Equities
Highlights Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2018. We will resume our regular publishing schedule on January 2, 2019 with a Special Report on urbanization/industrialization. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Jonathan LaBerge, CFA, Vice President Special Reports The evidence over the past year raises the odds that China’s economy has entered a multi-year period of frequent mini-cycles. A mini-cycle world would be a difficult one for investors to navigate, particularly if the boom and bust phases are asymmetrical in length or magnitude. There is no magic wand to quickly transform China into a services-oriented economy, and it is not clear that the gains in tertiary sector GDP since 2010 are sustainable. A slow transition would raise deep questions about China’s growth model over the coming 2-3 years, and would create a major dilemma for policymakers. Chinese stocks are considerably cheaper than they were a year ago, yet they may be cheap for a reason (even over the very long term). On a risk-adjusted basis, we do not find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral barring even lower prices or tangible evidence of successful structural reforms. Feature Following the publication of our special year end Outlook report for 2019,1 BCA's China Investment Strategy service recently expanded on our global view by outlining our three key themes for China over the coming year.2 As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their longer-term implications. Mini-Cycles, And The Policy Trade-Off Between Growth And Leveraging Over the past year we have described the progression of Chinese growth as part of an economic “mini-cycle”, one that actually began in early-2014 (we have focused on the expansion period of the cycle that started in mid-2015). While this is the first clear mini-cycle in China after a prolonged period of slowing activity that followed the enormous stimulus of 2008/2009, many investors and market participants have speculated about whether these types of events will become more prevalent in the future. In a March 2017 BCA Special Report,3 my colleague Arthur Budaghyan speculated about the potential for such cycles within the context of a falling primary growth trend. Arthur’s argument was that cyclical growth could hold up in China over the coming few years only if the government allows credit growth to continue booming, but that this would entail creeping socialism/statism that would cripple the country’s productivity and thus its potential growth. In fact, the experience of the past three years suggests that mini-cycles may occur over the coming few years even if policymakers do try to prevent a falling primary growth trend. Chart 1 shows that the slowdown in domestic demand that investors only began to price in the middle of this year has clearly been caused by a slowing in money & credit growth (as represented by our leading indicator), which in turn strongly appears to have occurred because of monetary tightening that began at the end of 2016 (panel 2). This tightening has been closely linked to the government’s attempt to de-risk the financial sector. Chart 1Tighter Monetary Policy Caused The Recent Mini-Cycle Slowdown In addition, we presented evidence in our August 29 Special Report suggesting that Chinese state-owned enterprises (SOEs) now have a negative net return on borrowed funds (Chart 2), underscoring that Chinese authorities now face a policy trade-off between growth and leveraging.4 The inference is that investors can expect more of these episodes so long as policymakers stay committed to reforming the financial sector, a policy that appears to remain a strong priority of the Xi government. Chart 2SOEs Now Have A Negative Net Return On Borrowed Funds Chart 3 presents three stylized scenarios as a possible multi-year roadmap for investors faced with a “mini-cycle world”. Scenario 1 represents the pessimistic case articulated by Arthur, a set of frequent cycles occurring against the backdrop of a falling primary (or potential growth) trend. Scenarios 2 and 3 represent possible outcomes emerging from successful structural reform: in scenario 2 the downtrend in potential growth is arrested and the primary growth trend becomes flat, whereas scenario 3 depicts the optimistic case, where reform initiatives unleash productivity gains that result in a net increase in potential growth. In both scenarios 2 and 3, the frequency of economic cycles is reduced to be more akin to that of typical business cycles in the developed world, ending the more rapid mini-cycle phase that preceded the success of the reforms. Chart 3A Potential Roadmap For Investors Living In A "Mini-Cycle World" For an investor primarily concerned with cyclical asset allocation, one response to Chart 3 might be that any of the scenarios are acceptable because there is money to be made in each case by shifting one’s investment stance in advance of key inflection points. However, as Arthur alluded to in last year’s report, the cycles depicted in Chart 3 are highly stylized and will not repeat themselves over regular, predictable intervals. In addition, even in scenarios 2 and 3, the higher frequency of oscillations depicted in the chart prior to the positive impact of structural reforms means that a mini-cycle world will be a difficult one for investors to navigate, particularly if the boom and bust phases are asymmetrical in length or magnitude. From a longer-term perspective, Chart 3 clearly outlines two key questions that investors should be asking themselves about China if we truly have entered a multi-year period of frequent mini-cycles: Is there tangible evidence of a falling primary growth trend in China, and can this be detected ex-ante rather than ex-post? What are the markers for successful structural reform, and how can progress be tracked in real-time? These are of course difficult questions to answer, and our thoughts are likely to evolve as more evidence presents itself. However, for now, we note the following: Chart 4 presents some evidence of declining potential growth in China, or more precisely a decline in the natural rate of interest. The chart shows that the rise in the weighted average lending rate since late-2016 was relatively minor compared with levels that have prevailed over the past decade, and yet it is clear that it succeeded in materially slowing the investment-driven sectors of China’s economy. Chart 4There Is Some Evidence That China's Natural Rate Of Interest Has Declined We also presented some evidence in our November 21 Weekly Report showing that China’s monetary policy transmission mechanism is impaired.5 Chart 5 shows that the recent decline in interbank repo rates implies that average lending rates are set to decline materially over the coming months; measuring the strength of the reaction in the old economy to this decline will provide investors with another crucial observation about the responsiveness of the economy to interest rates. Chart 5More Information On The Responsiveness Of The Economy To Interest Rates Will Soon Emerge Concerning potential signposts of successful structural reform, signs that the government is about to undertake a big-bang cleanup and reorganization of China’s SOEs, one that involves the large-scale transfer of bad SOE debts to the public sector, would obviously be the primary event for investors to watch for. We assume that this will not occur over the coming few years barring a major crisis. At the firm level, non-trivial deleveraging, privatization/incorporation, material capital injection/withdrawal, material divestment of non-core fixed assets and (to a lesser degree) reduction in the wage bill relative to the industry have all shown themselves to be significantly related to the odds of a “zombie” firm returning to a healthy financial state.6 Even quiet signs that SOEs may be going through this process would be a positive indication of the potential for reform. At the macro level, our signposts of successful structural reform would be indications that SOE return on assets is set to rise back above borrowing costs (because of a material rise in the former, not a significant decline in the latter), tangible evidence of passive deleveraging (debt to nominal GDP falling because of a sustained rise in the latter), and a structural rise in the presence of private firms in China’s economy. Chart 6 shows that, at least in the case of the latter, progress appears elusive. Chart 6The Size Of The Private Sector In China Is Now Moving In The Wrong Direction Over the shorter-term, global investors are strongly focused on whether we are about to enter another mini-cycle upswing, a view that we have recently argued against. We presented our base case view for 2019 in our December 5 Weekly Report2, which is that growth will modestly firm in the second half of 2019 and will provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. But we underscore that the character of the improvement is likely to be materially different than what occurred in 2016, implying that investors betting on substantial returns from China-related financial assets next year are likely to be disappointed. Transitioning To A Services-Oriented Economy: There Is No Magic Wand Part of the structural reform agenda articulated by Xi Jinping involves transitioning China's economy towards the tertiary sector (services). Services activity, in general, tends to have higher added value than manufacturing, construction, and raw material extraction, and it is hoped that a more services-oriented economy will increase China’s per capita GDP and help the country escape the middle-income trap. Chinese policymakers have been very clear about their intention to promote this shift and have emphasized their need to do so quickly, but have not been very clear about how they plan to do so. Admittedly, there is some evidence to suggest that this trend has already begun: Chart 7 shows that tertiary industry GDP has risen as a share of overall GDP by about 7.5 percentage points since 2010, tertiary industry electricity consumption as a share of total is rising steadily, and the market capitalization of information and communication technology-related sectors has risen in China’s domestic and investable equity market (sharply in the case of the latter).7 Chart 7Some Signs Of A Move Towards Services... However, BCA’s China Investment Strategy service has been and remains quite skeptical about the likely pace of this transition, which raises deep questions about China’s growth model over the coming 2-3 years: Chart 8 breaks down the increase in tertiary industry GDP as a share of total from 2010 – 2017 into individual sectors.8 The chart shows that finance-related sectors (financial intermediation, leasing & business services, and real estate) accounted for nearly half of the increase in services GDP over the period. It seems difficult to expect that this trend will continue in an environment where the government is trying to contain financial sector risk. Chart 8 shows that tech-related sectors accounted for the second largest increase in tertiary industry GDP over the period, which is not surprising given the data shown in panel 3 of Chart 7. However, there are three problems with assuming that China’s tech sector will expand at a very rapid pace from current levels. First, Chart 9 makes it clear that the incubation period for China’s largest two technology companies by market capitalization was quite long. Alibaba and Tencent were both formed nearly 20 years ago, and only recently gained significant traction. Second, neither of these firms appears to have succeeded because of Chinese industrial policy, underscoring the importance of dynamic, competitive, private markets in driving innovation. Third, other successful examples of “breakthrough” state support for industries show that the process is not a rapid one. In the U.S. between 1978 and 1992, the U.S. Department of Energy invested in the Eastern Gas Shale Program, which contributed somewhat to the development of fracking technology used in shale oil & gas production today. Chart 10 shows how long it took for this program to bear fruit: gas production began to trend higher 12 years after the end of the program, whereas it took nearly two decades for oil production to begin to move higher. And even in this case, the role of private industry in commercializing the technology was overwhelmingly dominant. Chart 9The Incubation Period Of China's Major Tech Success Stories Was Quite Long Chart 10The Dividends From State-Assisted R&D Can Take A Long Time To Occur It is encouraging to see that education spending in China has increased as a share of GDP over the past several years, as services activity typically requires a highly educated workforce as an input. But China’s post-secondary educational attainment (defined here as the share of 25-34 year olds with tertiary education) appears to be too low to make a meaningful leap over the next 2-3 years (Chart 11). We acknowledge that China’s educational achievement ranks quite highly relative to the world, and this speaks to the high quality of skilled labor in China. However, for now, China’s attainment rate appears to be too low for the country to rapidly shift to services. Finally, Chart 12 shows that while tertiary industry electricity consumption is rising as a share of total, it remains small compared with secondary industry consumption. This underscores that China’s shift to a truly-services oriented economy is something that will take a considerable amount of time. What does a slow transition from secondary to tertiary industry mean for investors? To us, it either raises the risk that: Chart 12A Long Way To Go policymakers will have to rely on China’s old growth model for longer than they intend, or that Chinese growth will slow considerably more over the coming few years than investors currently expect. In the first case, policymakers may be on a collision course with the reality of poor financial health among SOEs, which as we noted earlier already have a negative net return from leveraging. In the second case, the threat is clear: China’s contribution to global growth could decline sharply, with potentially severe consequences for China-related financial assets. Cheap(er) Chinese Stocks: A Great Long-Term Buying Opportunity? We have received several questions from clients over the past few months asking whether they have been presented with a great long-term buying opportunity for Chinese stocks, even if cyclical economic conditions are set to weaken from current levels. Chart 13In The U.S., Valuation Predicts Long-Term Returns Quite Successfully This is a valid line of inquiry. Over a 6-12 month time horizon, valuation rarely drives asset returns, and we recently argued against the view that valuation could act as an overwhelming rally catalyst for Chinese stocks in 2019. However, we agree that valuation should be increasingly considered as one’s time horizon expands. Chart 13 shows that valuation has been a powerful predictor of 10-year future performance for the U.S. equity market, and Chart 14 shows that the forward P/E ratio for both domestic and investable Chinese stocks has certainly improved over the past several months. In relative terms, Chinese stocks are not as cheap as they have ever been, but haven’t usually been cheaper (at least over the past decade). This is particularly true for the A-share market (Chart 15). Chart 14Chinese Stocks Are Now Considerably Cheaper Than A Year Ago...Chart 15...Although They Have Been Cheaper In Relative Terms We struggle to answer the question, because while valuation usually predicts future returns quite well, deviations from this relationship can exist. Chart 13 shows that material differences between the actual and predicted 10-year returns existed during the 1970s/early-1980s and as well during the late-1990s, and would have as well in 2008/2009 had the valuation extremes of the late-1990s not lined up so well with the timing of the global financial crisis a decade later. In short, cheap stocks can be cheap for a reason, and the structural issues that we noted above certainly highlight the potential for the next 10-years of Chinese equity market performance to be anomalous relative to what would normally be implied by current valuation. For now, the best answer we can provide is that Chinese stocks are a great long-term buy for investors who do not share our structural concerns. On a risk-adjusted basis, we do not find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral. But we will be watching closely over the coming few years for signs of successful structural reform as detailed above, and we are likely to upgrade our structural recommendation on any material progress, particularly if that progress involves a cyclical deterioration in the economy that further cheapens equities. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Pease see The Bank Credit Analyst “OUTLOOK 2019: Late-Cycle Turbulence”, dated November 27, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report “The Great Debate: Does China Have Too Much Debt Or Too Much Savings? ”, dated March 23, 2017, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. 6 IMF Working Paper WP/17/266 “Resolving China’s Zombies: Tackling Debt and Raising Productivity” 7 Note that we have included the consumer discretionary sector in Chart 8 owing to the recent GICS sector changes that have included e-commerce providers such as Alibaba in the discretionary sector. 8 Note that 2016 is the most recent data point for healthcare & social security, education, scientific research & technology services, public management & social organizations, and miscellaneous others. However, their change from 2010 – 2017 reflects almost all of the change in the sum of these categories from 2010 – 2017. Cyclical Investment Stance Equity Sector Recommendations
Dear Client, This will be the last Global Investment Strategy report of 2018. Publication will resume on January 4th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Feature 1. Will the Fed raise rates more or less than what is priced into the futures curve? Answer: More. The fed funds futures curve is pricing in less than one rate hike in 2019 and rate cuts beyond then. In contrast, we think the Fed will raise rates three or four times next year and continue hiking into 2020. For all the worries about a slowdown, U.S. real GDP growth is still tracking at 3% in Q4 according to the Atlanta Fed, while consumption is set to rise by 4.1%. Ongoing fiscal stimulus, decent credit growth, rising wages, and a decline in the savings rate should continue to support the economy in 2019. Housing construction should also stabilize thanks to a low vacancy rate and a pickup in household formation. The fact that mortgage applications for purchase have rebounded swiftly in recent weeks is evidence that the housing market is not as weak as many people believe (Chart 1). Chart 1U.S. Housing: No Oversupply Problem, While Demand Is Firming 2. Will U.S. 10-year Treasury yields rise more or less than expected? Answer: More. Treasurys almost always underperform cash when the Fed delivers more rate hikes than the market is discounting (Chart 2). We expect a modest bear flattening of the yield curve in 2019, with rising bond yields nearly offsetting the increase in short-term rates. Most of the flattening is likely to come in the next six months, as slower global growth and the disinflationary effects of lower oil prices keep bond yields contained. As we enter the second half of next year, global growth should reaccelerate as the effects of Chinese stimulus measures fully kick in and the drag on global growth from the recent tightening in financial conditions dissipates. By that time, the U.S. unemployment rate will be in the low 3% range, a level that could trigger material inflationary pressures. Chart 2Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected 3. Will the yield spreads between U.S. Treasurys and other developed economy bond markets widen? Answer: Yes, particularly at the short end of the curve. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will support wider differentials between Treasurys and non-U.S. bond yields. The greatest potential for spread widening will be for Treasurys versus JGBs. With Japanese inflation still stubbornly low and fiscal policy set to tighten from a hike in the sales tax, the BoJ will be in no position to abandon its yield curve control regime. The 10-year Treasury-gilt spread could also widen if the Bank of England is forced to stay on the sidelines until Brexit uncertainty is resolved. Likewise, the U.S.-New Zealand spread will widen as the RBNZ stays on hold due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be range-bound, with the Bank of Canada coming close to matching, but not surpassing, Fed tightening in 2019. While the ECB will refrain from raising rates next year, the U.S. Treasury-German bund spread should narrow marginally if the end of ECB QE lifts bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads, as both the RBA and Riksbank begin a tightening cycle. 4. What will happen to U.S. corporate credit spreads? Answer: They are likely to finish 2019 close to current levels. As a rule of thumb, corporate bond returns are highest when the yield curve is very steep, and lowest when it is inverted (Table 1). The former generally corresponds to the early stages of business-cycle expansions, while the latter encompasses the period directly preceding recessions. We are still in the intermediate phase, when excess corporate bond returns (relative to cash) are positive but low. This conclusion is consistent with the observation that corporate balance-sheet leverage has increased over the past four years, but not by enough to instigate a major wave of defaults. Table 1Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) 5. Will the U.S. dollar continue to strengthen? Answer: The dollar will strengthen until the middle of 2019 and then begin to weaken. Three main factors determine the short-to-medium term direction of the dollar: 1) momentum; 2) interest rate spreads between the U.S. and its trading partners; and 3) global growth. In general, the dollar does well when it is trending higher, spreads relative to the rest of the world are wide and getting wider, and global growth is slowing (Chart 3). For the time being, momentum continues to work in the greenback’s favor. Spreads have narrowed a bit recently, but the dollar still looks cheap relative to what one would expect based on the current level of spreads (Chart 4). As in 2017, the direction of global growth will likely be the key driver of the dollar next year. If growth bottoms in mid-2019, as we expect, the dollar will probably put in a top. Chart 3Dollar Returns Driven By Momentum, Rate Differentials, And Global Growth Chart 4Wider Spreads Bode Well For The Dollar 6. Will global equities rise or fall? Answer: Rise. Our tactical MacroQuant stock market timing model finally moved back into neutral territory on Monday after having successfully flagged the correction that began in October (Chart 5). Having downgraded global equities this past summer, we will return to overweight if the ACWI ETF drops to $64, which is only 2.4% below yesterday’s close. The cyclical backdrop for stocks is reasonably constructive. We expect the MSCI All-Country World Index to rise by about 10%-to-15% in dollar terms from current levels by the end of 2019. The higher end of this range would leave it slightly below its January 2018 peak (Chart 6). The index is currently trading at 13.3-times forward earnings, similar to where it was in early-2016. The U.S. accounts for over 50% of global stock market capitalization (Chart 7). As such, the U.S. equity market tends to influence non-U.S. stocks more than the other way around. Sustained U.S. equity bear markets are rare outside of recessions (Chart 8). With another U.S. recession unlikely to occur at least until late-2020, that gives global stocks enough room to rally. Indeed, history suggests that the late stages of business-cycle expansions are often the juiciest for equity investors (Table 2). Chart 5The MacroQuant Equity Score* Improves To Neutral Chart 6Global Stocks Have Cheapened Chart 7The U.S. Is The Dominant Equity Market Chart 8Recessions And Bear Markets Usually Overlap Table 2Too Soon To Get Out 7. Will cyclical stocks outperform defensives? Answer: Yes, although this is likely to be more of a phenomenon for the second half of 2019. Cyclicals typically outperform defensives when bond yields are climbing (Chart 9). Rising bond yields are usually a sign of stronger growth — manna from heaven for capital goods and commodity producers. As long as global growth is under pressure, cyclicals will struggle. But once growth bottoms in the middle of next year, cyclical stocks will have their day in the sun. Chart 9Cyclicals Tend To Outperform When Yields Rise 8. Will U.S. equities continue to outperform other global stock markets? Answer: Yes, but probably only until mid-2019. The U.S. stock market has less exposure to cyclical sectors such as industrials, materials, energy, and financials than the rest of the world (Table 3). Therefore, it stands to reason that an inflection point for cyclicals versus defensives will correspond to an inflection point for U.S. versus non-U.S. stocks. If this were to happen, it would resemble the period between October 1998 and April 2000, a time when bond yields rose, the dollar rally stalled, cyclicals outperformed defensives, and non-U.S. equities outperformed (Chart 10). Table 3Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials And Materials Are Overrepresented In Markets Outside The U.S. Chart 10Will The Late-1990s Pattern Be Repeated? 9. Will oil prices rise more than expected? Answer: Yes. The December-2019 Brent futures contract is currently trading at $61/bbl (Chart 11). Our energy strategists expect Saudi Arabia and Russia to cut production by enough to push prices to an average of $82/bbl in 2019. Looking further out, the outlook for oil prices is less favorable. As every first-year economics student learns, prices in a competitive market eventually converge to average costs. Shale companies are now the swing producers in the global petroleum market. Their breakeven costs are in the low-$50 range, a number that has been trending lower due to productivity gains. If that is the long-term anchor for oil prices, it means that any major rally in oil is unlikely to extend deep into the next decade. Chart 11Oil Prices Will Recover 10. Will gold prices finally rally? Answer: Yes, but only in the second half of 2019. Gold prices typically fall when the dollar is strengthening (Chart 12). Given our view that the dollar will rally into mid-2019, now is not the time to be loading up on bullion. However, once the dollar peaks and U.S. inflation moves decidedly higher late next year, gold should become a star performer. Chart 12Gold Will Shine Bright After The Dollar Peaks Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Going back to the mid-1960s there has been only one time when the stock market peaked prior to the yield curve inversion, in 1973: the SPX crested on January 11 and the yield curve inverted on January 16 (due to lack of data we use the effective fed funds…
Odds are that a structural bottom in this bourse’s relative performance versus the EM index may have been reached. Hence, our emerging markets strategists are putting Malaysian equities on our upgrade watch list while maintaining a market-weight allocation…
M2 is in positive territory. However, the effort can best be characterized as tepid, given the late-year collapse in bond issuance and a still-negative total social financing (TSF) impulse. TSF is the broadest measure of Chinese private credit. We expect a…
Highlights Portfolio Strategy The drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound, warranting an above benchmark allocation. An oil price rebound on the back of a more balanced supply/demand backdrop, a continuation in the global capex energy upcycle and compelling relative valuations all suggest that the path of least resistance is higher for oil majors. Recent Changes Boost the S&P Semiconductor Equipment index to overweight today, on a tactical three-to-six month time horizon. Table 1 Feature Equities attempted to stage a recovery last week and are in a triple bottom technical formation, still consolidating the October tremor. The Fed meeting later this week will likely prove a catalyst on the monetary policy front, especially if the closely watched FOMC median dots decrease for 2019 as the bond market has been expecting. As we mentioned in our 2019 High-Conviction calls Report two weeks ago,1 the Fed will dominate markets next year and any dovish change in interest rate expectations will breathe a sigh of relief into the SPX. Given the heightened volatility and violent recent equity market oscillations, it is important to separate the noise from the actual signal. While distinguishing between the two is hard at times, we are relying on a few key indicators to aid us in this process. First, our S&P 500 EPS growth model is still expanding near the 10% mark for next year as clearly 25% EPS growth is not sustainable. While the risk is that this growth rate decelerates further, as long as EPS do not contract next year, stock prices should recover (Chart 1). From a macro perspective, at this stage of the cycle with nominal GDP growth between 4-5%, organic EPS growth should at least mimic nominal output growth. Tack on a 2% buyback yield or artificial EPS growth and attaining a 7% EPS growth rate is likely next year. Second, while the 5/2 and 5/3 yield curve slopes have inverted and we heed these signals, the 10/2 and the Fed’s spread (2-year yield minus the fed funds rate) have yet to invert. Historically, the most significant yield curve signals for the equity market are when simultaneously all the different yield curve slopes are inverted. While everyone is infatuated with the yield curve inversion implications of recession, we are laser focused on the interplay between the yield curve and stock market peaks. Importantly, typically the 10/2 yield curve inversion occurs before stock market peaks. Going back to the mid-1960s there has been only one time when the stock market peaked prior to the yield curve inversion, in 1973: the SPX crested on January 11 and the yield curve inverted on January 16 (due to lack of data we use the effective fed funds rate instead of the 2-year yield prior to 1976). In all the other iterations, the yield curve inverts prior to the stock market top. Even in 1998 the yield curve inverted in late-May and the SPX peaked in mid-July before suffering a 20% drawdown. Similarly, on February 2, 2000 the yield curve inverted and on March 24, 2000 the SPX topped out for the cycle. Chart 3… And Then The SPX Peaks In other words, the yield curve inversion is a leading indicator and once the curve inverts, it signals that the stock market highpoint will follow soon thereafter (Charts 2 & 3). The broad market tops on average 248 days (median 77 days) following the yield curve inversion (Table 2), though the large variability in each iteration limits the usefulness of this average as an accurate predictor. Nevertheless, the implication remains that the SPX has yet to peak for the cycle. Table 2Yield Curve Inversions And S&P 500 Peaks Third, a slew of economically sensitive indicators have troughed. Sweden’s PMI and Swedish stock market relative performance have been in a V-shaped recovery. As we highlighted earlier this week,2 Sweden is a small open economy and it is likely sniffing out an improvement in global export volume growth and a likely de-escalation in the U.S./China trade tussle. EM FX, the CRB raw industrials commodities index, the Baltic Dry Index and semi equipment stocks (see more details in the next section) all suggest that the worst is over, and global trade will likely resume its advance in the coming months (Chart 4). Chart 4Hyper-sensitive Indicators Sniffing Out A Trough? Finally, inflation is coming off the boil and will likely decelerate in the months ahead courtesy of the fall in WTI crude oil prices. Were oil to move sideways from here, headline inflation would decelerate further, likely overwhelming core CPI (Chart 5). This is significant, as it could serve as a monetary policy catalyst. Put differently, decelerating inflation may cause the Fed to reconsider the pace of its interest rate hikes. A pause in the tightening cycle in March 2019 would be a welcome development for stocks, especially if the fed funds rate is nearing the terminal rate as we recently highlighted in our trough-to-peak fed funds rate tightening cycle analysis.3 Chart 5Inflation Will Decelerate Adding it all up, our still expanding SPX EPS growth model, a lack of a 10/2 yield curve inversion, a trough in a number of economically sensitive indicators and the potential for a temporary Fed hike pause in March next year, all signal that the equity bull market is not over and fresh all-time highs are looming in 2019. This week we are upgrading, on a tactical basis, a bombed out tech subgroup, and updating our view on a deep cyclical index. Semi Equipment: Enough Is Enough We are lifting exposure in the niche S&P semi equipment index from underweight to a modest overweight. Putting this in perspective, this small index comprises only 1.5% of the tech universe and commands a mere 0.3% weight in the S&P 500. There are high odds that most of the carnage in semi equipment stocks is already reflected in the violent swing of the sell side community from extreme bullishness up until August of this year to the current extreme bearishness. As a reminder, the S&P semi equipment index was part of U.S. Equity Strategy’s high-conviction underweight call revealed in November 27, 2017 when the sell-side could not have enough of semi equipment stocks as analysts were also mesmerized last winter by the near $20,000/bitcoin related mania.4 This timing coincided with the peak in performance of this hypersensitive early-cyclical tech index (Chart 6). Chart 6Extreme Bearishness... To get a sense of how far the pendulum has swung on the bearish camp, we note the following: The relative 12-month forward EPS growth has deflated from positive 60% to negative 20% (Chart 6). The index’s forward P/E is trading at a 40% discount to the SPX, relative 5-year EPS growth estimates are near previous troughs and even compared to the overall tech sector; semi equipment long-term EPS growth is now forecast to trail their tech brethren (Chart 7). Even forward sales growth has collapsed, falling to a multi-year low. Analysts now expect an outright contraction in revenues to the tune of 4% or 10 percentage points below the S&P 500 (Chart 6). Net EPS revisions have also been sinking like a stone, approaching the 2012 nadir (Chart 6). Technical conditions are oversold with cyclical momentum as bad as it gets (Chart 7). Chart 7...Reigns Beyond this overly pessimistic backdrop, there are some macro indicators that, were they to sustain their recent budding recoveries, would serve to catalyze the chip equipment group. First, trade policy uncertainty has dealt a blow to this tech subindex (trade policy uncertainty shown inverted, top panel, Chart 8). Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Table 3 highlights the excessive sensitivity these stocks have to the U.S. dollar. In fact, the correlation with J.P. Morgan’s EM FX index is an almost perfect one (Chart 8). If President Trump is serious about striking a deal with China, then this group would enjoy a relief rally. Chart 8Potential Positive Catalysts Table 3U.S. Semi Equipment Geographical Sales Breakdown Second, emerging market manufacturing PMIs are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (Chart 9). Chart 9EM Green Shoots? Third, while global semi sales will continue to decelerate for the next three-to-six months, the semi market is functioning as if the inventory liquidation cycle is in the later innings, with our industry pricing power proxy plummeting 180 percentage points from peak-to-the-recent trough, just below the contraction zone (Chart 10). Chart 10Inventory Liquidation Is In Late Stages Finally, any bounce in cryptocurrencies may also serve as a positive catalyst for additional demand for the semi equipment companies that enjoy monopolies in their respective manufacturing niches (Chart 10). In sum, the drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound. Bottom Line: Lift the S&P semi equipment index from underweight to overweight today, as a tactical move for the next three-to-six months. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX and KLAC. Oil Majors Are Holding Firm In early-February we upgraded the heavyweight integrated oil & gas energy subindex to an above benchmark allocation. Our thesis centered on a capex upcycle recovery and firming oil price backdrop that would unlock excellent value in this key energy subgroup. Since then, the relative share price ratio has moved laterally. Interestingly, this defensive energy subindex neither kept up with the steep oil price advance until the end of September, nor with the recent drubbing in crude oil prices (Chart 11). Put differently, oil majors never discounted sustainably higher oil prices, and are also refraining from extrapolating recent oil prices weakness far into the future. Chart 11Defensive Oil Equities While the Trump Administration’s flip-flop on the Iranian sanctions has injected extreme volatility into oil prices, some semblance of normality has returned to the crude oil markets as last week OPEC and Russia agreed to a production cut in order to help balance the market. Another key factor that has contributed to the recent fall in oil prices at the margin has been U.S. shale oil supplies. Roughly 30% per annum growth in U.S. crude oil production is unsustainable and, were production to remain near all-time highs and move sideways in 2019, then the growth rate would fall back to the zero line. Such a paring back in the growth rate, along with OPEC/Russia discipline, would likely balance the oil market and pave the way for an oil price recovery (oil production shown inverted, Chart 12). Chart 12U.S. Supply Response Is Looming Given that BCA’s Commodity & Energy Strategy service continues to forecast higher oil prices into 2019, the S&P integrated oil & gas index should stage a sustainable rebound next year. While the recent swift drop in oil prices is jeopardizing the still recovering capital expenditure cycle, we doubt $50/bbl oil would make current projects uneconomical and result in mothballing or outright canceling of ongoing oil exploration projects (Chart 13). Granted, a big assumption is that oil prices at least hold near the current level and do not suffer a relapse to the early-2016 lows. Historically, rising oil exploration outlays and integrated oil & gas share prices move in lock step and the current message is to expect a rebound in the latter (Chart 14). Chart 13Low Odds Of A Total... Chart 14...Capex Collapse Finally, sell-side analysts are throwing in the towel. Net earnings revisions have taken a beating of late, which is positive from a contrary point of view (second panel, Chart 15). Relative valuations are extremely compelling on a number of metrics including relative price-to-book, price-to-sales and relative forward price-to-earnings (third panel, Chart 15). Tack on a near 200bps positive delta in the dividend yield versus the broad market and yield hungry investors will also seek the relative safety of this defensive energy subindex (bottom panel, Chart 15). Chart 15Integrated Stocks Are On Sale Netting it all out, an oil price rebound on the back of a more balanced supply/demand backdrop, a continuation in the global capex energy upcycle and compelling relative valuations all suggest that the path of least resistance is higher for oil majors. Bottom Line: Stay overweight the heavyweight S&P integrated oil & gas energy subindex. The ticker symbols for the stocks in this index are: BLBG: S5IOIL – XOM, CVX and OXY. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Sector Insights, “Can Sweden Lead The SPX?” dated December 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, “2018 High-Conviction Calls,” dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights A progressing Sino-U.S. trade truce, rallying commodities and EM FX as well as improving Swedish economic activity point to a respite in the global growth slowdown. This should support commodity currencies and cause a correction in the dollar – moves we would fade. Ultimately, tightening U.S. policy and a rising Chinese marginal propensity to save point to both slower growth and a stronger dollar over the coming six to nine months. The European Central Bank is extremely data dependent, and in our view, our outlook on global growth will compromise the ECB’s ability to lift rates in September 2019. A tactical trade: Sell EUR/GBP. Feature Glimmers of hope are emerging for dollar bears and EM bulls. The Sino-U.S. trade truce seems to be progressing: Meng Wanzhou, the CFO of Huawei, was released on bail this week, and U.S. President Donald Trump suggested he would lean in her favor; China dropped its tariffs on U.S. auto imports to 15%; and the communication channels between China and the U.S. are clearly open. Green shoots for global growth have also emerged, with commodity prices staging a bit of a rebound, and data in some small, open economies very levered to global growth showing improvement. These developments can easily help risk assets temporarily rebound, lifting EM currencies and G-10 commodity currencies in the process while hurting the greenback for a month or two. However, we remain doubtful that these glimmers of hope for global growth will morph into a sustained rebound in global industrial activity. Consequently, we are inclined to use any weakness in the greenback to buy the dollar, and any rebound in EM and commodity currencies to sell them in anticipation of deeper lows. A Set Up For Some Dollar Weakness… The continued warming up in Sino-U.S. relations is encouraging, but as we argued last week, a more important consideration is whether global growth is finding a floor.1 In recent weeks, a few market signals have offered some hope. The growth-sensitive CRB Raw Industrials index has been firming, and the Baltic Dry index has recouped 40% of its loss from August to November (Chart I-1). Chart I-1Green Shoots In The Commodity Space... EM FX has also staged a bit of a rebound, led by the Turkish lira. The most positive development on this front has been the recent gains in the yuan. Its rebound keeps at bay a large deflationary shock for the global economy, and the stability in EM FX means that EM financial conditions are not deteriorating further (Chart I-2). Chart I-2...Green Shoots In EM FX... In our view, the greatest source of optimism comes from the Swedish economy. Sweden is a small, open economy where industrial and intermediate goods account for 25% of exports, or 11% of GDP. Its manufacturing PMI have been rebounding – a phenomenon repeated across multiple data sets. In fact, our diffusion index of 15 Swedish economic variables has been recovering. Based on history, the current recovery in the Swedish economic advance/decline line points to an upcoming rebound in EM exports growth, and to a temporary stabilization in the Global Leading Economic Indicator (Chart I-3). Chart I-3...And Green Shoots In Sweden As Well! Any sign of stabilization in global economic activity will generate a period of weakness in the dollar, a traditionally countercyclical currency, which has now been made more vulnerable to good global growth by extended long speculative positioning. However, before bailing on the greenback, we need to see if this period of respite for the world will prove durable. Bottom Line: Indications that the Sino-U.S. trade truce has staying power for now, coupled with signs from both financial market prices and from Sweden – one of the G-10’s most growth sensitive economies – are likely to prompt a dollar correction over the next month or two. Short-term traders are likely to be able to take advantage of this move. ...But Not For A Cyclical Top… Even the most ferocious dollar bull markets can be punctuated by periods of weakness. This was the case throughout the first half of the 1980s and the second half of the 1990s. There is no reason why this rally will prove different. Thus, a period of stabilization in global growth prompting a dollar correction should not come as a surprise. However, at this juncture, the global policy set up still favors remaining long the dollar and using any correction to build up bigger long-dollar bets. Today, our BCA central bank monitor continues to point to the need of tightening U.S. monetary policy. However, the same cannot be said about the rest of the G-10 in aggregate. We estimated the performance of G-10 currency pairs versus the dollar when, like today, the BCA central bank monitors showed a greater need for policy tightening in the U.S. than in the rest of the world. What we found was during the past 26 years, this kind of environment is associated with depreciations versus the U.S. dollar in the euro, the yen, the Australian dollar, the Canadian dollar, the Swiss franc and the Scandinavian currencies (Chart I-4). Interestingly, the GBP and the NZD seem to buck this trend. Chart I-4The Current Currency Setup Is Dollar Bullish The EUR/USD pair is of particular interest, as it accounts for 58% of the DXY dollar index and is often the preferred vehicle for investors to bet on the dollar’s trend. Right now, in sharp contrast with the U.S., the euro area central bank monitor points to a need for easing policy in Europe (Chart I-5). Chart I-5Economic Conditions Warrant More Hikes In The U.S., But Not In Europe... We expect our monitors to continue to point toward the need for tighter U.S. than European monetary policy. Today, European growth has decelerated, and the slowdown in euro area M1 money supply indicates that continental growth will slow further before finding a bottom (Chart I-6, top panel). The European Central Bank is not immune to growth risks. Chart I-6...And This Is Not About To Change Meanwhile, the Federal Reserve is fixated on inflationary developments, especially those emanating from the labor market. While U.S. core PCE has disappointed, U.S. wages, as measured by average hourly earnings and the Atlanta Fed Wage Tracker, are all trending higher (Chart I-6, middle panel). Moreover, while there has been a concerning slowdown in the U.S. housing sector, mortgage applications are beginning to regain some vigor (Chart I-6, bottom panel). The Fed may thus pause in March, but we do not think it is done hiking for the remainder of 2019, as markets currently expect. As a result, we anticipate one-year-ahead policy differentials between the U.S. and the DXY-weighted G-10 central banks to widen, lifting the dollar in the process (Chart I-7). Therefore, any dollar correction should be short-lived. Investors with longer investment horizons than three months should ride the volatility and remain long the dollar. Chart I-7More Dollar Upside Bottom Line: BCA’s Fed monitor is pointing to the need for further U.S. rate hikes. Meanwhile, outside the U.S., G-10 policy should remain easy. Historically, this set-up is associated with dollar strength. The dichotomy between slowing European growth and growing U.S. wages suggests expected policy differentials will remain negative for EUR/USD. Stay long the dollar. ...Especially As China Remains Challenged China is now such an important diver of the global industrial cycle that it could nullify any of the conclusions noted above. However, at this point, Chinese economic dynamics seem to reinforce the dollar-bullish outcome, not weaken it. Chinese policy rates have collapsed, and the People’s Bank of China has cut the Reserve Requirement Ratio to 14.5%, injecting RMB 750 billion into the interbank market. This apparent easing in policy lifted hopes that we would see a significant rebound in the credit number in November. However, as Chart I-8 illustrates, total social financing excluding equity issuance has not picked up and continues to crawl along at a 16-year low. Moreover, the shadow-banking sector remains weak. Chart I-8Despite Stimulus, Chinese Credit Is Still Slowing Why is the Chinese economy not responding to what seems like an easing in liquidity conditions? First, it is far from clear that Beijing has abandoned its desire to limit the growth of indebtedness in China. As a result, bankers remain reluctant to open the lending taps aggressively. Second, Chinese borrowers themselves have curtailed their appetite for credit. After binging on easy credit, state-owned enterprises have misallocated vast amounts of capital and are now unable to generate sufficient returns on assets to cover their costs of borrowing (Chart I-9). Meanwhile, the private sector is also reluctant to borrow aggressively amid uncertainty regarding the Chinese growth outlook. Chart I-9Too Much Debt Leads To Misallocated Capital The result is a sharp rise in the Chinese marginal propensity to save (MPS). We can approximate China’s MPS by looking at the growth of M2 money supply relative to M1. The difference between the two monetary aggregates are savings deposits. If M2 grows faster than M1, Chinese economic agents are parking their funds in savings deposits faster than they are adding to their checking accounts, despite low interest rates. This suggests a greater desire to save. This means it will take much more stimulus than what has so far been injected into the Chinese economy to put a floor under growth. Indeed, this proxy for China’s MPS has historically been a reliable leading indicator of Chinese economic activity, announcing turning points in the Li Keqiang index (Chart I-10, top panel). The rising MPS is currently signaling a further deceleration in Chinese import volumes growth (Chart I-10, second panel), which is reflected in a call for greater downside to global export growth (Chart I-10, third panel). Finally, China’s MPS also forewarns that global industrial activity, as measured by our nowcast, will slow more (Chart I-10, bottom panel). In aggregate, China’s rising marginal propensity to save clearly points toward further global growth weakness. Chart I-10China's Rising Marginal Propensity To Save Hurts Global Growth As we have shown many times, slowing global growth is good for the dollar, as it has a more negative impact on economic activity outside the U.S. than inside.2 Additionally, when global growth decelerates in response to slowing Chinese economic activity, Chinese interest rates also normally fall relative to U.S. ones, as China is forced to ease policy vis-a-vis the U.S. This interest rate differential has already narrowed considerably. If the correlation of the past 12 years is any guide, this means the recent rebound in the CNY is to be faded, and that USD/CNY has significant upside in the upcoming six to nine months (Chart I-11). This is deflationary for the global economy. Chart I-11Chinese Rates Will Further Lag U.S. Ones, The Yuan Will Follow The impact of falling Chinese interest rates relative to the U.S. is not limited to the USD/CNY. As Chart I-12 shows, when U.S. one-year rates rise relative to China, the DXY also strengthens. This is again because U.S. rates overtake Chinese rates in an environment where global growth is slowing. Today, U.S. 12-month rates are higher than Chinese rates, and the differential will widen as Chinese policymakers are forced to continue stimulating. Hence, any correction in the USD should prove transitory. Chart I-12When U.S. Rates Rise Relative To China, The DXY Appreciates The impact of these dynamics is most evident in the currencies of the economies most exposed to the Chinese business cycle. As Chart I-13 shows, when Chinese 12-month interest rates fall relative to U.S. 12-month rates, EM FX and G-10 commodity currencies depreciate significantly. A further drop in the Sino-U.S. spread, a consequence of a high and rising MPS hurting Chinese growth, will lead to further weakness in EM FX, the AUD, the NZD, the CAD, and the NOK against the dollar. Thus, it seems any respite these currencies may currently enjoy will prove temporary. Chart I-13Falling Sino-U.S. Spreads Will Hurt EM FX And Commodity Currencies Bottom Line: Despite injections of stimulus, China’s credit growth is not rising because the Chinese marginal propensity to save has risen significantly. It will take much more stimulus before credit growth rises anew. Thus, Chinese and global growth will not find a durable bottom for at least two more quarters. This implies that rate differentials between China and the U.S. will fall further, and hence USD/CNY and the DXY have more upside on a six- to nine-month basis, even if they weaken in the coming weeks. Meanwhile, EM FX and commodity currencies have a lot more downside in their future. ECB: The End Of An Era Yesterday, the ECB announced the well-anticipated end of its asset purchase program, but couched its discussion in rather hedged terms. The ECB focused on the importance of forward guidance and is open to adding to the TLTRO program if need be. The first rate hike being through the summer of 2019 is clearly conditional on economic circumstances. In this regard, the ECB downgraded its growth forecast for 2018 and 2019 to 1.9% from 2% and to 1.7% from 1.8%, respectively. The inflation forecast was revised up to 1.8% from 1.7% in 2018 and was revised down to 1.6% from 1.7% in 2019. Additionally, ECB President Mario Draghi highlighted that risks to the forecasts are balanced, but downside risk is growing. Not only do we agree that downside risk is growing, we also agree on the source of this risk: foreign growth and global protectionism. However, on this front, we are more pessimist than the ECB as we expect a greater deterioration in EM conditions and global trade. As a result, we think that risks are very significant that the ECB will find it difficult to implement a first rate hike in September 2019, yet markets are currently pricing in a 10 basis-point move that month. Hence, we expect that if our view on global growth is correct, the ECB will guide markets to price in the first hike later than September 2019, a process that will weigh on the euro, especially as investors already take a dim view on the capacity of the Fed to lift rates next year. Bottom Line: The ECB is ending its asset purchase program, but it remains committed to supporting growth in the euro area. The ECB is now heavily leaning on forward guidance, and any policy tightening is conditional on economic circumstances. BCA’s view on global growth suggests that it will be hard for the ECB to lift rates in September 2019. Short-Term Trade: Sell EUR/GBP This week’s political survival of Prime Minister Theresa May means that for another year, the hard Brexiters cannot challenge her for leadership of the Conservative Party. While it does not mean that the Brexit saga is over, it does mean that the probability of a Hard, No-Deal Brexit has fallen even further. As such, this implies that the politically driven rally in EUR/GBP since mid November is likely to reverse (Chart I-14). Chart I-14Tactical Trade: Sell EUR/GBP Additionally, the outperformance of British wages relative to the euro area should also support the pound in the short term (Chart I-15). A lower risk of a crash Brexit together with an ECB displaying a somewhat dovish side should cause an upgrade by investors in the expected path of monetary policy in the U.K. relative to the euro area. Moreover, while the euro area current account surplus has rolled over, the U.K.’s is steadily improving, making the pound progressively less dependent on international flows. Chart I-15Relative Wages Favor BoE Hikes Versus ECB Hikes As such, we are opening a tactical trade: selling EUR/GBP with a tight stop at 0.9100 and a target at 0.8700. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Waiting For A Real Deal”, dated December 7, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled “Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation”, dated November 23, 2018, as well as the Foreign Exchange Strategy Weekly Report, titled “The Dollar And Risk Assets Are Beholden To China’s Stimulus”, dated August 3, 2018. Both are available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Core inflation came in line with expectations at 2.2%. This measure also increased from last month’s reading. Meanwhile, the JOLTS job openings outperformed expectations, coming in at 7.079 million However, while nonfarm payrolls underperformed expectations, coming in at 155 thousand, U.S. average hourly earnings remains solid DXY has risen by 0.5% this past week. We continue to be bullish on the U.S. dollar. The current environment of falling global growth and inflation has historically been very positive for this currency. Moreover, the market has already priced out any Fed hikes beyond December. This means that the risk for U.S. rates vis-à-vis the rest of the world remains to the upside. Report Links: Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: Industrial production yearly growth surprised to the upside, coming in at 1.2%. However, the Sentix Investor Confidence index surprised negatively, coming in at -0.3. Finally, Gross domestic product yearly growth underperformed expectations coming in at 1.6%. EUR/USD has been flat this week. Yesterday, the ECB downgraded its 2018 and 2019 growth forecasts. Moreover ECB president Mario Draghi hinted at increasing caution, as he remarked that downside risks where growing. We believe that EUR/USD has further downside, towards the 1.08-1.05 range, as the ECB will be unable to tighten monetary policy in the current environment of slowing global growth. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Machinery orders yearly growth underperformed expectations, coming in at 4.5%. Moreover, the final revisions to GDP annualized growth also surprised downside, coming in at -2.5%. Finally, the leading economic index also surprised negatively, coming in at 100.5. USD/JPY has risen by 0.8% this week. We are positive on the yen for the first quarter of 2019, especially on its crosses. The current risk off environment should be positive for safe havens like the yen. We are particularly negative on EUR/JPY, as this cross is very well correlated with bond yields, which have possess short-term downside. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial production yearly growth underperformed expectations, coming in at -0.8%. Moreover, the claimant count change also surprised negatively, coming in at 21.9 thousand. However, average hourly earnings excluding and including bonus both outperformed expectations, coming in at 3.3%. GBP/USD has fallen by 1.2% this week on political risks. However, on Wednesday PM Theresa May survived a vote of no confidence that would have removed her from the leadership of the tory party. With this win, Prime Minister May is now protected from intra-party challenges for at least a year, strengthening her ability to fend-off demands by hard-brexiters. This event has created a tactical opportunity to sell EUR/GBP. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: The house price index yearly growth came in line with expectations, declining by -1.5%. Moreover, home loans growth outperformed expectations, coming in at 2.2%. AUD/USD has been flat this week. We believe that the AUD is the currency with the most potential downside in the G10. After all, Australia is the G-10 economy most leveraged to the Chinese industrial cycle, due to Australia’s high reliance on industrial metal and coal exports. This means that the continued tightening by Chinese authorities should be most toxic for this currency. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has fallen by 0.5% this week. After being bullish in the NZD for a couple of months, we have recently turned bearish, as this currency is very likely to suffer in the current environment of declining inflation and global growth. said that being said, we remain bullish on the NZD relative to the AUD, given that the kiwi economy is less exposed to the Chinese industrial cycle than Australia’s. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been positive: Net change in employment surprised positively, coming in at 94.1 thousand. Moreover, the unemployment rate also surprised positively, coming in at 5.6%. Finally, housing starts growth also surprised to the upside, coming in at 216 thousand. After falling by nearly 1%, USD/CAD finished the week flat. While we are bearish on the Canadian dollar relative to the U.S. dollar, we are more positive on the CAD against the AUD. Renewed tightening in oil supply should serve as a support for global oil producers. Meanwhile, Chinese deleveraging will continue, hurting base metals in the process. This will cause oil to outperform base metals, which means that the CAD should have upside against currencies like the AUD. Finally, domestic economic conditions favor BoC hikes versus RBA hike, even after the recent pause flagged by the BoC. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has been flat this week. Our bullish view on EUR/CHF is a high conviction view for the first part of 2019. This is because the recent strength in the franc is choking out any inflationary pressures in the Swiss economy. Thus, we are reaching the threshold at which the SNB is very likely to intervene in the currency market to prevent the franc’s strength from derailing the path toward the inflation target. In fact, the SNB even acknowledged this reality this week by downgrading its inflation outlook. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by 0.7% this week. While we maintain a bearish stance toward the krone versus the U.S. dollar, we are short AUD/NOK, as a way to take advantage of stabilizing oil prices and a continued growth slowdown in China. Moreover, AUD/NOK is expensive in PPP terms, and is technically overbought. Finally, this currency is one of the most mean-reverting within the G10, which means that the recent surge in this cross is likely to reverse. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by 0.9% this week. On a short-term basis, we are negative on the krona, given that this currency is very sensitive to global growth dynamics, which means that the continued tightening by both Chinese authorities and the Fed will create a headwind for any SEK rally. That being said, on a longer-term basis we are more positive on the krona, as the Riksbank has a lot of room to lift rates as the Swedish economy is increasingly displaying large internal imbalances that need to be addressed. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades