionary ones, which is a precursor to recession at a time when overall consumer outlays have sunk below 1% (real PCE growth shown inverted, top panel, Chart 10). The implication is that hypermarkets will continue to garner a larger slice of consumer outlays as the going gets tough. In sum, the souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. Bottom Line: Boost the S&P hypermarkets index to overweight. The ticker symbols for the stocks in this index are: BLBG – S5HYPC – WMT, COST. Initiate A Long Global Gold Miners/Short S&P Oil & Gas E&P Pair Trade One way to benefit from the global growth soft-patch and looming global liquidity injection is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. While this market neutral and intra-commodity pair trade has already enjoyed an impressive run, there is more upside owing to a favorable macro backdrop. The key determinant of this share price ratio is the relative move in the underlying commodities that serve as pricing power proxies (top panel, Chart 11). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel, Chart 11). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel, Chart 11). Chart 11Global Soft-Patch… Chart 12…Disinflation… As a result of this growth scare that can easily morph into recession especially if the U.S./China trade war continues into next year, inflation is nowhere to be found. Unit labor costs are slumping (top panel, Chart 12), the NY Fed’s Underlying Inflation Gauge has rolled over decisively (not shown),4 and the GDP deflator is slipping (middle panel, Chart 12). Parts of the yield curve first inverted in early-December and the 10-year/fed funds rate slope is still inverted, signaling that gold miners will continue to outperform oil producers (yield curve shown on inverted scale, bottom panel, Chart 13). The near 100bps dive in real interest rates since late-December ties everything together and is a boon to bullion (and gold producers) that yields nothing (TIPS yield shown inverted, top panel, Chart 13). Meanwhile, bond volatility has spiked of late and the bottom panel of Chart 14 shows that historically the MOVE index has been joined at the hip with relative share prices. Chart 13…Melting Real Yields And… Chart 14…The Spike In Bond Vol, All Favor Gold Miners Over Oil Producers On the relative demand front, we peer over to China to take a pulse of the marginal moves in these commodity markets. China (and Russia) has been aggressively shifting their currency reserves into gold, and bullion holdings are rising both in volume terms and as a percentage of total FX reserves. In marked contrast, oil demand is feeble and Chinese apparent diesel consumption that is closely correlated with infrastructure and manufacturing activity has tumbled. Taken together, the message is to expect additional gain in relative share prices (middle & bottom panels, Chart 15). Adding it all up, the global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Bottom Line: Initiate a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Chart 15Upbeat Relative Demand Backdrop Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com. 4 https://www.newyorkfed.org/research/policy/underlying-inflation-gauge Current Recommendations Size And Style Views Favor value over growth Favor large over small caps
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Highlights The breakout in financial asset prices stands at odds with a deteriorating profit outlook. This suggests a high probability of a coiled-spring reversal in one of the two variables as we enter the thin summer trading months. We are maintaining a pro-cyclical currency stance, but are making a few portfolio tweaks in case we are caught offside during what could be a volatile summer. Maintain very tight stops on cable at 1.25, but look to sell EUR/GBP between 0.92 and 0.94. Our top pick for long positions are petrocurrencies, as geopolitical support is unlikely to ebb anytime soon. Buy a speculative basket of the Norwegian krone, Russian ruble, Mexican peso, and Colombian peso versus the euro. The latest RBA interest rate cut might be the ultimate insurance backstop needed to jumpstart the Australian economy. Remain long the Aussie dollar versus both the greenback and the kiwi, but with tight stops on the former. Any “flash crashes” are likely to favor the currencies of countries where tradeable bonds are in short supply. Remain short USD/JPY. Also, tactically sell gold bullion versus the yen. Feature Chart I-1The Markets And Data Diverge Financial markets are at an important crossroads as we head into the thin summer trading months. Asset prices have been reflated by plunging bond yields, with the S&P 500 hitting fresh highs this week. On the other hand, incoming manufacturing data across the major economies continue to deteriorate, suggesting the profit cycle remains in a downtrend. Either markets get better visibility into an improving profit outlook, or stock prices will succumb to the pressure of incoming data weakness (Chart I-1). For currency strategy, this means fundamentals could be temporarily put to the wayside, as markets flip the switch towards risk aversion. Our recommendations this week are threefold. First, maintain tight stops on tactical positions, especially those susceptible to summer volatility. Topping this list is our long position in the British pound. Second, our top pick for long positions are petrocurrencies, as geopolitical support is unlikely to ebb anytime soon. Finally, maintain portfolio insurance by being short the USD/JPY. Also, sell gold against the yen, given that relative sentiment has shifted in extreme favor of the former. A Summer Attack On The Pound? The episodes leading to the collapse of the pound in 1992 have important lessons for today.1 Britain entered the Exchange Rate Mechanism (ERM) in October of 1990 in an attempt to find a stable nominal anchor. In the years preceding entry into the ERM, inflation in the U.K. had been high and rising, leading to an appreciation in the real exchange rate. The rationale was that by adopting German interest rates, inflation would finally be tempered, and the real exchange rate would eventually be realigned. Most of the adjustment in the pound happened quickly, but a key difference from today is that exit from the ERM was unanticipated, unlike Brexit. During the ensuing years, pressure on the pound was relatively short-lived and could be quickly reversed by foreign exchange interventions or modest increases in interest rates. Meanwhile, the prospect of a European Monetary Union (EMU) also provided an anchor for expectations, since it would allow for more sound domestic policies. Problems began to surface in June 1992, when the Danes voted no in a referendum on the Maastricht Treaty that included a chapter on the EMU. This led to severe doubts about the progress made towards a union, especially as the outcome of the French referendum in September was expected to be close. Investors began to question where the shadow exchange rate for ERM currencies lay, especially where the Italian lira or the Spanish peseta were concerned. In August of that year, Britain began to massively step up interventions in the foreign exchange market, having to borrow excessively through the Very Short Term Financing facility (VSTF) to increase reserves. It also promised to raise interest rates from 10% to 12%, and later to 15%. But as an overvalued exchange rate had generated extremely sluggish GDP growth going into the 1990s, markets were not convinced the U.K. would tap into its unlimited borrowing facility or raise interest rates sufficiently to defend the pound. On black Wednesday in September 1992, Britain suspended membership to the ERM. There are a few important lessons that stand in stark contrast to a hard Brexit: Most of the adjustment in the pound happened quickly, but a key difference from today is that exit from the ERM was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly, usually with overshoots or undershoots. From its peak, GBP/USD depreciated by 24% by the end of October 1992. It subsequently fell to a low of 1.418 in February 1993 (Chart I-2). Peak to trough, cable has already fallen by 28%. Judging from the real effective exchange rate adjusted for consumer prices, the pound was overvalued as the U.K. entered the ERM. A persistent inflation differential between the U.K. and Germany had led to significant appreciation in the real rate. That gap is much narrower today (Chart I-3). Chart I-2The Pound Drop During ERM Was Quick And Violent Chart I-3Not Much Misalignment In##br## U.K. Prices Today The overvaluation of the pound meant that domestic growth was under tremendous pressure. Growth was already at recessionary levels entering into the ERM. Meanwhile, a bursting real estate bubble necessitated lower, not higher interest rates. This put to test the credibility of the peg. Today, U.K. growth is outpacing that of Germany, and will only improve if the pound drops further (Chart I-4). Productivity in the U.K. has kept pace with that of Germany over the last several years, suggesting the fall in the pound has been unwarranted. The Tory government runs a balanced budget and the Bank of England has much foreign exchange reserves to intervene in the market should confidence in the pound collapse. More importantly, the British currency is freely floating meaning there are less “hidden sins” compared to the fixed exchange rate period when it had to use the VSTF facility to boost reserves (Chart I-5). Chart I-4The U.K. Is Growing Faster Than The Eurozone's Engine Chart I-5Britain Has Lots Of ##br##FX Reserves A new conservative leadership is, at the margin, more negative for the pound (the assessment of our geopolitical strategists is that the odds of a hard Brexit have risen to 21% from 14%). However, our simple observation is that the pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union (Chart I-6). The pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union. This dichotomy might be the reason why in a speech this week, BoE Governor Mark Carney continued to highlight the growing divergence between market interest rate expectations (almost a 50% probability of a cut this year) and the central bank’s more hawkish bias. The experience of the ERM suggests it will be extremely destabilizing for the pound if the BoE is unable to anchor market interest rate expectations. This is especially true since the second quarter is likely to be a very weak one, leaving little time for data improvement until the October 31st Brexit deadline. Chart I-6More People In Favour Of The Union Chart I-7Cable Valuation Reflects Brexit Risk Putting it all together, our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. The real effective exchange rate of the pound is now lower than where it was after the U.K. exited the ERM in 1992, with a drawdown that has been of similar magnitude (24% in both episodes) (Chart I-7). In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its (or above) historical real effective exchange rate range, which will pin it 15-20% higher, or at around 1.50. As for EUR/GBP, U.K. gilt yields stand at 108-basis-point over German bunds, an attractive spread should carry trades return in favor. Historically, such a spread has usually pinned the EUR/GBP much lower (Chart I-8). Yes, incoming data in the U.K. has softened, but employment growth has been holding up, wages are inflecting higher and the average U.K. consumer appears in decent shape. Investment and construction have been the weak spot in the U.K. economy, but may marginally improve on lower rates. Meanwhile, from a technical perspective, the pound is also oversold versus the euro (Chart I-9). Chart I-8EUR/GBP Is A Sell Long-Term Chart I-9EUR/GBP Is Overbought Bottom Line: Stay long the pound as we enter volatile summer trading, but maintain tight stops at 1.25. Sell EUR/GBP if 0.94 is touched. Buy A Speculative Basket Of Petrocurrencies Rising geopolitical tensions between the U.S. and Iran continue to support oil prices. Meanwhile, at its latest meeting, OPEC agreed to extend its production cuts to the first half of 2020. This will put upward pressure on forward curves, nudging oil near our Commodity & Energy Strategy service’s target of $75 per barrel.2 Should demand pick up later this year, it will supercharge the uptrend. More importantly, the risk of escalation between Iran and the U.S. is high, given that the former has been backed up into a corner on falling oil exports. Together with a weakening U.S. dollar, this will be categorically bullish for petrocurrencies. In our currency portfolio, we are long the NOK versus both the SEK and CAD as exposure to both crude oil prices and the Brent premium. This week, we are adding a speculative basket of the Colombian peso, Mexican peso and Russian ruble to benefit from any surge in the oil geopolitical risk premium. This basket is attractive for two reasons. First, the currencies are trading at a discount to what is implied by the oil price (Chart I-10). This discount could rapidly close if it becomes evident that oil supplies are at major risk. It is also beneficial that the shipping routes these supplies take categorically avoids the Straits of Hormuz, or the epicenter of the conflict. Second, the carry from the trade is attractive at 5%, which provides some cushion against downside risks. The risk of escalation between Iran and the U.S. is high. Together with a weakening U.S. dollar, this will be categorically bullish for petrocurrencies. The positive correlation between petrocurrencies and oil has been gradually eroded as the U.S. economy has become less and less of an oil importer. Meanwhile, Norwegian production has been falling for a few years. This is why it may be increasingly more profitable to be long a basket of petrocurrencies versus oil-consuming nations rather than the U.S. Going long versus the euro is also a cushion against a knee-jerk rally in the dollar. Also going long a basket of higher-yielding EM petrocurrencies versus DM ones is a good bet (Chart I-11). Chart I-10Petrocurrencies Are Attractive Chart I-11EM Versus DM Oil Basket Bottom Line: Buy a speculative basket of the Norwegian krone, Russian ruble, Mexican peso and Colombian peso versus the euro. Investors should also consider a basket of EM petrocurrencies versus DM ones. A Final Note On Gold The short-term technical picture for gold has become unfavorable. This suggests that investors could be caught offside in the interim holding gold as a hedge. We recommend swapping some gold bullion for yen to insure against this risk for three reasons: As both are safe-haven proxies, yen in gold terms has tended to mean revert since 2012, so as to maintain a stable ratio of 138,000 JPY per ounce of gold. Today, the yen is sitting at two standard deviations below this range (Chart I-12). Open interest for gold is surging towards new highs, while that of the yen is making fresh lows. In the case of a rush towards safe havens, the liquidity squeeze is likely to favor appreciation in the yen (Chart I-13). Chart I-12Sell Some Bullion For Yen Paper Chart I-13A Liquidity Squeeze Could Favor The Yen Speculators are long gold but short the yen, which is attractive from a contrarian standpoint (Chart I-14). Chart I-14Speculators Are Long Gold And Short Yen Bottom Line: Remain short USD/JPY and sell a basket of gold versus some yen. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). 2 Please see Commodity & Energy Strategy Weekly Report, titled “Oil Volatility Will Abate As Financial Conditions Ease,” dated July 4, 2019, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been soft: Headline PCE fell to 1.5% year-on-year in May. Core PCE was unchanged at 1.6% year-on-year. Personal income growth was unchanged at 0.5% month-on-month in May, while personal spending fell to 0.4% month-on-month. Markit composite and manufacturing PMI both increased to 51.5 and 50.6 in June. However, ISM manufacturing and non-manufacturing PMI both decreased to 51.7 and 55.1 in June. Chicago purchasing managers’ index fell to 49.7 in June. Trade deficit widened to $55.5 billion in May. Factory orders contracted by 0.7% month-on-month in May. Also, durable goods orders fell by 1.3% month-on-month in May. DXY index increased by 0.4% this week. Our bond-to-gold indicator continues to point towards a weaker dollar. We believe that the combination of Chinese stimulus and the lagged effects from easing financial conditions should lift the global growth later this year, which would be a headwind for the dollar. Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline inflation was unchanged at 1.2% year-on-year in June, while core inflation increased to 1.1% year-on-year in June. Money supply (M3) grew by 4.8% year-on-year in May. Markit composite PMI increased to 52.2 in June. Manufacturing PMI fell to 47.6, while services PMI increased to 53.6. Unemployment rate fell to 7.5% in May. Producer price inflation fell to 1.6% year-on-year in May. Retail sales growth fell to 1.3% year-on-year in May. EUR/USD fell by 0.8% this week. IMF managing director Christine Lagarde was nominated to replace Mario Draghi as European Central Bank president this week. Analysts believe that she will likely maintain the ECB’s accommodative stance. This was confirmed by the plunge in 10-year bund yields to -40bps. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: The Tankan survey for Q2 was a mixed bag. The index for large manufacturers fell from 12 to 7. That for non-manufacturers increased from 21 to 23. Importantly, capex intentions rose from 1.2% to 7.4%. Housing starts contracted by 8.7% year-on-year in May. Construction orders continue to fall by 16.9% year-on-year in May. Nikkei composite PMI increased to 50.8 in June. Manufacturing PMI fell to 49.3, while services PMI increased to 51.9. Consumer confidence fell to 38.7 in June. USD/JPY has been flat this week. While Trump and Xi agreed to delay the trade talks during the G20 summit last weekend, there is no real progress toward a final trade agreement that could alleviate the tariffs. We continue to recommend the yen as a safe-haven hedge. Report Links: Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been negative: GDP growth was unchanged at 1.8% year-on-year in Q1. Current account deficit widened to £30 billion in Q1. Markit composite PMI fell to 49.7 in June. Manufacturing PMI decreased to 48; Construction PMI fell to 43.1; Services PMI fell to 50.2. Mortgage approvals fell to 65.4 thousand in May, while the Nationwide house price index was up 0.5% year-on-year. GBP/USD fell by 1% this week. BoE governor Carney warned in a speech this week that “a global trade war and a no deal Brexit remain growing possibilities not certainties.” Moreover, he stated that monetary policy must address the consequences of such uncertainty for the behavior of business, household, and financial markets. The probability of a BoE rate cut by the end of this year has thus increased from 21% to 46% following his speech. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: The Markit manufacturing PMI increased from 51.7 to 52.0 Terms of trade remain in a powerful uptrend. HIA new home sales increased by 28.8% month-on-month in May. This is beginning to put a floor under building approvals. Trade surplus increased to A$5.8 billion in May, the highest on record. Retail sales increased by 0.1% month-on-month in May. AUD/USD increased by 0.3% this week. Following the rate cut last month, the RBA again cut interest rates by another 25 basis points to a historical low of 1% this week. During the policy statement, Governor Philip Lowe stated that this should support employment growth and provide greater confidence to achieve the inflation target. We continue to favor the Australian dollar from a contrarian perspective. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: Consumer confidence increased by 2.8% month-on-month in June. Building permits increased by 13.2% month-on-month in May. NZD/USD fell by 0.3% this week. With its policy rate 50 basis points higher than its antipodean counterpart, the RBNZ is now under pressure to cut rates in the coming weeks. The market is currently pricing an 84% probability of a rate cut for the next policy meeting in August, and 94% chance rates will be cut before year-end. Should data disappoint in the interim, additional cuts could be priced in. Hold on to our long AUD/NZD and SEK/NZD positions. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: GDP growth increased to 1.5% year-on-year in Q1. Bloomberg Nanos confidence continues to rise to 58.3 last week. This tends to lead GDP growth by a quarter or two. Markit manufacturing PMI increased to 49.2 in June. Exports and imports both increased to C$53.1 billion and C$52.3 billion in May. The trade balance turned positive to C$0.8 billion on surging exports to the U.S. USD/CAD fell by 0.5% this week. The BoC Business Outlook Survey published last Friday highlighted that business sentiment has slightly improved, and that hiring intentions continue to be healthy. This should underpin the loonie in the near-term. Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell to 93.6 in June. Real retail sales contracted by 1.7% year-on-year in May. Manufacturing PMI fell to 47.7 in June. Headline inflation was unchanged at 0.6% year-on-year in June, while core inflation increased to 0.7% year-on-year in June. USD/CHF increased by 0.4% this week. The CHF/NZD cross has been correcting in recent weeks, and could eventually trigger our limit buy order at 1.45. Stay tuned. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing PMI fell from 54.1 to 51.9 in June. Registered unemployment was unchanged at 2.1% in June. House prices are inflecting higher, to the tune of 2.6% year-on-year in June. USD/NOK fell by 0.5% this week. This week’s OPEC meeting extended the production cuts into 1Q20. Easing global financial conditions and Chinese stimulus should help revive oil demand. Our Commodity & Energy Strategy team continues to expect Brent to average $75/bbl by the end of this year. Stay long NOK/SEK and short CAD/NOK. Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Retail sales fell by 0.5% year-on-year in May. Composite PMI fell to 50.5 in June. Manufacturing and services PMI both fell to 52 and 49.9. USD/SEK increased by 0.4% this week. The Riksbank held its interest rate unchanged at -0.25% this week as widely expected. However, the tone in the communique was hawkish. That said, the trade disputes between U.S. and China, and the Brexit chaos remain downside risks to the European economy, and the Riksbank might push the planned rate hike further down the road. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Oil prices will remain volatile as markets work through the lingering effects of tighter financial conditions prevailing last year, which, along with extended angst over Sino-U.S. trade tensions, slowed commodity demand growth (Chart of the Week). In 2H19, globally accommodative monetary policy and fiscal stimulus will revive demand for industrial commodities, particularly in EM economies. This will be most apparent in oil markets, where we continue to expect demand growth to strengthen going into 2020, aided in part by a weaker USD. On the supply side, this week’s extension of OPEC 2.0’s production cuts into 1Q20 means growth will remain constrained. Prices will rise, and forward curves, particularly for Brent, will steepen as refiners are forced to draw inventories to meet product demand.1 We continue to expect Brent to average $73/bbl this year and $75/bbl next, respectively. We expect WTI to trade $7/bbl and $5/bbl below that this year and next. Chart of the WeekEasing Financial Conditions Will Spur Oil Demand Highlights Energy: Overweight. Venezuela’s oil production reportedly recovered to 1.1mm b/d in June. Most of the increased production found its way to China, which accounted for just under 60% of crude and product exports.2 Given its modus operandi, we believe OPEC 2.0 likely will accommodate higher production in Venezuela by reducing production in other member states, keeping overall output relatively constant. Base Metals: Neutral. Copper treatment and refining charges fell to new lows at the end of last week, with Fastmarkets MB’s Asia – Pacific TC/RC index recording its lowest level on record at $52.40/MT ($0.0524/lb).3 TC/RC levels fall when supplies are low, as refiners have to discount their services to attract concentrate supplies. Elsewhere, workers at Codelco’s Chuquicamata copper mine agreed to a new contract last week, ending a brief strike. Precious Metals: Neutral. Gold’s rally resumed this week, reflecting investors’ expectations for expanded central-bank accommodation globally, which, all else equal, will keep interest rates lower for longer. The Fed's dovish turn, in particular, will weaken the USD later this year, which will be positive for EM commodity demand, the engine for commodity demand growth globally. Ags/Softs: Underweight. The USDA reported 56% of corn in the ground was in good to excellent condition last week, vs. 76% of the crop last year. For soybeans, 54% of the U.S. crop was in good or excellent condition, vs. 71% last year. The USDA’s Crop Progress reports cover 92% and 95% of total acreage planted in the U.S., respectively. Feature Oil prices will remain volatile over the short term, as markets transition from tighter monetary conditions to a more accommodative global backdrop (Chart 2). Based on our research into the drivers of oil-price volatility, this should translate into a less stressful pricing environment for industrial commodities generally, base metals and oil in particular (Chart 3).4 Chart 2Volatility Indicators Are Moderating Chart 3Signaling Oil Price Volatility Will Fall Much of the current oil-price volatility is being driven by worries over damage to aggregate global demand and growth expectations in the wake of the Sino-U.S. trade war, and by what now appears to be a too-aggressive posture by central banks implementing rates-normalization policies last year. Both of these can affect consumption and investment locally and globally.5 Fear That Real Demand Will Weaken At present, any indication real demand is faltering – e.g., weaker manufacturing PMIs – gives industrial commodities an excuse to sell off (Chart 4). In the case of the Sino-U.S. trade war, presidents Xi and Trump appear to have agreed to re-start trade negotiations. Markets are not going to be terribly concerned with the specifics of a trade deal between the U.S. and China, but it does appear some rollback in U.S. tariffs will be necessary for a trade deal – perhaps in exchange for greater access to Chinese markets. However, our geopolitical strategists make the odds of a trade deal by the time U.S. elections roll around 1:3. Our colleagues in BCA Research’s Global Investment Strategy note, “The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a ‘small’ trade war and a ‘moderate’ trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system.”6 As for monetary policy, major central banks are embarked on a coordinated effort to reverse falling inflation expectations, and will be vigorously stimulating their money supply and credit growth over the balance of the year. In addition, fiscal stimulus globally – in the U.S. and China most prominently – will boost real demand for industrial commodities, particularly oil and base metals.7 Monetary and fiscal stimulus operates with a lag, which is why we continue to expect its more visible for commodity demand to become apparent in commodity prices later in 2H19 and next year. This lagged effect can be seen in our expectation for the evolution of EM import volumes to year end, which we estimate using data compiled the CPB World Trade Monitor (Chart 5). EM import volumes are closely tied to the evolution of EM income, which drives global commodity demand.8 Chart 4Globally, The Real Economy Has Slowed Chart 5EM Imports and Income Will Rebound In our modeling of supply-demand balances and prices, we accounted for the reduced EM GDP growth brought about by more restrictive monetary policy last year and the slowdown in global trade in our most recent forecast. In our base case, we took our expected global oil-demand growth this year down to 1.35mm b/d from 1.5mm b/d earlier, and to 1.55mm b/d next year from 1.6mm b/d previously. These adjustments reduced our price expectation for Brent crude oil slightly to $73/bbl this year and $75/bbl next year, with WTI trading $7/bbl and $5/bbl below those respective levels (Chart 6). Chart 6Our Forecasts Reflect Lower Demand, Tighter Supply Oil Markets Will Get Tighter For all of the concern over real demand, prompt demand remains stout relative to available supply, as can be seen in the backwardations for global benchmark crude oil prices (Chart 7). This week’s extension of OPEC 2.0’s production cuts into 1Q20 means supply growth will remain constrained, which, given our demand expectation, will tighten balances globally (Chart 8).9 Chart 7Global Oil Benchmarks Remain Backwardated Chart 8Oil Supply Demand Balances Will TightenChart 9Oil Inventories Will Fall, As Supply Is Constrained As balances tighten in the wake of global fiscal and monetary stimulus, oil prices will rise, and forward curves, particularly for Brent, will steepen as refiners are forced to draw inventories to meet product demand (Chart 9). For this reason we remain long September – December 2019 Brent vs. short September – December 2020 Brent, expecting backwardation to increase.10 Bottom Line: We remain constructive toward oil markets, as they transition to a more accommodative monetary backdrop globally. Combined with fiscal stimulus in the U.S. and China in particular, demand will remain supported in 2H19 and 2020. The extension of OPEC 2.0’s production-cutting deal will tighten markets, forcing refiners to draw down inventories. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 OPEC 2.0 is a name we coined for the OPEC/non-OPEC oil-producing coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Their agreement to extend production cuts of 1.2mm b/d into 1Q19 was announced this week in Vienna. Please see OPEC/non-OPEC rolls over oil output cuts for 9 months published by S&P Global Platts on July 2, 2019. Compliance with these cuts has been higher by ~ 400k b/d in 1H19 by our reckoning. 2 Please see Venezuela's June oil exports recover to over 1 million bpd: data published July 2, 2019, by reuters.com. 3 Please see Copper concs TCs drop marginally on traders purchase; Cobre Panama’s fresh supply hits market published by Fastmarkets MB June 28, 2019. 4 We are using “volatility” in the technical sense here – i.e., the standard deviation of per-annum returns. We have shown this can be explained by different variables, including EM volatility; U.S. financial conditions – as seen in the St. Louis Fed’s financial-stress index; and by speculative positioning, which tends to follow the evolution of prices as news flows change. For discussions of our volatility modeling, including the construction of Working’s T index, please see Specs Back Up The Truck For Oil, published April 26, 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility, published May 10, 2018, by BCA Research’s Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. 5 Please see The economic implications of rising protectionism: a euro area and global perspective published by European Central Bank April 24, 2019. 6 Please see Third Quarter 2019 Strategy Outlook: The Long Hurrah, BCA Research’s global macro outlook for 3Q19, published June 28, 2019, by our Global Investment Strategy. It is available at gis.bcaresearch.com. The larger issues that will have to be addressed at some point in the future are non-tariff barriers to trade, exemplified by Huawei’s exclusion from access to U.S. technology on national security grounds. An expansion of such non-tariff barriers would strand huge amounts of capital globally, which likely would lead to a global recession. 7 Our chief global strategist, Peter Berezin, notes in the above-cited BCA Research third-quarter outlook that Fed policy is expected to remain ultra-accommodative into late 2021, which will push the USD lower later this year, and will support commodity demand generally. 8 We use an FX-based model to estimate EM import volumes to year end off the CPB data. 9 We will be updating our Venezuela and OPEC 2.0 production estimates to reflect this development in our July global oil market balance publication later this month. 10 We have been long 2H19 Brent vs. short 2H20 Brent since February 28, 2019. The July and August pieces of this position returned 222.7% and 273% since inception. We remain long the September – December exposure. Investment Views and Themes Recommendations Strategic Recommendations TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
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
Highlights The sharp fall in the bond-to-gold ratio is an important signal to pay heed to. It might suggest that confidence in the U.S. dollar is finally waning. If correct, the sharp rally in crypto currencies over the past few months warrants monitoring. We are maintaining a pro-cyclical currency stance, while cognizant of the fact that many growth barometers remain in freefall. Oil and petrocurrencies are being supported by geopolitical risk, but a rebound in underlying demand could supercharge the uptrend. We are looking to buy a speculative basket of the Russian ruble and Colombian peso versus the U.S. dollar or Japanese yen. The Norges Bank remains the most hawkish G10 central bank. Hold long NOK/SEK positions. Meanwhile, North Sea crude should continue trading at a premium to WTI, while Norway should also outperform Canada domestically. Remain short CAD/NOK at current levels. Feature Chart I-1Major Peak In The Bond-To-Gold Ratio Gold continues to outperform Treasurys, which has historically been an ominous sign for the U.S. dollar. Ever since the end of the Bretton Woods agreement broke the gold/dollar link in the early ‘70s, bullion has stood as a viable threat to dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick for tick. With the Federal Reserve’s dovish shift, we may just have triggered one of the necessary catalysts for a selloff in the U.S. dollar (Chart I-1). The implications for currency strategy could be far and wide, especially vis-à-vis our procyclical stance. For example, one of the crosses we are watching fervently is the AUD/JPY exchange rate, since the Aussie tends to be a high-beta currency among G10 FX traders, while the yen tends to be the lowest. More importantly, the AUD/JPY cross is bouncing off an important technical level, having failed to punch below the critical 72-74 zone. In our eyes, the recent bounce could be the prologue to a reflationary rally. On Gold One beneficiary from a lower U.S. dollar is gold. Gold may be breaking out to multi-year highs, but the important takeaway for macro traders is that we may be entering a seismic shift in the investment landscape. Almost every major economy now has or is inching towards negative real interest rates. So, investors who are worried about the U.S. twin deficits and the crowded trade of being long Treasurys will shift into gold, given other major bond markets are getting perilously expensive. Gold has a long-standing relationship with negative interest rates, though the correlation has shifted over time (Chart I-2). The intuition behind falling real rates and rising gold prices is that low rates reduce the opportunity cost of holding non-income generating assets such as gold. And while odds are that yields may creep higher from current low levels, this will still be bullish for gold, if driven by rising inflation expectations. Gold tends to be a “Giffen good” meaning physical demand tends to increase as prices rise. Support for the dollar is fraying at the edges, judging from relative interest rate differentials, international flows and balance-of-payment dynamics. Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. At the same time, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart I-3). The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fading. Chart I-2Gold And Real ##br##Yields Chart I-3Central Banks Are Absorbing Most Gold Production Gold tends to be a “Giffen good” meaning physical demand tends to increase as prices rise. Ever since the gold bubble burst in 2011, both financial and jewelry demand has evaporated. The reality is that both China and India went on a buying binge of coins and jewelry during gold’s last bull market, and there is no reason to expect this time to be different (Chart I-4). For all the talk about flexible exchange rate regimes, it seems as if the world’s major central banks have been fixing their exchange rates to the gold price (Chart I-5). This suggests that gold price risks could be asymmetric to the upside, at least for now. A fall in prices encourages accumulation by EM central banks as a way to diversify out of their dollar reserves, while a rise in prices encourages financial demand and jewelry consumption. Chart I-4Gold Is A Giffen Good Chart I-5Fixed Exchange Rates Versus Gold? The explosive rise in cryptocurrency prices highlights that the world is becoming flush again with liquidity, but also signals trepidation against global monetary policy settings (Chart I-6). In its basic function, money should be a store of value, a unit of account and a medium of exchange. Bitcoin’s high price volatility violates its function as a unit of account, but so do other currencies such as the Venezuelan peso or the Turkish Lira. In all, this boosts the demand for alternative assets, including gold. Bottom Line: Interest rate differentials are moving against the dollar, but our important takeaway – that gold continues to outperform Treasurys – is an ominous sign. This is bullish for pro-cyclical currency trades and gold. Chart I-6Confidence In The Dollar Is Waning On Oil Oil prices have been supported by rising geopolitical tensions between the U.S. and Iran, but will be supercharged if demand bottoms later this year. The view of our Geopolitical strategists is that the risk of escalation between the two factions is high, given Iran has been pinned into a corner with falling oil exports.1 Together with a falling U.S. dollar, this will be categorically bullish for petrocurrencies. In the cases of Canada and Norway, petroleum represents around 20% and 60% of total exports, so it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Our baseline still calls for Brent prices to touch $75/bbl by year-end. Oil demand tends to follow the ebbs and flows of the business cycle, and demand is contracting along with the slowdown in global trade (Chart I-7). But there is rising evidence of more and more activity along sea routes, judging from the Baltic Dry and Harpex shipping indexes. With over 60% of global petroleum consumed fueling the transportation sector, this is positive. This obviously hinges critically on a resolution to the trade war between the U.S. and China. However, with Chinese and Indian oil imports still growing healthily, this should also put a floor under global demand growth (Chart I-8). Chart I-7Global Oil Demand Has Been Weak Chart I-8Oil Demand Green Shoots Any increase in oil demand will materialize at a time when OPEC spare capacity is low. Global spare capacity cannot handle the loss of both Venezuelan and Iranian exports. Unplanned outages wiped off about 1.5% of supply in 2018, and lost output from both countries is nudging the oil market dangerously close to a negative supply shock (Chart I-9). The explosive rise in cryptocurrency prices signals trepidation against global monetary policy settings. In terms of petrocurrencies, there remains a gaping wedge that has opened vis-à-vis the price of oil (Chart I-10). While it is true that the landscape for oil production is rapidly shifting with the U.S. shale revolution grabbing market share from both OPEC and non-OPEC members, terms of trade still matter for petrocurrencies. Chart I-9A New Oil Baron Chart I-10Opportunity Or Regime Shift? The positive correlation between petrocurrencies and oil has been gradually eroded as the U.S. economy has become less and less of an oil importer. Meanwhile, Norwegian production has been falling for a few years. In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time U.S. production was about to take off (Chart I-11). Since then, that correlation has fallen from around 0.8 to roughly 0.3. This is why it may be increasingly more profitable to be long petrocurrencies versus a basket of oil-consuming nations, rather than the U.S. Chart I-11Shifting Landscape For Petrocurrencies Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian and Mexican pesos. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Transportation bottlenecks for Canadian crude and falling production in Norway are also added negatives. Remain Long NOK/SEK And Short CAD/NOK The Norges Bank remains the most hawkish G10 central bank, having hiked interest rates to 1.25% at last week’s meeting. Governor Øystein Olsen signaled further rate increases later this year – at a time when global central banks are turning dovish. This will continue to put upward pressure under the Norwegian krone. Our recommendation is to stay long NOK/SEK and short CAD/NOK. Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian and Mexican pesos. The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher (Chart I-12). Short CAD/NOK positions are an excellent way to play U.S. dollar downside (Chart I-13). The 6.50-6.60 level for the CAD/NOK has proven to be a formidable resistance since 2015. Chart I-12The Norwegian Economy Will Rebound Chart I-13Sell USD Via CAD/NOK At $20/bbl, the discount between Western Canadian Select crude oil and Brent has narrowed, but remains wide. This has usually pinned CAD/NOK around the 6.30 level (Chart I-14). The NOK tends to outperform the SEK when oil prices are rising. This trade also benefits from a positive carry. Both the Canadian and Norwegian housing markets continue to be frothy, but in the latter it has been concentrated in Oslo, with Bergen and Trondheim having had more muted increases. In Canada, the rise in house prices could rotate to smaller cities, as macro-prudential measures implemented in Toronto and Vancouver nudge investors away from those markets. The Canadian government has decided to provide residents with a potential line of credit in exchange for equity stakes of up to 10% in residential homes. While this does little to improve the affordability of houses in expensive cities, it almost guarantees that those in competitive markets will be bid up. This will encourage a continued buildup of household leverage, which is a long-term negative for the Canadian dollar (Chart I-15). Chart I-14Oil Differentials Will Weigh On CAD/NOK Chart I-15The CAD Looks Vulnerable Longer-Term Bottom Line: Remain short CAD/NOK and long NOK/SEK for a trade. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, titled “Escalation … Everywhere,” dated June 21, 2019, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly negative: The Markit composite PMI fell to 50.6 in June. Both manufacturing and services fell to 50.1 and 50.7 respectively. On the housing market front, existing home sales increased by 2.5% month-on-month in May. However, new home sales contracted by 7.8% month-on-month. The house price index increased by 0.4% month-on-month in April. Both Dallas and Richmond Fed Manufacturing indices fell to -12.1 and 3 in June. Advanced goods trade balance fell to $74.55 billion in May. Final annualized Q1 GDP was unchanged at 3.1% quarter-on-quarter, and core PCE increased by 1.2% quarter-on-quarter in Q1. DXY index has been flat this week. As we mentioned in last week’s report, we are closely monitoring the bond-to-gold ratio to gauge the direction of the U.S. dollar. Gold prices continue to soar this week by 5% due to safe-haven buying, the Fed’s dovish pivot, and rising inflation expectations. Our bias is that the balance of forces are moving away from the U.S. dollar. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area remain negative: The Markit composite PMI increased to 52.1 in June. The manufacturing PMI increased slightly to 47.8, and services PMI increased to 53.4. Sentiment remains depressed in June: Business climate fell to 0.17; Industrial confidence decreased to -5.6; Economic sentiment dropped to 103.3; Services sentiment came in at 11; Consumer confidence declined to -7.2. EUR/USD has been flat this week. The dovish message by Mario Draghi last week has limited the upside for the euro recently. However, in the long term, the dovish contest by global central banks will support a global economic recovery. That said, the trade war remains one of the biggest downside risks to our baseline scenario. Any deal or no-deal coming out of the G20 summit will likely re-shape expectations for the global economy and the euro. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Headline and core CPI fell to 0.7% and 0.5% year-on-year respectively in May. The Nikkei manufacturing PMI declined to 49.5 in June. The leading economic index increased to 95.9 in April. The coincident index rose to 102.1 in April. Retail sales grew by 1.2% year-on-year in May. USD/JPY rose by 0.2% this week. The BoJ published the monetary policy meetings minutes this week, highlighting the upside and downside risk factors to their forecast. Close attention is being paid to outside economic developments and the scheduled consumption tax hike for the fiscal year 2019, and peaking-out of Olympic games-related demand and IT sector developments for the fiscal year 2020. Besides that, the BoJ members agree that the accommodative monetary policy should be sustained for an extended period. Report Links: Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been negative: Public sector net borrowing fell to £4.5 billion in May. CBI retailing survey fell to -42 in June, from a previous reading of -27. GBP/USD fell by 0.4% this week. The probability of a “no-deal” Brexit has increased as a result of the new leadership contest. However, during the inflation report hearings this week, BoE Governor Carney highlighted that unless the next PM makes a “no-deal” Brexit their preferred policy, additional dovishness might not be warranted. We continue to favor the pound but will respect the stop loss at 1.25 if triggered. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: CBA composite PMI increased to 53.1 in June. Manufacturing and services PMI increased to 51.7 and 53.3 respectively. ANZ Roy Morgan weekly consumer confidence increased slightly from 114.2 to 114.3. AUD/USD increased by 1% this week, now trading around 0.6996. Any good news coming out of the trade deal during the G20 summit could support the Aussie dollar and put a floor under this cross. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Exports and imports both increased to NZ$5.81 billion and NZ$5.54 billion in May. The total trade balance fell to NZ$264 million in May. ANZ activity outlook fell to 8 in June, and business confidence fell to -38.1. NZD/USD increased by 1.7% this week. On Wednesday, the RBNZ kept interest rates unchanged at 1.5% and the market is currently pricing a 71.6% probability of rate cuts for the next policy meeting in August. Our bias remains that while the kiwi will benefit from broad dollar weakness, it will underperform its antipodean counterpart. We remain long AUD/NZD and SEK/NZD. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly positive: Retail sales growth slowed down to 0.1% month-on-month in April. Wholesale trade sales soared by 1.7% month-on-month in April. Bloomberg Nanos weekly confidence index rose to 57.8. CFIB business barometer increased to 61.5 in June. USD/CAD fell by 0.8% this week. The Canadian dollar continues to strengthen on the back of positive data surprises and recovering oil prices. U.S. EIA reported falling commercial crude oil inventories for last week. The tension continues between the U.S. and Iran. Moreover, OPEC is likely to cut their oil supply during the next meeting beginning in July. All these factors point to higher oil prices and will likely lift the loonie. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There is little data from Switzerland this week: ZEW expectations index fell to -30 in June. USD/CHF has been flat this week. We remain overweight the franc in the long run due to solid Swiss economic fundamentals, including a high savings rate, rising productivity, and current account surplus. It also serves as a perfect hedge to any downside risks, both economic and geopolitical. The long CHF/NZD recommendation in our April 26 weekly report remains valid, though we do not have this trade on. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There is little data from Norway this week: Retail sales contracted by 1.3% in May. USD/NOK has been flat this week. The Norwegian krone remains one of our favorite currencies due to the rising oil prices and widening interest rate differentials. The front section of this bulletin reinforces our bullish petrocurrency view. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly positive: Producer price inflation fell to 3.5% year-on-year in May. Trade balance increased to 8.3 billion SEK in May. USD/SEK fell by 0.8% this week. As we mentioned before, the Swedish exports could be a very powerful leading indicator of the global economy. In May, the Swedish exports increased to 137 billion SEK from 129 billion SEK in April. Hold on to our long SEK/NZD position. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades