Financial Markets
Highlights The coronavirus is a real threat for the global economy and financial markets: We expect that the epidemic will be contained before it takes too much of a bite out of global output, but it has become the biggest market wild card. We are watching for a peak in new infections as a tell for when markets may move on from it. Earnings season was once again a ho-hum affair: S&P 500 earnings per share are on track to post 2% growth in 4Q19, about three percentage points above downwardly revised estimates. Profit margin contraction was in line with the previous three quarters. The biggest banks don’t see any immediate signs of credit problems, … : Net charge-off and non-performing loan ratios remain very low and the banks don’t see borrower performance worsening any time soon. … and think an uptick in business confidence is overdue: The banks’ calls occurred before the coronavirus broke out, but every management team saw the easing of trade tensions as a prelude to a pickup in corporate confidence. While We Were Out Chart 1Risk Off, Everywhere But Stocks We last published a Weekly Report on January 6th, and the ensuing five weeks have been anything but boring. The US assassinated Iran’s foremost military leader, escalating the two nations’ conflict; and the coronavirus burst forth in China’s ninth-largest city, sparking worldwide concerns. The VIX awakened, Treasury yields slid, crude oil swooned and the dollar surged, but the S&P 500 only declined 3% trough to peak, and now sits 2-3% above its January 6th close (Chart 1). The coronavirus is a significant threat to the global economy and global markets, and geopolitical tensions have escalated, but the underpinning of our market views has not changed. We continue to view monetary policy as the critical swing factor for financial markets and the macro cycles that influence them. Assuming the coronavirus or another exogenous event does not tip over the US economy, the next recession will not begin until monetary policy settings turn restrictive. Nothing that has happened since the beginning of year has changed our view that the Fed is almost certain not to hike rates before its November meeting, and we think it is unlikely that it will do so at all in 2020. As long as monetary policy remains accommodative, the economy will keep expanding, the equity bull market will roll on, and spread product will continue to generate excess returns over Treasuries and cash. When China Gets Locked Down It has long been said that when the US sneezes, the rest of the world catches a cold. Conversely, challenges in the rest of the world often fail to leave much of a mark on the US. Should US investors really be that concerned about a virus outbreak in China? The answer is yes, despite the S&P 500’s surge last week. There is no such thing as full-on decoupling, even for the US. The US may respond to global events with a longer lag than more export-oriented economies, but they eventually have an impact. Investors should bear in mind that the S&P 500 is considerably more attuned to global conditions than the domestic economy, given that more than a third of its revenues come from abroad. The coronavirus outbreak has turned into the main source of market uncertainty and is the largest risk to our bullish view on global growth and risk assets. For now, our base case is that the global growth recovery will be delayed, though we expect growth will pick up later this year, provided that the outbreak begins to recede by the end of March. That base case is heavily data-dependent, however, subject to the disease’s course and the Chinese government’s response. From a market perspective, tracking the number of new infections may provide a window on investor sentiment. In 2003, the bottom in equities coincided with the peak in the number of new SARS infections (Chart 2). However, a direct analogy between 2003 and 2020 may underplay the impact on growth. China exerts a lot more influence on the global economy than it did at the turn of the millennium (Table 1). A turn in investor sentiment may not be enough to support risk assets in the face of a significant growth headwind. Chart 2Infections Peak, Market Troughs Table 1China’s Importance Now And In 2003 Since it entered the World Trade Organization in 2001, China has grown from being the sixth-largest economy to the second, trailing only the US. It now accounts for 16% of global GDP in dollar terms. Its total imports of goods and services – the main growth transmission mechanism from China to the rest of the world – currently account for 13.5% of global trade, three times its 2002 share. The scale of the Chinese government response is also very different. While the SARS epidemic caused relatively mild disruptions to the travel and retail sectors, quarantines have put some areas in total lockdown, placing meaningful elements of the country’s overall production on indefinite hold. That’s bad enough from a domestic perspective, but it could swiftly lead to a sharp reduction in global manufacturing output if it derails global supply chains that depend on Chinese-produced components. Last week, Hyundai idled a production line in South Korea for lack of essential China-sourced parts, and Fiat Chrysler has warned that it might have to close a European factory in two to four weeks if critical Chinese suppliers are not able to operate. China exerts considerably more influence on the global economy today than it did in 2003. Extended quarantines will have a readily observable impact. Chart 3Services Now Account For A Majority Of Chinese Output Moreover, this time around the outbreak coincided with the Lunar New Year celebration, when spending on services is usually elevated. Services engender less pent-up demand than durable goods; while demand for durables may merely be deferred until the epidemic is contained, demand for services is much more likely to be destroyed. Nonmanufacturing sectors’ increasing importance in the Chinese economy (Chart 3) implies that relative to 2003, less "lost" spending will be made up later. Using SARS’ impact on Chinese GDP to support a back-of-the-envelope estimate, our Global Investment Strategy colleagues judge that the coronavirus could zero out Chinese growth in the first quarter. Our Global Fixed Income Strategy service estimates that major country sovereign bonds are pricing in two months of lost Chinese growth. The prospect of a stagnant two to three months could well force policymakers to focus exclusively on encouraging growth. They have already signaled they will pull forward some scheduled infrastructure investments, and our China strategists note that 2020 is policymakers’ deadline for meeting their target to double GDP over the decade. Bottom Line: The coronavirus outbreak is a serious threat to the global economy and financial markets, but we do not expect that it will induce a US recession or S&P 500 bear market. The Same Old Earnings Song-And-Dance Chart 4A Typical Quarter With 305 of the companies in the S&P 500 having reported earnings through last Thursday’s open, the fourth quarter appears to be nearly exactly like the first three quarters. Earnings growth was nothing to write home about, but it’s tracking to be a few percentage points better than expected when the big banks kicked off reporting season (Chart 4). Revenue growth continues to be in step with nominal global GDP growth, but profit margins are contracting at about the same rate that they did in the first three quarters (Chart 5). The source of the margin contraction remains a mystery, and unraveling it is near the top of our research to-do list. Chart 5The Incredible Shrinking Profit Margin Earnings don't matter much in the near term, but they've been good enough to allay the undercurrent of worry that was a prominent feature of the equity market all of last year. We have previously written about earnings’ limited effect on equity prices.1 In the near term, moves in the S&P 500 exhibit little to no correlation with either earnings growth or the magnitude of earnings beats. Earnings do matter in the long term, and the uneventful 4Q19 reports at least suggest that stocks give no indication of falling off their currently projected path. As has been the case throughout 2019, the bears’ worst fears failed to come to pass in the fourth quarter. Once the coronavirus is contained, accommodative monetary conditions should help keep them at bay in 2020, as well. Follow The Money The big banks reported their fourth quarter earnings in mid-January, and the market reaction suggested their torrid fourth quarter run has fully played out, at least until long yields perk up again. Our review of their earnings calls is not meant to tell us anything about bank stocks, however. We review the calls to gain some insight into the lending market and where it might be headed, seeking color on banks’ willingness to lend, consumers’ and businesses’ appetite for credit, borrower performance, and the banks’ bottom-up perspective on the economy. This time around, we also wanted to hear if the brand-new CECL (Current Expected Credit Loss) loan-loss provisioning standard could constrain lending. 4Q19 Big Bank Beige Book As a group, the banks were constructive on the economy.2 They agree that the consumer is in fine fettle, and they see signs that corporate confidence is returning as trade tensions recede. Overall loan growth has dipped to 4% on a year-over-year basis (Chart 6), while corporate and industrial (C&I) loan growth has contracted on a thirteen-week basis (Chart 7). The C&I contraction is not a sign that corporations are circling the wagons, however, it’s simply that they’ve turned to the corporate bond market instead (Chart 8). Businesses seeking credit generally have access to all they want at tight spreads, given the paucity of yield in the ZIRP/NIRP era. Chart 6Overall Bank Lending Is Decelerating, ... Chart 7... And C&I Lending Is Contracting, ... Chart 8... But The Bond Market Is Capable Of Picking Up The Slack Positive operating leverage was a mantra that all of the management teams recited. Branch footprints are being rationalized, and the biggest banks are successfully automating manual tasks and driving mundane activity to websites and apps and away from branches and ATMs. Shrinking branch counts could intensify the pressure at the margin for retail landlords, and automation could squeeze bank head counts. Every bank grew deposits faster than loans, furnishing them with dry powder for future lending, and padding their holdings of Treasury and agency securities in the meantime. Households And Businesses [S]entiment on the corporate side appears to be looking better. We’re going to be signing [the Phase I] trade agreement with China today, … and the US-Mexico-Canada agreement is well on its way. So I think that some of that uncertainty that might have been impacting discretionary spend on the commercial side of the equation has been alleviated. [W]e feel pretty good. (Dolan, USB CFO) Every bank cited trade tensions as a drag on corporate confidence last year, and pointed to USMCA and the Phase 1 agreement with China as a sign that it will rebound. [T]he US consumer remains in very strong shape, … from a credit perspective, sentiment, [and] spending, [and] obviously [the] labor market is very strong[.] [C]apital spending is still a bit soft, but sentiment is … certainly better than it was six months ago. [B]roadly speaking, [we have a] constructive outlook as we’re heading into 2020[.] (Piepszak, JPM CFO) [T]hroughout the year, we saw … a lot of things out there that [were] driving uncertainty, be it the lack of the China trade deal, USMCA, Brexit, Hong Kong and … now … the horizon looks like some of those things may clear[,] … and we [may] get a bit more action out of the C-suite. [T]he [capital markets] backlog looks pretty good[,] … [a]nd the forward calendar [does, too]. (Corbat, C CEO) [C]ustomers [in our consumer business] are coming off a strong [spending] finish in 2019. In addition, there’s good loan demand, … result[ing] from good employment levels and growing wages. We saw solid loan demand in our commercial client base throughout the year, [though it] moderated in the second half of the year as worries about global economic uncertainty … dragged on. Today we see some resolution of those issues and that combined with continued consumer strength leads us to expect to see businesses continue their solid activity and we’re hearing more optimism. All this provides a great backdrop[.] (Moynihan, BAC CEO) Borrower Performance Overall credit quality indicators in our commercial portfolio remained strong with our fourth quarter internal credit grades at their strongest levels in two years. Non-accrual loans … in the fourth quarter [were at] their lowest level in over ten years. (Shrewsberry, WFC CFO) [Credit quality metrics] show … that asset quality remained strong in [consumer and commercial] categories. (Donofrio, BAC CFO) [C]redit quality was stable in the fourth quarter. … The ratio of non-performing assets … improved linked quarter and year-over-year. (Dolan, USB) [CLO is] still an asset class that we feel comfortable with the risk/reward … in spite of where we are in the cycle[.] (Shrewsberry, WFC) [There’s nothing] we’re overly concerned about [in our own loan portfolio], given how [conservatively] we manage [lending], but we’re certainly paying attention to leveraged lending. We’re certainly paying attention to energy with respect to natural gas prices, we’re certainly looking at retail … malls. (Donofrio, BAC) CECL Impacts We would expect provisions to be a little higher than net charge-offs in 2020 due to CECL. … All else equal, [the new increased provision] would lower our Common Equity Tier 1 capital ratio by roughly 20 basis points[, but we have a sizable capital buffer, and the capital charge] is phased in … evenly through 2023. (Donofrio, BAC CFO) [I]t’s fair to say, under CECL, [that] you could have incremental volatility [of provisioning expenses]. [But] incremental volatility would [not] be material for us. … It’s just timing [of expense recognition, not any increase in expenses.] (Piepszak, JPM) [A]t this point, it’s not likely that [CECL would] change our appetite for longer-duration consumer loans[.] … [I]t hasn’t caused anything to drop below a hurdle level that says to us, we need to either meaningfully reprice it or … [consider] whether [we want to be] in the business. (Shrewsberry, WFC) Investment Implications Chart 9US Data Have Also Weighed On Yields The coronavirus outbreak is a serious threat, but its very seriousness is likely to provoke Chinese policy responses that may better ensure a turnaround once it can be brought under control. Our view is subject to the real-time course of events on the ground, but our base case is that the business cycle and the bull markets in risk assets remain intact, even if they may sputter here and there until the epidemic is brought to heel. While we acknowledge that economic data have been spotty, and the decline in Treasury yields has not solely been a function of coronavirus fears (Chart 9), we think that yields are near the bottom of their likely 2020 range and have more scope to rise than fall from current levels. We continue to recommend below-benchmark duration positioning. We also continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond portfolios. We would relish the chance to buy an S&P 500 dip to 3,000 if it were to occur when the coronavirus threat appeared to be manageable. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst JenniferL@bcaresearch.com Footnotes 1 Please see the November 11, 2019 US Investment Strategy Weekly Report, "Why Bother With Earnings?" available at usis.bcaresearch.com. 2 The calls were all held before the coronavirus outbreak.
Highlights A currency portfolio comprised of the US dollar, the Japanese yen and the Norwegian krone is likely to outperform a more diversified basket over multiple macroeconomic scenarios. Our work suggests that valuation matters for currencies over the long term. The cheapest currencies in our universe are the Norwegian krone, the Swedish krona and the Japanese yen, although the pound and euro are also attractive. Tactical investors should remain short the DXY index, but also have a higher concentration of dollar-neutral trades given the uncertainty surrounding global growth. Feature A currency investor can construct a long-term portfolio based on three criteria. The first task is to figure out what macroeconomic environment she or he is residing in. During inflationary periods, “hard” currencies tend to do best, since they are usually associated with countries where the private sector is running surpluses. The lack of excess demand in these countries leads to lower inflation, which tends to boost real rates. Examples in recent history include the deutschemark during the 1970s or the Japanese yen throughout most of the ‘80s. In a disinflationary world, the high-yielders tend to be the outperformers. This is not only because the lack of an inflationary pulse leads to very positive real rates, but these are also the countries that tend to be at the forefront of the disinflationary boom, leading to rising demand for their currencies. For example, the 2000s saw emerging market and commodity currencies as the outperformers on the back of a resources boom, while the ‘90s saw the dollar rise on the back of a US productivity boom. Over the long term, a currency portfolio should include a combination of both “hard” and carry currencies. Over the long term, a currency portfolio should include a combination of both “hard” and carry currencies, with the weights adjusted based on investor preferences. For example, the risk to the world economy today remains deflation. Looking at core inflation across countries, most prints are below the magical 2% target level (Chart I-1). Inflation aside, the biggest catalyst for an investor to favor the disinflationary camp is the sequence of events we have experienced over the last two years – a trade war, Chinese deleveraging, a protracted economic expansion, bear markets in everything from sugar futures to energy stocks, and a virus outbreak. With the US 10-year versus 3-month yield curve having inverted anew, the obvious corollary is that a recession in the next few years (even of the stagflationary variety), will benefit the “hard” currencies. If we assume that the US 10-year CPI swap is a good reflection of investors’ perceptions of an inflationary versus deflationary world, then there are two crucial observations today. The first is that the British pound is the currency most attune to inflation today, while the Japanese yen thrives in deflation (Chart I-2). The second is that both the US dollar and the euro have been very indifferent to inflationary or deflationary risks over the past three years (Chart I-2, bottom panel). Using a very simple rule, an equally weighted basket of the British pound, US dollar1 and Japanese yen will make sense in this macroeconomic framework Chart I-1A Big F For Central ##br##Banks Chart I-2Inflation And Deflation Protection Are Important The Value Factor Our work suggests that valuation matters for currencies over the long term, a point we will discuss in an upcoming report. Therefore, the next challenge in building a protective portfolio is choosing currencies with the potential for long-term appreciation. While we look at a wide swathe of currency valuation models, we tend to adhere to the very simple and time-tested purchasing power parity (PPP) model. Our in-house PPP models have made two crucial adjustments. In order to get closer to an apples-to-apples comparison across countries, we divide the consumer price index (CPI) baskets into five major groups. In most cases, this breakdown captures 90% of the national CPI basket: food, restaurants and hotels (1), shelter (2), health care (3), culture and recreation (4), and energy and transportation (5). The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five subgroups grouped as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted-average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% in the US CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, compared to using the national CPI weights. Our in-house PPP models have made two crucial adjustments. The results show that the cheapest currencies today are the Swedish krona, the Norwegian krone and the Japanese yen (Chart I-3). This is good news. The Japanese yen was already favored in our simple macroeconomic framework, and so it remains in the portfolio. However, given that the Swedish krona, the Norwegian krone, and the British pound tend to be highly correlated, it may be useful to reduce the list. Of all three, the Norwegian krone has the same macroeconomic attributes as the pound (most correlated to rising nominal rates), but comes at a cheaper price (Chart I-4). And so, it replaces the British pound in the portfolio. Chart I-3Lots Of Value In NOK, SEK And JPY Chart I-4NOK And USD Remain Carry Currencies The Sentiment Factor Sentiment is difficult to measure in currency markets, since it is hard to find an exhaustive list that encompasses investor biases. Speculative positioning tends to be our favorite contrarian indicator, but has limitations as a timing tool. Meanwhile, certain currencies tend to be momentum plays, while others are mean-reversion plays. In general, when both positioning and momentum are at an extreme and rolling over, this is generally a potent signal for a currency cross. Being long Treasurys and the dollar has been a consensus trade for many years now. According to CFTC data, this has been expressed mostly through the aussie and the yen, although our bias is that the Swedish krona and Norwegian krone have been the real victims (Chart I-5). That said, long positioning in the dollar has been greatly reduced over the past several weeks. Flow data supports this view. Net foreign purchases of US Treasurys by private investors are still positive, but the momentum of these flows is clearly rolling over. This is being more than offset by official net outflows. As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Being long Treasurys and the dollar has been a consensus trade for many years now. The US dollar is a momentum currency, and the crossover between the 50-day and 200-day moving average has been good at signaling shifts in its intermediate trend (Chart I-6). Despite the recent uptick in the DXY, this still suggests downside in the coming months. Chart I-5Lots Of USD Longs Chart I-6Watch The DXY Technical Pattern So What? Chart I-7Who Will Be The Leaders In 2022? Regular readers of our bulletin are well aware that we are dollar bears. However, in constructing a currency portfolio that will stand resilient in the face of multiple macroeconomic shocks, our recommendation is an equal-weighted basket of the US dollar, the Japanese yen and the Norwegian krone. How has this protector portfolio performed over time? Not so well. Since the financial crisis, the basket has underperformed the DXY index, but has been relatively flat over the last half decade, while generating a positive carry (Chart I-7). In the aftermath of the Great Financial Crisis, positive returns on the Norwegian krone and Japanese yen offset dollar weakness, an environment that could be replayed once global growth bottoms. Obviously, this requires further research. Portfolio Calibration Our portfolio strategy for the last half year or so has focused on dollar-neutral trades, given the uncertainty that has been grappling currency markets. Most of these trades are agnostic to the three fundamental factors outlined above. Stick with them. Long AUD/NZD: This is a play on rising terms of trade between Australia and New Zealand, as well as a much more advanced housing downturn in Australia. Over the past five years, the cross has fluctuated between 1.02 and 1.12, currently sitting at the lower bound of this range. Increased agricultural exports from the US to China will hurt New Zealand at the margin, but long-term Aussie LNG imports and coal exports to China should remain relatively resilient. Long AUD/CAD: It is becoming clearer that the People’s Bank of China has a stronger incentive to stimulate its economy relative to the Fed. This will benefit the Chinese and Australian economies at the margin, and by extension the AUD/CAD cross (Chart I-8). Short CAD/NOK: A play on diverging oil fundamentals between North Sea crude and Canadian heavy oil. A swift rebound in the European economy relative to the US will also benefit this cross. Short USD/JPY: A top recommendation for the protector portfolio. It is noteworthy that this cross has a strong positive correlation to rising gold prices (and falling real rates). Long SEK/NZD: A mean reversion trade, primarily based on valuation and relative fundamentals. The latest PMI print suggests a meaningful improvement in the Swedish economy in the months ahead (Chart I-9). Chart I-8Stay Long AUD/CAD Buy ##br##AUD/CAD Chart I-9Bet On A Swedish (And European) Recovery A Tentative Bottom In Euro Area Data Short USD/NOK: A top recommendation for the protector portfolio as well as a play on rising oil prices. Ditto for the petrocurrency basket. Long EUR/CAD: A swift rebound in the European economy relative to the US will benefit this cross, similar to short CAD/NOK positions. Short CHF/JPY: Low-cost portfolio insurance negatively correlated to rising yields, and a strong positive correlation to rising gold prices (Chart I-10). Chart I-10The Yen Is Better Insurance Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 We use the USD/EUR exchange rate since the carry is positive. Returns are unhedged. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM manufacturing PMI soared to 50.9 while the Markit manufacturing PMI increased slightly to 51.9. The ISM non-manufacturing PMI increased to 55.5 and the Markit services PMI edged up to 53.4 in January. Nonfarm productivity grew by 1.4% quarter-on-quarter on an annualized basis in Q4 2019. Initial jobless claims fell to 202K from 217K for the week ended January 31st. The Johnson Redbook index of same-store sales grew by 5.7% year-on-year in January. The DXY index appreciated by 0.4% this week. In addition to coronavirus fears, a strong showing in domestic data has helped push up the USD. With the number of new coronavirus cases flattening outside of the Hubei province, it appears the rally in the DXY could end as early as mid to late-February. Report Links: Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 On Oil, Growth And The Dollar - January 10, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: GDP growth fell to 0.1% year-on-year from 0.3% in Q4 2019. The Markit manufacturing PMI moved up slightly to 47.9 while the services PMI increased to 52.5 in January. Retail sales growth slowed to 1.3% year-on-year from 2.3% in December. Core CPI inflation decreased slightly to 1.1% in January. The euro depreciated by 0.3% against the US dollar this week. While retail sales disappointed, the manufacturing and services PMI numbers beat expectations, confirming our expectations for a global growth rebound. With a European green deal on the horizon, and interest rates near the lower bound of negative territory, the euro is poised for recovery. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: The Markit manufacturing PMI declined to 48.8 from 49.3 in January while the services PMI increased to 51 from 49.4. Passenger vehicle sales continued to contract, going down 11.5% year-on-year in January. Construction orders rebounded strongly by 21.4% year-on-year in December, moving out of contractionary territory. The contraction in housing starts slowed to 7.9% year-on-year in December. The Japanese yen depreciated by 0.8% against the US dollar this week. The contraction in passenger vehicle sales can be largely attributed to extensive damage from typhoon Hagibis and typhoon Faxai. However, the Japanese economy will be buoyed by strong construction growth ahead of the summer Olympics, putting a floor under our short USD/JPY hedge. Report Links: Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased to 50 from 49.8 in January while the services PMI increased to 53.9 from 52.9. The GfK Group consumer confidence index ticked up to -9 from -11 in January. Consumer credit increased to GBP 1.22 billion in December from 0.66 billion in November. The British pound depreciated by 0.9% against the US dollar this week. In a speech delivered an hour before the UK left the European Union, PM Boris Johnson appeared defiant, rejecting EU rules on British industry and demanding a free trade agreement. Despite a decent uptick in the PMI numbers, the pound is weighed down by uncertainty about coming negotiations with the European Union. For option traders, pound volatility is set to rise. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: The Markit manufacturing PMI increased to 49.6 from 49.1 while the services PMI increased to 50.6 from 48.9 in January. Building permits grew by 2.7% year-on-year in December, moving out of contractionary territory. Exports grew by 1% month-on-month in December, slowing slightly from a growth rate of 1.3% the previous month. The Australian dollar appreciated by 0.5% against the US dollar this week. Despite concerns about coronavirus, and the bushfires, the Reserve Bank of Australia (RBA) decided to hold rates at 0.75%. The recovery in house prices now making its mark on building permits data, and the manufacturing PMI edging towards expansionary territory giving the RBA’s wiggle room in being patient. We are long AUD/NZD, AUD/CAD and AUD/USD. This makes a rebound in AUD one of our most potent bets. Stick with it. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: Building permits soared by 9.9% month-on-month in December, from an 8.4% contraction the prior month. The labor force participation rate moved down slightly to 70.1% in Q4 2019. The labor cost index grew by 2.4% year-on-year in Q4 2019, compared to growth of 2.3% in the previous quarter. The unemployment rate fell slightly to 4% in Q4 2019. The New Zealand dollar depreciated by 0.2% against the US dollar this week. With the data remaining positive and cases of the coronavirus outside the Hubei province set to peak in the coming weeks, the downward pressure on the New Zealand Dollar should ease. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been solid: The Markit manufacturing PMI increased to 50.6 from 50.4 in January. Canadian GDP growth remained fairly flat at 0.1% month-on-month in November. Imports increased slightly to C$ 49.69 billion in December 2019 while exports moved up to C$ 48.38 billion. The raw material price index grew by 2.8% in December, picking up pace from November’s reading of 1.4%. The Canadian dollar depreciated by 0.5% against the US dollar this week. The growth in Canadian exports was led by crude oil exports, which posted a monthly gain of 18% following the resolution of a rupture in the Keystone pipeline in North Dakota. However, a widening trade deficit with countries other than the US will put downward pressure on the Canadian dollar at the crosses. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: The SVME manufacturing PMI decreased to 47.8 from 48.8 in January. Real retail sales grew by 0.1% year-on-year in December, slowing from 0.5% in November. The SECO consumer climate indicator for Q1 2020 printed slightly better at -9.4 from -10.3 in Q4 2019. The Swiss franc depreciated by 0.5% against the US dollar this week. Domestically, consumer sentiment was buoyed by the general outlook on economic growth. However, the outlook for households’ own budget remains gloomy. The decrease in global volatility will undermine the Swiss franc and with an uncertain domestic outlook, stealth intervention might be on the horizon. Report Links: Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: The credit indicator, which measures growth in private sector debt, grew by 5.1% year-on-year in December, slowing from 5.6% the previous month. Registered unemployment (NSA) increased to 2.4% from 2.2% the previous month. The Norwegian Krone depreciated by 0.3% against the US dollar this week. However, the dramatic plunge in the NOK over the last few weeks, which has mirrored a similar drop in the WTI oil price, has taken contrarian investors by surprise. Our Commodity & Energy Strategists currently expect OPEC to respond with additional cuts of 500k barrels per day. In addition, if coronavirus cases peak sooner than expected, this will quicken the recovery in Asian economies, bolstering oil demand and driving up prices. Remain short USD/NOK. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly positive: The Swedbank manufacturing PMI soared to 51.5 from 47.7 in January. Industrial production contracted by 3.2% year-on-year in December, compared to growth of 0.1% the previous month. Manufacturing new orders contracted by 4.7% year-on-year in December, deepening the contraction of 1.8% in November. The Swedish Krona remained flat against the US dollar this week. As we noted last week, the Swedbank PMI has risen in lockstep with the business confidence number. It is now in expansionary territory for the first time since August of last year. Within the Swedbank survey, the sub-indices for new orders and production posted the largest gains. While the hard data on production and new orders for the month of December was disappointing, we expect it to follow the soft data upwards in the coming months as global growth concerns fade. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights Trump's odds are still only around 55%. Biden remains the frontrunner in the Democratic primary election, albeit a weak one. Sanders brings forward the risk to this view. Evidence does not suggest that Trump would beat Sanders in a landslide. Bloomberg’s “moment” is arriving but Biden and Buttigieg must fall for him to win. The Democrats will likely avoid a contested convention. If they don’t, Trump benefits. Expect equity volatility in the near term. The market must clear the coronavirus and Democratic primary hurdles before it can rally sustainably. Feature Chart 1China: Bad News, Then Stimulus Boost Over the past week we visited clients in New York and Toronto and debated a range of intriguing questions. The coronavirus impact was top of mind. The outbreak will delay the Chinese economic rebound we expected in the first quarter. It also reinforces one of our key geopolitical views on Chinese policy: bad news will be followed by good news in the form of increased stimulus (Chart 1). The problem is that this is good news for the second half of the year at best, while the near term is extremely murky. After the virus, the US election cycle was clearly the greatest source of policy uncertainty. Because clients asked so many questions on this topic, we devote this report to the election. We still expect US equity volatility in the near term. Aren’t Trump’s Odds Of Reelection Better Than 55%? No. Clients hardly raised an eyebrow this time when we argued that President Trump was favored to win reelection – a stark turnaround from just three months ago, when many believed that his goose was cooked. So much has the climate changed that many clients now argue that Trump’s odds have reached 70% and he is likely to win by a landslide. But that is going too far – according to the data. Certainly Trump is coming off a string of successes. So far this year he has deterred Iran, struck trade deals with the US’s top trading partners – China, Canada, and Mexico – and been acquitted of impeachment articles (Chart 2). The Republican-led Senate resisted a last-ditch effort to admit witnesses and prolong the impeachment trial, and few Republicans defected in the final vote.1 Chart 2Trump Acquittal: Political Constraints In Action Chart 3Trade Deals, Impeachment Boosted Trump Approval Trump’s approval rating hit its all-time high just as the Senate voted to acquit (Chart 3). The impeachment process backfired on the Democrats, a point corroborated by the recent shift in the public’s party identification that puts the Republicans right alongside the Democrats after a period in which they trailed (Chart 4). Just before his acquittal, the president delivered a State of the Union Address in which he rattled off a catalogue of record-setting, late-cycle economic statistics. Meanwhile the Democrats suffered a debacle at their first primary election, the Iowa caucus, when a rushed attempt to improve their digital savvy in the electoral process resulted in a software malfunction that delayed the announcement of election tallies. Nevertheless, the ballot is nine months away and the path to reelection is fraught with danger. First, President Trump has not yet proven that he can keep his approval rating in the upper 40s, let alone over 50%. A true game changer would be cracking 50% on a sustainable basis. If Trump slips beneath the 46% of the vote he received in 2016 his odds fall back toward 50%. Assuming the economy rebounds he cannot afford to slip much below his stable range of 43% and still win, according to the model. Second, the manufacturing sector is only just poking its head out of the woods, leaving the critical swing states of Michigan, Pennsylvania, and Wisconsin hanging in the balance, albeit with positive news (Chart 5). Chart 4More Voters Identify As Republican Post-Impeachment Chart 5US Manufacturing Rebounding, But Watch For Virus Hit Our quantitative election model suggests the election is too close to call. Technically the model shows Trump slipping beneath the threshold for victory for the first time since we unveiled it in November (Chart 6). The reason is that the leading economic indicators in Wisconsin and especially Pennsylvania took a turn for the worse in December. These indicators are forward-looking – they predict the 6-month growth rate of the state coincident indexes, which include nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index. Chart 6Quantitative Election Model Shows Election A Toss Up Chart 7Pennsylvania Job Growth A Risk To Trump Of course, the state leading indicators also tend to be heavily revised in subsequent prints, which can make our model volatile. Month-on-month total employment growth from the Bureau of Labor Statistics corroborates the shaky status of Pennsylvania, but not Wisconsin (Chart 7). This slight shift in our model from a Trump win to a Trump loss does not change our overall election forecast, which has a qualitative overlay. The point is that Trump is still skating on thin ice, the US manufacturing sector.2 Going forward, the US and global economy should continue improving, especially in the second half of the year. The demand shock emanating from the coronavirus outbreak in China should be temporary. The eventual rebound in Chinese demand combined with the lagged effect of China’s new stimulus measures will benefit US manufacturing states. The manufacturing sector’s woes are still a clear and present danger for Trump. Bottom Line: Trump is still favored but his odds of winning are still only 55% qualitatively. The election will remain a major source of uncertainty throughout the year. Investors need to be prepared for either outcome. Volatility is also frontloaded due to the coronavirus shock to the global economy. Is Biden Still The Frontrunner? Yes. Former Vice President Joe Biden bombed in the Iowa caucus, the first of the Democratic Party’s primary elections, coming in fourth place behind South Bend Mayor Pete Buttigieg, Vermont Senator Bernie Sanders, and Massachusetts Senator Elizabeth Warren. He barely beat the sensible but uninspiring Minnesota Senator Amy Klobuchar (Chart 8). Chart 8Iowa: Buttigieg Surged, Biden Slumped Chart 9Biden Still The Democrats’ Frontrunner Traditionally Iowa delivers a polling boost to the victor, since it goes first and attracts attention disproportionate to its size. But this year the first-comer effect is largely moot because of the reporting debacle. Both Buttigieg’s win and Biden’s loss have been drowned out. This is consolation for Biden because he is far more competitive in later states than Buttigieg – he is in fact still the (weak) frontrunner in national polling (Chart 9). Biden also continues to lead our back-of-the-envelope projection of the delegates who will be pledged to candidates at the end of the primary election season on June 6 in Washington, DC. True, Biden is lined up for a plurality at best, not a majority. There are still plenty of “other” delegates to be redistributed, which could leave Biden in the dust if his polling breaks down due to a loss of momentum in the early states (Chart 10A). Nevertheless the centrist “lane” now has a commanding lead over the progressive lane for the first time in the race, creating our base case in which Biden wins a plurality of votes that translates into winning the nomination (Chart 10B). Chart 10ABiden Leads Back-Of-Envelope Delegate Count For Democratic Nomination Chart 10BCentrists Lead Back-Of-Envelope Delegate Count For Democratic Nomination If Biden continues to underperform his polling in New Hampshire and Nevada then he could stumble into a huge disappointment in South Carolina, his bulwark, on February 29 (Chart 11). As the first southern state, South Carolina is the bellwether for Super Tuesday, March 3, when about 35% of the delegates are up for grabs, 54% of which are southern (Chart 12). Anything that shakes Biden’s substantial lead in South Carolina sets him up for failure overall and pushes Sanders into the frontrunner position. Chart 11Biden’s Bulwark Is South Carolina Chart 12Biden’s ‘Southern Strategy’ Should Pay On Super Tuesday Sanders would then face an emerging centrist in the shape of Buttigieg or Bloomberg. (Or Warren will pivot to the center.) Aside from Biden’s lead in the national polling, and many of the southern and Midwestern states, he continues to benefit from a tailwind in that he is the more “electable” or competitive candidate against Trump. Head-to-head polls continue to bear this out (Chart 13). These polls will congeal around almost any candidate once he or she becomes the de facto nominee, but over the past year Biden has performed far better than any of the others. Chart 13Biden Beats Trump Head-To-Head In Every Swing State (So Far) Bottom Line: Anyone who wants to show their electability against Trump must first prove it by dethroning Biden. This could happen in February if Bernie Sanders generates runaway momentum in the early primaries, so the equity market faces major election risk imminently. Is A Sanders Nomination Suicide For The Democrats? Not Necessarily. Chart 14Sanders Generating Momentum In Early Primaries Sanders is only slightly less likely to win the Democratic nomination than Biden. He is clearly capable of doing so – he rivals Biden in the nationwide polling and surpasses him in the early states. Strong finishes in New Hampshire and Nevada are expected and could generate momentum that lasts through Super Tuesday and beyond (Chart 14). Ideologically Sanders is not unthinkable for most Democrats – the average Democrat is shifting to the left of the political spectrum (Chart 15). Most Biden supporters say Sanders is their second choice (Chart 16). Voters are interested in electability, so if Sanders can prove that he is more electable than Biden, voters will flock to him. Chart 15Democrats More Liberal Than In The Past Chart 16Biden Voters Support … Sanders! Thus the question of Sanders is more about the general election than the primary. “Movement candidates” like Alf Landon, Barry Goldwater, and George McGovern have racked up some of the most humiliating defeats in the history of US elections. The self-described democratic socialist Bernie Sanders has some of the defining traits – he has a movement, he is ideologically “pure” and outside the mainstream, and his nomination is a gamble on whether his youthful supporters’ enthusiasm will carry over to the general public. It is plausible that the Democratic Party could choose Sanders out of a desire to fight populist fire with fire, only to find that Trump overwhelmingly benefits from the stigma of socialism in the swing states. Sanders could still win the nomination and even the White House. So far, however, the evidence does not bear out this interpretation. The aforementioned Chart 13 shows that Sanders is second only to Biden against Trump. It is notable that he outperformed Hillary Clinton versus Trump in 2016 (Chart 17). He is specifically competitive against Trump in the Midwest swing states because of his ability to compete for the vote of the blue-collar worker. Thus he has a viable path to winning the Electoral College: the Clinton 2016 states plus Michigan, Pennsylvania, and Wisconsin. Biden’s primary advantage, by this measure, is that he is also competitive in Florida as well as the Midwest, which broadens his Electoral College options. And while Sanders captivates the youth, Biden appeals to African Americans and moderates who turn out to vote more reliably (Chart 18). Chart 17Sanders Outperformed Hillary Versus Trump Chart 18Biden’s Supporters Have Higher Turnout Ultimately presidential elections are referendums on the incumbent party. Since World War II, incumbent parties have lost because of major shifts in the economic, social, or international context that discredit the current administration and drive voters to demand “regime change.” Sitting presidents strengthen the incumbent party and have only lost in a recessionary environment (1980, 1992) or a massive scandal (1976). And Trump’s scandal has been neutralized, for now, due to his acquittal in the Senate. Unless Trump suffers from a faltering economy, a policy humiliation at home or abroad, or a third party candidate who splits the Republican vote, he is unlikely to be discomfited. By the same token, if major changes occur, Sanders will be as good as or even better than Biden at riding the wave of disenchantment with the ruling party and its figurehead. PredictIt, the online betting site, currently puts Sanders at 29% chance of winning the White House, while Biden stands at 7%. Both are underrated given our assessment that Trump’s odds of election still stand at 55% and that he is only likely to fall as a result of economic weakness or an unforeseen policy humiliation. As things stand, either Biden or Sanders would see their chance of winning the White House rise toward 45% if they won the nomination. If Sanders wins the nomination, yet events all play to Trump’s favor such that he wins resoundingly, Sanders will forever after be seen as confirming the curse of the “movement candidate.” Yet under those circumstances Biden would likely have met the same fate. Bottom Line: Investors would be wrong to buy risky assets on a Sanders nomination in the belief that it guarantees Trump’s victory. Clinching the nomination sharply – and mathematically – increases any candidate’s chance of winning the White House. A Sanders White House in turn would be a paradigm shift in US politics: the first left-wing populist president. He would threaten a major increase in economically significant regulation even if no legislation were passed and as such would weigh on corporate profits and animal spirits. As a result, we expect volatility in the near term, since Sanders’s best hope is to build momentum now, unseat Biden, and then fend off Biden’s centrist replacements. Even if Sanders is only successful for a brief period in Q1, the market will have to discount the higher probability of a progressive populist in the Oval Office. What About Mayor Bloomberg? Show Us The Votes, Not Just The Money. Billionaire former New York Mayor Michael Bloomberg is a notable challenger both to other Democrats and to Trump based on the fact that his aggressive advertising campaign is producing some results in opinion polling – as it would for anyone given the volume! He is polling just ahead of Buttigieg and thus is first in line to benefit if Sanders knocks off Biden (Chart 19). Chart 19Bloomberg Benefits If Biden Falls Chart 20Biden Beats Bloomberg In Big Primaries However, Bloomberg’s attempt to pole-vault over the early states and rack up big wins in March is untested. Moreover the data do not yet reflect the elite optimism about Bloomberg’s chances. First, Biden will be harder to knock off than the consensus holds. He has a strong base in the South, he still leads in many Midwestern states, unlike Iowa, while Bloomberg’s base is the Northeast, where he has to split votes with most of the other candidates (including Biden). Looking ahead to March, Biden is beating Bloomberg in all of the key states where Bloomberg’s strategy requires a win (Chart 20). While Biden beats Trump head-to-head in the swing states, Bloomberg loses to Trump in most of them. This reflects Biden’s electability, a tailwind in the primaries (Chart 21). Bloomberg also has the worst favorability among voters – although admittedly Trump once held that distinction (Chart 22). Chart 21Trump Beats Bloomberg In Swing States Chart 22Trump And Biden More Favorable Than Bloomberg Hence Bloomberg can emerge as the leading centrist or establishment candidate if Biden crumbles, and Buttigieg fails to replicate his Iowa success, but not before then. Otherwise his significance lies in that he could become a dark horse candidate at a contested Democratic National Convention in July – say if the leading progressive candidates prove capable of blocking Biden’s nomination but not securing their own. Bloomberg may be waiting in the wings for just such a moment. Bloomberg could also act as the grand spoiler of the election should he decide to run as an independent candidate in November. Ostensibly his candidacy would hurt the Democrats, especially if they choose a candidate who suffers from the taint of socialism. However, contrary to popular wisdom, a strong third party candidate is historically a negative sign for the incumbent.3 Third party candidacies are only strong if the general public is dissatisfied – and when the public is dissatisfied it swings heavily against the incumbent party. Thus on the whole a large third party vote would tend to hurt Trump in 2020, just as it helped him in 2016 (by hurting the incumbent party). The fact that Bloomberg was formerly a Republican reinforces his risk to Trump – like the independently wealthy Ross Perot in 1992, he could produce a Democratic victory by splitting the conservative vote.4 Remember that 9-10% of Republicans believed that Trump should have been removed from office, according to impeachment polls over the past six months. If the economy holds up, this third party challenge is less likely to succeed, but it is still a risk. Such an outcome is far from assured and the Democratic Party would vilify Bloomberg for fear of him stealing votes from the Democratic candidate, especially if the occasion of his independent run were the nomination of a “socialist” like Sanders. Thus far Bloomberg claims he and his billions will support the Democratic Party’s nominee. Bottom Line: If Bloomberg’s intention were solely to unseat Trump, then he should have spent, or will spend, his billions waging a vigorous third party candidacy. On the contrary, by seeking the nomination of one of the two major parties, he apparently seeks to become president of the United States. In doing so he may weaken Biden and thus help Sanders. But we will not know the effect until we can observe his performance in actual elections, which he starts contesting in March. Nevertheless the big surprise of 2020 could well be an independently wealthy candidate capable of stealing enough votes from Trump to erase his very fine margins in the swing states. Bloomberg or someone else could play this role. Will There Be A Contested Convention? Probably Not. A contested convention – or its cousin, the “brokered convention” – is a situation in which the Democratic Party must decide its presidential nominee at its national convention, having failed to do so through the primary elections. Democratic delegates are awarded proportionately to the popular vote, unlike the Republican primary system which features many winner-take-all states. Several candidates each earning less than a third of the popular vote can continue struggling without any one of them hitting the “jackpot” and surging ahead. If none of the candidates has a majority of pledged delegates – or even a strong plurality – at the conclusion of the primaries on June 6 then the candidates will have to negotiate a solution. Otherwise they will show up in Milwaukee on July 13 for a chaotic four days in which the party delegates would have to hold a series of votes, on live television, to determine the nominee. The last time the Democrats had a contested convention was 1952, when they voted for three rounds; the Republicans saw a shorter-lived contest in 1976. In today’s context, in which a left-wing populist could win the nomination, such an unpredictable and arcane process would present a source of uncertainty for investors throughout June and July. A contested convention is more likely than usual because the party has four, possibly five viable candidates if we count Bloomberg. Biden, Bloomberg, and Sanders all have the financial ability to persist over the long haul. Yet with Buttigieg having won in Iowa and polling well in New Hampshire, he remains in the race, as does Warren, assuming they keep meeting the minimum threshold of 15% of the vote needed to receive delegates. So why isn’t a contested convention likely? Because there is a clear constraint: it would be a train wreck for the party. It would prolong divisions over ideology, it would exhaust everyone’s coffers (except Bloomberg’s), it would send a picture of a party in disarray to the general public (much like the Iowa caucus debacle), and it would deprive the party of months in which the de facto nominee could challenge President Trump. The bad press and divisiveness would actually increase Trump’s chances of winning. In the wake of the impeachment backfire, the candidates will be more attuned to these risks. Instead, with a common enemy, it is more likely that candidates will be pressured to drop out of the race once it is clear they cannot win. Democrats will bind together to pick a nominee – a contested convention helps Trump. Chart 23Iowans Want A Winner, Not A Platform Democratic voters are primarily concerned with beating President Trump – this has been confirmed in polling at the Iowa caucus (Chart 23). Therefore several candidates have a basis for sacrificing their own presidential bid. In exchange those who drop out will be offered cabinet positions, which they will sell as a political “dream team” against Trump’s small circle of loyalists and family members. The risk is that insurgent progressive candidates defy the party leadership and refuse to bow out. While Buttigieg is young and can live to fight another day, neither Sanders nor Warren will drop out easily if they think they still have a chance of winning the presidency. These two are also unlikely to cooperate with each other to consolidate the left-wing bloc. Bottom Line: Multiple competitive candidates make it possible that instead of bandwagoning around the candidate with a plurality – likely Biden – no candidate will have a commanding plurality of pledged delegates by June 6. If that is the case then expect the candidates to negotiate a solution prior to the convention. If a solution cannot be found, a contested convention will reflect a deeply divided party and hence imply higher odds of President Trump’s reelection, other things being equal. Investment Conclusions Investors can look at the three options as follows. Biden, Buttigieg, or Bloomberg would be a “known known,” a moderate Democratic whose policies would largely seek to restore and solidify those of the Obama administration. However, we still see this as negative for equities because of the increase in regulation that would ensue plus the high chance that victory would also bring the Senate and thus give rise to a more progressive policy shift than the consensus expects. Chart 24Centrists Outperformed In Iowa Trump is a “known unknown,” an unorthodox and aggressive president whose tactics have become familiar but whose approach is globally disruptive and would be more so in a second term relatively free of electoral constraints. We expect any melt-up in equities before or after a Trump win to be a sell signal given our base case that Trump’s reelection means Trade War II. Sanders or Warren would be an “unknown unknown,” the first-ever left-wing populist to take the White House. Above we show this is not at all improbable if one of them wins the nomination – which itself is about a 35% probability. The same odds apply to the Senate as under Biden, although moderate Democrats there would act as a constraint on a progressive pushing revolutionary legislation. Still, a progressive populist would be a generational paradigm shift in US policy and would justify a bear market. Where is the median voter? In the primary election, the Iowa caucus results reinforce the national trend suggesting that the median voter prefers a centrist or establishment candidate (Chart 24). If Biden falters, either Buttigieg or Bloomberg will take up the slack. Nevertheless the risk of a Sanders success is imminent and therefore we expect volatility to be frontloaded this year, especially in February but also possibly in March if Sanders does a bang-up job on Super Tuesday. In the general election, polling consistently shows that the economy is the most salient issue for voters in 2020. This plays to President Trump’s favor. Health care is usually ranked second, which plays to the Democrats’ favor. However, a recent open-ended poll by Morning Consult suggests that security issues have supplanted health care as the second-highest voter concern, which would reinforce Trump’s position (Chart 25). Further economic deterioration would not only undermine Trump’s approval on his handling of the economy but would also increase concern over health care, since insurance is tied to employers. So this is a critical risk to Trump in wobbly swing states like Pennsylvania. Chart 25Median Voter Focused On Economy, Trump’s Strong Suit We maintain that Trump is slightly favored with 55% odds. But our mathematical model highlights how close of a call the election is, at least until the manufacturing sector and broader economy durably rebound. Investors need to be prepared for either electoral outcome, which means hedging against sectors under bipartisan scrutiny such as Big Pharma and Big Tech. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Senator Mitt Romney of Utah, no fan of President Trump, voted to convict him of the charge of abuse of power but not of obstruction of Congress. 2 This is the second time Wisconsin has switched across the threshold in our model since November – all else equal, a 0.01% increase in the state’s leading index would move it back to the Republicans. 3 See Allan J. Lichtman, Predicting The Next President (New York: Rowman & Littlefield, 2016), 30-31. 4 Alternately he could ensure a Trump victory by producing an Electoral College tie! Demographic projections of the US electorate in 2020 by Robert Griffin, Ruy Teixeira, and William H. Frey show that a 2020 election in which voters behave exactly as they did in 2016, except that the third party vote normalizes from 5.7% (2016) to 1.7% (2012), would produce an Electoral College tie of 269-269 votes. Obviously this would be a Black Swan event. And the fact that electors in the college can be “faithless” to the candidate that their state elected complicates such projections. Nevertheless the result would be an extraordinary House of Representative vote according to state delegations in which Trump would emerge as the victor and the legitimacy of the election would be contested and debated once again. See "America’s Electoral Future: Demographic Shifts and the Future of the Trump Coalition," April 2018, brookings.edu.
Highlights Base metals appear to be pricing the impact of the Chinese 2019-nCoV coronavirus in line with the 2003 SARS outbreak. We expect an earlier peak in reported (ex-Hubei) cases than is currently discounted by markets, implying Asian economies – and base metals – will recover sooner than expected, perhaps by end-February. We estimate the marginal impact of 2019-nCoV on global oil demand implied by the recent sell-off translates to a loss of ~ 800k b/d over February-July 2020. This leads us to expect OPEC 2.0’s technical committee will recommend additional cuts of 500k b/d for 2Q-4Q20 to the full coalition, following their meetings in Vienna. This would be bullish, if Asian economies recover as quickly as we expect. Safe-haven assets – chiefly gold and the USD – rallied but do not signal an exodus from risky assets. After breaching $1,580/oz last week, gold traded lower, while the broad trade-weighted USD index rallied 1%, mildly reversing a decline begun at the end of 2019. Risky-asset markets are anticipating monetary accommodation by systemically important central banks will remain in place this year; fiscal stimulus in China and EM economies is likely. This remains supportive of commodity demand. Feature Our view differs from the markets’, which makes us relatively more bullish base metals prices. There is a tight relationship between Asian economic activity and base metals prices, which provides a window on how markets currently expect the 2019-nCoV outbreak will impact aggregate demand in Asia (Chart of the Week). Our view differs from the markets’, which makes us relatively more bullish base metals prices. Chief among the assumptions driving our view is our expectation markets will stage a recovery once the number of 2019-nCoV cases peaks outside the epicenter of the outbreak in Wuhan, a city of 11mm people in Hubei Province, which remains locked down per Chinese containment efforts.1 This is our House view, as well. Alert: The peak in cases ex-Wuhan could come sooner than expected. Our colleagues at BCA’s China Investment Strategy (CIS) note, “New cases outside of the epicenter continue to rise, but a peak may be in sight. Our sense is that financial markets are likely to bottom earlier than the consensus expects. The economic impact on China from the outbreak will be large, but manufacturing activities in the majority of Chinese cities should resume by the end of February.”2 Chart of the WeekBase Metals Prices Lead Changes in Asian Economies This will be important for base metals demand. China accounts for ~ 50% of global supply and demand for refined base metals (Chart 2). These markets are exquisitely attuned to the decisions of Chinese policymakers, so much so that they resemble a vertically integrated system: Policymakers allocate and direct credit to industries and projects – creating a demand signal – and the supply side, which includes numerous state-owned enterprises, responds. What cannot be consumed domestically is exported to neighboring economies. Chart 2China Dominates Base Metals This largely explains why base metals are so entwined with Chinese economic activity, and with Asian activity generally. Our research indicates base-metals prices lead our Asia Economic Diffusion index, reflecting the information-processing capacity of these markets vis-à-vis the evolution of the regional economies.3 This is one reason we use base-metals markets as information sources in conjunction with our proprietary models and indicators. At present, it appears base metals markets are pricing in a recovery trajectory similar to what was seen during the 2003 SARS episode. Chart 3Markets Price Metals Hit Similar To SARS At present, it appears base metals markets are pricing in a recovery trajectory similar to what was seen during the 2003 SARS episode (Chart 3), when the LMEX fell 9% from February to April, then fully recovered by year end (Chart 4). Also noteworthy is the fact that most commodity markets were processing this information and reflecting it in their own trajectories, as seen in the path taken by our proprietary Global Commodity Factor (Chart 4, bottom panel). Chart 4Once SARS Infection Peaked, Base Metals Recovered Quickly The market call from our CIS colleagues implies base metals – summarized by the LMEX – will begin to rally this month as the odds of a peak in 2019-nCoV cases outside Hubei increases. We expect this rally will be aided by increased fiscal stimulus in China (e.g., infrastructure and construction spending), and monetary stimulus (Chart 5), which will renew the lift in manufacturing that appeared toward the end of 2019 (Chart 6).4 Chart 5Higher China Policy Stimulus Expected Chart 6Early 2019-nCoV Peak Would Revive China's Growth Oil Marches To A Different Drummer Oil markets primarily are pricing to expectations of a deep hit to crude oil demand, driven by 2019-nCoV’s impact on China’s consumption.5 Based on our modeling, we estimate the marginal impact of 2019-nCoV on global oil demand priced into WTI and Brent prices earlier in the week translates to a loss of ~ 800k b/d over February-July 2020. This leads us to expect OPEC 2.0’s technical committee will recommend additional cuts of 500k b/d for 2Q-4Q20, following meetings in Vienna this week. These cuts would be in addition to the 1.7mm b/d cuts agreed by the coalition at its November 2019 meeting, for the January to March 2020 period. OPEC’s (the old cartel) crude oil production in January fell 640k b/d from December levels to 28.35mm b/d, as the additional cuts of 1.7mm b/d agreed in November kicked in, according to Reuters. Additionally, Gulf Cooperation Council (GCC) member states over-complied on their cuts. Output from Libya also is down by ~ 1mm b/d since last month. Importantly, the latest OPEC output levels are ~ 1.3mm b/d below average 2019 production, which Platts estimates at 29.66mm b/d – the lowest output since 2011. We will be updating our balances and price forecasts in two weeks, which will reflect these data more fully. This will allow us to include more information on the demand destruction in China, the evolution of 2019-nCoV, and OPEC 2.0 supply decisions. Additional production cuts by OPEC 2.0 as demand recovers – along with the likely acceleration of the slow-down in US shale-oil production following the recent oil price rout and continued parsimony in capital markets – also would allow backwardation to return to the oil forward curves. Although China’s share of global oil demand amounts to ~ 14% – far less than its share of base metals’ supply and demand – the fact that more than 70% of its 10.2mm b/d of imports comes from OPEC 2.0 is focusing the coalition on the need to restrain supply (Chart 7).6 If, as discussed above, 2019-nCoV cases peak sooner than expected, Asia’s economies likely will recover sooner than expected, which will rally oil prices sooner than expected. Additional production cuts by OPEC 2.0 as demand recovers – along with the likely acceleration of the slow-down in US shale-oil production following the recent oil price rout and continued parsimony in capital markets – also would allow backwardation to return to the oil forward curves (Chart 8). Chart 7China's Share Of Global Oil Demand Chart 8An Early Peak In 2019-nCoV Cases Would Restore Backwardation To Oil Based on this assessment, we are getting long 4Q20 WTI vs. Short 4Q21 WTI at tonight’s close, in expectation of a return to backwardation. Bottom Line: Base metals markets could rally sharply if, as we expect, 2019-nCoV cases peak sooner than expected outside the epicenter of Wuhan. This also will lift oil demand in China and Asia. Lastly, it will restore backwardation in the benchmark crude oil curves – Brent and WTI – which is why we are going long 4Q20 WTI vs. short 4Q21 WTI at tonight’s close. Commodities Round-Up Energy: Overweight Uncertainty around the potential impact of the new coronavirus in China pushed WTI prices down to $49.6/bbl as of Tuesday’s close, a 22% drop since the onset of the outbreak. Oil speculators are rapidly exiting the market; non-commercial long WTI positions fell to 564k from 626k on January 7, 2020. On the supply side, OPEC’s oil production dropped to 28.4mm b/d in January, according to Bloomberg, in line with Reuters estimate. This partly reflects the collapse in Libya’s oil production following the closure of its main export terminals by forces loyal to General Khalifa Haftar. Production there was estimated at 204k b/d – the lowest level since the uprising against Muammar Qaddafi in 2011 – vs. an average of 1.1mm b/d in 2019. Base Metals: Neutral China’s net export of steel products declined throughout 2019 amid strong production growth and range-bound inventories. This suggests steel consumption in China remained buoyant, supported by strong new property starts and infrastructure investments (Chart 9). Our commodity-demand indicators suggest most metals’ fundamentals turned constructive in late 2019. However, the coronavirus outbreak will delay the rebound in prices we expected. Over the medium term, we continue to expect prices to pick up, fueled by accommodative monetary policy, and stronger-than-expected monetary and fiscal stimulus in China to offset the negative effect of the 2019-nCoV. Precious Metals: Neutral Fears of wider contagion of the coronavirus are keeping gold above $1,550/oz despite the rise in the US dollar powered by upbeat US manufacturing data. Over the long term, periods of elevated uncertainty are associated with rising households’ precautionary demand for savings as future income becomes increasingly uncertain. This pushes up asset prices as total savings increase, and specifically safer assets, such as gold, until uncertainty abates. This high savings rate acted as a floor to gold prices in the aftermath of the global financial crisis and is currently a crucial contributor to its elevated price (Chart 10). Ags/Softs: Underweight Abating fears of a pandemic spread of the 2019-nCoV lifted CBOT March corn futures to $3.8225/bu on Tuesday, reversing some of the damage done by disappointing export reports from the USDA and favorable crop conditions in South America supporting expectations for a large corn harvest there. Strong sales of soybeans to Egypt and favorable export inspections helped beans reverse last week's negative trend. USD strength on the back of the 2019-nCoV, particularly against the Brazilian real, remains a headwind to bean prices. Chart 9China's Steel Consumption Remained Buoyant In 2019 Chart 10Uncertainty Drives Demand For Safe Havens Footnotes 1 It is important to note this is a highly speculative call, and that even the public-health experts are groping for understanding on the trajectory of 2019-nCoV at this point. It is possible the virus is not contained and extinguished as SARS was in 2003, but becomes a recurrent feature of the flu season globally. Please see Experts envision two scenarios if the new coronavirus isn’t contained, published by Stat February 4, 2020. Stat is a life sciences and medical news service produced by Boston Globe Media. 2 Please see Recovery, Temporarily Interrupted, published by BCA Research’s China Investment Strategy February 5, 2020. It is available at cis.bcaresearch.com. 3 Our Asia Economic Diffusion index was developed by BCA Research’s Global Investment Strategy team. The “information” we refer to here is the actual buying and selling of base metals, and contracting for services related to the economic activity accompanying a revival in manufacturing, infrastructure buildouts and construction that drives that demand. This will show up in various measures of economic activity, among them BCA’s Asia Economic Diffusion index and different gauges used by the IMF and World Bank. In other words, base metals prices lead the Asia Economic Diffusion index based on our analysis of Granger causality. This is valuable because the metals price in real time. In earlier research, we showed that, among commodity markets, base metals prices – via copper prices, the LMEX, and the IMF’s metals index – can be used to confirm the signals from our econometric indicators and models of EM and global economic activity. Please see World Bank Lowers Growth Forecast; Commodity Demand Will Pick Up, published January 16, 2020, and Godot … Trade Deal … Wait For It … Base Metals Are Primed For A Rally, published November 28, 2019, by BCA Research’s Commodity & Energy Strategy. They are available at ces.bcaresearch.com. 4 Iron ore and steel prices also will revive on the back of this economic recovery; we will be looking into this next week. 5 Earlier this week, Bloomberg reported the initial hit to oil demand in China amounted to 3mm b/d – the largest such hit since the Global Financial Crisis. This represented ~ 20% of daily Chinese oil demand. 6 We discuss China’s position in the global oil market – and, importantly, in the global air-transportation markets – in last week’s publication, Expect OPEC 2.0 To Cut Supply In Response to Demand Shock. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them. At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure. Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Dear clients, Over the next couple of weeks, we will be further analyzing China’s coronavirus outbreak, its economic impact, and the likely policy response, as well as the attendant investment recommendations. We will also examine any sector-related or regional themes that stem from the outbreak. Stay tuned. Jing Sima, China Strategist Highlights The peak in the number of new cases outside of the crisis epicenter will be more market-relevant than the total number of infections. New cases outside of the epicenter continue to rise, but a peak may be in sight. Our sense is that financial markets are likely to bottom earlier than the consensus expects. The economic impact on China from the outbreak will be large, but manufacturing activities in the majority of Chinese cities should resume by the end of February. It will take longer for the service sector to recover, implying a larger hit to the economy compared with the SARS episode given that services have grown in importance. This will force Chinese policymakers to set their financial deleveraging agenda aside for the rest of the calendar year. We maintain an overweight stance on Chinese stocks both tactically and cyclically, based on our view that the outbreak will soon be contained outside of Hubei province and that China’s budding economic recovery will be delayed, but not prevented, by the crisis. Feature The coronavirus (2019-nCoV) outbreak in China has sparked a selloff in risk assets around the globe. China’s A-share equity market, after an extended Chinese New Year market closure, was in a free fall when it reopened on February 3. In the offshore market, the MSCI China Index has declined by 9% from its most recent high on January 13, 2020 (Chart 1). When attempting to forecast a turning point in bearish investor sentiment stemming from the outbreak, it is important to note that during the 2003 SARS epidemic, both global and Chinese equity markets rebounded when the number of new cases peaked in Hong Kong SAR and globally (Chart 2). Chart 1Chinese Stocks Have Been Hit Hard By The Virus Outbreak Chart 2Markets Bottomed As Total SARS Infections Peaked We maintain our long stance both tactically and cyclically on Chinese stocks, based on the following assessments: In the next three months, the panic brought on by 2019-nCoV will abate before the total number of new cases peaks, as investors focus on the turning point in the outbreak outside of the epicenter (Hubei province). Beyond the next three months, the outbreak will likely delay China’s economic recovery. However, this means that Chinese policymakers will not likely reduce the scale of their stimulative efforts this year. The Market Correction May Be Short-Lived Since the onset of the 2019-nCoV outbreak, many studies have attempted to predict the speed and magnitude of the spread of the virus. Using a mathematical model called Susceptible-Exposed-Infected-Recovered (SEIR), The Lancet,1 The University of Hong Kong,2 and Johns Hopkins CSSE3 all drew a conclusion that a peak in the current episode is likely to occur between late April and early May. The number of cases outside of the crisis epicenter will likely drive financial market sentiment. While we think this conclusion may be true for the total number of new cases, the total count will be less relevant to investors during this episode than during the 2003 SARS outbreak. Instead, it will be more useful to break down the total infection count into two sets of data: the number of new cases within the city of Wuhan and Hubei Province (the epicenter of the outbreak), and the number of new cases outside of Hubei. The latter is more likely to be the primary driver of short-term outbreak-related market sentiment. While Hubei is experiencing an acceleration in the daily rate of new cases, the number of new cases across the rest of China seems to be flattening off of late (Chart 3). We think that the number of cases outside of Hubei will peak earlier than within the epicenter. This is in contrast to the 2003 SARS outbreak when the peak of new cases in the rest of China and globally lagged the epicenter Hong Kong SAR by a month (Chart 4). Chart 3Number Of 2019-nCoV New Cases Flattening Outside The Epicenter Chart 4SARS Outbreak Peaked Globally A Month After Peaking In The Crisis Epicenter There are two reasons for the difference between the 2003 SARS peak and projections for the 2019-nCoV outbreak: Timely cutoff of virus mobility outside of epicenter: The world responded quickly to contain the virus. During the 2003 SARS episode, Chinese authorities responded with protective measures only after the outbreak had already peaked in the epicenter. This time the Chinese government intervened at an early stage of the outbreak with forceful and in some cases extreme actions, including a near-complete lockdown of Wuhan (the crisis epicenter) and restrictions on inter- and intra-city traffic in other major metropolitan areas. Foreign governments in North America, Europe, and Southeast Asia took unprecedented measures to ban or limit air traffic to/from China. Furthermore, with timely and sufficient medical care, the fatality rate outside of the epicenter has been much lower4 – a significantly underreported fact. Mishandling of the crisis within the epicenter: Within Hubei province, particularly the city of Wuhan where the virus originated, the number of infections will likely continue climbing in the next two to even three months. The abovementioned studies suggest the number of cases in the epicenter is five to seven times higher than the official count. Local hospitals are experiencing severe shortages of medical supplies, meaning that people with mild-to-medium symptoms have reportedly been turned away. These patients are not included in the official statistics as confirmed or suspect cases. The discrepancy in reporting means these cases will be confirmed and recorded at a much later date. Without quarantine and treatment, these patients may continue to transmit the virus to others within the epicenter. This will have a tragic human cost, but it will hold few consequences for financial markets. The corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Bottom Line: Market sentiment will rebound following the peak in new 2019-nCoV cases outside the epicenter of Wuhan/Hubei. We think the peak may come as early as mid to late-February, which suggests the corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Economic Recovery In Sight Beyond the near-term, our view on China’s likely policy response and the economy’s fundamentals support a positive outlook for Chinese stocks over the next 6 to 12 months. In absolute dollar terms, the scale of the economic impact from the 2019-nCoV outbreak will likely be larger than the SARS episode in 2003. Unlike with SARS, when disruptions were mild and limited to the travel and retail sectors, the extreme measures China took in response to the coronavirus outbreak have essentially placed Chinese economic activity on hold. Chart 5Service Sector Now A Larger Part Of China's Economy Compared With 2003 China’s service sector is also likely to be more affected than manufacturing, because the outbreak coincided with the Chinese New Year holiday when services are normally in high demand. In addition, the service sector accounts for a much larger share of the Chinese economy than in 2003 (Chart 5). Therefore, the reduction in services output will have a comparatively bigger economic impact. However, as we think the 2019-nCoV outbreak outside of the epicenter will likely peak in February, the majority of nationwide manufacturing activity should resume no later than the last week of February. Chinese authorities have already signaled they will speed up government-led infrastructure investment as early as March. Chart 6Service Sector Took Longer To Recover After SARS Outbreak The service sector will take longer to recover. Following the 2003 SARS outbreak, the recovery in the service sector lagged the manufacturing and primary sectors by one quarter (Chart 6). This will likely delay the bottoming of the aggregate Chinese economy. We project a bottom in China’s economy towards the end of the second quarter of 2020. A delay in economic recovery will force Chinese policymakers to put aside their financial deleveraging agenda, and focus on economic growth for the year. 2020 marks the final year for policymakers to accomplish their goal to double GDP from 2010. This means policymakers will likely augment the amount of stimulus in order to stabilize the economy and avoid falling short of their growth target. Bottom Line: Business activities should resume in late February, with a bottoming in the economy towards the end of the second quarter of 2020. Monetary Support Already Lining Up The Chinese economy is on a structurally slowing trend, but is in an early stage of cyclically recovering from last year (Chart 7). This is in contrast with 2003 during the SARS outbreak when China’s economic growth was structurally accelerating, but the monetary environment was in a tightening cycle and industrial profit growth was downshifting (Chart 8). Chart 7Chinese Economy Is On A Structurally Slowing Trend, But Is Cyclically Recovering... Chart 8...And Is In An Expansionary Monetary Cycle As the performance of Chinese onshore stocks reflects domestic policy, Chinese A-shares, after briefly rebounded when the 2003 SARS outbreak peaked, underperformed the global benchmark during much of the 2004-2006 period when monetary policy tightened (Chart 9). Contrasting with 2003, we expect the PBoC to maintain a more accommodative monetary stance throughout 2020 (Chart 10): the PBoC cut the open market operation interest rates by 10bps on February 3. We expect this move to lead to a 5bps LPR and MLF rate cut in March. Moreover, the chance that the PBoC will cut the bank reserve requirement ratio (RRR) in Q2 is also increasing. Chart 9Chinese Onshore Equity Market Largely Driven By Domestic Policy Chart 10Easy Monetary Stance Is Here To Stay Bottom Line: Monetary policy will become more accommodative this year. Investment Conclusions Chinese stocks just went on sale, but the sale likely will not last long. Chart 11Chinese Stocks Are Priced At An Even Deeper Discount Over the next 0-3 months, Chinese equities will likely rebound as soon as the peak in the number of new cases outside of Wuhan/Hubei occurs. We believe the peak will happen within the next two weeks, and manufacturing activities in the majority of Chinese cities will resume following the peak in the outbreak. Depressed valuations in Chinese stocks compared with the global benchmark and the expectation of a rebound in Chinese economic activity should provide a good buying opportunity for global investors (Chart 11). In short, Chinese stocks just went on sale, but the sale likely won’t last long. Over a cyclical time horizon, we had previously predicted that China’s authorities may reduce the scale of the stimulus in the second half of this year as the economy starts to recover in Q1. The 2019-nCoV outbreak will alter the leadership’s policy trajectory and extend pro-growth support through 2020, and both the central and regional governments have announced a slew of policies in supporting businesses, particularly for the private sector. Our expectation that the viral outbreak will not derail China’s economic recovery suggests that corporate earnings will also rebound over a 6-12 month time horizon. One risk that we will be monitoring over the coming several months is the potential for firm- or sector-specific effects on earnings. The nationwide city lockdowns are certain to reduce or halt the flow of cash to businesses, and it is unclear whether this will have any disproportionate effects on corporate earnings relative to what we expect will occur for the economy beyond Q1. However, for now, our assumption is that the trend in earnings growth is likely to match that of the economy more generally unless evidence to the contrary presents itself. This supports an overweight position in Chinese stocks compared with their global peers over the coming 6-12 months. Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Footnotes 1 “Nowcasting and forecasting the potential domestic and international spread of the 2019-nCoV outbreak originating in Wuhan, China: a modelling study”, The Lancet, January 31, 2020. 2 “Real-time nowcast on the likely extent of the Wuhan coronavirus outbreak, and forecasts domestic and international spread”, Hong Kong University, January 27, 2020 3 “Modeling the Spreading Risk of 2019-nCoV”, John Hopkins Center For Systems Science And Engineering, January 31, 2020. 4 As of February 3, 2020, the fatality rate of 2019-nCoV outside of Hubei stands at 0.2%, compared with a 3% fatality rate in Hubei province and 5.5% in Wuhan, according to the World Health Organization (WHO). Cyclical Investment Stance Equity Sector Recommendations
Highlights Chart 1The 2003 SARS Roadmap The bond market impact from the coronavirus has already been substantial. The 10-year Treasury yield has fallen back to 1.51%, below the fed funds rate. Meanwhile, the investment grade corporate bond index spread is back above 100 bps, from a January low of 93 bps. The 2003 SARS crisis is the best roadmap we can apply to the current situation. Back then, Treasury yields also fell sharply but then rebounded just as quickly when the number of SARS cases peaked (Chart 1). The impact on corporate bond excess returns was more short-lived (Chart 1, bottom panel). Like in 2003, we expect that bond yields will rise once the number of coronavirus cases peaks, but it is difficult to put a timeframe on how long that will take. The economic impact from the virus could also weigh on global PMI surveys during the next few months, delaying the move higher in Treasury yields we anticipated earlier this year. In short, we continue to expect higher bond yields and tighter credit spreads in 2020, but those moves will be delayed until markets are confident that the virus has stopped spreading. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 80 basis points in January. The sector actually outpaced the Treasury benchmark by 7 bps until January 21 when the impact of the coronavirus started to push spreads wider. As stated on page 1, we expect the impact of the coronavirus on corporate spreads to be short lived. Beyond that, low inflation expectations will keep monetary conditions accommodative. This in turn will encourage banks to ease credit supply, keeping defaults at bay and providing a strong tailwind for corporate bond returns.1 Yesterday’s Fed Senior Loan Officer survey showed a slight easing of C&I lending standards in Q4 2019, reversing the tightening that occurred in the third quarter (Chart 2). We expect that accommodative Fed policy will lead to continued easing of C&I lending standards for the remainder of the year. Despite the positive tailwind from accommodative Fed policy and easing bank lending standards, investment grade corporate bond spreads are quite expensive. Spreads for all credit tiers are below our targets (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 111 basis points in January. Junk outperformed the Treasury benchmark by 30 bps until January 21 when the coronavirus outbreak sent spreads sharply wider. Once the negative impact of the coronavirus passes, junk spreads will have plenty of room to tighten in 2020. In fact, the junk index spread is now at 390 bps, 154 bps above our target (Chart 3).3 While spreads for all junk credit tiers are currently above our targets, Caa-rated bonds look particularly cheap. We analyzed the divergence between Caa and the rest of the junk index in a recent report and came to two conclusions.4 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for 2019’s Caa spread widening that make us inclined to downplay any negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of 2019’s underperformance (bottom panel). Absent significant further declines in the oil price, this sector now has room to recover. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 53 basis points in January. The sector was only lagging the Treasury benchmark by 7 bps as of January 21, when the coronavirus outbreak sent spreads wider. The conventional 30-year zero-volatility spread widened 8 bps in January, driven by a 7 bps widening of the option-adjusted spread (OAS) and a 1 bp increase in expected prepayment losses (aka option cost). The fact that expected prepayment losses only rose by a single basis point even though the 30-year mortgage rate fell by 23 bps is notable. It speaks to the high level of refi burnout in the mortgage market, which is a key reason why we prefer mortgage-backed securities over investment grade corporate bonds in our portfolio. Essentially, most homeowners have already had at least one opportunity to refinance during the past few years, so prepayment risk is low even if rates fall further. Competitive expected compensation is another reason to move into Agency MBS. The conventional 30-year MBS OAS is 49 bps, only 7 bps below the spread offered by Aa-rated corporate bonds (Chart 4). Also, spreads for all investment grade corporate bond credit tiers are below our cyclical targets. Risk-adjusted compensation favors MBS even more strongly. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 14 basis points in January. The index was up 2 bps versus the Treasury benchmark until January 21, when the coronavirus outbreak hit. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, and Foreign Agencies underperformed by 28 bps. Local Authorities, however, bested the Treasury benchmark by 60 bps. Domestic Agency bonds underperformed Treasuries by 2 bps in January, while Supranationals outperformed by 2 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Local Authorities and Foreign Agencies, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 33 basis points in January (before adjusting for the tax advantage). They were up 39 bps versus the Treasury index before the coronavirus outbreak hit on January 21. The average Aaa-rated Municipal / Treasury (M/T) yield ratio swung around during the month, but settled close to where it began at 77% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Yield ratios have tightened a lot since then, but value remains at long maturities. Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all below average pre-crisis levels at 62%, 65% and 78%, respectively. But 20-year and 30-year yield ratios stand at 89% and 93%, respectively, above average pre-crisis levels. Fundamentally, state and local balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in January. Treasury yields declined across the curve, and the 2/10 slope flattened from 34 bps to 18 bps. The 5/30 slope flattened from 70 bps to 67 bps. Despite the significant flattening, the 2/10 slope remains near the middle of our target 0 – 50 bps range for 2020, and we anticipate some bear-steepening once the coronavirus is contained.8 The front-end of the curve also moved in January to price-in 57 bps of Fed rate cuts during the next 12 months (Chart 7). At the beginning of the year the curve was priced for only 14 bps of rate cuts. We expect that the Fed would respond with rate cuts if the coronavirus epidemic worsens, leading to inversion of the 2/10 yield curve. However, for the time being the safer bet is that the virus will be contained relatively quickly and the Fed will remain on hold for all of 2020. Based on this view, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. The position offers positive carry and looks attractive on our yield curve models (see Appendix B).9 TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate fell 12 bps on the month and currently sits at 1.66%. The 5-year/5-year forward TIPS breakeven inflation rate fell 16 bps on the month and currently sits at 1.71%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target since mid-2018 (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. It takes time for expectations to adapt to a changing macro environment, but even accounting for those long lags, our Adaptive Expectations Model pegs the 10-year TIPS breakeven inflation rate as 31 bps too low (panel 4).10 It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor long-term inflation expectations. As a result, the actual inflation data will lead expectations higher, causing the TIPS breakeven inflation curve to flatten.11 ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 14 bps on the month. It currently sits at 26 bps, below its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector performed so well in January when other spread sectors struggled. ABS also offer higher expected returns than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends are slowly shifting in the wrong direction. The consumer credit delinquency rate remains low, but has put in a clear bottom. This is also true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 43 basis points in January. The index option-adjusted spread for non-agency CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level (Chart 10). In last week’s Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle, and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.12 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds from a risk/reward perspective (see our Excess Return Bond Map in Appendix C), and that the macro environment is only slightly unfavorable for CMBS spreads. Specifically, CRE bank lending standards are just in “net tightening” territory. But both lending standards and loan demand are very close to neutral (bottom 2 panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 34 basis points in January. The index option-adjusted spread tightened 4 bps on the month to reach 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 57 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 31, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 31, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 33 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 33 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Excess Return Bond Map (As Of January 31, 2020) Footnotes 1 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2 For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 9 For further details on our recommended yield curve trade please see US Bond Strategy Weekly Report, “The Best Spot On The Yield Curve”, dated January 21, 2020, available at usbs.bcaresearch.com 10 For further details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 12 Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Feature Everyone’s asset-allocation plans for the year have been disrupted by the novel coronavirus (2019-nCoV). Our view is that, while the virus is serious and will hurt the Chinese and global economy in the short term, it does not change the 12-month structural outlook for financial markets. Once the epidemic is under control (which it is not yet), there will be an excellent buying opportunity for risk assets and for the most affected asset classes. Many commentators have pointed to the lessons from SARS in 2003. Markets bottomed around the time that new cases of the disease peaked (Chart 1). But there are risks with such a simplistic comparison. The US invasion of Iraq happened at the same time – between 19 March and 1 May 2003 – with arguably a bigger impact on global markets. The Chinese economy was much less significant: China represented only 4% of global nominal GDP in 2003 (versus 17% now), 7% of global car sales (35% now), and 10-20% of commodity demand (50-60%). And it is still unclear how similar 2019-nCoV is to SARS: it appears to be spreading more rapidly (Chart 2) but (so far, at least) is less deadly, with a mortality rate of about 2%, compared to 10% for SARS. Recommended Allocation Chart 1The Lesson From Sars Chart 2But Is Novel Coronavirus Different? Nonetheless, the basic theory that markets should bottom around the time that new cases and deaths peak is likely to prove correct. With the number of deaths still growing, however, that is not yet the case. Our advice to investors would be not to sell at this point. The hedges we have in our portfolio (overweight cash and gold) should help to cushion any further downside. But, within a few weeks, assets such as EM equities, airline stocks, commodities, or the Australian dollar should look very attractive again (Chart 3). For the next few months, economic data, particularly from China, will be hard to interpret. In 2003, Chinese GDP was reduced by 1.1% because of SARS, according to estimates by the Brookings Institute.1 The global economy is likely to be more heavily impacted this time, given today’s closely integrated supply chains. On the other hand, most academic research shows that consumption and production lost during an epidemic are later made up. Additionally, the Chinese government is likely to respond with easier fiscal and monetary policy. Once the air clears, we think our thesis that the manufacturing cycle bottomed in late 2019 will remain intact. The data over the past few weeks supports this. In Asia, in particular, PMIs for the major emerging economies are back above 50 (Chart 4). Europe’s rebound has lagged a little but, in the key German economy, indicators of business and investor sentiment have bottomed. Demand in the auto sector, crucial for Europe and Japan, is clearly starting to recover. Data in Europe and EM have generally surprised to the upside recently (Chart 5). Chart 3Some Assets May Soon Look Attractive Chart 4Asian And European Data Picking Up Chart 5Positive Surprises The theory that markets should bottom around the time that new cases and deaths peak is likely to prove correct. To a degree, the new virus gave investors an excuse to take profits in some over-bought markets. The US equity market, in particular, looked expensive at the start of the year, with a forward PE of 19x. But we would dismiss the common view that investors had become too optimistic. The bull-bear ratio is not elevated (Chart 6), with only 37% of US individual investors at the start of January believing that the stock market would go up over the next six months, not particularly high by historical standards – it has fallen now to 32%. Last year, investors took money out of equity funds, despite strong returns from stocks. In the past – for example 2012 and 2016 – when this happened, it was followed by further gains for equities, as investors belatedly bought into the rally (Chart 7). Chart 6Retail Investors Aren't So Bullish... Chart 7...Indeed, They Have Been Selling Stocks On a 12-month investment horizon, therefore, we remain overweight risk assets such as equities and credit, albeit with some hedges. The upside to global growth remains underestimated: the economists’ consensus is for only 1.8% GDP growth in the US and 1.0% in the euro area this year. A combination of accelerating global growth and central banks that will stay dovish should allow equities to outperform bonds over the next 12 months (Chart 8). Chart 8If PMIs Pick Up, Equities Will Outperform Chart 9First Signs Of US Equity Underperformance? Equities: In December, we moved underweight US equities and recommended shifting into more cyclical markets: overweight the euro zone, and neutral on EM, the UK, and Australia. Before the outbreak of 2019-nCoV, this had worked in EM, but less well in Europe (Chart 9). Once the effects of the virus have cleared, we still believe this allocation will outperform as the global manufacturing cycle picks up. But we have a couple of concerns. (1) The recent US/China trade deal will require China to increase imports from the US by a highly unrealistic 83% year-on-year in 2020 (Chart 10). Our China strategists don’t expect this target to be fully met, but think any increase will come from substitution.2 This would hurt exporters in Europe and Asia. (2) The outperformance of euro area equities is very much determined by how banks fare. The headwinds against them continue: the ECB recently decreed that six major banks fall below required capital ratios; loan growth to corporates in the euro area has fallen to 3.2% year-on-year. Much, though, depends on the yield curve (Chart 11). If it steepens, as a result of stronger growth this year, as we expect, bank stocks should outperform, especially since they remain very cheap (the average price/book ratio of euro area banks is currently only 0.65). Chart 10China’s Import Targets Are Unrealistic Chart 11Bank Performance Depends On The Yield Curve Once the air clears, we think our thesis that the manufacturing cycle bottomed in late 2019 will remain intact. Fixed Income: Government bond yields have fallen in recent weeks as investors sought cover, with the US Treasury 10-year yield dropping to 1.55%. While it may test last September’s low of 1.46%, we do not see much further room for global yields to fall. They tend to be highly correlated with manufacturing PMIs, which we expect to rise over the next 12 months (Chart 12). Also, we see the Fed staying on hold this year, not cutting rates twice, as the market is now pricing in. This mildly hawkish surprise should push up rates (Chart 13). We continue to prefer credit over government bonds. Our global fixed-income strategists consider that, from a valuation standpoint, US high yield, and UK investment grade and high yield are the most attractive (Chart 14).3 Chart 12Rates Move In Line With PMIs Chart 13What If The Fed Doesn't Cut Rates? Chart 14US Junk Looks Most Attractive Currencies: Defensive currencies such as the yen, Swiss franc, and US dollar have benefitted from the recent risk-off move. We see this as temporary. Once investors refocus on growth, the US dollar should start to depreciate again (the DXY index did fall by 3% between September and early January). The dollar is a counter-cyclical currency. It is 15% overvalued relative to PPP (Chart 15). It is also very momentum-driven – and, since December, momentum has pointed to depreciation and continues to do so (Chart 16). Chart 15Dollar Is 15% Overvalued... Chart 16...And Momentum Has Moved Against USD Commodities: Industrial metals prices had started to pick up over the past few months, reflecting the stabilization of Chinese growth (Chart 17). How they fare from now will depend on: (1) how sharply Chinese growth slows as a result of 2019nCoV, and (2) how much stimulus the Chinese government rolls out to offset this. Given the degree of decline in some commodity prices (zinc down by 16% since mid-January, and copper by 9%, for example), there should be an attractive buying opportunity in these assets over coming weeks. Gold has proved to be a handy hedge against geopolitical risks (Iran) and unexpected tail risks (the coronavirus), rising by 4% year-to-date. We continue to believe it has a useful place in investors’ portfolios as a diversifier and hedge, particularly in a world of very low interest rates where cash is unattractive (Chart 18). The oil price has been hit by the disruption to air travel in January, but supply remains tight (and OPEC is likely to cut supply further in response to the demand shock).4 As long as economic growth picks up later this year, we see the crude oil price recovering over the coming months. Chart 17Metals Reflect Chinese Growth Chart 18Gold Attractive With Bond Yields So Low Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see Globalization and Disease: The Case Of SARS, Jong-Wha Lee and Warwick J. McKibbin, Brookings Discussion Paper No. 156, available at https://www.brookings.edu/wp-content/uploads/2016/06/20040203-1.pdf 2 Please see China Investment Strategy Weekly Report “Managing Expectations,” dated 22 January 2020, available at cis.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report “How To Find Value In Corporate Bonds,” dated 21 January 2020, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report “Expect OPEC 2.0 To Cut Supply In Response to Demand Shock,” dated 30 January 2020, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Portfolio Strategy China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Lofty valuations, overbought technicals, declining capex and weak operating metrics, are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Recent Changes Trim the S&P tech hardware, storage & peripherals index to underweight, today. Table 1 Feature The S&P 500 fell for a second straight week and has now given back almost all of the year-to-date gains. While the coronavirus has served as an excuse to sell as we warned last week,1 we are nowhere near in unwinding the extreme overbought conditions in the broad equity market. We are no epidemiology experts, however, what concerns us most is when the news will eventually hit that coronavirus deaths are sprucing up outside of China’s borders. This will likely catalyze more equity selling and a capitulation point will subsequently ensue. Importantly, beneath the surface macro divergences remain wide. The yield curve peaked at the turn of the year. Similarly, the real 10-year Treasury yield crested around the same time and so did the hyper growth sensitive AUD/CHF cross rate all predating the coronavirus epidemic news (Chart 1). Our sense is that the bond market in particular is likely reflecting Bernie Sander’s rise in the polls along with persistently soft economic data. Other indicators we track confirm that the handoff from liquidity-to-growth we have all been waiting for remains on hold. The oil-to-gold and copper-to-gold ratios have no pulse, warning that growth remains elusive (third & bottom panels, Chart 2). Chart 1Souring Macro Predates Coronavirus Chart 2Watch Gold Closely Moreover, in our January 13 report we highlighted that gold was sniffing out two or three fed cuts in 2020, leading the fed funds futures market, as it did in the spring of 2019.2 Since our last update, the fed funds discounter in the coming 12 months has sunk from negative 20bps to negative 42bps (year-on-year change in the fed funds rate shown inverted, second panel, Chart 2). It is disconcerting that despite the sloshing liquidity and de-escalation in the US/China trade war, CEOs remain on the sidelines. The Q4 GDP release showed that non-residential investment is now contracting on a year-over-year (yoy) basis (bottom panel, Chart 3) and has been subtracting from real output growth for three consecutive quarters. Hard data continues to warn that the manufacturing recession is not over as the 15% yoy contraction in non-defense durable goods orders revealed last week (third panel, Chart 3). Equity market internals also warn that the SPX is skating on thin ice. Worrisomely, the Philly semiconductors index (SOX) peaked versus the NASDAQ 100 last year and has been losing steam of late. The equally- versus market cap-weighted S&P 500 and NASDAQ 100 ratios remain near multi-year lows, and small caps are still stalling versus large caps (Chart 4). The implication is that, at least, an indigestion period looms for the broad equity market. Chart 3Ongoing Manufacturing Recession Chart 4Weak Market Internals Netting it all out, there are high odds that the coronavirus epidemic may serve as a catalyst and short-circuit the already frail handoff from liquidity-to-growth, warning that equity market caution is warranted at this juncture. This week we are trimming a key tech subgroup to underweight, and updating a heavyweight basic materials sub-index. To Infinity And Beyond? While we have been neutral the S&P tech hardware, storage & peripherals index and thus participating in the monster rally over the past year, the time is ripe to downgrade exposure to below benchmark. Undoubtedly, relative share prices are extremely extended. The second panel of Chart 5 shows that the relative share price ratio is at the highest level as a percentage of its 200-day moving average since the late-1990s. Shown as a z-score, this technical indicator is stretched to the tune of two standard deviations above the historical mean (third panel, Chart 5). The last three times technical conditions were so overbought, it marked a multi-year peak in relative performance (top panel, Chart 5). Importantly, the forward multiple explains all of the return in this tech sub-group’s stellar relative performance since the 2018 Christmas Eve lows (Chart 6). In fact, stagnant-to-lower relative profit growth subtracted from relative returns over the same time period (bottom panel, Chart 6). Chart 5Up, Up And Away? Moreover, the parabolic move in the forward P/E ratio that climbed from a 25% discount to the SPX to a 15% premium (i.e. a 53% multiple jump), was because the 10-year US Treasury yield plunged by 175 basis points from peak to trough (10-year US Treasury yield shown inverted, Chart 7). Chart 6EPS Have To Do The Heavy Lifting Chart 7Multiple Expansion Phase Has Run Its Course Such enormous easing in financial conditions is unlikely to repeat in the coming twelve months in order to push the forward multiple even higher and sustain the “goldilocks” conditions for the S&P tech hardware, storage & peripherals index. In contrast, BCA’s higher interest rate view is a harbinger of a multiple contraction phase and compels us to trim exposure on this high-flying tech sub group to underweight. Another market narrative substantiating the multiple expansion phase is that heavyweight AAPL is now a services oriented company and rightly so commands a sky-high multiple similar to the cloud and software stocks. While there is some truth to the push into services, the iphone and other hardware still dominates AAPL’s sales and will continue to do so for the foreseeable future especially on the eve of a 5G smartphone rollout. Turning over to the macro backdrop, this still mostly manufacturing-based industry moves with the ebbs and flows of the ISM manufacturing survey. Overall business investment is contracting and so is industry capex. Worrisomely, most of the ISM manufacturing subcomponents remain below the boom/bust line warning that investment will remain soft in the coming months, despite the Sino-American trade détente (middle panel, Chart 8). CEO confidence in capital spending remains downbeat and corroborates that at least a wait and see attitude toward greenfield expansion plans is a high probability outcome (bottom panel, Chart 8). Moreover, global export expectations continue to plumb cyclical lows. Similarly, the Emerging Asian (a key tech manufacturing hub) leading economic indicator broke below the GFC lows warning that industry exports are at risk of a further collapse (second & third panels, Chart 9). Chart 8Something’s Gotta Give Chart 9Weak Operating Metrics Chart 10Soft Pricing Power… Chart 11…Will Continue To Weigh On Margins Beyond soft exports, industry new orders are also contracting (bottom panel, Chart 9). This deficient demand backdrop will continue to weigh on industry sales, owing to the recent drubbing in pricing power (third panel, Chart 10).\ Deflating selling prices are also negative for profit margins. The wide gap between industry and SPX margins is clearly unsustainable (Chart 11). Already there is tentative evidence that S&P tech hardware, storage & peripherals margins have peaked and will remain under downward pressure, especially given our expectation of underwhelming profit growth in the coming months. In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Nevertheless, there is one risk that is worth monitoring: the US consumer. A tight labor market should continue to bid up the price of labor and sustains wage gains which means more money in consumers’ wallets. As a result, brisk consumer outlays on computers & peripherals could reverse the ongoing industry sales deceleration (bottom panel, Chart 12). In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Bottom Line: Downgrade the S&P tech hardware, storage & peripherals index. The ticker symbols for the stocks in this index are: BLBG S5CMPE – AAPL, HPQ, WDC, HPE, STX, NTAP, XRX. Chart 12Risk To Bearish View Hazardous Chemicals The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. Relative share prices have broken below the GFC lows and it would not surprise us if they would retest the 2006 lows (Chart 13). Now that the chemicals M&A activity dust has settled for good, China dominates the direction of chemical equities. Chinese authorities are still easing monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel, Chart 13). The Australian currency, which is hyper-sensitive to China’s growth, corroborates that Chinese economic activity remains soft (second panel, Chart 13). Broad-based US dollar strength also confirms that global growth has yet to stage a durable comeback. The implication is that US chemical exports will continue to lose market share, weighing on industry profits (third panel, Chart 13). Chart 13China Leads The Way In fact, sell-side analysts are expecting a relative profit growth acceleration phase, but a decline in relative revenue prospects. This suggests that already uncharacteristically high chemical profit margins will continue to outpace the broad market (bottom panel, Chart 13). Our indicators suggest that it pays to lean against such relative EPS and profit margin euphoria. Importantly, our chemicals profit margin proxy is sinking, warning that a profit margin squeeze looms. Not only are selling prices deflating, but also the industry’s wage bill is gaining steam (bottom panel, Chart 14). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Moreover, chemical railcar loads are contracting at a time when the ISM manufacturing survey remains squarely below the boom/bust line (middle panel, Chart 14). This deficient chemical demand backdrop is deflationary (second panel, Chart 15) and will eat into industry profit margins. Chart 14Downbeat Demand Backdrop Chart 15Deflation Getting Entrenched On the operating front, our chemicals industry productivity proxy (industrial production/employment) is also in negative territory, underscoring that profits will likely surprise to the downside (third panel, Chart 15). Chemical industrial production is contracting at an accelerating pace and industry shipments are in retreat, warnings that the risk is high of an inventory liquidation phase (bottom panel, Chart 15). While we remain bearish on chemical stocks on a cyclical horizon, there are two key risks we are closely monitoring that would push our view offside. The global reflation handoff to actual growth is the key risk. If the global economy enters a V-shaped recovery, global bond yields will immediately reflect such a growth backdrop and push interest rates higher. This would put downward pressure on the greenback and significantly reflate chemical earnings (middle panel, Chart 16). Finally, chemical stocks are cheap and trade at a steep discount to the broad market. When our relative valuation indicator has plunged to such depressed levels in the past fifteen years, bottom-fishing buyers have come back in the market and added chemical stock exposure to their portfolios (bottom panel, Chart 16). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS. Chart 16Two Risks To Monitor Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “When The Music Stops...” dated January 27, 2020, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, 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%)