Equities
Highlights Portfolio Strategy Soft housing demand, the trough in interest rates, new home price deflation and weak industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. Firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Recent Changes Downgrade the S&P homebuilding index to underweight, today. Table 1 Feature Equities made a run for fresh all-time highs last week, continuing to cheer the trade war “phase one” deal and breathing a big sigh of relief on better-than-expected bank earnings. We doubt a real deal will materialize which would include Intellectual Property and the tech sector. Instead all we got was a trade truce, at best. Larry Kudlow’s recent football analogy is worth repeating: “It's like being on the seven-yard line at a football game…And as a long suffering New York Giants fan, they could be on the seven and they never get the ball to the end zone…When you get down to the last 10 percent, seven-yard line, it's tough". As a reminder, steep tariffs remain in place and there are high odds that the damage already done to global trade is severe enough that it will be months before the emergence of any green shoots. Meanwhile, following up on our “chart of the year candidate” we published two weeks ago, we drilled deeper and discovered two additional economically sensitive indexes that have consistently peaked prior to the SPX in the past three cycles (Chart 1). They now comprise the U.S. Equity Strategy’s Equity Leading Indicator – an equally weighted composite of the S&P Banks index, the Russell 2000 index and the Value Line Geometric index – which signals that the easy money has already been made this cycle in the SPX (Chart 2). Chart 1Three Bulletproof Signals... Chart 2...Combined Into One Leading Equity Indicator Importantly, absent profit growth, it remains extremely difficult for equities to embark on a sustainable fresh leg up by solely relying on multiple expansion. Chart 3 shows our updated Corporate Pricing Power Indicator (CPPI) and it continues to deflate. In fact the steep fall in our CPPI more than offsets the fall in wage growth warning that the margin contraction in the S&P 500 has staying power1 (bottom panel, Chart 3). Drilling beneath the surface, our CPPI is waving a red flag. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Only 42% of the industries we cover are lifting selling prices by more than 1%, and 33% are outright deflating. Worrisomely, only 26% of sectors are raising prices at a faster clip than overall inflation. With regard to pricing power trends, two thirds of the industries we cover are either flat or in a downtrend (Table 2). Chart 3Nil Corporate Pricing Power Table 2Industry Group Pricing Power Gold has jumped to the top of our table galloping at a 26%/annum rate (keep in mind it was deflating in our early July update), and only three additional commodity-related industries made it to the top twenty (Table 2). The disappearance of the commodity complex from the top ranks is consistent with global PPI ills and U.S. dollar strength. This week we update two groups, one early and one deep cyclical. Interestingly, defensive sectors have a healthy showing in the top ten spots with five entries. On the flip side, commodities in general and energy-related industries in particular occupy the bottom of the ranks as WTI crude oil is steeply deflating from the October 2018 peak. Adding it up, corporate sector selling price inflation is sinking in line with depressed inflation expectations. As we posited in our recent profit margin Special Report, profit margins have already peaked for the cycle. We reiterate our cautious overall equity market view on a cyclical 9-to-12 month time horizon. This week we update two groups, one early and one deep cyclical. Cracking Homebuilding Foundations We recommend downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Since the Great Recession, homebuilders have been in clearly defined mini up-and-down cycles, and there are high odds we will soon enter a down oscillation (bottom panel, Chart 4). Interest rates bottomed in early September and there is little additional push they can exert to relative share prices (10-year Treasury yield shown inverted, top panel, Chart 4). Chart 4Relative Gains Are Exhausted Worrisomely, consumers’ expectations to purchase a new home nosedived last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 5). Chart 5Cracks Forming 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 recently. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 6). While the mortgage application purchase index (MAPI) has been rising on the back of the plunge in interest rates, the 30bps rise in the 10-year Treasury yield since September 1 signals that the MAPI has tentatively crested (second panel, Chart 7). Chart 6Contracting Sales Chart 7Margin Trouble Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels, Chart 7). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel, Chart 7). Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. On the operating front, the labor market is also emitting a distress signal. Job openings in the construction industry are sinking like a stone and residential construction employment growth is flirting with the contraction zone. Historically, the ebbs and flows in construction jobs have moved in lockstep with relative share price performance and the current message is to expect a drawdown in the latter (Chart 8). Most of the indicators we track underscore a challenging homebuilding backdrop in the coming months. However, there is a key risk to our view: interest rates. Were the 30-year fixed mortgage rate to fall further from current levels, it would entice first time home buyers and cushion the blow to homebuilding demand (mortgage rates shown inverted, top panel, Chart 9). Similarly, bankers are willing extenders of mortgage credit and are reporting rising demand for residential real estate loans as a lagged consequence of falling rates. But, our sense is that the easy gains are exhausted and a reversal is in the offing in most of these measures (Chart 9). Chart 8Heed The Labor Market's Message Chart 9Potentially Lower Rates Are A Key Risk Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. Bottom Line: Downgrade the S&P homebuilding index to underweight, today. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Stick With Refiners While our bullish take on refiners got to a slippery start, it has recovered all the losses and this position is now in the black. Factors are falling into place for additional gains in the coming months and we recommend investors stick with this overweight recommendation in pure-play downstream stocks. Encouragingly, refining stocks have been trouncing the overall energy index of late and have resumed their multi-year relative uptrend (top panel, Chart 10). With regard to the export relief valve, U.S. net exports of refined products are on a secular uptrend and surprisingly unaffected by the greenback’s moves (bottom panel, Chart 10). Tack on the soon to be adopted International Maritime Organization (IMO) Sulfur 2020 regulations in maritime transportation fuel, and U.S. refiners that produce lower-sulfur fuel oil are well positioned to outearn the SPX. Chart 10Resumed Uptrend Domestic refined product consumption remains upbeat and should serve as a catalyst to unlock excellent value in this niche energy subgroup (middle panel, Chart 11). In fact, gasoline consumption is expanding anew on the back of rising vehicle miles travelled (bottom panel, Chart 11). Chart 11Solid Demand... Refining product supply dynamics are also moving in the right direction. Gasoline inventories are getting whittled down and should boost beaten down refining relative profit expectations (inventories shown inverted, bottom panel, Chart 12). Importantly, this firming demand/supply backdrop has been a boon to refining margins and should continue to underpin relative share price momentum (middle panel, Chart 12). In terms of what is baked in the cake for this industry, the expected profit growth bar is extremely low and falling and relative value has been fully restored. First in terms of relative valuations, the relative trailing price-to-sales ratio has corrected 35% from the mid-2018 peak (middle panel, Chart 11). On a forward PE ratio basis refiners are extremely appealing compared with the SPX following a near halving in the relative forward PE in the past fifteen months (second panel, Chart 13). Chart 12...Supply Backdrop Is Boosting Crack Spreads Chart 13Profit Hurdle Is Uncharacteristically Low Second, relative EPS growth has sunk below the zero line both twelve months and five years forward. Such pessimism is overdone and we would lean against sell-side bearishness (bottom panel, Chart 13). Even the refining industry’s net earnings revisions ratio has collapsed, which is contrarily positive (third panel, Chart 13). Adding it all up, firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Bottom Line: Stay overweight the S&P oil & gas refining & marking index. The ticker symbols for the stocks in this index are: BLBG – S5OILR – MPC, VLO, PSX, HFC. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Special Report, “Peak Margins” dated October 7, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights The interim “phase 1” trade agreement reached last week represents a significant step forward towards reaching a détente in the China-U.S. trade war. Regardless of what happens next in the Brexit negotiations, a hard exit will be avoided. Stay long the pound. U.S. earnings growth is likely to be flat in the third quarter, in contrast to bottom-up expectations of a year-over-year decline. Earnings growth should pick up as global growth reaccelerates by year end. Stronger global growth will put downward pressure on the U.S. dollar. Remain overweight global equities relative to bonds over a 12-month horizon. Cyclical stocks should start to outperform defensives. Financials will finally have their day in the sun. Favorable Tradewinds In our Fourth Quarter Strategy Outlook published two weeks ago, we argued that global equities had entered a “show me” phase, meaning that tangible evidence of a de-escalation in the trade war and a recovery in global growth would be necessary for stock indices to move higher.1 We received some positive news on the trade front last Friday. In exchange for suspending the planned October 15th hike in tariffs from 25% to 30% on $250 billion of Chinese imports, China agreed to purchase $40-$50 billion of U.S. agricultural products per year, improve market access for U.S. financial services companies, and enhance the transparency of currency management. Admittedly, there is still much to be done. The text of the agreement has yet to be finalized. Both sides are aiming to conclude the deal by the time of the APEC summit in Santiago, Chile on November 16-17. Considering that a number of key issues remain unresolved, including what sort of enforcement and resolution mechanisms will be included in the deal, further delays or even a breakdown in the talks are possible. The interim deal agreed upon last week also punts the thorny issue of how to handle intellectual property protections to a “phase 2” of the negotiations slated to begin soon after “phase 1” is wrapped up. According to the independent and bipartisan U.S. Commission on the Theft of American Intellectual Property, U.S. producers lose between $225 and $600 billion annually from IP theft.2 China has often been considered among the worst offenders. Given the importance of the IP issue, meaningful progress will be necessary to ensure that tariffs of 15% on about $160 billion of Chinese imports are not introduced on December 15th. Trump Wants A Deal Despite the many hurdles that remain, last week’s developments significantly raise the prospects of a détente in the 18 month-long trade war. As a self-professed “master negotiator,” President Trump has put his credibility on the line by describing the negotiations as a “love fest,” calling the trade pact “the greatest and biggest deal ever made for our Great Patriot Farmers,” and saying that he has “little doubt” that a final agreement will be reached. Just as he did with NAFTA’s successor USMCA – a deal that is substantively similar to the one it replaced – Trump is likely to shift into marketing mode, trumpeting the “tremendous” new deal that he has negotiated on behalf of the American people. From a political point of view, this makes perfect sense. Rightly or wrongly, President Trump gets better marks from voters on his handling of the economy than anything else (Chart 1). A protracted trade war would undermine the U.S. economy, thereby hurting Trump’s re-election prospects. Chart 1Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 2Chinese Business Are Not Paying The Bulk Of The Tariffs Notwithstanding his claims to the contrary, the evidence firmly suggests that U.S. consumers, rather than Chinese businesses, are paying the bulk of the tariffs. Chart 2 shows that U.S. import prices from China have barely declined, even as tariff rates on Chinese imports have risen. To the extent that the latest rounds of tariffs are focused on Chinese goods for which there is little U.S. or third-country competition, the ability of Chinese producers to pass on the cost of the tariffs will only increase. If all the tariff hikes that have been announced were implemented, the effective tariff rate on Chinese imports would rise from around 15% as of late August to as high as 25% in December (Chart 3). Such a tariff rate would reduce U.S. household disposable incomes by over $100 billion, wiping out most of the gains from the 2017 tax cuts. Trump can’t let the trade war reach this point. Chart 3Successive Rounds Of Tariffs Have Started To Add Up Will China Play Hardball? One risk to a favorable resolution to the trade war is that China will increasingly see Trump as desperate to make a deal. This could lead the Chinese to take a hardline stance in the negotiations. While this risk cannot be dismissed, we would downplay it for three reasons: First, even though China’s exporters have been able to maintain some degree of pricing power during the trade war, trade volumes have still suffered, with exports to the U.S. down nearly 22% year-over-year in September. Second, as the crippling sanctions against ZTE have demonstrated, China remains highly dependent on U.S. technologies. This gives Trump a lot of leverage in the trade negotiations. Chart 4Who Will Win The 2020 Democratic Nomination? Third, as Trump himself likes to say, China will find it easier to negotiate with him in his first term in office than in his second. Hoping that Trump would lose his re-election bid might have made sense for China a few months ago when Joe Biden was riding high in the polls; but now that Elizabeth Warren has emerged as the favorite to secure the Democratic nomination, that hope has been dashed (Chart 4). As we noted several weeks ago, China is likely to find Warren no less vexing on trade matters than Trump.3 All this suggests that China, just like Trump, will look for ways to cool trade tensions over the coming weeks. Brexit Breakthrough? As we go to press, the prospects for a Brexit deal have brightened. Although the details have yet to be released, the proposed deal would effectively put Northern Ireland in a veritable quantum superposition where it is both in the European common market and in the U.K. at the same time. This feat will be achieved by keeping Northern Ireland within the U.K. political jurisdiction but still aligned with EU regulatory standards. Negotiations could still go awry. Despite Prime Minister Boris Johnson’s assurance that he secured “a great new deal,” the Conservative’s coalition partner, the Northern Irish Democratic Unionist Party, is still withholding its support for the accord. Labour leader Jeremy Corbyn has also rejected the deal, saying that it is even worse than Theresa May’s originally proposed pact. Regardless of what transpires over the coming days, we continue to think that a hard Brexit will be avoided. Throughout the entire Brexit ordeal, we have argued that there was insufficient political support within the British ruling class for a no-deal Brexit. That conviction has only grown as polling data has revealed that an increased share of voters would choose to stay in the EU if another referendum were held (Chart 5). We have been long the pound versus the euro since August 3, 2017. The trade has gained 6.6% over this period. Investors should stick with this position. Based on real interest rate differentials, GBP/EUR should be trading near 1.30 rather than the current level of 1.16 (Chart 6). We expect the cross to move towards its fair value as hard Brexit risks diminish further. Chart 5Brexit Angst: A Case Of Bremorse Chart 6Substantial Upside In The Pound Global Growth Prospects Improving Chart 7Growth Slowdown Has Been More Pronounced In The Soft Data Chart 8Manufacturing Output Rebounds Amid The ISM Slump A détente in the trade war and a resolution to the Brexit saga should help support global growth. The weakness in the economic data has been much more pronounced in so-called “soft” measures such as business surveys than in “hard” measures such as industrial production (Chart 7). Notably, U.S. manufacturing output has stabilized over the past three months, even as the ISM manufacturing index has swooned (Chart 8). As sentiment rebounds, the soft data should improve. Global financial conditions have eased significantly over the past five months, thanks in large part to the dovish pivot by most central banks (Chart 9). The net number of central banks cutting rates generally leads the global manufacturing PMI by 6-to-9 months (Chart 10). In addition, the Fed’s decision to start buying Treasurys again will increase dollar liquidity, thus further contributing to looser financial conditions. Chart 9Easier Financial Conditions Will Boost Global Growth Chart 10The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy Stepped-up Chinese stimulus should also help jumpstart global growth. Chinese money and credit growth both came in above expectations in September. The PBoC has been cutting reserve requirements, which has helped bring down interbank rates. Further cuts to the medium-term lending facility are likely over the remainder of this year. Changes in Chinese credit growth lead global growth by about nine months (Chart 11). Chart 11Chinese Credit Should Support The Recovery In Global Growth Stay Overweight Global Equities While the road to finalizing a “phase 1” trade deal in time for the APEC summit is likely to be a bumpy one, we continue to reiterate our recommendation that investors overweight global stocks relative to bonds over a 12-month horizon. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out. Ultimately, the trajectory of stocks will hinge on what happens to earnings. The U.S. earnings season began this week. As of last week, analysts expected S&P 500 EPS to decline by 4.6% in Q3 relative to the same quarter last year according to data compiled by FactSet. Keep in mind, however, that EPS growth has beaten estimates by around four percentage points since 2015 (Chart 12). Thus, a reasonable bet is that U.S. earnings will be flat this quarter, clearing a low bar of expectations. Chart 12Actual EPS Has Generally Beaten Estimates Chart 13Earnings And Nominal GDP Growth Tend To Move In Lock-Step The fact that 83% of the 63 S&P 500 companies that have reported earnings thus far have beaten estimates – better than the historic average of 64% – supports the view that current Q3 estimates are too dour. Looking out, earning growth should pick up as nominal GDP growth accelerates (Chart 13). European and EM equities generally outperform the global benchmark when global growth is speeding up (Chart 14). This is due to the more cyclical nature of their stock markets. In addition, as a countercyclical currency, the dollar tends to weaken in a faster growth environment. A weaker dollar disproportionately benefits cyclical stocks (Chart 15). Chart 14EM And Euro Area Equities Usually Outperform When Global Growth Improves Chart 15Cyclical Stocks Will Outperform If The Dollar Weakens We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank profits and share prices (Chart 16). Cyclical stocks are currently quite cheap compared to defensives (Chart 17). Likewise, non-U.S. equities are quite inexpensive compared to their U.S. peers, even if one adjusts for differences in sector composition across regions. While U.S. stocks trade at 17.5-times forward earnings, international stocks trade at a more attractive forward PE ratio of 13.7. The combination of higher earnings yields and lower interest rates abroad implies that the equity risk premium is roughly two percentage points higher outside the United States (Chart 18). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17Cyclical Stocks Are More Attractive Than Defensives Chart 18The Equity Risk Premium Is Quite High, Especially Outside The U.S. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy, “Fourth Quarter 2019 Strategy Outlook: A ‘Show Me’ Market,” dated October 4, 2019. 2 “Update to IP Commission Report: The Report of the Commission on the Theft of American Intellectual Property,” The National Bureau of Asian Research, 2017. 3Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” dated September 13, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights New structural recommendation: long GBP/USD. The substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. The most powerful equity play on a fading Brexit discount would be the U.K. homebuilders. Specifically, Persimmon still has a further 25 percent of upside. Take profits in long Euro Stoxx 50 versus Shanghai Composite. Within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Stay overweight banks versus industrials. Stay overweight the Euro Stoxx 50 versus the Nikkei 225. Fractal trade: long NZD/JPY. Feature Chart of the WeekThe Pound Has Substantial Upside If The Brexit Discount Fades Carnival Says The Pound Is Cheap Carnival, the world’s largest cruise liner company, lists its shares on both the London and New York stock exchanges. But there is an apparent riddle: in London the shares trade on a forward PE of 8.8, while in New York they trade on 9.4. How can Carnival trade at different valuations on the two sides of the Atlantic when the market should instantly arbitrage the difference away? The answer to the riddle is that the London listing is quoted in pounds, the New York listing is quoted in dollars, while Carnival’s sales and profits are denominated in a mix of international currencies. Neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. Carnival is trading on a higher valuation in New York versus London because the market is expecting its mixed currency earnings to appreciate more in dollar terms than in pound terms. Put another way, the valuation differential is expecting the pound to appreciate versus the dollar to a ‘fair value’ of around $1.40 (Chart I-2). Likewise, BHP Billiton shares are trading on a higher valuation in their Sydney listing compared to their London listing. This valuation differential is expecting the pound to appreciate versus the Australian dollar to around A$2.00 (Chart I-3). Chart I-2Carnival Says The Pound Is Cheap Chart I-3BHP Billiton Says The Pound Is Cheap In other words, the market believes that neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. We tend to agree. The Wrong Way To Pick Stock Markets… And The Right Way Before continuing with the pound’s prospects, let’s wander into the wider investment landscape. One important lesson from dual-listed companies like Carnival and BHP Billiton is that a multinational’s valuation will appear attractive in a market where the currency is structurally cheap.1 This lesson has deep ramifications. Today, multinationals dominate all the major stock markets, meaning that the entire stock market will appear cheap if its currency is cheap. The stock market will also appear cheap if it is skewed towards lower-valued sectors. But sectors trade on a low valuation for a reason – poor long-term growth prospects. Through the past decade, Japanese banks seemed a relative bargain, trading on a forward PE of less than half of that on personal products companies (Chart I-4). Yet Japanese banks were not a relative bargain. Quite the contrary. Through the past decade Japanese personal products have outperformed the banks by 500 percent! (Chart I-5) Chart I-4Japanese Banks Seemed A Relative Bargain... Chart I-5...But Japanese Banks Were Not A Relative Bargain Hence, beware of picking stock markets on the basis of observations such as ‘European stocks are cheaper than U.S. stocks’. Given that a stock market valuation is the result of its currency valuation and its sector composition, assessing relative value across major stock markets is extremely difficult, if not impossible. To repeat, Carnival appears to be trading at a valuation discount in London versus New York, but the cheapness is illusory. Here’s the right way to pick major stock markets. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In this regard, large underweight sector skews also matter. For example, China and EM have a near-zero exposure to healthcare equities, so their performances tend to correlate negatively with that of the global healthcare sector – albeit the causality could run in either direction. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In early May, we noticed that the extreme outperformance of technology versus healthcare was at a critical technical point at which there was a high probability of a trend reversal. This high conviction sector view implied overweight Europe versus China, as well as overweight Switzerland and underweight Netherlands within Europe (Chart I-6 and Chart I-7). Chart I-6When Tech Underperforms Healthcare, China Underperforms Switzerland Chart I-7When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland Given that this sector trend reversal has played out exactly as anticipated, it is time to bank the profits: Close long Euro Stoxx 50 versus Shanghai Composite. And within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Right now, it is appropriate to overweight banks versus industrials. It is the pace of the bond yield’s decline that has weighed on bank performance this year. But if the sharpest decline in bond yields is behind us, as seems likely, then banks should fare better versus other cyclicals (Chart I-8). Chart I-8If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials Once again, this sector view carries an equity market implication: stay overweight the Euro Stoxx 50 versus the Nikkei 225 (Chart I-9). Chart I-9Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen The Pound Is A Long-Term Buy Back to the pound. The message from the dual listings of Carnival and BHP Billiton is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40 (Chart of the Week and Chart I-10). Chart I-10The Pound Has Substantial Upside If The Brexit Discount Fades In the Brexit psychodrama, we do not claim to know exactly how the next few days or weeks will play out. In the short term, Brexit is a classic non-linear system, and non-linear systems are inherently unpredictable. However, in the longer term we expect the Brexit discount to fade in any sort of transitioned resolution that allows the U.K. to adapt to a new trading relationship with the world, or alternatively to stay in a relationship broadly similar to the current one. Whatever the eventual endpoint is, the key requirement to remove the Brexit discount is to avoid a cliff-edge. We expect the Brexit discount to fade in any sort of transitioned resolution. The stumbling block to a resolution is that the three key actors – the EU, the U.K. government, and the U.K. parliament – have conflicting red lines, so the Brexit ‘Venn diagram’ has had no overlap. The EU will not countenance a customs border that divides Ireland; the current U.K. government wants a Free Trade Agreement, which implies casting away Northern Ireland into the EU customs union; and the current U.K. parliament – unless its intentions suddenly change – wants the whole of the U.K., including Northern Ireland, to remain in the EU customs union. Given that the EU will not budge its red line, the only way to a lasting resolution is for the government and parliament red lines to realign, This could happen via parliament being willing to sacrifice Northern Ireland, via a second referendum, or via a general election in which the government’s intentions and/or the composition of parliament changed. Given a long enough investment horizon – 2 years or more – it is likely that the government and parliament will realign their red lines to a Free Trade Agreement or to a customs union, one way or another. On this basis, the substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. Accordingly, today we are initiating a new structural recommendation: long GBP/USD. For equity investors, the most powerful play on a fading Brexit discount would be the U.K. homebuilders (Chart I-11). Specifically, if the pound reached $1.40, Persimmon still has a further 25 percent of upside. Chart I-11U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades Fractal Trading System* Based on its collapsed fractal structure, we anticipate a countertrend rally in NZD/JPY within the next 130 days. Accordingly, go long NZD/JPY setting a profit target of 3 percent and a symmetrical stop-loss. Chart I-12 For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 There are also several companies with dual listings in the U.K. and the euro area. Unfortunately, these valuation differentials have been temporarily distorted by the risk of a no-deal Brexit, in which EU27 investors may have been forbidden from trading in the U.K. listed shares. Fractal Trading System Cyclical Recommendations Structural Recommendations Fractal Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Dear Client, In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese automobile industry outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima China Strategist Feature Chart 1Chinese Economy Likely To Bottom In Q1 President Trump announced last Friday the first phase of a potential trade agreement with China. For now, the most concrete aspect of the announcement has been the deferral of an increase in tariffs that had been scheduled to occur this week, in exchange for agriculture purchase commitments from China. Market participants initially reacted with caution to the news, given the U.S. administration’s about-face in early-May and given signs from Beijing that China “needs time” to finalize a deal. However, Chinese policymakers have subsequently played up the progress made during the negotiations, and characterized both sides as being on “the same page”. We noted in last week’s report that China’s economy was likely to stabilize in Q1 of next year (Chart 1), but that a further shock to China’s external sector and/or internal policy missteps could easily tip the Chinese economy into a deeper growth slowdown.1 This, to us, justified a tactically bearish stance towards Chinese stocks, despite our positive cyclical bias. Indeed, following our tactical underweight call initiated on July 24,2 relative to global stocks, Chinese investable stocks dropped nearly 3% in the months of August and September in reaction to intensified trade tension. Chart 2Chinese Stocks Have Been Underperforming Since Late April While it is not yet clear how substantive the final deal between the U.S. and China will be, it is our judgment that the odds of a further escalation in the trade war have legitimately fallen over the past week. Both sides of the negotiating table have strong incentives to reach a deal (particularly the U.S.), and both U.S. and Chinese policymakers may finally be acting in a way that is consistent with each side’s respective constraints. As such, we no longer feel that a tactical underweight stance is warranted, and we recommend that clients maintain a neutral stance towards Chinese stocks over the near term. The potential for the talks to collapse once again is keeping us from recommending an outright overweight tactical stance, as well as the small but still non-trivial chance that the final deal is not meaningful enough to help revive economic activity. Cyclically, a substantive trade deal would be bullish for Chinese stocks, as the relative performance of both the investable and domestic markets are meaningfully below their late-April highs (Chart 2). The stimulus that policymakers have already provided should be enough to stabilize Chinese domestic demand, and a trade deal should help reinforce a stabilization in sentiment and activity over the coming year. However, one risk to our cyclical positioning is that the removal of uncertainty for China’s exporters strengthens the will of Chinese policymakers to curb “excess” credit growth. For now, this remains “a story for another day”, as investors will almost certainly bid up Chinese stocks (particularly the investable market) in reaction to a deal. But the behavior of China’s credit impulse following the surge in Q1 of this year underscores that policymakers are very serious about preventing another significant rise in the macro leverage ratio. This could lead to a less optimistic outlook over the coming 6-12 months than we originally expected when we recommended upgrading Chinese stocks earlier this year, and is a risk that we will be continually monitoring over the coming months. Stay tuned! Jing Sima China Strategist JingS@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing”, dated October 9, 2019, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Portfolio Strategy The trade-weighted U.S. dollar’s appreciation along with the still souring manufacturing data are weighing on SPX profit growth, at a time when heightened geopolitical uncertainty and a looming reversal in financial conditions has the potential to wreak havoc on stock prices. Stay cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Firming operating metrics, the resilient U.S. dollar, compelling valuations and depressed technicals, all signal that there is an exploitable tactical trading opportunity in a long S&P industrials/short S&P tech pair trade, irrespective of the trade war outcome. A tentative tick up in EM and China data along with improving relative operating metrics signal that the time is ripe to initiate a long machinery/short semis pair trade. Recent Changes Initiate a long S&P Industrials/short S&P Tech pair trade on a tactical three-to-six month time horizon, today. Initiate a long S&P Machinery/short S&P Semiconductors pair trade on a tactical three-to-six month time horizon, today. Feature The S&P 500 oscillated violently again last week, as the barrage of declining economic data, heightened trade war-related volatility and political upheaval dominated the news flow. While the Fed remains the backstop of last resort, we doubt additional interest rate cuts, which are already aggressively priced in the bond market, will boost lending and entice CEOs to invest in capital expenditure projects. Investors have to stay patient and disciplined, let this economic slowdown play out and allow for the natural healing of the economy. As a reminder, the ISM manufacturing index has been decelerating for twelve months and only been below the boom bust line for two. If history is an accurate guide, an additional three-to-six months of manufacturing pain are in store before a definitive bottom is in place (bottom panel, Chart 1). Such a macro backdrop, still warrants caution on the prospects of the broad equity market. Chart 1Allow Time For Economic Healing Beginning in August, a number of BCA publications became a tad more cautious on risk assets. Following our October editorial view meeting last week, this cautiousness was cemented with a tactical downgrade of global equities to neutral from previously overweight in the BCA House View matrix. While this marks a clear shift toward this publication’s less sanguine view of the U.S. equity market adopted during the summer, BCA's cyclical 12-month House View remains overweight global equities. Worryingly, the majority of the indicators we track continue to emit distress signals and warn that the SPX has further downside (Chart 2), especially absent profit growth. Importantly, we first correctly posited last May that the back half of the year global growth reacceleration was in jeopardy and would go on hiatus courtesy of rising policy uncertainty.1 Such a backdrop would boost the U.S. dollar and simultaneously take a bite out of SPX EPS.2 Chart 2Soft Data Red Flag Last week we highlighted that the U.S. dollar is the most important indicator to monitor given its global deflationary/reflationary properties. Were the greenback to maintain its year-to-date gains, it will continue to dent SPX profitability via P&L translation loss effects and likely sustain the profit recession into early 2020 (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 3). Chart 3Greenback Weighing On Profits U.S. Equity Strategy’s S&P 500 four-factor macro EPS growth model remains downbeat (middle panel, Chart 4). Were we to isolate the U.S. dollar as a single variable and re-run the regression it is clear that additional greenback appreciation will further weigh on SPX profit growth (bottom panel, Chart 4). Meanwhile, the easing in financial conditions and drubbing of the 10-year Treasury yield since the Christmas Eve lows is already reflected in the 23% jump in the forward PE multiple, which explains over 90% of the SPX’s rise since the Dec 24, 2018 trough (top & middle panels, Chart 5). In other words, for multiples to expand anew, financial conditions would have to further ease, which in our view is a tall order (bottom panel, Chart 5). Chart 4EPS Model Warrants Caution Chart 5Financial Conditions Are The Forward P/E This week we are initiating two related pair trades to exploit the mispricing of the trade war within the deep cyclical sector universe. Thus, we would lean against the narrative that easy financial conditions are not fully reflected into stocks. In contrast, our worry is that junk spreads are on the verge of a breakout and such a backdrop would tighten financial conditions and aggravate an SPX drawdown (junk OAS shown inverted, Chart 6). Adding it all up, the trade-weighted U.S. dollar’s appreciation along with the still souring manufacturing data are weighing on SPX profit growth, at a time when heightened geopolitical uncertainty and a looming reversal in financial conditions has the potential to wreak havoc on stock prices. Stay cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are initiating two related pair trades to exploit the mispricing of the trade war within the deep cyclical sector universe. Chart 6Watch Junk Spreads Initiate A Long Industrials/Short Tech Pair Trade… Ever since the Sino-American trade war started in March 2018, the market has punished industrials, but tech has escaped unscathed. While the global growth soft patch preceded the U.S./China trade spat, courtesy of the Fed’s tightening cycle and Chinese policymakers’ slamming on the brakes, the trade war has served as a catalyst to aggressively shed deep cyclical equities except for tech stocks (Chart 7). We think this misalignment presents a playable opportunity to generate alpha by going long industrials/short tech, irrespective of the trade war’s outcome. In other words, this market neutral trade will be in the black either because the trade spat gets resolved or because there will effectively be no “real” deal including intellectual property and the tech sector. If the two sides manage to iron out their differences and strike a deal, industrials stocks should benefit from a greater catch-up phase because they have been depressed over the past two years, while tech stocks are near relative all-time highs. In contrast, a “no deal” scenario, should also re-concentrate investors’ minds and lead to a relative selling in tech stocks versus their already beaten-down deep cyclical peers: industrials. Chart 7Bifurcated Deep Cyclicals Market Chart 8Lots Of Bad Trade War News Reflected In Prices Chart 8 shows the drubbing in relative share prices as three key macro drivers have felt the trade war’s wrath. In more detail, were a deal to get struck, growth expectations will reverse course and a bond market sell-off will almost immediately reflect such an improvement in the global macro backdrop. Rising interest rates on the back of a reflationary/inflationary impulse are a boon for industrials and a bane for high growth tech stocks (top panel, Chart 8). Similarly, the middle panel of Chart 8 highlights that the ISM manufacturing survey should climb above the boom/bust line and outshine the San Francisco Fed’s Tech Pulse Index (that comprises “coincident indicators of activity in the U.S. information technology sector”3) on news of a successful deal. Finally, relative capital expenditure outlays should also veer in favor of industrials as previously mothballed infrastructure projects will come out of hibernation (bottom panel, Chart 8). In contrast, tech capex has been resilient of late with analytics, security and cloud computing being the most defensive capex corner, leaving little room for additional relative capex gains. Taking the opposite side i.e. a “no deal”, we doubt the metrics we depict in Chart 8 would sink that much further. If anything we believe that there is an element of exhaustion and relative share prices would jump on news of a breakdown in trade talks as tech sector fire sales would trump the sell-off in already depressed industrials. Meanwhile, the U.S. dollar and relative share prices have been steeply diverging recently and this gap will likely narrow via a catch-up phase in the latter (top & middle panels, Chart 9). According to Factset’s latest data the S&P industrials sector garners 37% of its sales from abroad, whereas the S&P information technology sector’s foreign exposure stands at 57% of total revenues.4 Therefore, given this 20% delta, a rising greenback should be beneficial to the more domestically geared industrials stocks (bottom panel, Chart 9). On the operating front, industrials also have the upper hand. The relative wage bill is sinking like a stone (shown inverted, middle panel, Chart 10) at a time when relative selling price inflation is holding its own (top panel, Chart 10). The upshot is that a relative profit margin jump is in store in the coming months which should boost the relative share price ratio (bottom panel, Chart 10). Chart 9Unsustainable Divergence Chart 10Industrials Have The Upper Hand U.S. Equity Strategy’s proprietary relative Cyclical Macro Indicators and relative profit growth models capture all these drivers and both signal that an industrials versus tech earnings-led outperformance phase looms into year end (Chart 11). Chart 12 shows that the relative earnings breadth and relative net earnings revisions are both deep in negative territory. In terms of technicals, the relative percentage of groups trading with a positive 52-week rate of change has hit the lowest level in the past two decades (second panel, Chart 12) and our composite relative technical indicator is roughly one standard deviation below the historical mean (bottom panel, Chart 11). Chart 11Profit Models And... Chart 12...Washed Out Breadth Say Buy Industrials At The Expense Of Tech Finally, relative valuations are also bombed out. Our relative valuation indicator has been in a six-year uninterrupted drop, falling from two standard deviations above the mean to one standard deviation below the mean (fourth panel, Chart 11). Such entrenched bearishness in relative value is unwarranted. Bottom Line: Firming operating metrics, the resilient U.S. dollar, compelling valuations and depressed technicals, all signal that there is an exploitable tactical trading opportunity in a long S&P industrials/short S&P tech pair trade, irrespective of the trade war outcome. …And A Long Machinery/Short Semis Pair Trade A more speculative and higher octane vehicle to explore this trade war-related mispricing is via a long S&P machinery/short S&P semiconductors pair trade. Most of the drivers mentioned above also hold true in this subsector market-neutral trade. However, in this section we will drill deeper in the China/EM drivers. The Emerging Asia leading economic indicator (EALEI) has plummeted to levels last hit around the 1998 LTCM bailout (top panel, Chart 13). While more pain is likely in the coming months as global trade has ground to a halt, we doubt the carnage in the EALEI can continue indefinitely. In fact, a tentative trough in the Emerging Markets (EM) manufacturing PMI heralds a brighter outlook for relative share prices (bottom panel, Chart 13). Chart 13Same Trade War Theme, Different Vehicles To Play It Chart 14China... Encouragingly, 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 spike 20% near the late-2018 highs (Chart 14). Chinese money supply growth is showing some signs of life and capital committed to infrastructure spending is coming out of hibernation. Goldman Sachs’ China current activity indicator is on a similar upward trajectory, underscoring that the path of least resistance is higher for relative share prices (Chart 15). Chart 15...Holds The Key Chart 16Firming Final Demand... On the operating front, relative new orders and relative shipment growth have both ticked higher (top & middle panels, Chart 16). Importantly, our relative demand proxy suggests that the relative end-demand backdrop is also firming. Using Caterpillar’s global sales to dealers data compared with global chip sales reveals that a wide gap has formed between relative share prices and our relative demand gauge (bottom panel, Chart 16). If our thesis pans out in the upcoming three-to-six months then machinery will trounce semis. Finally, relative pricing power corroborates that machinery demand has the upper hand versus semiconductor final demand. The Commodity Research Bureau’s raw industrials index is climbing relative to Asian DRAM prices. The upshot is that the compellingly valued relative share price ratio will gain steam in the months ahead (Chart 17). In sum, a tentative up-tick in EM and China data along with improving relative operating metrics signal that the time is ripe to initiate a long machinery/short semis pair trade. Bottom Line: Initiate a long S&P machinery/short S&P semiconductors pair trade today. The ticker symbols for the stocks in the S&P machinery and S&P semis indexes are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS, and BLBG – S5SECO – INTC, TXN, NVDA, AVGO, QCOM, MU, ADI, AMD, XLNX, QRVO, MCHP, MXIM, SWKS, respectively. Chart 17...Is A Boon To Relative Pricing Power Key Risk To Monitor One important risk to both of our newly recommended market-neutral trades is China. We recently touched base with our ex-Chief Geopolitical Strategist and currently Chief Strategist at the Clocktower Group, Marko Papic. He warned us that all bets would be off because: “I think we will look back at the recession of 2020 and it will be known as the “China recession”. Basically, China just decided to stop playing, pick up its toys, and go home”. If Marko’s wise words were to ring true, then such a Chinese policy shift will truly be a game changer with negative global economic growth implications. With regard to our pair trades, they would both be offside. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Consolidation” dated May 21, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “On Edge” dated May 13, 2019, available at uses.bcaresearch.com. 3 https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 4 https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_100419A.pdf 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%)
Overweight Last week Costco reported its fiscal fourth-quarter earnings, which came in beating expectations. These results are good news for our S&P hypermarkets overweight call as Costco accounts for nearly 50% of the index. We first recommended investors increase their exposure to this plain vanilla consumer defensive industry just under 3 months ago, and this position is already up 8% relative to the SPX since inception. Macroeconomic data remains soft across the board heralding more gains for the S&P hypermarkets index (second panel). Meanwhile, industry specific data is encouraging, with Big Box retail sales slated to firm further (third & bottom panels). Specifically, hypermarkets’ pricing power is set to increase as the relative consumer confidence by income (defined as the ratio of Americans who make less than $35,000/annum to those who make above $35,000/annum) has climbed to fresh cyclical highs (bottom panel). Bottom Line: Consumer staples stocks in general and hypermarkets in particular continue to shine. Stay overweight the S&P hypermarkets index. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.
With respect to equity leadership rotation, it is crucial to note that equity leadership rotations typically occur during or after bear markets and/or corrections in global share prices. The chart above illustrates EM stock prices relative to DM along…
Analysis on Turkey is available below. Highlights A dovish Fed or robust U.S. growth does not constitute sufficient conditions for a bull market in EM. China’s business and credit cycles are much more important factors for EM than those of the U.S. A recovery in the Chinese economy and global manufacturing is not imminent. The common signal reverberating from various financial markets is that the risks to the global business cycle are still skewed to the downside. Feature Current investor perceptions of emerging markets are mixed. Some expect EM to benefit greatly from low U.S. interest rates. These investors view even a partial trade deal between the U.S. and China as sufficient for EM to embark on a bull market. BCA’s Emerging Markets Strategy team disagrees with this narrative. We deliberated the significance of the U.S.-China confrontation to EM in our September 19 report; therefore, we will not go over this subject here. Rather, in this report we discuss some of the more common misconceptions surrounding EM currently, and infer what these mean for investment strategies. Perception 1: The share of resource sectors (materials and energy) in the EM equity benchmark has declined substantially. This along with the expanded role of consumers and consumer stocks (Alibaba, Tencent and Baidu) in EM economies and equity markets has made their share prices less exposed to the global trade cycle and commodities prices. Reality: It is true that in many EM bourses, the weight of consumer stocks has been growing. Nevertheless, their financial markets in general, and equity markets in particular, remain very sensitive to the global trade cycle and commodities prices. Chart I-1 illustrates that the aggregate EM equity index has historically been and continues to be strongly correlated with the global basic materials stock index. The latter includes mining, steel and chemical companies. Global materials stocks also exhibit a very strong correlation with Chinese banks’ share prices. Moreover, global materials stocks also exhibit a very strong correlation with Chinese banks’ share prices (Chart I-2). The rationale for the high correlation is that both mainland banks’ profits and global demand for basic materials are driven by a common factor: China’s business cycle. Chart I-1EM And Global Materials Stocks Move Together Chart I-2Chinese Bank And Global Materials Share Prices Are Highly Correlated For example, construction in China is contracting (Chart I-3), which entails both higher NPLs for Chinese banks and lower demand for basic materials. China accounts for about 50% of global consumption of industrial metals, cement and many other basic materials. Finally, EM ex-China bank stocks also correlate strongly with global basic materials share prices. The basis is as follows: Many emerging economies export raw materials, and commodities price fluctuations impact their business cycle, exports and exchange rates. Chart I-3China: Construction Activity Is Contracting Chart I-4High-Yielding EM: Currencies And Local Bond Yields Historically, in high-yielding EM markets, currency depreciation has led to higher interest rates and lower bank share prices, and vice versa (Chart I-4). Lately, EM bond yields have not risen in response to EM currency depreciation. However, we believe this correlation will soon be re-established if EM currencies continue drifting lower. In short, China’s money/credit cycles drive not only the mainland’s business cycle, banking profits and NPLs, but also global trade and commodities prices. The latter two - via their impact on exchange rates and in turn interest rates - have historically explained credit and domestic demand cycles in high-yielding EM. Perception 2: EM stocks are a high-beta play on the S&P 500, i.e., EM equities outperform when the S&P 500 rallies, and vice versa. Reality: Since 2012, the beta for EM equity versus the S&P 500 has often been below one (Chart I-5). Furthermore, since 2012, EM share prices often failed to outpace their DM peers during global equity rallies. Indeed, EM relative equity performance versus DM, as well as the EM ex-China currency total return index, have been closely tracking the relative performance of global cyclicals versus global defensive stocks (Chart I-6). Chart I-5EM Equities Beta To The S&P 500 Chart I-6Global Cyclicals-To-Defensives Equity Ratio And EM In short, EM equities and currencies have been, and will remain, sensitive to the global business cycle rather than the S&P 500. Since 2012, the latter has - on several occasions - decoupled from the global manufacturing and trade cycles. Perception 3: EM stocks, currencies and fixed-income markets are very sensitive to U.S. interest rates. Hence, a dovish Fed will lead to EM currency appreciation. Reality: Chart I-7 reveals that EM currencies, total returns on EM local currency bonds in U.S. dollar terms and EM sovereign credit spreads do not exhibit a strong relationship with U.S. Treasury yields. U.S. interest rate expectations have a much smaller impact on EM financial markets than commonly perceived by the investment community. Overall, U.S. interest rate expectations have a much smaller impact on EM financial markets than commonly perceived by the investment community. Chart I-7EM And U.S. Bond Yields: No Stable Correlation Chart I-8China Cycle And EM Stocks Led U.S. Bond Yields On the contrary, the declines in U.S. bond yields in both 2015/16 and in 2018/19 were due to the growth slowdown that emanated from China/EM. The top panel of Chart I-8 illustrates that Chinese import growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. What is more, EM share prices have been leading U.S. bond yields in recent years, not the other way around (Chart I-8, bottom panel). Perception 4: If the U.S. avoids a recession, EM risk assets will recover. Chart I-9EM Profits Are Driven By Chinese Not U.S. Business Cycle Reality: EM per-share earnings contracted in 2012-2014 and in 2019, despite reasonably robust growth in U.S. final demand (Chart I-9, top panel). This suggests that even if the U.S. economy avoids a recession, that will not be a sufficient condition to be bullish on EM. EM corporate profits are highly driven by China’s business cycle. The bottom panel of Chart I-9 illustrates that mainland domestic industrial orders have been the key driver of EM corporate profit cycles since 2008. Perception 5: EM equities, fixed-income markets and currencies are cheap. Reality: EM stocks are not cheap. They are fairly valued. Equity sectors with very poor fundamentals have very low multiples. Hence, they are “cheap” for a reason. These include Chinese banks, state-owned enterprises in various countries and resource companies. Equity segments with robust fundamentals are overpriced. Given that Chinese banks, state-owned enterprises in various countries, resource companies, and cyclical businesses have very large market caps, EM market-cap based equity valuation ratios are low – i.e., they appear cheap. To remove the impact of these large market cap segments, we constructed and have been publishing the following valuation ratios: median, 20% trimmed mean and equal-sub-sector weighted (Chart I-10). Each of these is calculated based on the average of trailing and forward P/E ratios, price-to-book value, price-to-cash earnings and price-to-dividend ratios. EM equities relative to DM are not cheap either. Chart I-11 demonstrates the same ratios – median, 20% trimmed-mean and equal-sub-sector weighted values for EM versus DM. Chart I-10EM Equities Are Not Cheap Chart I-11Relative To DM EM Stocks Are Not Cheap Further, when valuations are not at extremes as in the case of EM equities at the moment, the profit cycle holds the key to share price performance over a 6 to 12-month horizon. EM earnings are presently contracting in absolute terms, and underperforming DM EPS. Two currencies that offer value are the Mexican peso and Russian ruble. Chart I-12EM Local Yields Are Low In Absolute Terms And Relative To U.S. In the fixed-income space, EM local bond yields are very low in absolute terms and relative to U.S. Treasury yields (Chart I-12). EM sovereign and corporate spreads are not wide either. As to exchange rates, the cheapest currencies are those with the worst fundamentals, such as the Argentine peso, Turkish lira and South African rand. The majority of other EM currencies are not very cheap. Two currencies that offer value are the Mexican peso and Russian ruble. Yet foreign investors are very long these currencies, and a combination of lower oil prices and portfolio outflows from broader EM will weigh on these exchange rates as well. Takeaways And Investment Strategy Chart I-13EM Currencies And Industrial Metals Prices EM risk assets and currencies exhibit the strongest correlation with global trade and commodities prices. Chart I-13 indicates that the EM ex-China currency total return index closely tracks commodities prices. This corroborates the messages from Chart I-1 on page 1 and Chart I-6 on page 4. China’s business and credit cycles are much more important for EM than those of the U.S. A dovish Fed or strong U.S. growth are not sufficient reasons to bet on an EM bull market. A recovery in the Chinese economy and global manufacturing is not imminent. Individual EM countries’ domestic fundamentals such as return on capital, inflation, banking system health, competitiveness and politics drive individual EM performance. On these accounts, the outlook varies among EM. Readers can find analyses on specific EM economies in our Countries In-Depth page. Asset allocators should continue underweighting EM stocks, credit and currencies versus their DM counterparts. Absolute-return investors should outright avoid EM, or trade them on the short side. Within the EM equity space, our overweights are Mexico, Russia, Central Europe, Korea ex-tech, Thailand and the UAE. Our underweights are South Africa, Indonesia, Philippines, Hong Kong, Turkey and Colombia. The path of least resistance for the U.S. dollar is up. Continue shorting the following basket of EM currencies versus the dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We are also short the CNY versus the greenback. As always, the list of our country allocations for local currency bonds and sovereign credit markets is available at the end of our reports – please refer to page 16. Take Cues From These Markets We suggest investors take cues from the following financial market signals. They are unequivocally sending a downbeat message for global growth and risk assets: The ratio between Sweden and Swiss non-financial stocks in common currency terms is heading south (Chart I-14). Swedish non-financials include many companies leveraged to the global industrial cycle, while Swiss non-financials are dominated by defensive stocks. Hence, the persistent decline in this ratio presages a continued deterioration in the global industrial sector. Where is the next defense line for this ratio? To reach its 2002 and 2008 nadirs, it will need to drop by another 10%. In the interim, investors should maintain a defensive posture. Chart I-14A Message From Swedish And Swiss Equities Chart I-15A Breakdown In The Making? U.S. FAANG stocks appear to be cracking below their 200-day moving average. The relative performance of global cyclical versus global defensive stocks is relapsing below the three-year moving average that served as a support last December (Chart I-15). U.S. FAANG stocks appear to be cracking below their 200-day moving average (Chart I-16). If this support gives, the next one will be about 17% below current levels. Finally, U.S. high-beta share prices are on the verge of a breakdown (Chart I-17). The next technical support is 10% below current levels. Chart I-16FAANG Are On The Support Line Chart I-17U.S. High-Beta Stocks Are On The Edge Bottom Line: The common message reverberating from these financial markets corroborates our fundamental analysis that a global business cycle recovery is not imminent, and that global risk assets in general, and EM financial markets in particular, are at risk of selling off further. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Turkey: Is The Mean-Reversion Rally Over? Turkish financial markets have rebounded to their respective falling trend lines (Chart II-1). Are they set to break out or is a setback looming? Chart II-1Back To Falling Trend Chart II-2TRY Is Cheap Pros The economy has undergone a considerable real adjustment and many excesses have been purged: The current account balance has turned positive as imports have collapsed. Going forward, lower oil prices are likely to help the nation’s current account dynamics. The lira has become cheap (Chart II-2). According to the real effective exchange rate based on unit labor costs, the currency is one standard deviation below its fair value. Core and headline inflation have fallen, allowing the central bank to cut interest rates aggressively. However, the exchange rate still holds the key: if the currency depreciates anew, local bonds yields will rise and the ability of the central bank to reduce borrowing costs further will diminish. Finally, private credit and broad money growth have decelerated substantially and are contracting in inflation-adjusted terms (Chart II-3). Chart II-3Money & Credit Have Bottomed Chart II-4Banks Have Been Aggressively Buying Government Bonds The recent gap between broad money and private credit growth has been due to commercial banks buying government bonds (Chart II-4). When a commercial bank purchases a security from non-banks, a new deposit/new unit of money supply is created. Banks’ purchases of government bonds en masse have capped domestic bond yields. However, if pursued aggressively, such monetary expansion could weigh on the currency’s value. Cons Presently, potential sources of macro vulnerability in Turkey are: Foreign debt obligations (FDOs) – which are calculated as the sum of short-term claims, interest payments and amortization over the next 12 months – are at $168 billion, which is sizable. The annual current account surplus has reached only $4 billion and is sufficient to cover only 2.5% of FDOs, assuming the capital and financial account balance will be zero. Clearly, Turkey needs to both roll over most of its foreign debt coming due and attract foreign capital to finance a potential expansion in its imports if its domestic demand is to recover. Critically, $20 billion of net FX reserves, excluding gold, swap lines with foreign central banks and net of domestic banking and non-banking corporations’ foreign exchange deposits, are not adequate either to cover foreign debt obligations. Even though headline and core inflation measures have fallen, wage inflation remains rampant (Chart II-5). If wage inflation does not drop substantially very soon, rapidly rising unit labor costs will feed into inflation leading to negative ramifications for the exchange rate. This is especially crucial in Turkey given President Erdogan has undermined the central bank’s credibility and is resorting to populist measures to revive his popularity. Finally, Turkish banks remain under-provisioned. Currently, the banking regulator is requiring banks to boost their non-performing loans (NPL) ratio to 6.3% of total loans.This a far cry from the 2001 episode when the NPL ratio shot up to 25% (Chart II-6). Even though interest rates rose much more in 2001 than last year, the private credit penetration in the economy was very low in the early 2000s. A higher credit penetration usually implies weaker borrowers have borrowed money and heralds a higher NPL ratio. Typically, following a credit boom and bust, it is natural for the NPL ratio to exceed 10%. We do not think Turkish banks stocks, having rallied a lot from their lows, are pricing in such a scenario. Chart II-5Surging Wages Are A Risk Chart II-6NPL Ratio Is Unrealistic Investment Recommendation We recommend both absolute-return investors and asset allocators not to chase Turkish financial markets higher. Renewed market volatility lies ahead. Given we expect foreign capital outflows from EM, Turkish companies and banks will encounter difficulties in rolling over their external debt and attracting foreign capital into domestic markets. This will produce a new downleg in the exchange rate. In turn, currency depreciation will weigh on performance of local bonds as well as sovereign and corporate credit. Stay underweight. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Business confidence peaked in March 2018 and has been in a freefall ever since, with the steepest drop taking place in recent months as the Sino-American trade war has re-escalated (CEO confidence shown inverted, top panel). Moreover, there is mounting evidence that the trade tensions are further infecting the economy beyond manufacturing including services and the consumer. Using data from the Conference Board’s Consumer Confidence survey and from the University of Michigan Sentiment survey the chart shows that consumer intentions to buy large household durable goods (shown inverted, second panel), cars (shown inverted, third panel) and homes (shown inverted, bottom panel), all have taken a massive hit of late. Historically, all three survey measures have been excellent leading indicators of the labor market and the current message is to expect a rise in the unemployment rate in coming months. Bottom Line: While we are on the sidelines on the defensive/cyclical portfolio bent we stand ready to move to a defensive over cyclical preference. Once our S&P software trailing stop gets triggered, which will move this heavyweight tech subgroup to neutral, then the broad tech sector will shift to underweight and our defensive/cyclical bent to overweight. Stay tuned.