Equities
Highlights We expect tensions from the Sino-US trade war to marginally ease in 2020, in the run-up to the US presidential election. The “Phase One” trade deal will likely be signed with a good possibility of some tariff rollbacks. Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the domestic economy and exports to only modestly accelerate. During the next 6 to 12 months, investors should remain bullish on both Chinese A shares and investable stocks, while keeping in mind that relative outperformance, particularly for A-shares, could be frontloaded in the first half of the year. Despite sharply rising amount of defaults, Chinese onshore bonds are priced at a much higher premium than warranted by their default risk. We continue to favor Chinese onshore corporate bonds in both absolute terms and in relative to duration-matched government bonds. Feature BCA Research recently published its special year end Outlook report for 2020, which described the macro themes that are likely to drive global financial markets over the coming year. In this week’s China Investment Strategy report we elaborate on the Outlook, by reviewing our four key themes for China in the year ahead. Key Theme #1: Tension From The Trade War With The US Will Ease In 2020 Despite the harsh rhetoric and threats of retaliation from both the US and China, we expect that the real risks to the global economy from the Sino-US trade war will decline in 2020. In trade negotiations next year, both President Trump and President Xi will need to adjust to their respective constraints. Both President Trump and President Xi will need to adjust to their respective constraints next year. Trump must sustain a strong domestic economy to increase his re-election odds. He will cater to the US economy and financial markets, by trying to de-escalate trade tensions and keeping negotiations going with China. This means he is likely to hold off on tariffs on China, and quite possibly even agree to roll back tariffs to August 2019 or April 2019 levels (Chart 1). Chart 1Some Tariff Rollback Is Possible President Xi also faces economic constraints as the Chinese economy is on an unsure footing. The buildup in leverage in the non-financial sector over the past decade has prevented Chinese policymakers from aggressively stimulating the economy by relying on the old debt-oriented policies. Chinese policymakers are concerned about employment stability.1 The private sector, which accounts for 80% of all job creation in China, has been disproportionally hit by the trade war and tariffs compared to the more domestically oriented state-owned enterprises. These economic constraints suggest that it is in China’s best interest to avoid any further friction with the US. Therefore, the “Phase One” trade deal will likely be signed, with a good possibility of some tariff rollbacks. Trade talks will continue in the run-up to the US presidential election, and any escalation will probably occur in non-trade, non-tariff areas. This means that policy uncertainty surrounding the Sino-US trade war will decline in 2020. Bottom Line: We expect tensions from the Sino-US trade war to marginally ease in 2020. However, the risk to this base case view is high and geopolitical uncertainty remains elevated, as suggested by our Geopolitical Strategy team.2 Trade war tensions could re-emerge, which potentially could end the global business cycle and equity bull market. Key Theme #2: Stimulus Versus Shock: Approaching An Inflection Point We presented some simple “arithmetic” in May showing that in order for investors to be bullish on Chinese stocks, the impact of China’s reflationary efforts needed to more than offset the negative shock to the economy from tariffs.3 In other words, a bullish Chinese equity scenario required Stimulus – Shock > 0. In terms of China’s real economy, 2019 essentially panned out to be a Stimulus – Shock =0 scenario, with a “half strength” reflationary response (measured by its credit impulse) barely offsetting the trade shock to the economy (Chart 2). So far on an aggregate level, the shock from tariffs on China’s economy has had a limited direct impact. This is because exports to the US account for only 3.6% of China’s aggregate economy, whereas domestic capex accounts for more than 40% (Chart 3). Our calculation suggests a 10% annualized decline in export growth to the US would shave off 0.4 percentage points from China’s nominal GDP growth. Chart 2This Year, Measured Stimulus Has Just Offset Shocks To The Economy Chart 3Domestic Demand Much More Important Than Exports To The US Additionally, evidence suggests that a large portion of China’s exports to the US has been rerouted through peripheral countries, such as Taiwan and Vietnam (Chart 4). This fact explains why China’s exports have been in-line with the trend of global trade this year (Chart 5). Chart 4Chinese Exports Finding Alternative Routes To The US... Chart 5...And Total Exports Have Been Holding Up Chart 6China's Economic Slowdown Predates The Trade War It is important for investors to remember that China’s current economic slowdown predates the trade war and is due to its domestic financial deleveraging campaign that began in early 2017. The trade war exacerbated an existing downward trend in the economy, but was not the cause of it (Chart 6). In 2020, while we expect a ceasefire in the trade war and a potential rollback of tariffs would ease the shock to China’s economy, we also believe that more pro-growth policy support is underway.4 From an investment perspective, this means both China’s economic conditions and corporate earnings will improve, supporting a bullish cyclical outlook for China-related assets. Still, several reasons point to the overall scale of stimulus being less than that of 2015-16, and the upside to China’s export growth will likely be limited given elevated geopolitical uncertainties. Therefore, it is unrealistic to expect a material acceleration in Chinese economic growth in 2020: China is still falling short of its target to double urban income by 2020. Chart 7A 6% Growth Next Year May Just Make The Cut Next year will mark the final year for Chinese policymakers to accomplish the goal of “Doubling GDP by 2020”. Without the recent upward revision to the level of its 2018 nominal GDP by 2.1%, China's economy would have to expand by at least 6.1% in 2020 to achieve the goal. The upward revision allows a lower economic growth rate in 2020 to reach the goal (Chart 7). China is still falling short of its target to double urban income by 2020 (Chart 8). While keeping economic growth and employment stable remains a top priority, the recent slight improvement in employment should provide some relief to Chinese policymakers (Chart 9). Chart 8China Is Falling Short Of Urban Income Target... Chart 9...But There Is Some Relief In The Labor Market Monetary policy will remain accommodative, with room for further cuts to interest rates and the reserve requirement ratio (RRR). Nonetheless, we think Chinese policymakers will only allow monetary policy to loosen incrementally and modestly, while keeping a lid on corporate leverage. According to a recent article published by Yi Gang, the governor of China’s central bank, the PBoC will be keen to avoid another boom-bust cycle.5 Fiscal stimulus will continue to take the center stage in supporting growth in 2020, as noted in our November 20th China Investment Strategy Weekly.6 We expect that the National People’s Congress in March 2020 will approve higher quotas on issuing local government bonds, and loosened capital requirements will likely further boost local governments’ infrastructure project funding and expenditures. Transportation and urban development infrastructure projects will likely to continue receiving the most policy support in 2020. Other areas such as environmental protection, education, and social security will continue to be the Chinese government’s focus. These areas are unlikely to translate into immediate economic growth, but will improve China’s long-term economic and social structures. In contrast, compared to the 2015-2016 cycle, housing construction will receive less fiscal support (Chart 10). Overall, we expect the Chinese government to set next year’s real GDP growth target between 5.5 - 6.0%, a half of a percentage point lower than the growth target for 2019. Despite slower real output growth, nominal GDP and economic conditions will bottom in the first quarter of 2020, subsequently pushing up core inflation and reversing an ongoing deflation in the industrial sector (Chart 11). Chart 10Transportation And Urban Development Projects Are Again In Favor Chart 11Nominal Output Will Tick Up Soon Bottom Line: Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the economy and export to only modestly accelerate. Key Theme #3: Improved Earnings Outlook Supports A Cyclically Bullish View On Chinese Stocks A combination of further policy support, improved earnings and decreased trade tensions should provide tailwinds to Chinese stocks in 2020. Chinese stocks will outperform the global benchmark over a cyclical time horizon (6- to 12-months), for the following reasons: Valuations are depressed relative to global averages: the forward P/E ratios of both China’s onshore A-shares and offshore investable stocks are well below the global benchmark (Chart 12). While the forward P/E ratio of the A-share index is hovering around 12 times, the investable market has particularly suffered a setback from uncertainties surrounding the trade war. Even taking into account that structural weakness in the Chinese corporate earnings growth justifies for a lower multiple than the global average, both Chinese onshore and offshore stocks are offering even deeper discounts than their peaks in 2018, compared to global benchmarks. Chart 12Valuations Of Chinese Stocks Are Depressed Chart 13Chinese Corporate Earnings Closely Track Economic Conditions Both the economy and earnings growth will improve: We expect the Chinese economy to bottom in the first quarter of 2020. Given the close correlation between the coincident economic activity and earnings cycle, we expect earnings to also improve in 2020 (Chart 13). Improved corporate earnings next year will be the catalyst for the currently cheap multiples in Chinese stocks to re-rate, and re-approach their early 2018 high. Our Earnings Recession Probability Model shows that the probability of an upcoming earnings recession has dropped to 35% from its peak of 85% in early 2019 (Chart 14). Additionally, Chart 15 highlights that the 12-month forward EPS momentum has turned modestly positive. Chart 14Probability Of An Upcoming Earnings Recession Has Significantly Dropped Chart 1512-Month Forward EPS Momentum Has Turned Modestly Positive There are, however, a few caveats to our bullish cyclical view on Chinese stocks. First, while it is not our base case view, geopolitical risks, particularly the Sino-US trade war, could end the global business cycle and equity bull market in 2020. Within the context of falling global stocks, we think Chinese domestic A shares would passively outperform global benchmarks, as A shares are mostly driven by China’s domestic credit and economic growth, and are less sensitive to trade frictions. But investable stocks would clearly underperform in this scenario. The odds are decent that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. Secondly, the odds are decent that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. We expect credit growth, infrastructure spending and the economy to improve in the first quarter. If the “Phase One” trade deal is also signed during that period, onshore A shares and investable stocks will significantly outperform their global counterparts in the first and possibly the early part of the second quarter. However, in the second half of next year, if the Chinese economy stabilizes but stimulus does not ramp up further, then the upside potential in both bourses may be capped as investors will question whether Chinese stocks will continue to gain ground in relative terms. We will closely monitor Chinese credit growth and trade negotiations throughout 2020 to determine if there is more eventual upside potential to economic growth, and thus Chinese earnings prospects, than we currently believe. While we recommend a cyclically bullish stance towards Chinese stocks for next year, our tactical (i.e. 0-3 month) stance remains neutral. We expect to align our tactical and cyclical stances soon, and are awaiting confirmation of a hard data improvement alongside a breakout of key technical conditions to do so.7 Bottom Line: During the next 6 to 12 months, investors should remain bullish on both Chinese A shares and investable stocks within a global equity portfolio. However, investors should also keep in mind that the relative outperformance, particularly for the A-share market, could be frontloaded in the first half of 2020. Key Theme #4: We Continue To Favor Chinese Onshore Bonds, Despite Default Concerns Chart 16Global Investors Are Piling Into The Chinese Bond Market Despite sharply rising defaults, Chinese onshore bonds are still priced at a much higher premium than warranted by their default risk. This view is increasingly shared by global investors, as evident in the capital flows into China’s onshore bond market (Chart 16). While the total amount of bond defaults in the first eleven months of 2019 was an astonishing 120.4 billion yuan, they account for only half percent of China’s total onshore bonds issued. A 0.5 percent default rate is in line with global ex-US, and 160 bps below the default rate in the US (Chart 17). Yet, Chinese corporate bond spreads are about 150-175 bps higher than their US counterparts, an overpriced risk premium in our view (Chart 18). Recently, despite mounting defaults, China’s corporate bond spreads have continued to narrow. This suggests that investors do not expect the record-high level of defaults in the past two years to damage China’s corporate sector in the near future. Moreover, China’s monetary policy remains ultra-loose, liquidity conditions have been largely stable, RMB devaluation and capital outflows have both been under control, and the Chinese economy is expected to bottom in the next quarter. Chart 17Chinese Default Rate Well Below Global Average Chart 18The Risk Premium Assigned To Chinese Corporate Bonds Seems Overdone Bottom Line: We continue to favor Chinese onshore corporate bonds in both absolute terms, and in relative to duration-matched government bonds. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 “China to take multi-pronged measures to keep employment stable,” State Council Executive Meeting, December 4, 2019. 2 Please see Geopolitical Strategy Special Report "2020 Key Views: The Anarchic Society," dated December 6, 2019, available at gps.bcaresearch.com 3 Please see China Investment Strategy Weekly Report "Simple Arithmetic," dated May 15, 2019, available at cis.bcaresearch.com. 4, 6, 7 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com. 5 https://www.chainnews.com/articles/745634370915.htm Cyclical Investment Stance Equity Sector Recommendations
Highlights Our take on the key macro drivers of financial markets is quite similar to last year’s, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... because the Fed and other central banks have reset the monetary policy clock, … : At this time last year, we projected that the Fed would be on the cusp of tightening monetary policy enough to induce a recession by the middle of 2020. Three rate cuts later, we now expect that policy won’t become restrictive until 2021. … pushing the inflection points investors care about further out into the future: The next recession won’t begin before monetary policy settings are tight, and stocks won’t peak until about six months before the recession starts. We are keeping close tabs on the trade negotiations and potential election outcomes, but we expect that 2020 will be another rewarding year for riskier assets: The equity bull market is likely to last for all of next year, and spread product will keep cranking out excess returns over Treasuries and cash for a while longer, too. Overweight equities and spread product. Feature Mr. and Ms. X made their annual visit to BCA last month, giving us an opportunity to gather our thoughts for 2020, while reviewing how our calls turned out in 2019. Both BCA and US Investment Strategy got the asset allocation conclusion right – overweight equities and spread product, while underweighting Treasuries – but the Fed did the opposite of what we expected heading into 2019, putting us on the wrong side of the Treasury duration call for most of the year. We still think investors are overly complacent about the potential for future inflation, but we concede that the future remains further off than we initially expected. Monetary policy settings got more accommodative nearly everywhere in the world in 2019, ... Our Outlook 2020 theme, as detailed in the year-end edition of The Bank Credit Analyst, is Heading into the End Game,1 and it is clear that the expansion is in its latter stages. We do not think that the end of the expansion, the equity bull market, or credit’s extended stretch of positive excess returns is at hand, however. The full-employment/low-inflation sweet spot is still in place, and the Fed has no plans to get in the expansion’s way, even if inflation begins to gain some traction. Its biggest policy priority is trying to get inflation expectations back to the 2.3 – 2.5% range consistent with its inflation target. Chart 1Globalization Hits A Wall Central banks around the world followed the Fed’s lead this year, cutting their policy rates in an attempt to shield their economies from potentially worsening trade tensions. Though no central banker would say it out loud, joining the rate-cutting parade also helped to defend against currency appreciation, as no one wants a strong currency when growth is in such short supply. The upshot is that global central banks are deliberately promoting reflation. That’s a supportive policy backdrop for risk assets, and while it may well lead to a bigger hangover down the road, it will ramp up the party now. Exogenous challenges remain. Trade tensions are a thorn in businesses’, consumers’ and investors’ sides. Even if US-China tensions die down, a belligerent US administration appears bent on using tariffs and other trade barriers as a cudgel to force concessions from other nations. The trade tailwind that boosted economic growth and investment returns across the last two decades has been stilled (Chart 1). Saber rattling by the US, or mischief from the usual rogue-state and non-state suspects, could also keep markets on edge. The looming election could give investors heartburn, and clients around the world remain anxious about the prospects of a Warren administration. Exogenous risks abound, but it is not our base case that a critical mass will coalesce to disrupt our view that generous-to-indulgent monetary policy settings will delay the day of reckoning, and keep the bull market going all the way through the coming year. As The Cycles Turn From our perspective, the practice of investment strategy is properly founded on the study of cycles. The key cycles – the business cycle, the credit cycle, and the monetary policy cycle – determine how receptive the macroeconomic backdrop is for taking investment risk. Investments made when the backdrop supports risk taking have a much better likelihood of generating excess returns over Treasuries and cash than investments made against an unfriendly macro backdrop. We therefore start every investment decision with an assessment of the key cycles. Determining whether the economy is expanding or contracting may seem like an academic debate with little practical application when the official business cycle arbiters don’t even determine the beginning and ending dates of recessions until well after the fact.2 Equity bear markets reliably coincide with recessions, however, and over the last 50 years, they have begun an average of six months before their onset (Chart 2). An investor who recognizes that a recession is at hand has a good chance of outperforming his/her competitors as long as s/he aggressively adjusts portfolio allocations in line with that recognition. Chart 2Bear Markets Rarely Occur Outside Of Recessions, ... Our key view, then, is that the start of the next recession is at least 18 to 24 months away. Tight monetary policy is a necessary, albeit not sufficient, condition for a recession (Chart 3), and we consider the Fed’s current monetary policy settings to be easy, especially after this year’s three rate cuts. A recession can’t begin until the Fed reverses those three cuts and, per our estimate of the equilibrium rate, tacks on at least three additional hikes. Tightening along those lines is decidedly not on the Fed’s 2020 agenda. Chart 3... And Recessions Only Occur When Monetary Conditions Are Tight Our recession judgment compels us to be overweight equities. Even if the next recession begins exactly halfway through 2021, history suggests that 2020 returns will be robust. Over the last 50 years, the S&P 500 has peaked an average of six months before the start of a recession, and returns heading into the peak have been quite strong, especially in the last four expansions (Table 1). Those results are consistent with bull markets’ tendency to sprint to the finish line (Chart 4). Table 1Stocks Don't Quit Until A Recession Is Near Chart 4Bull Markets End In Stampedes The Fed Funds Rate Cycle We estimate that the equilibrium fed funds rate is currently around 3¼%, and project it will approach 3½% by the end of next year. If we are correct that the Fed’s main policy aim is to prod inflation expectations higher, it follows that it will remain on hold at 1.75% well into 2020. A desire to avoid even the appearance of meddling in the election may well keep the FOMC sidelined until its November and December meetings. The implication is that monetary policy will have no chance to cross into restrictive territory before the first half of 2021. The bottom line for investors is that the day when the economy and markets will have to confront tight monetary conditions has been indefinitely postponed. The Fed has effectively deferred the inflections in the business cycle and the equity market to some point beyond 2020. A longer stretch of accommodation would also continue to fuel the equity bull market, as Phases I and IV of the fed funds rate cycle, in which the fed funds rate is below our estimate of equilibrium (Chart 5), have been equities’ historical sweet spot. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 2), while Treasuries have shined when it’s tight (Table 3). Chart 5The Fed Funds Rate Cycle Table 2Equities Love Easy Policy, … Table 3… When They Leave Treasuries Far Behind The Credit Cycle Our 30,000-foot view of the credit cycle is based on the banking mantra that bad loans are made in good times. When an expansion has been going on for a while, loan officers focus more on maintaining market share than lending standards, while managers of credit funds attract more assets, pushing them to find a home for their new inflows. Banks and bond managers are thereby pro-cyclical at the margin, keeping the good times going by lending to increasingly marginal borrowers and/or relaxing the terms on which they will lend. (They’re conversely stingy when real-time conditions are bad.) Lenders’ lagging/coincident focus keeps lending standards and borrower performance closely aligned in real time (Chart 6). Chart 6Standards Are Coincident In Real Time, ... Standards are a contrarian indicator over longer periods, though, because shoddily underwritten loans eventually show their true colors. We find a solid fit between corporate bond default rates and lending standards in the preceding 20 quarters (Chart 7). Lending standards tightened slightly in 2015, but were still quite easy in an absolute sense. A majority of banks tightened standards in 2016 amidst the oil rout, which could point to marginally better 2020-21 performance, but post-2010 standards have hardly been stringent. Chart 7... And Leading Over Five-Year Periods The stock of outstanding loans and bonds is therefore vulnerable. The relaxation of corporate bond covenants so soon after the financial crisis has not escaped the notice of bearish investors and reporters. It is not enough for an investor to identify a vulnerability, however; s/he also has to identify the catalyst that is going to cause a rupture. The challenge is that ultra-accommodative monetary policy delays the formation of negative catalysts. To the utter torment of an observer with an attraction to the Austrian School of Economics’ survival-of-the-fittest ethic, it is not at all easy to default in a ZIRP/NIRP world. The stock of $12 trillion of bonds with negative nominal yields (down from August’s $17 trillion peak) has ginned up a fervent search for yield among large institutional investor constituencies that have to meet a fixed distribution schedule, like life insurers and pension funds. These income-starved investors help explain why nearly any borrower, no matter how sketchy, can draw a crowd of would-be lenders simply by offering an incremental 50 or 75 basis points of yield. Borrowers default when no one is willing to roll over their maturing obligations; they get even more leveraged when lenders are climbing over each other to lend to them. It is also hard to default when central banks are deliberately pursuing reflation. Inflation makes debt service easier, and central banks are all-in for reflation as a means to bolster inflation expectations, defend against further trade tensions, and to ensure currency strength doesn’t undermine exports. The credit cycle is well advanced, and the Austrians may be at least partially vindicated when the ensuing selloff is worse than it would otherwise have been for having been delayed, but it looks to us like it has more room to run. The rapture remains out of reach for Austrian School devotees, who slot between Tantalus and New York Knicks fans on the cosmic persecution scale. Bonds We remain bearish on Treasuries and reiterate our below-benchmark duration recommendation, though we recognize that the 10-year Treasury yield is unlikely to rise beyond the 2.25-2.5% range in the next year. There’s only one more rate cut to price out of the OIS curve, and neither inflation expectations nor the term premium will return to normal levels quickly. The intermediate- and long-term outlook for the Federal budget is grim, given the size of the deficit while unemployment is at a 50-year low (Chart 8), but Dick Cheney will maintain the upper hand over deficit hawks for 2020 and several years beyond. We do think investors are complacent about inflation’s eventual return, though, and continue to advocate for TIPS over nominal Treasuries. It is tough to default in a ZIRP/NIRP world, when several institutional investor constituencies have a voracious appetite for yield. Chart 8The Budget Outlook Is Grim Chart 9IG Spreads Are Wafer Thin Our benign near-term view of the credit cycle makes us comfortable continuing to overweight spread product, subject to our US Bond Strategy colleagues’ preferences. They are only neutral on investment-grade corporates, given their scant duration-adjusted spread over Treasuries (Chart 9). They recommend overweighting high-yield corporate bonds instead, given that high-yield spreads still offer ample positive carry. They also recommend agency mortgage-backed securities as a high-quality alternative to investment-grade corporates, noting that their low duration (three years versus nearly eight for corporates) offers better protection against rising rates. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive until early to mid-2021 at the earliest, the bull market should be able to continue through all of 2020. We do not foresee a return to double-digit earnings growth, but the upward turn in leading indicators across a wide swath of countries outside of the US suggests that a revival in the rest of the world could help S&P 500 constituents grow earnings by mid-single digits, via a pickup in non-US demand and some softening in the dollar. Net share retirements could even nudge earnings growth into the high single digits. If earnings multiples hold up (they’ve expanded at a 5.5% annual rate in Phase IV of the fed funds rate cycle, and don’t typically contract until Phase II), S&P 500 total returns could reach the high single digits, easily putting them ahead of prospective Treasury returns. Multiple expansion isn’t required to support an overweight equities recommendation, but we would not be at all surprised if it occurred. Bull markets often get silly as they sprint to the finish line, and it would be unusual if some froth didn’t bubble up before this bull market, the longest of the postwar era, calls it quits. The Dollar We expect the dollar to weaken against other major currencies in 2020. As the rest of the world finds its footing and begins to accelerate, the growth differential between the US and other major economies will narrow. The dollar will attract less safe-haven flows as the rest of the world’s major economies escape stall speed. Though we expect the countercyclical dollar will rally again when the next recession hits, weakening in 2020 is consistent with our constructive global growth view. Putting It All Together We are sanguine about the US economy, which continued to trundle along at a trend pace in 2019 despite a series of headwinds. It withstood 4Q18’s sharp equity selloff and bond-spread blowout that tightened financial conditions and made corporate and investor confidence wobble. It withstood the 35-day federal government shutdown that lasted nearly all of January. It kept marching forward despite the trade war with China, and it overcame, at least for now, the angst over the inverted yield curve. If the economy continued to expand at roughly its trend pace despite those obstacles, it may not really have needed 25-basis-point rate cuts in July, September and October. The thread connecting our macro views and investment recommendations is the idea that monetary policy settings are highly accommodative and are likely to stay that way until the 2020 election. We expect that risk assets will outperform against an accommodating monetary backdrop. The naysayers are as likely to be confounded by central banks in 2020 as they have been throughout the entire ZIRP/NIRP era. The scolds scouring the data to try to find signs of excesses, and the Chicken Littles who have been frightened by clickbait headlines and strategists deliberately pursuing pessimistic outlier strategies, get one thing right. The market selloffs when the equity and credit bull markets end will be worse than they would have been if the Fed and other central banks were not deliberately attempting to reflate their economies. But their timing is likely to be as bad now as it has been all throughout 2019 (and for the entire post-crisis period for card-carrying, sandwich-board-wearing Austrians). You can’t fight the Fed, much less the ECB, the Bank of Japan, the Bank of England, the Swiss National Bank, the Reserve Banks of Australia and New Zealand, and a broad swath of all of the rest of the world’s central banks. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the December 2019 Bank Credit Analyst, “Outlook 2020: Heading Into The End Game,” available at www.bcaresearch.com. 2 The NBER’s Business Cycle Dating Committee announced in December 2008 that the last recession began in December 2007. It announced in September 2010 that it had ended in June 2009.
Highlights We are upgrading Pakistani equities to overweight within an EM equity portfolio. Fixed-income investors should consider purchasing 5-year local currency government bonds. The balance-of-payments adjustment is probably over. Hence, the currency will be stable, allowing inflation and interest rates to drop. Feature The country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Chart I-1Pakistani Stocks: The Worst Is Over We downgraded Pakistani equities in March 2017 and put this bourse on our upgrade watch list this past May (Chart I-1). In the past two years, the country has been going through a severe balance-of-payments crisis and a correspondingly painful adjustment. In recent months, the country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Today we are upgrading Pakistani stocks to overweight within an EM equity portfolio and recommend buying 5-year local currency government bonds. The worst is over for the economy and its financial markets for the following reasons. First, the country’s balance-of-payments position will improve. In real effective exchange rate (REER) terms, the Pakistani rupee has depreciated 15% over the past two years (Chart I-2). This will boost exports and cap imports, narrowing both trade and current account deficits further (Chart I-3). Chart I-2Considerable Depreciation In Pakistani Rupee… Chart I-3…Will Boost Exports And Cap Imports We expect exports to grow 5-10% next year. The country’s competitiveness has improved considerably, with its top commodities exports all having shown impressive growth in volume terms, despite weakening global growth (Chart I-4). Besides, in order to boost exports, the government has reduced the cost of raw materials and semi-finished products used in exportable products by exempting them from all customs duties in fiscal 2020 (July 2019 – June 2020). The government has also promised to provide sales tax refunds to the export sector. Chart I-4Increasing Competitiveness In Pakistan Exports In addition, falling oil prices will help reduce the country’s import bill. Remittance inflows – currently equaling 9% of GDP – have become an extremely important source of financing for Pakistan’s trade deficit. In the past 12 months, remittances sent from overseas have risen to US$22 billion, and have covered most of the US$28 billion trade deficit. Financial inflows are also likely to increase in 2020 and will be sufficient to finance the current account deficit. The IMF will disburse roughly US$2 billion to Pakistan. Other multilateral/bilateral lending/grants and planned issuance of Sukuk or Euro bonds will provide the government with much-needed foreign funding. As the economy recovers, net foreign direct inflows are also likely to increase. Net foreign direct investment received by Pakistan has grown 24% year-on-year in the past six months, with 56% of the increase coming from China. Overall, the improvement in Pakistan’s balance-of-payments position will continue, resulting in a refill of the country’s foreign currency reserves. Odds are that the central bank will purchase foreign currency from the government as the latter gets foreign funding. This will provide the government with local currency to spend. At the same time, the central bank’s purchases of these foreign exchange inflows will boost the local currency money supply – a positive development for the economy and stock market. Chart I-5 shows that the Pakistani stock market closely correlates with swings in the nation’s narrow money growth. The Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Chart I-5Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Chart I-6Pakistan: Improving Fiscal Balance Second, Pakistan’s fiscal balance also shows signs of improvement. Pakistan and the IMF have agreed to set the target for the overall budget and primary deficits at 7.2% of GDP and 0.6% of GDP, respectively, for the current fiscal year (Chart I-6). This will be a considerable improvement from the 8.9% of GDP and 3.3% of GDP, respectively, last fiscal year. In early November, the IMF praised Pakistan for having successfully managed to post a primary budget surplus of 0.9% of GDP during the first quarter (July 1, 2019 – September 30, 2019) of its current fiscal year. The authorities are determined to maintain strict fiscal discipline. The country’s tax-to-GDP ratio is at about 12%, one of the lowest in the world, so there is room to expand the tax base. Third, the Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Both headline and core inflation seem to have peaked (Chart I-7). Headline inflation fell to 11% in October, which already lies within the central bank’s target range of 11-12% for the current fiscal year. The policy rate is currently 225 basis points higher than headline inflation. As inflation drops and the currency finds support, interest rates will be reduced to facilitate the economic recovery. In addition, there has been much less public debt monetization by the central bank. After borrowing Rs3.16 trillion from the central bank in the previous fiscal year, the federal government has curtailed such borrowing to only Rs122 billion in the first three months of this fiscal year. Diminishing debt monetization will also help ease domestic inflation. Chart I-7Inflation Has Peaked Chart I-8Manufacturing Activity Is Likely To Recover Soon Fourth, manufacturing activity in Pakistan has plunged to extremely low levels, comparable to the 2008 Great Recession (Chart I-8). With a more stabilized local currency, easing domestic inflation and interest rate reductions, Pakistan’s economic activity is set to recover soon from a very low base. Finally, Phase II of the China-Pakistan Economic Corridor (CPEC) is set to begin this month. Under Phase II of the CPEC, five special economic zones will be established with Chinese industrial relocation. Phase II will also bring forward dividends from Phase I projects. The nation’s infrastructure facilities built by China over the past several years have enhanced the productive capacity of the Pakistani economy. The significant increase in electricity supply and improved railway/highway transportation will promote higher productivity/efficiency gains. Bottom Line: We are upgrading Pakistani equities to overweight within the emerging markets space. Both absolute and relative valuations of Pakistani stocks appear attractive (Charts I-9 and I-10). Chart I-9Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Chart I-10…And Relative To EM Equities Meanwhile, we recommend going long Pakistani 5-year local currency government bonds currently yielding 11.5%, as we expect interest rates to drop quite a bit (Chart I-11). Chart I-11Go Long Pakistani 5-Year Local Currency Government Bonds Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
The S&P 500 has made thirteen new all-time highs, or about one every other day, since the last week of October. The S&P SmallCap 600, on the other hand, just narrowly topped its year-to-date high, and remains more than 9% from its all-time high, set…
Highlights China’s PMIs continue to flash a positive signal, but the hard data trend remains negative. There has been a notable improvement in China’s cyclical sectors (versus defensives) over the past month, but broad equity market performance has been flat-to-down. China’s lackluster equity index performance in the face of rising PMIs suggests that investors can afford to wait for an improvement in the hard economic data before tactically upgrading to overweight. Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets versus the global benchmark, favoring the former over the latter. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, China’s November PMIs were clearly positive, and the rise in the official manufacturing PMI above the 50 mark is notable. However, the odds continue to favor a bottoming in the economy in Q1 rather than Q4, in large part because China’s “hard” economic data has continued to deteriorate during the time that the Caixin PMI has been signaling an expansion in manufacturing activity. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, China’s cyclical sectors have outperformed defensives, which is consistent with the positive message from China’s PMIs. But China’s broad equity markets have been flat-to-down versus the global index over the past month, suggesting that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight (from neutral). Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets, but favor the former over the latter in a trade truce scenario. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Both measures of the Li Keqiang index (LKI) that we track indicated no obvious improvement in Chinese economy activity in October. The BCA China Activity indicator, a broader coincident measure of China’s economy, also moved sideways in October and (for now) remains in a downtrend. Thus, based on the “hard data”, Chinese economic activity has not yet bottomed. Chart 1A Moderate Strength Economic Recovery Will Begin In Q1 The components of our LKI leading indicator continue to tell a story of easy monetary conditions and sluggish money & credit growth (Chart 1). The indicator itself remains in an uptrend, but it is a shallow one that does not match the intensity of previous credit cycles. While the uptrend in the indicator suggests that China’s economy will soon bottom, the shallow pace suggests that the coming rebound in growth will be less forceful than during previous economic recoveries. The uptrend in headline CPI is a notable macro development, with prices having risen 3.8% year-over-year in Oct (the fastest pace in almost eight years). This rise has been driven almost entirely by a surge in pork prices, which have risen over 60% relative to last year (panel 1 of Chart 2). While some investors have questioned whether the rise in headline inflation will cause the PBoC to tighten its stance at the margin, we argued with high conviction in our November 20 Weekly Report that this will not occur.1 Panel 2 of Chart 2 shows that periods of easy monetary policy line up strongly with periods of deflating producer prices, arguing that the PBoC will see through transient shocks to headline inflation. China’s October housing market data highlighted three points: housing sales are modestly improving, the pace of housing construction has again deviated from the trend in sales, and housing price appreciation is slowing in Tier 2 and Tier 3 markets. For now, we are inclined to discount the surge in floor space started, given previous divergences that proved to be unsustainable. The bigger question is whether investors should be concerned about slowing housing prices. Chart 3 shows that floor space sold and property prices have been negatively correlated over the past three years, in contrast to a previously positive relationship. Deteriorating affordability and tight housing regulations have contributed to this shift in correlation, which helps explain why the PBoC’s Pledged Supplementary Lending (PSL) program has been so closely related to housing sales over the past few years. While the growth in PSL injections is becoming less negative, it has not risen to the point that it would be associated with a strong trend in sales. As such, we continue to see poor affordability as a threat to further housing price appreciation, absent stronger funding assistance. Poor affordability will continue to be a headwind for China’s housing market. Chart 2The PBoC Will See Through Transient Shocks To Headline Inflation Chart 3Poor Affordability Will Continue To Weigh On Housing Demand Chart 4Investors Need To See Concrete Signs Of A Hard Data Improvement China’s November PMIs were quite positive, which legitimately increases the odds that China’s economy is beginning the process of recovery. However, we see two reasons to believe that the odds continue to favor a bottoming in the economy in Q1 rather than Q4. First, while they improved in November, several important elements of the official PMI remain in contractionary territory, particularly the new export orders subcomponent. Second, while the Caixin PMI has now been above the 50 mark for 4 consecutive months, China’s hard data has continued to deteriorate since the summer (Chart 4). Given the historical volatility of the Caixin PMI, we advise investors to wait for concrete signs of a hard data improvement before firmly concluding that China’s economy is recovering. Over the last month, China’s investable stock market has rallied roughly 1% in absolute terms, while domestic stocks have fallen about 3%. In relative terms, A-shares underperformed the global benchmark, while the investable market moved sideways. In our view, the underperformance of China’s domestic market reflects increased sensitivity to monetary conditions and credit growth compared with the investable market,2 and a weaker credit impulse in October appears to have been the catalyst for A-share underperformance. Over the cyclical horizon, earnings will improve in both the onshore and offshore markets in response to a modest improvement in economic activity, suggesting that an overweight stance is justified for both markets. But we think the investable market has more upside potential in a trade truce scenario. The outperformance of cyclical versus defensive sectors is sending a positive signal, but investors can afford to wait for better economic data before tactically upgrading. Chart 5A Positive Sign From Cyclicals Versus Defensives Within China’s investable stock market, it is quite notable that cyclicals have outperformed defensives over the past month on an equally-weighted basis (Chart 5). Interestingly, key defensive sectors such as investable health care and utilities have sold off significantly, and equally-weighted cyclicals have also outperformed defensives in the domestic market. The outperformance of cyclicals and underperformance of defensives is consistent with the positive message from China’s PMIs, but the fact that this improvement is occurring against the backdrop of flat-to-down relative performance for China’s equity market suggests that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. China’s government bond yields fell slightly in November, potentially reflecting expectations of further modest easing. Our view that monetary policy will likely remain easy over the coming year even in a modest recovery scenario suggests that Chinese interbank rates and government bond yields are likely to range-trade over the coming 6-12 months. We expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. Chinese onshore corporate bond spreads eased modestly over the past month. Despite continued concerns about onshore corporate defaults, the yield advantage offered by onshore corporate bonds have helped the asset class generate a 5.4% year-to-date return in local currency terms. Barring a substantial intensification of the pace of defaults, we expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. The RMB has moved sideways versus the US dollar over the last month. USD-CNY had fallen below 7 in October following the announcement of the intention to sign a “phase one” trade deal, but the move ultimately proved temporary given the deferral of an agreement. We would expect the RMB to appreciate following a deal of any kind (a truce or something more), and it is also likely to be supported next year by improving economic activity. Still, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors. As such, we expect a modest downtrend in USD-CNY over the coming year. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated November 27, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of November 29, 2019. The model has not made any directional change in its allocations this month. In terms of magnitude, however, the underweight of the US and the UK are both reduced slightly at the expense of other countries, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed the MSCI World benchmark in November by 22 bps, caused by the underperformance from both the Level 1 (11 bps) and the Level 2 (27 bps) models. Four out of the five underweights worked well, especially the large underweight in Japan. However, none of the seven overweights panned out, especially the large overweight in Spain and Italy. Since going live, the overall model has outperformed by 51 bps, with 237 bps of outperformance by the Level 2 model, offset by 58 bps of underperformance from the Level 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) For more on historical performance, please refer to our website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of November 29, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The global growth proxies used in our model have turned slightly bearish, reflecting concerns about the rebound. This in turn led the model to reverse a few of the overweights it had instated last month on sectors such as Industrials and Consumer Discretionary. The valuation component remains muted across all sectors except Energy. The model is now overweight three sectors in total, one cyclical versus two defensive sectors. These are Consumer Staples, Health Care, and Information Technology. Chart 4Overall Model Performance Table 3Overall Model Performance For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates”, dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 4Current Model Allocations Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Research Associate amrh@bcaresearch.com
Highlights Portfolio Strategy Interest rates are one of the most important macro drivers of overall equity returns via valuations. BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as BCA predicts, will have significant knock on effects on sector selection. Recent Changes There are no changes to our portfolio this week. Table 1 Feature As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. We remain perplexed by the market’s euphoric rise and near total neglect of weak profit growth fundamentals. This “hope rally”, as we have characterized it in the recent past, may have some more legs with the traditional Santa Rally around the corner, but the set up for stocks could not be more treacherous for 2020. Importantly, we deem the risk of not getting a Sino-American trade deal to be significantly greater than a relief rally in case of a successful deal. Most of the positive trade-related news is already reflected into equities. This complacent backdrop is reminiscent of the early 2018 SPX catapult to 2,870 as back then the fresh fiscal easing package was all priced into stocks in the first 20 trading days of that year. Chart 1 vividly depicts this euphoric melt-up in stocks with the longest dated VIX future trouncing the squashed front month VIX future. While this ratio is not at the stratospheric level hit in late-December 2017, it hit a wall recently forewarning that equities are skating on thin ice. Chart 1VOL... Similarly, speculators are net short vol, but a snap can occur at any time. This is eerily reminiscent of February 2018. Since 2017, this vol positioning measure has consistently troughed prior to the SPX peak on three occasions and a “four-peat” likely looms (vol net spec positions shown inverted, bottom panel, Chart 2). On the profit front, sector earnings breadth is sinking like a stone confirming the negatively anchored S&P 500 net EPS revisions ratio (Chart 3). We doubt that 10% EPS growth for calendar 2020 is even plausible, especially given the looming steep deceleration in equity retirement that we highlighted recently.1 Tack on the mighty US dollar, and profit headwinds abound. Chart 2...A Coiled Spring Chart 3No Earnings Pulse Market internals are also screaming that something is off in the equity markets. Small caps are trailing large caps, transports are at stall speed, weak balance sheet stocks are underperforming strong balance sheet stocks, the median stock as per the Value Line Geometric Index is far from all-time highs and high yield bonds (especially CCC rated) are also not confirming the SPX breakout (Chart 4). Importantly, the CBOE’s S&P 500 implied correlation index, which gauges “the expected average correlation of price returns of S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX”,2 is rising again over the 40% mark, underscoring that stocks are more and more beginning to move in tandem. Historically this has been a negative omen (implied correlation index shown inverted, top panel, Chart 5). Chart 4Watch Market Internals Chart 5Reflation No More? Downtrodden M&A activity is also firing a warning shot. A steep divergence of M&A deals from stock prices is atypical at this late stage of the business cycle (middle panel, Chart 5). In fact, out Reflation Gauge comprising the greenback, oil prices and the 10-year Treasury yield has taken a turn for the worse, signaling that economic surprises will likely suffer the same fate (bottom panel, Chart 5). All of this, warns that the risks of a significant pullback in the SPX are rising. What follows is four high-conviction overweight and four underweight calls. Similar to last year, we are using BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls.3 While last year this was offside, the collapse in the 10-year US Treasury yield from 3% last December to 1.75% currently offers a better backdrop for this view to pan out. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as our BCA house view predicts, will have significant knock on effects on sector selection.4 As a reminder, interest rates are one of the most important macro drivers of overall equity returns via valuations (10-year Treasury yield shown inverted, Chart 6). Moreover on a sector basis, the ebbs and flows of the risk free asset directly influence utilities, real estate, financials, consumer discretionary and tech growth stocks or more than half of the S&P 500’s market capitalization. Chart 6Priced To Perfection What follows is four high-conviction overweight and four underweight calls. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com S&P Managed Health Care (Overweight) We upgraded the S&P managed health care group to overweight in April shortly after Bernie Sanders re-introduced his revamped “Medicare For All” bill. Despite the recent explosive run up in relative share prices – partly owing to the drop in Elizabeth Warren’s odds of winning the Democratic candidacy and partly given her watering down of her “Medicare For All” take up plan – we are adding this health care sub-group to our high-conviction overweight call list. HMOs are finally raising prices at the steepest rate of the past fifteen years and while such breakneck pace is unsustainable, profit margins are set to expand smartly (Chart 7). The profit margin backdrop is enticing for health insurers for another reason: labor cost containment. CEOs have been extremely prudent refraining from adding to headcount. One final profit margin booster is the rising 10-year Treasury yield, as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves. Thus, if BCA’s bond view materializes, it will prove a tonic to both margins and profits. With regard to technicals, relative share prices are not as oversold as they were mid-year, but remain below the neutral zone still offering investors a compelling entry point to this position (bottom panel, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG. Chart 7S&P Managed Health Care S&P Machinery (Overweight) A tentative up-tick in EM data in general and China in particular along with improving operating metrics signal that the US/China trade war wounded machinery stocks deserve a high-conviction overweight status for 2020. In more detail, the budding recoveries in the EM and Chinese manufacturing PMIs herald a brighter outlook for relative share prices. China’s fiscal and credit impulse also signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can reclaim the early-2018 highs. On the operating front, the new orders-to-inventories momentum has traced a bottom. Assuming that the Chinese manufacturing PMI reading stays on an upward trajectory, machinery demand will make a durable comeback. None of these green shoots are reflected in sell-side analysts’ bombed out relative profit and sales growth expectations (bottom panel, Chart 8). The ticker symbols for the stocks in this index are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS. Chart 8S&P Machinery S&P Banks (Overweight) The expected price of credit, still pristine credit quality, and a looming reacceleration in credit growth all argue for including the S&P banks index in our high-conviction overweight list. Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market. As the bond sell-off gained steam, the bank outperformance phase also caught on fire. BCA’s view for next year calls for a 50-75bps selloff in the 10-year Treasury yield, further boosting the allure of bank equities (top panel, Chart 9). Beyond the rising price of credit, credit growth is another key industry profit driver. Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher. The upshot is that bank credit growth will likely reaccelerate in the first half of 2020 (third panel, Chart 9). Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine. Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that there is a long runway ahead for relative bank valuations (bottom panel, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC. Chart 9S&P Banks Long Large Caps/Short Small Caps (Overweight) The large cap size bias is our sole hold out from last year’s high-conviction list despite getting stopped out and booking a handsome 9% profit. Today we recommend reinstating a large cap size bias. This call actually represents a slight hedge on BCA’s overall higher interest rates view for next year. Financials comprise 13% of the SPX, but the weight jumps to 18% in small cap indexes. Thus, if the rising interest view is off the mark, the large cap bias will provide an offset. Relative forward profit growth favors mega caps and by a wide margin. One key factor underpinning this increasing profit gap is the massive profit margin divergence (Chart 10). Tack on the fact that index providers omit negative forward profits from their index EPS calculations and the narrative that small caps have cheapened versus large caps falls flat on an adjusted basis. Why? Because a large number of small caps have negative forward EPS. Moreover, we recently created a relative employment proxy that is firing on all cylinders. Not only is the small business labor market crumbling according to the latest NFIB survey, but hard data also suggest that nonfarm private small business payroll employment has ground to a halt. Finally, small caps are debt saddled compared with large caps and small cap b/s have actually been degrading of late (Chart 10). Chart 10Long Large Caps/Short Small Caps S&P Homebuilding (Underweight) We downgraded homebuilders to underweight in late-October, and today we are adding it to our high-conviction underweight call list. Most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drubbing in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Now that interest rates are moving in reverse, more pain lies ahead for the S&P homebuilding index (Chart 11). Worrisomely, consumers’ expectations to purchase a new home plunged anew last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 11). Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 11). Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Chart 11S&P Homebuilding S&P Semi Equipment (Underweight) While year-to-date chip equipment stocks are the best performing index in the SPX, we deem them a mania, and include them in our high-conviction underweight basket for 2020. The top panel of Chart 12 shows this irrational exuberance that has permeated the semi equipment universe is similar to the dotcom era excesses. Back in the late-1990s relative profit growth was sky high, but today it is flirting with the zero line, warning that gravity will pull these stocks back down to earth (second panel, Chart 12). The contracting ISM manufacturing survey signals that relative share price momentum running at a breakneck pace is unwarranted. The same holds true for relative forward profit and revenue growth expectations, especially given the ongoing contraction in global semi sales (middle panel, Chart 12). This deficient demand for semis and therefore semi equipment manufacturers is also apparent in deflating DRAM prices, our industry pricing power proxy. Historically, relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy. Net earnings revisions have slingshot from extreme pessimism to extreme optimism during the past quarter and are vulnerable to disappointment (bottom panel, Chart 12). In sum, lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the mania in the S&P chip equipment index will likely turn into a panic next year. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. Chart 12S&P Semi Equipment S&P Utilities (Underweight) Heavily indebted utilities are a high-conviction underweight call for next year. · Relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (Chart 13). Utilities command a 19.4 forward P/E multiple representing roughly a 10% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 400bps. Our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession (Chart 13). On the operating front, natural gas prices are contracting at the steepest pace of the past four years, and electricity capacity utilization is in a multi-decade downtrend, warning that the relative profitability will remain under pressure in 2020. The implication is that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam as BCA expects. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES. Chart 13S&P Utilities S&P Real Estate (Underweight) We would refrain from chasing high yielding real estate stocks higher, and instead we are including them in our high-conviction underweight call list for 2020. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown). Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble. Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (Chart 14). Occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects. The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum (Chart 14). Finally, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the selloff in the bond market gains steam as BCA expects. (Chart 14). The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC. Chart 14S&P Real Estate Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “Gasping For Air” dated November 18, 2019, available at uses.bcaresearch.com. 2 https://www.cboe.com/micro/impliedcorrelation/impliedcorrelationindicator.pdf 3 Please see BCA The Bank Credit Analyst Monthly Report, “OUTLOOK 2020: Heading Into The End Game” dated November 22, 2019, available at bca.bcaresearch.com. 4 Ibid. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Feature Recommended Allocation In late November, BCA Research published its 2020 Outlook titled Heading Into The End Game, an annual discussion between BCA’s managing editors and the firm’s longstanding clients Mr. and Ms X.1 We recommend GAA clients read that document for a full analysis of the macro and investment environment we expect in 2020. In this Monthly Portfolio Outlook, we focus on portfolio construction: how we would recommend positioning a global multi-asset portfolio for the 12-month investment horizon in light of that analysis. First, a brief summary of the BCA macro outlook. We believe the global manufacturing cycle is starting to bottom out, partly because of its usual periodicity of 18 months from peak to trough, and also because of easier financial conditions, and some moderate fiscal and credit stimulus from China (Chart 1). Central banks will remain dovish next year despite accelerating growth. The Fed, in particular, worries that inflation expectations have become unanchored (Chart 2) and, moreover, will be reluctant to raise rates ahead of the US presidential election. This environment implies a moderate rise in long-term interest rates, with the US 10-year Treasury yield rising to 2.2-2.5%. Chart 1Reasons To Expect A Rebound Chart 2Unanchored Inflation Expectations Worry The Fed For an asset allocator, this combination of an improving manufacturing cycle and easy monetary policy looks like a very positive environment for risk assets (Chart 3). We, therefore, remain overweight equities and underweight fixed income. We have discussed over the past few months the timing to turn more risk-on and pro-cyclical in our recommendations.2 Since we are increasingly confident about the probability of the manufacturing cycle turning up, this is the time to make that change. Consequently, the shifts we are recommending in our global portfolio, shown in the Recommended Allocation table and discussed in detail below, add to its beta (Chart 4). Chart 3A Positive Environment For Risk Assets Chart 4Raising The Beta Of Our Portfolio Chart 5Some Signs Of Risk-On Still Missing Nonetheless, we still have some concerns. China’s stimulus (particularly credit growth) remains half-hearted compared to previous cyclical rebounds in 2012 and 2016. We expect a “phase one” ceasefire in the trade war. But even that is not certain, and it would not anyway solve the long-term structural disputes. To turn fully risk-on, we would want to see signs of a clear rebound in commodity prices and a depreciation of the US dollar, which have not yet happened (Chart 5). The 2020 Outlook proposed some milestones to monitor whether our scenario is playing out and whether we should turn more or less risk-on. We summarize these milestones in Table 1. Given these uncertainties, to hedge our pro-cyclical positioning we continue to recommend an overweight in cash, and we are instituting an overweight position in gold. Table 1Milestones For 2020 Chart 6Recessions Are Caused By Inflation Or Debt How will this cycle end? All recessions in modern history have been caused either by a sharp rise in inflation, or by a debt-fueled asset bubble (Chart 6). The Fed will likely fall behind the curve at some point as, after further tightening in the labor market, inflation starts to pick up. How the Fed reacts to that will determine what triggers the recession. If – as is most likely – it lets inflation run, that could blow up an asset bubble (and it was the bursting of such bubbles which caused the 2000 and 2007 recessions); if it decides to tighten monetary policy to kill inflation, the recession would look more like those of the 1970s and 1980s. But it is hard to see either happening over the next 12-18 months. Equities: As part of our shift to a more pro-risk, pro-cyclical stance, we are cutting US equities to underweight, and raising the euro zone to overweight, and Emerging Markets and the UK to neutral. US equities have outperformed fairly consistently since the Global Financial Crisis (Chart 7) – except during the two periods of accelerating global growth, in 2012-13 (when Europe did better) and 2016-17 (when EM particularly outperformed). The US today is expensive, particularly in terms of price/sales, which looks more expensive than the P/E ratio because the profit margin is at a record high level (Chart 8). The upside for US stocks in 2020 is likely to be limited. In 2019 so far, US equities have risen by 29% despite earnings growth close to zero. Multiples expanded because the Fed turned dovish, but investors should not assume further multiple expansion in 2020. Our rough model for US EPS growth points to around 8% next year (sales in line with nominal GDP growth of 4%, margins expanding by a couple of points, plus 2% in share buybacks). Add a dividend yield of 2%, and US stocks might give a total return of 10% or so. Chart 7US Doesn't Always Outperform Chart 8US Equities Are Expensive To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Euro zone stocks have a higher weighting in sectors we like such as Financials and Industrials (Table 2). European banks, in particular, look attractively valued (Chart 9) and offer a dividend yield of 6%, something investors should find appealing in this low-yield world. EM is more closely linked to China and commodities prices, which are not yet sending strong positive signals. We worry about the excess of debt in EM (Chart 10), which remains a structural headwind: the IMF and World Bank put total external EM debt at $6.8 trillion (Chart 11). Table 2Equity Sector Composition Chart 9Euro Zone Banks Are Especially Cheap Chart 10EM Debt Remains A Headwind Japan is another likely beneficiary of a cyclical recovery. But, before we turn positive, we want to see (1) signs of a stabilization of consumption after the recent tax rise (retail sales fell by 7% year-on-year in October), and (2) clarification of a worrying new investment law (which will require any investor which intends to “influence management” to get prior government approval before buying as little as a 1% stake in many sectors). For an asset allocator this combination of an improving manufacturing cycle and easy monetary policy looks very positive for risk assets. We raise the UK to neutral. The market has been a serial underperformer over the past few years, but this has been due to the weak pound and derating, rather than poor earnings growth (Chart 12). It now looks very cheap and, with the risk of a no-deal Brexit off the table, sterling should rebound further. The UK is notably overweight the sectors we like (Table 2). However, political risk makes us limit our recommendation to neutral. Although the Conservatives look likely to win a majority in this month’s general election, which will allow them to push through the negotiated Brexit deal, subsequent arguments over the future trade relationship with the EU will be divisive. Chart 116.8 Trillion In EM External Debt Chart 12The UK Has Been Derated Since 2016 Fixed Income: We remain underweight government bonds. Stronger economic growth is likely to push up long-term rates (Chart 13). Nonetheless, the rise in yields should be limited. The Fed looks to be on hold for the next 12 months, but the futures market is not far away from that view: it has priced in only a 60% probability of one rate cut over that time. The gap between market expectations and what the Fed actually does is what our bond strategists call the “golden rule of bond investing”. US inflation is also likely to soften over the next few months due to the lagged effect of this year’s weaker growth and appreciating dollar. We do not expect the 10-year US Treasury to rise above 2.5% – the current FOMC estimate of the long-run equilibrium level of short-term rates (Chart 14). Chart 13Growth Will Push Up Rates... Chart 14...But Only As Far As 2.5% Within the fixed-income universe, we remain positive on corporate credit. But US investment-grade bond spreads are no longer attractive and so we downgrade them to neutral (Chart 15). Investors looking for high-quality bond exposure should prefer Agency MBS, which trade on an attractive spread relative to Aa- and A-rated corporate bonds. European IG should do better since spreads are not so close to historical lows, risk-free rates should rise less than in the US, and because the ECB is increasing its purchases of corporate bonds. Chart 15US IG Spreads Are Close To Historical Lows Chart 16US Caa Bonds Have Some Catching Up To Do We continue to like high-yield bonds, both in the US and Europe. But we would suggest moving down the credit curve and increasing the weight in Caa-rated bonds. These have underperformed this year (Chart 16), mainly because of technical factors such as their overweight in the energy sector and relatively smaller decline in duration.3 With a stronger economy and rising oil prices, they should catch up to their higher-rated HY peers in 2020. To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Currencies: Since the US dollar is a counter-cyclical currency (Chart 17), we would expect it to weaken against more cyclical currencies such as the euro, and commodity currencies such as the Australian dollar and Canadian dollar. But it should appreciate relative to the yen and Swiss franc, which are the most defensive major currencies. We expect EM currencies to continue to depreciate. Most emerging markets are experiencing disinflation (Chart 18), which will push central banks to cut rates and inject liquidity into the banking system. This will tend to weaken their currencies. Overall, we are neutral on the US dollar. Chart 17The Dollar Is A Counter-Cyclical Currency Chart 18Disinflation Will Push EM Currencies Down Further Commodities: Industrials metals prices are closely linked to Chinese stimulus (Chart 19). A moderate recovery in Chinese growth should be a positive, and so we raise our recommendation to neutral. But with question-marks still lingering over the strength of the rebound in the Chinese economy, we would not be more positive than that. Oil prices should see moderate upside over the next 12 months, with supply tight and demand growth recovering in line with the global economy. Our energy strategists forecast Brent crude to average $67 a barrel in 2020 (compared to a little over $60 today). Chart 19Metals Prices Depend On China Chart 20Gold: Short-Term Negatives, But Remains A Good Hedge Gold looks a little overbought in the short term, and less monetary stimulus and a rise in rates next year would be negative factors (Chart 20). Nonetheless, we see it as a good hedge against our positive economic view going awry, and against geopolitical risks. If central banks do decide to let economies run hot next year and ignore rising inflation, gold could do particularly well. We, therefore, raise our recommendation to overweight on a 12-month horizon. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see "Outlook 2020," dated November 22 2019, available at bcaresearch.com 2 Please see, for example, last month’s GAA Monthly Portfolio Update, “Looking For The Turning-Point,” dated November 1, 2019, available at gaa.bcaresearch.com 3 For a more detailed explanation, please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Signs Or Buying Opportunity,” dated 26 November 2019, available at usbs.bcaresearch.com GAA Asset Allocation
Our decision to upgrade non-US equities stems from the conviction that global growth has turned the corner. Manufacturing has been at the heart of the global slowdown. Manufacturing cycles tend to last about three years – 18 months of weaker growth…