Financial Markets
Highlights Portfolio Strategy There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. Rising total mutual fund assets under management, improved trading revenue prospects, rising investor confidence along with a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index. Recent Changes There are no changes in our portfolio this week. Table 1 Feature “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Charles Owen "Chuck" Prince III (ex-CEO of Citigroup) The SPX remains near all time highs and the invincible tech sector continues to lead the pack. Two weeks ago we showed that the market capitalization concentration of the top five stocks in the S&P 500 surpassed the late-1990s parallel (Chart 1), and Table 2 shows that late in the cycle a handful of stocks explain a sizable part of the broad market’s return.1 However, in terms of valuation overshoot the current forward P/E of these top five stocks is roughly half the late-1990s parabolic episode (Chart 2). Chart 1Vertigo Warning Chart 2Unlike The Late-1990s While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. Table 2Contribution To Late Cycle Rallies In The SPX Chart 3Correlation Breakdown Contrary to popular belief, during manias historical correlations break down and the forward multiple becomes positively correlated with the discount rate. So in the late 1990s, the fed funds rate and the 10-year yield jumped 200bps in a short time span and the SPX forward P/E soared 40% from roughly 18x to 25x (Chart 3) before collapsing to 14x soon thereafter. Simultaneously, the US dollar was roaring as real interest rates were 4%, but the NASDAQ 100 outperformed the emerging markets, another break in historical correlations. As Chuck Prince mused in 2007, there is a narrative in the equity market today that, “as long as the music is playing, you’ve got to get up and dance”. While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. We filtered for large cap stocks that are at all-time highs and have increased in value at a minimum 10x since 2010. Among the stocks that met these criteria, five really stand out, Apple, Tesla, Lam Research, Amd & Salesforce, and comprise our “ATLAS” index; the mania in these stocks will likely end in tears (Chart 4). Even their forward P/E ratio has gone exponential, hitting a 60 handle last year similar to top five SPX stocks in the late-1990s. Chart 4ATLAS: Holding The World On His Shoulders Currently, SPX profits are barely growing and the sole reason equities are higher is the massive injection of liquidity via the drubbing in interest rates and the restart of QE. From peak-to-trough the 10-year yield fell 175bps in nine months, and the Fed commenced expanding its balance sheet by $60bn/month since last September; yet profits have barely budged. Ultimately, profits have to show up and the news on this front remains grim. The current non-inflationary trend-growth backdrop is a “goldilocks” scenario especially for tech stocks that thrive during disinflationary periods. While stocks can go higher defying weak EPS fundamentals as they have yet to reach a fully euphoric state according to our Complacency-Anxiety Indicator (Chart 5), a sell-off in the bond market will likely cause some consternation in equities in general and tech stocks in particular similar to early- and late-2018. Chart 5Not Max Complacent Yet Other catalysts that can suddenly cause “the music to stop” are either the recent coronavirus becoming an epidemic or a geopolitical event that would result in a risk off backdrop. Ultimately, profits have to show up and the news on this front remains grim. Our mid-January “Three EPS Scenarios” analysis still suggests that the SPX is 9% overvalued.2 This week we are updating our capital markets view and adding a sixth long-term theme and a related investment implication to our mid-December 2019, Special Report titled, “Top US Sector Investment Ideas For The Next Decade”.3 Sixth Big Theme For The Decade And Investment Implications China’s ascendancy on the world scene was a mega driver of equity markets in the 2000s following its inclusion in the WTO. The commodity super-cycle captured investors’ imaginations and China’s insatiable appetite for commodities caused a massive bubble in the commodity complex in general and commodity-related equities in particular. Nevertheless, the Great Recession posed a severe threat to China and the authorities injected an extraordinary amount of stimulus into the economy (15% of GDP over two years). This succeeded in doubling real GDP growth, but only temporarily. The unintended consequence was an enormous debt binge fueled by cheap money. Moreover, this debt burden along with falling labor force growth and productivity forced the government to re-think its policies as they caused a steady down drift in real output growth. The sixth big theme for the 2020s is a sustained deceleration of Chinese real GDP growth to a range of 4% to 2% (Chart 6). Not only is the debt overhang weighing on real output growth, but Chinese leaders are adamant about transitioning the economy to developed market status, which is synonymous with higher consumption expenditures at the expense of gross fixed capital formation. Chart 6From Boom… Chart 7…To Bust In other words, China remains committed to weaning its economy off of investment and reconfiguring it toward consumption (Chart 7). This is a strategic plan but it is possible that the Chinese economy can achieve this transition in due time. While this will not happen overnight, the implication is steadily lower real GDP growth as is common among large, mature, developed market economies. China will remain one of the top commodity consumers in the world, as urbanization is ongoing, but the intensity of commodity consumption will continue to decelerate (Chart 8). At the margin, this change in consumption behavior will have knock on effects on the broad basic resources sector in general and the S&P 1500 metals & mining index in particular. Were this Chinese backdrop to pan out in the coming decade as we expect, it would sustain the relative underperformance of metals & mining equities as Chart 6 & 7 depict. Chart 8Commodity Consumption Deceleration Will… Chart 9…Continue To Weigh On Metals & Mining Profits Importantly, these commodity producers will have to adjust their still bloated cost structures to lower run rates which is de facto negative both for relative sales and profit growth (Chart 9). Tack on the large negative footprint mining extraction has on the environment, and if ESG investing (our fifth big theme for the decade4) also takes off, investors should avoid the S&P 1500 metals & mining index on a secular basis. Bottom Line: There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. The ticker symbols for the stocks in this index are: BLBG S15METL – NEM, FCX, NUE, RS, RGLD, STLD, CMC, ATI, CRS, CLF, CMP, X, KALU, WOR, MTRN, HCC, AKS, SXC, HAYN, CENX, TMST, ZEUS. Capital Markets Update Capital markets stocks have come out of hibernation recently and are on the cusp of breaking out – in a bullish fashion – of their 18-month trading range. A number of the indicators we track signal that an earnings-led outperformance period is in the cards for this financials sub-group and we reiterate our overweight stance. Sloshing liquidity has pushed investors out the risk spectrum and high yield bond option adjusted spreads are flirting with multi-year lows. Such a tame junk bond market backdrop coupled with easy financial conditions are conducive to rising M&A activity (Chart 10). Importantly, the Fed’s Senior Loan Officer Survey paints an improving profit backdrop for investment banks. Not only are bankers willing extenders of credit, but demand for credit for the majority of loan categories that the Fed tracks is squarely in positive territory (top panel, Chart 11). Chart 10Subsiding Risks Are A Boon To Capital Markets Chart 11Positive Profit Catalysts This is likely a consequence of last year’s drubbing in the price of credit. M&A activity usually goes hand in hand with loan growth, underscoring that business combinations are on track to accelerate (third panel, Chart 10). This will revive a lucrative business line for capital markets firms. Total mutual fund assets are expanding at a brisk rate and hitting fresh all-time highs, signaling an uptick in risk appetite (third panel, Chart 11). Rising investor confidence will facilitate both new and secondary share issuance, an important source of fee generation for capital markets firms. Moreover, equity trading volumes have sprang back to life in recent weeks underscoring that the recent impressive Q4 earnings results will likely continue into Q1/2020 (bottom panel, Chart 10). Meanwhile, the three Fed rate cuts last year should work through the economy and at least stem further losses in the ISM manufacturing survey. The US/China trade détente will also lead to a stabilization in global growth. In fact, the V-shaped recovery in the global ZEW survey suggests that capital markets profits will likely outpace the broad market this year (second & bottom panels, Chart 11). Finally, the recent surge in the stock-to-bond ratio reflects a massive psychological shift, from last year’s recessionary fears to growing investor confidence that tail risks are abating (Chart 12). Still depressed valuations neither reflect the firming capital markets profit outlook nor the rising industry ROE (bottom panel, Chart 12). Adding it all up, accelerating total mutual fund assets under management, improved trading revenue prospects, rising investor confidence and a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index. Bottom Line: Stay overweight the S&P capital markets index. The ticker symbols for the stocks in this index are: BLBG S5CAPM – GS, CME, SPGI, MS, BLK, SCHW, ICE, MCO, BK, TROW, STT, MSCI, NTRS, AMP, MKTX, CBOE, NDAQ, RJF, ETFC, BEN, IVZ. Chart 12Valuation Re-Rating Looms Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com 1 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 2 Ibid. 3 Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For the Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 4 Ibid. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights Most central banks still consider economic risks asymmetrical to the downside. This means that even if global growth rebounds in earnest, policy is likely to stay pat over the next three to six months. The conclusion is that relative growth fundamentals rather than central bank policy will likely drive FX price action in the next few months. Our bias remains that the growth impulse will be strongest outside the US during the first half of this year. Stay short the DXY index. The BoJ’s inaction this week makes long yen bets cheap insurance against a rise in FX volatility. Remain short USD/JPY and go short CHF/JPY. The pound remains a buy on dips but will likely underperform the euro over the next few months. EUR/GBP should touch 0.88. The BoC kept rates on hold, but erred on the dovish side, in line with our expectations. Stay short CAD/NOK and long AUD/CAD. We were stopped out of our long NOK/SEK trade for a profit of 1.8%. We will look to rebuy the cross at lower levels. Feature Chart I-1Currency Markets Have Priced In A Benign Recovery The powerful bounce in global equity markets since the August lows has pushed many stock indices into overbought territory. Chart I-1 shows that the rise in global stocks has already discounted an improvement in global manufacturing in order of magnitude similar to the 2012 and 2016 episodes. However, currency markets have been discounting a much more benign outcome (bottom panel). The divergence between currency and equity performance is a marked change from what has prevailed during past cycles. For example, trough to peak, AUD/JPY, a key barometer of greed versus fear in currency markets, appreciated 40% during the 2012 episode, and 25% in 2016-2017, along with rising equity prices. The performance of even more high-octane currency pairs such as the RUB/JPY, the ZAR/JPY, or even the BRL/JPY, was explosive. More muted currency action this time around therefore calls into question the durability of this recovery. Perhaps given that equities are long-duration assets, it is quite plausible that the drop in interest rates in 2019 has increased their relative appeal, boosting nominal values. While that makes sense, most bond markets have also seen higher yields over the past few months, making this explanation questionable. Alternatively, the easing in trade tensions and/or the Federal Reserve’s liquidity injections may have rekindled animal spirits among domestic investors. Or perhaps, a synchronized recovery has narrowed G10 growth differentials, muting currency performance in the process but boosting share prices. The rise in global stocks has already discounted an improvement in global manufacturing. However, currency markets have been discounting a much more benign outcome. Either way, the resolution to this dissonance will be either through marked improvement in global economic data in the coming months (which will support pro-cyclical currencies), or a period of indigestion for stock markets (which will lift volatility) – or a combination of both. At a minimum, this suggests tweaking currency portfolios in anticipation of these dynamics. On Volatility And The Dollar Everyone understands that currency markets are about relative trends. Therefore, the implicit assumption that the dollar will weaken as global growth picks up is that the epicenter of this recovery will be outside the US. Chart I-2 shows that economic data is not yet surprising to the upside outside the US, even though there has been marked improvement on a rate-of-change basis. Beneath the surface, the strongest data surprises have been in the euro area, Switzerland, New Zealand and Australia, while disappointments have been in Canada and the UK. In hindsight, the chart also highlights why the Canadian dollar was the best performing G10 currency in 2019, while the Swedish krona was the weakest. Chart I-2Growth Dispersion Has Fallen The drop in economic dispersion has pushed currency volatility near record lows (Chart I-3). Every seasoned investor does and should pay attention to low volatility. This is because what destroys portfolios is not exuberance, but complacency. This might sound like a tautology, but during the last three episodes of volatility dropping to these levels, the dollar soared and pro-cyclical currencies suffered severe losses. Everyone remembers 1997-1998, 2007-2008 and 2014-2015. Will this time be the same? While a rise in volatility is usually associated with a higher dollar, there are three key differences this time around. First, real rates turned positive in the US relative to its G10 counterparts in 2014 (Chart I-4). This meant the US dollar, which has typically been a funding currency (not least because it is a reserve currency), became the object of carry trades. It is a fair contention that any capital that wanted to find its way into US Treasurys has had more than five years of positive real carry to do so. With real relative yields in the US now rolling over, which way will capital gravitate? Chart I-3Volatility Near Record Lows Chart I-4Real Rates Lower In The US The dollar has been in a bull market since 2011, which has shifted valuations towards expensive quartiles. This is a key difference from previous low-volatility episodes when the dollar was much earlier into bull-market territory (Chart I-5). The dollar tends to run in long cycles, and a spike in volatility can either mark the beginning or the end of a cycle. As we have emphasized numerous times in previous reports, being long the US dollar is a consensus trade. Our primary basis for this is CFTC positioning data. However, a timelier leading indicator to watch is the gold-to-bond ratio. Currencies are about confidence, and a key measure of confidence in the US dollar is the total return in the US 10-year Treasury compared to gold bullion, which has collapsed (Chart I-6). The budget deficit in the US is about to explode, while it was low and falling during prior dollar riot points. Chart I-5The Dollar Is Expensive Chart I-6Tug Of War Between US Bonds And Gold More importantly, currency markets are likely to gyrate with relative fundamentals. The slowdown in the global economy was driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. Historically, cyclical swings in most economies tend to be driven by manufacturing and exports rather than services (and consumption). More specifically, the currencies that have borne the brunt of the manufacturing slowdown should logically be the ones to experience the quickest reversals. This is already being manifested in a very steep rise in their bond yields vis-à-vis those in the US. For example, yields in Norway, Sweden, Switzerland and Japan have risen significantly versus those in the US since the bottom. A synchronized recovery in global growth will go a long way in further eroding the US’ yield advantage. Currencies are about confidence, and a key measure of confidence in the US dollar is the total return in the US 10-year Treasury compared to gold bullion. Bottom Line: Remain short the DXY index with an initial target of 90 and a stop loss at 100. The Yen As Portfolio Insurance Should our thesis that the dollar is in a downtrend for 2020 be correct, it is unlikely to occur in a straight line. This argues for having some portfolio insurance. The Bank of Japan’s inaction this week may have been a red herring, since one of the most potent moves in asset markets in recent months has been the +130-basis-point move in favor of Japanese yields (Chart I-7). The gap between the USD/JPY and real rates has opened up a rare arbitrage opportunity. Should a selloff in global risk assets materialize, the yen will strengthen. On the other hand, if global growth does eventually accelerate, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This keeps short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. The rise in Japanese yields has been driven by three key pivotal developments: For most of the past five years, the BoJ was one of the most aggressive central banks in terms of asset purchases. This was a huge catalyst for a downturn in the trade-weighted yen (Chart I-8). With a renewed expansion in the Fed’s balance sheet, monetary policy is tightening on a relative basis in Japan. Total annual asset purchases by the BoJ are currently running at about ¥20 trillion, while JGB purchases are running at ¥15 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon. Chart I-7Japanese Bond Yields Have Surged Chart I-8The Yen And QE Movements in the yen are as influenced by external conditions as what is happening domestically, given Japan’s huge export sector. Credit default swap spreads of cyclical sectors are collapsing to new lows, symptomatic of an improving profit outlook (Chart I-9). This suggests it is the growth component driving Japanese yields higher (Japanese CPI swaps have indeed been flat). This also mirrors the recent outperformance of Asian cyclical sectors relative to defensive ones. The Abe government announced a huge fiscal package last year, in part driven by the disastrous typhoons as well as the upcoming Olympics. This allowed the BoJ to upgrade its growth forecasts in its latest policy minutes. The relative performance of construction and engineering stocks are an important barometer for when the funds are flowing into the economy (Chart I-10). Chart I-9Default Risk Easing In Japan Chart I-10Fiscal Stimulus And Construction Stocks As a defensive currency, the yen tends to weaken as global growth improves, given it is usually used to fund carry trades. That said, our contention is that the yen will surely weaken at the crosses, but could still strengthen versus the dollar. As mentioned above, one catalyst is the divergence from the traditional relationship with real rates. More importantly, the USD/JPY and the DXY tend to have a positive correlation, because the dollar drives the yen most of the time. Meanwhile, net short positioning in the yen versus the dollar makes it attractive from a contrarian standpoint (Chart I-11). Given extremely low volatility, this places short USD/JPY bets as an attractive vehicle to play a rise in volatility. Chart I-11Investors Are Short The Yen More conservative investors could go short CHF/JPY. The recent rise in the Swiss franc threatens the nascent recovery in inflation (Chart I-12), while weakness in the Japanese yen will help lift domestic tradeable goods prices. This puts more pressure on the Swiss National Bank rather than the BoJ. Meanwhile, as a safe haven, the yen is cheaper than the franc. This is confirmed by many of our in-house models. In simple terms, relative inflation with the US has been lower in Japan over the last several decades, but the franc has been stronger. In simple terms, relative inflation with the US has been lower in Japan over the last several decades, but the franc has been stronger (Chart I-13). Meanwhile, over the last two years, a rise in volatility has benefited the yen more than the franc. Chart I-12Strong Franc Is A Headwind For Swiss Inflation Chart I-13The Yen Is Cheaper ##br##Insurance Bottom Line: The yen is the most attractive safe-haven currency at the moment. Remain short USD/JPY and sell CHF/JPY. Housekeeping We were stopped out of our long NOK/SEK trade for a profit of 1.8%. We will look to rebuy this cross at lower levels. The trade is mostly about carry, and we are both positive on the NOK and SEK. This makes market timing important. NOK/SEK at 1.04 will be attractive. There were no new insights from the Norges bank this week, in the context of all the central bank meetings. We will also be looking to opportunistically buy the pound, but buying EUR or GBP volatility might be a better bet. For now, despite the robust labor report, economic surprises in the UK remain negative (Chart I-14). Stay tuned. Chart I-14GBP Is Vulnerable Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: Industrial production fell by 1% year-on-year in December. The preliminary Michigan consumer sentiment index fell slightly to 99.1 in January. MBA mortgage applications fell by 1.2% for the week ended January 17th. However, existing home sales surprised to the upside, rising 3.6% month-on-month in December. Chicago Fed national activity index fell to -0.35 from 0.41 in December. Initial jobless claims increased to 211K for the week ended January 17th, better than expectations. The DXY index increased by 0.4% this week. There are growing concerns over whether China's coronavirus would significantly drag down global growth. While this is a hiccup in the short term, we remain positive and believe that global growth will accelerate this year on easy financial conditions and faded trade war risks. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly positive: The current account balance came in at €33.9 billion in November. Headline and core inflation were both unchanged at 1.3% year-on-year respectively in December. The ZEW economic sentiment survey soared to 25.6 from 11.2 in January. The euro fell by 0.8% against the US dollar this week. On Thursday, the ECB maintained interest rates at -0.5%. The key takeaway from the ECB is that they are grappling with a review of their monetary policy objective in a manner that might increase accommodation. A switch to an explicit 2% inflation target and/or including a climate change objective into quantitative easing decisions heralds a much more dovish ECB. We are tightening our stop on long EUR/CAD to 1.42. 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 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Industrial production fell by 8.2% year-on-year in November. The trade deficit widened to ¥152.5 billion in December. Imports and exports both fell by 4.9% and 6.3% year-on-year, respectively. All industry activity index increased by 0.9% month-on-month in November. Both the coincident index and the leading economic index fell to 94.7 and 90.8, respectively in November. The Japanese yen appreciated by 0.3% against the US dollar this week. The BoJ kept interest rates unchanged, in line with expectations. More importantly, the outlook report revised the growth forecast upward to 0.9% from 0.7% for the fiscal year 2020. Moreover, the BoJ revised down the inflation forecast by 10 bps due to lower crude oil prices. Please refer to our front section this week for a more in-depth analysis on the Japanese yen. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Retail sales grew by 0.9% year-on-year in December. The Rightmove house price index increased by 2.7% year-on-year in January. The ILO unemployment rate was unchanged at 3.8% in November. Average earnings grew by 3.2% year-on-year in November. This followed a 3-month improvement in employment of 208K, after what had been a dismal employment report for most of 2019. The British pound appreciated by 0.7% against the US dollar this week. The biggest volatility in European currencies in the next few weeks is likely to emerge in the EUR/GBP cross. European economic data has had the best positive surprises in the last few weeks, in part due to base effects. However, the ECB’s transcript this week suggests leaning against any currency strength. In the UK, the pound will still trade partly on politics for now. Buying GBP and EUR volatility looks like a good bet. 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 Westpac consumer confidence index fell by 1.8% in January. Consumer inflation expectations increased to 4.7% from 4% in January. 28.9K new jobs were created in December, above consensus. This was a combination of 29.2K part-time jobs but a loss of 0.3K full-time jobs. The participation rate was unchanged at 66% in December, while the unemployment rate fell further to 5.1%. The Australian dollar fell by 0.6% against the US dollar this week. The positive jobs report placed a bid under AUD, but that quickly dissipated as the coronavirus scare started to dominate headlines. We discussed AUD in depth last week and are buyers at 68 cents. Our primary rationale is that this is a potent contrarian bet. 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 negative: Visitor arrivals fell by 3.5% year-on-year in November. Net migration fell to 2610 from 3400 in November. The performance services index fell to 51.9 from 52.9 in December. The New Zealand dollar fell by 0.5% against the US dollar this week. While we believe that the kiwi dollar will outperform the US dollar this year amid improving global growth, domestic constraints including decreasing net migration might limit upside potential. Stay long AUD/NZD and SEK/NZD. 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 soft: Manufacturing sales fell by 0.6% month-on-month in November. Headline inflation was unchanged at 2.2% year-on-year in December. Core inflation however, fell to 1.7% from 1.9% in December. New house prices grew by 0.1% year-on-year in December. The Canadian dollar fell by 0.8% against the US dollar this week. On Wednesday, the BoC decided to put interest rates on hold, while opening the door for possible rate cuts later this year if the Canadian data disappointed. In short, like most other central banks, the BoC is data dependent. Our story for CAD is simple – if the epicenter of a growth rebound is outside the US, CAD will underperform its antipodean counterparts. Stay long AUD/CAD. 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 There have been scant data from Switzerland this week: Producer prices fell by 1.7% year-on-year in December, compared with a decrease of 2.5% the previous month. Money supply (M3) grew by 0.7% year-on-year in December. The Swiss franc has been more or less flat against the US dollar this week. We continue to favor the Swiss franc as global risks persist, including concerns about the coronavirus. However, as discussed in the front section of this report, the yen is a better hedge than the franc at the current juncture. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The Labor Force Survey recorded an increase in the unemployment rate to 4% in November. The Norwegian krone fell by 1.3% against the US dollar this week amid lower energy prices. On Thursday, the Norges Bank kept interest rates on hold at 1.5%, as widely expected. Moreover, the Bank Governor Øystein Olsen said that "The Committee’s current assessment of the outlook and the balance of risks suggests that the policy rate will most likely remain at the present level in the coming period," implying no change in the policy rate in the near-term. This suggests that going forward, relative fundamentals rather than policy decisions will dictate NOK’s path. Our bias is that a valuation cushion offers a margin of safety for long NOK positions. Remain short USD/NOK and CAD/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 There was scant data out of Sweden this week: After rising from 6% to 6.8% in November, the unemployment rate fell back to 6% in December. The Swedish krona fell by 0.2% against the US dollar this week. Going forward, improving global growth, diminished trade tensions, and fewer concerns about a near-term recession all underpin the Swedish economy and the krona. SEK is the most potent G10 cross to play a global manufacturing rebound. 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 The Wuhan coronavirus outbreak in China is now being priced into commodity markets, with comparisons to the 2003 SARS outbreak serving as an early benchmark.1 If it follows the SARS trajectory its impact likely will be limited, although oil demand could fall at the margin as global travel falls. The IMF expects growth in EM economies, the engine for commodity demand, to come in at 4.4% and 4.6% this year and next, respectively, down two-tenths of a percent from its previous forecast, but still up from 2019’s 3.7% rate. The Fund’s risk assessment tilts slightly to the upside, nonetheless, in the wake of global monetary and fiscal stimulus. We introduce our 2021 oil balances and price forecasts this week. We expect Brent crude oil to average $70/bbl next year, and for WTI to average $4/bbl below that. We are maintaining our $67/bbl Brent and $63/bbl WTI 2020 forecasts (Chart of the Week). Chart of the WeekCrude Oil Price Forecasts For 2020, 2021 Feature In its latest World Economic Outlook – Tentative Stabilization, Sluggish Recovery? – the IMF flags key risks to EM growth, which will continue to feed the economic policy uncertainty that dogs commodity demand.2 The Fund’s “downward revision primarily reflects negative surprises to economic activity in a few emerging market economies, notably India, which led to a reassessment of growth prospects over the next two years. In a few cases, this reassessment also reflects the impact of increased social unrest.” That said, the Fund sees the balance of risk slightly tilted to the upside versus its earlier assessment in October, in the wake of global monetary and fiscal stimulus. This is in line with our view that the effects of monetary stimulus – deployed over the better part of last year and still expected to remain accommodative this year – will boost growth this year. Our view remains tempered by risks we’ve been highlighting that keep political and economic policy uncertainty elevated – e.g., trade tensions, civil unrest, and the still-underappreciated risks to oil markets arising from US-Iran tensions and social unrest in Iraq, which remains high (Chart 2). The loss of 800k b/d from Libya is significant, but the world does not lack spare light-sweet crude oil production capacity – the US shales, in particular, abound in this type of crude oil. Chart 2Policy Uncertainty Will Trend Lower, But Continues To Dog Commodities Oil Fundamentals Improving As is typically the case, we expect global oil-demand growth this year will be led by EM economies. Crude oil fundamentals continue to favor higher prices: Production management and capital discipline will constrain the rate of growth of oil supplies, and, as discussed above, demand will benefit from policy stimulus globally (Chart 3). Oil demand growth will recover this year, following a lower-than-normal rate of just 830k b/d last year, based on the US EIA’s most recent estimates of historical consumption. We continue to expect demand to grow 1.4mm b/d this year. For 2021, we expect growth of just under 1.5mm b/d, reaching 103.65mm b/d globally. For its part, the EIA’s estimating growth of 1.34mm and 1.37mm b/d for 2020 and 2021, respectively. As is typically the case, we expect global oil-demand growth this year will be led by EM economies, proxied by non-OECD oil consumption, of 1.26mm b/d. For next year, we expect EM demand growth to come in at 1.34mm b/d, or just over 90% of global oil consumption growth in 2021. On the supply side, we continue to expect OPEC 2.0 output to increase slightly in 2Q20 and return to levels consistent with its previous agreement to cut 1.2mm b/d of production. Our modeling also assumes this level of production remains flat for the rest of 2020. Chart 3Fundamental Supply-Demand Balances Support Higher Crude Oil Prices Next year, we assume the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to increase production by 350k b/d in 1H21. In addition, we gradually remove 300k b/d of KSA’s overcompliance of 400k b/d next year, which moves its crude oil output in 2021 to 9.94mm b/d vs 9.76mm b/d this year. For Russia, we anticipate an increase in its condensate production, which it lobbied for last year. This will put our estimate of Russia’s crude and condensate production at 11.4mm b/d in 2020 and 11.64mm b/d in 2021.3 Most of the production cuts realized by OPEC 2.0 – ~ 2mm b/d – come at the expense of Venezuela and Iran, both of which are under sanctions limiting their production imposed by the US. We are holding Venezuela’s production at ~ 700k b/d in 2021, and will be monitoring this closely for any indication it is significantly changing. For Iran, we are keeping its production at 2.10mm b/d this year and next, assuming US sanctions remain in place. Oil production in both countries could be impacted by the outcome of US elections in November, and right now this is a near-impossible call to make. US Shales: No Longer A Growth Story? We continue to see slower production growth in the US than the EIA, particularly in the shales, as we expect capital markets to continue to discipline shale producers by only funding those firms that are able to return capital to shareholders or to deliver steady and increasing dividends. In our modeling, total US onshore production this year and next is expected to rise 800k b/d, and 310k b/d for 2021. We also continue to expect drilled-but-uncompleted (DUC) wells to continue to make significant contributions to overall shale-oil production in the US. Indeed, we expect DUCs to continue to offset part of the decline implied by lower rig counts, as they require less capex than drilling and completing new wells. We add ~ 500k b/d of production from DUCs completion over 2020 and 2021. Future production will depend heavily on the Majors and on productivity and lateral length. Our US crude and condensate production estimates for 2020 and 2021 reflect these constraints, and the slowing rate of growth being imposed by capital markets. For 2020, we expect total US crude and condensate production of 13.16mm b/d, of which 9.20mm b/d will come from the main shale basins led by the Permian.4 Tighter Fundamentals, Steeper Backwardations Our fundamental supply-demand balances are tighter than those assumed by the US EIA and the Paris-based IEA (Table 1). We expect US crude and liquids production to grow 1.6mm b/d this year, and only 500k b/d next year. We see global production growing 1.15mm b/d and 1.39mm b/d in 2020 and 2021, respectively. With demand growing 1.4mm b/d and close to 1.5mm b/d in 2020 and 2021, respectively, against this supply backdrop, our balances point to a deficit this year vs. the surplus expected by the IEA (Table 2 and Chart 4). Table 1Fundamentals Comparison Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Chart 4BCA Research's Balances Estimates Point To Falling Inventories Chart 5Tighter Storage, Steeper Backwardation For this reason, we continue to anticipate a steepening in the Brent and WTI forward curves – i.e., more backwardation – which will support our long 2H20 Brent vs. short 2H21 Brent curve trade (Chart 5). As a result of the steeper backwardation, we expect higher volatility, and will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls (Chart 6). Bottom Line: We continue to expect crude oil markets to tighten, given persistent production restraint by OPEC 2.0, capital-market-imposed restraint on US shale-oil producers, and revived global demand growth in 2020 and 2021. The IMF’s assessment re the balance of risk being tilted to the upside, in the wake of global monetary stimulus, is broadly consistent with our maintained view. While we expect global policy uncertainty to fall following the so-called phase-one US-China trade deal and a definitive Brexit vote in the UK, geopolitical tension remains high, particularly in the Persian Gulf. Chart 6Steeper Backwardation To Higher Implied Volatility We will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories. As a result, we are keeping our 2020 Brent forecast at $67/bbl, and are expecting 2021 Brent to trade at $70/bbl; WTI is expected to trade $4/bbl below Brent this year and next, on average. At tonight’s close, we will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Brent prices traded sideways ~ $64/bbl since last Tuesday, dismissing the US and China phase-one agreement and disruptions to Libyan production and exports which could total as much as 800k b/d. Over the weekend, concerns re the Wuhan coronavirus outbreak in China started being priced into commodities, particularly oil. Separately, the US Treasury Department renewed Chevron’s waiver to operate in Venezuela for another three months. The company is scheduled to export 1mm barrels of oil produced by PDVSA via a joint-venture, partially dodging US sanctions on Venezuelan oil.5 We expect the country’s output to stabilize close to its current level of 710 kb/d this year. Base Metals: Neutral On Tuesday Beijing reported more than 400 people had been infected with the Wuhan coronavirus, confirming person-to-person transmission of the virus. Concerns that a wider spread over the lunar New Year holidays starting this weekend will impact economic growth in the world’s top metal consumer brought copper prices down 1.8% on Tuesday. Zinc reached two-month highs this week amidst concerns of low LME warehouses stocks, now close to their 20-year lows at 50,900 MT (Chart 7). Supply concerns stemming from low iron ore stocked in China’s ports, along with good Chinese macro data, lifted iron-ore prices. Precious Metals: Neutral The US dollar is a key missing piece needed to propel gold prices higher from current levels. The 2.4% decline in the trade-weighted dollar index supported gold’s 5% increase since October 1, 2019 (Chart 8). We expect the dollar to continue depreciating in 2020, as global growth rebounds and the Fed remains accommodative, keeping gold prices well bid. Most precious metals have followed gold’s lead this year; palladium and platinum are up 17.63% and 3.15%, respectively. Chart 7 Chart 8 Ags/Softs: Underweight CBOT Corn and soybeans futures traded lower on Tuesday as markets awaited evidence of China purchasing additional U.S. agricultural goods, fulfilling its commitment to buy $32 billion of agricultural goods over two years per the phase-one deal negotiated between China and the US earlier this month. Corn traded lower, as US grain elevators have yet to confirm any Chinese buying. Soybeans, further weakened by expectations of a massive harvest in rival exporter Brazil. Wheat was the only ag posting gains early in the week on the back of strong Black Sea export demand. Footnotes 1 Please see CDC SARS Response Timeline, published by the US Centers for Disease Control and Prevention. The SARS outbreak was identified in February 2003 and lasted six months. The CDC noted: “Globally, WHO received reports of SARS from 29 countries and regions; 8,096 persons with probable SARS resulting in 774 deaths. In the United States, eight SARS infections were documented by laboratory testing and an additional 19 probable SARS infections were reported.” According to Chinese officials, there were 440 confirmed cases of the new coronavirus as of Wednesday; nine people were reported to have died thus far. The World Health Organization met Wednesday to assess the Wuhan coronavirus outbreak. The 2003 coronavirus outbreak was minor compared to the typical influenza outbreak: by way of comparison, every year there are an estimated one billion cases of influenza, resulting in 290,000 to 650,000 deaths, according to the International Federation of Pharmaceutical Manufacturers & Associations in Switzerland. 2 Economic policy uncertainty is a recurrent theme in our research. It has been driving safe-haven demand for the USD and gold for months, as we recently discussed in Iran Responds To US Strike; Oil Markets Remain Taut. It is available at ces.bcaresearch.com. 3 We use World Bank growth estimates to drive our EM demand forecasts. Earlier this month, the Bank forecast EM GDP growth of 4.1% for 2020 and 4.3% for next year. This will outpace last year’s growth rate of 3.5%. 4 US production growth, particularly in the Permian and Bakken basins, could be constrained by environmental restrictions, if state regulators crack down on the massive flaring occurring in both states. Please see Lingering Oil-Demand Weakness Will Fade, published November 21, 2019, where we discuss this risk in more depth. 5 Please see Exclusive: PDVSA's partners act as traders of Venezuelan oil amid sanctions - documents, published by reuters.com January 13, 2020. 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 An analysis on India is available on page 12. There is extreme complacency in global financial markets. With currency markets’ implied volatility at a record low, we recommend going long EM currency volatility. The latter will rise in the next six month regardless the direction of global risk assets. For now, we remain long the EM MSCI equity index with a stop point at 1050. In India, nominal income growth has fallen below lending rates. The latter have not declined despite monetary easing. The authorities will force banks to reduce their lending rates, which will hurt bank stocks. Feature “…we have probably seen the end of the boom-bust cycle.” Bob Prince, Co-CIO of Bridgewater World Economic Forum, Davos January 22, 2020 Low Volatility = Complacency Chart I-1Go Long Currency Volatility The comment above by co-CIO of the largest hedge fund declaring the end of boom-bust cycle is consistent with lingering complacency in global financial markets. Any time an influential person made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets. It does not mean that the world economy will crash but financial markets volatility in general and currency market volatility in particular are bound to rise considerably in the months ahead. The risk-reward profile of going long EM currency or US dollar volatility appears very attractive. Today we recommend investors to go long EM currency volatility. The latter will rise regardless the direction of global risk assets. Concerning overall strategy, EM financial markets are entering a testing period. How broader EM risk assets and currencies perform in the coming weeks will signal how durable and long-lasting the current EM rally will be. Given global risk assets are overbought, a correction or consolidation phase is overdue. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. If during budding market turbulence EM risk assets and currencies underperform their DM peers, it will signal their vulnerability in 2020.Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. For now, we remain long the EM MSCI equity index with a stop point at 1050. We will upgrade our EM equity and credit market allocations versus DM if the EM universe generally exhibits relative resilience in the coming weeks, and more of our indicators confirm China’s growth recovery. Hints Of Recovery… December economic data out of China were strong, and it seems that the credit and fiscal stimulus are finally beginning to lift growth: Chinese imports and nominal industrial output – among the most reliable measures of the Chinese business cycle – posted very robust growth numbers in December (Chart I-2). DRAM and NAND semiconductor prices are climbing, and China’s container freight index is also in revival mode (Chart I-3). These high-frequency (daily and weekly) data confirm improving business activity in both the global semiconductor sector and in overall world trade. Chart I-2China's December Economic Data Were Strong Chart I-3Asia's Trade Is Recovering There are tentative signs of amelioration in our proxies for marginal propensity to spend by households and enterprises in China (Chart I-4). A more decisive improvement in these indicators is needed to reinforce the positive outlook for China’s growth. …But Doubts Still Linger Despite the recent improvement in Chinese economic data and the rebound in China-related plays, there are a number of financial market indicators that are not yet confirming a sustainable business cycle recovery in China and global trade. In particular: First, apart from semiconductor stocks, global cyclical equity sectors and sub-sectors – industrials, materials, and freight and logistics – have begun, once again, underperforming defensive sectors (Chart I-5). Outperformance by these cyclical sectors against defensives is essential in confirming that global and Chinese capital spending – which were the primary sources of the most recent slowdown – are picking up again. Chart I-4China: Tentative Improvement In Household And Corporate Marginal Propensity To Spend Chart I-5Global Equities: Cyclicals Are Again Underperforming Defensives Notably, the relative performance of EM share prices to the global equity benchmark historically tracks the relative performance of global materials versus the global overall stock index.1 However, the two have recently diverged (Chart I-6). In short, global materials are not corroborating sustainability in the recent EM outperformance. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. Second, the rebound in Chinese and EM shares prices is not corroborated by Chinese onshore government bond yields, which are dipping to new cyclical lows (Chart I-7). In other words, interest rate expectations in China are falling – i.e., they are not confirming a robust recovery. Chart I-6Unsustainable Decoupling Chart I-7A Message From The Chinese Fixed-Income Market Third, EM ex-China currencies have not yet broken out versus the US dollar (Chart I-8). Consistently, the broad trade-weighted US dollar has not yet broken down. Chart I-9 illustrates that the greenback’s advance-decline line has not yet fallen below its 200-day moving average, a condition that has historically been required to confirm the dollar’s cyclical bear market. Chart I-8EM Currencies: No Breakout Yet Chart I-9The US Dollar Is At A Critical Juncture We view these exchange rate patterns as a litmus test to validate turning points in the global business cycle. Finally, the technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive (Chart I-10). These markets have rebounded but seem to be confronting a critical technical test. If they decisively break above these technical levels, it will be a sign that the EM bull market will be lasting and durable. Otherwise, caution is still warranted. Bottom Line: There is a good amount of complacency among global investors at a time when there are several market signals that are still challenging the view of enduring revival in China/EM growth. Corporate Profits Will Be The Arbiter Ultimately, economic growth and corporate profits will determine the direction of not only share prices but also EM sovereign and corporate credit spreads as well as their currencies. So far, the EM equity rebound of the past 12 months has been solely due to multiples expansion amid a deepening EM profit recession: Earnings per share in US dollar terms has been contracting by 10% from a year ago, and the rate of change has so far not turned around (Chart I-11). Chart I-10The KOSPI And Copper Are Facing A Resilience Test Chart I-11EM Equities: A Profitless Rally? Going forward, however, EM corporate profits growth is set to improve. Our indicator for semiconductor companies’ revenues is heralding a revival in semi sector profits (Chart I-12, top panel). The rate-of-change improvement in commodities prices is also foreshadowing potential amelioration in corporate earnings growth among energy producers and materials (Chart I-12, middle and bottom panels). Chart I-12EPS Growth In EM Technology, Energy And Materials We are negative on EM bank profits due to their need to recognize and provision for non-performing loans as well as the authorities’ mounting pressures on them to reduce lending rates. The latter will shrink banks’ elevated net interest rate margins. The profit profile of other EM equity sectors is illustrated in Chart I-13A and I-13B. Chart I-13AEM EPS Growth By Sectors Chart I-13BEM EPS Growth By Sectors Provided technology, materials and energy stocks account for 33% of the MSCI EM aggregate equity index’s earnings (banks account for another 28% of total profits), it is safe to assume that the growth rate of EM EPS will move from -10% currently to zero or mildly positive territory by mid-2020. Nevertheless, beyond the next several months, our leading indicators on the EM profit outlook are not positive. China’s narrow money growth leads EM EPS by 12 months, and currently suggests the EPS recovery will be both muted and short-lived (Chart I-14). The technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive. Further, China’s broad money impulse points to a peak in the credit impulse in the first half of the year (Chart I-15). Given that EM share prices bottomed a year ago, simultaneously with China’s credit impulse, odds are that EM equities could slump with a rollover in the latter. Chart I-14EM EPS: Marginal Improvement Ahead But No Robust Recovery Chart I-15China: A Signpost Of A Potential Top In The Credit Impulse Chart I-16DM Central Banks' Assets And EM Stocks And Currencies: No Stable Correlation What if the current liquidity-driven rally continues? In our report last week titled A Primer On Liquidity, we elaborated at great length about the different liquidity measures and how they influence financial asset prices. Empirically, changes in DM central banks’ balance sheets have had no stable correlation with either EM share prices or EM local currency bonds, as demonstrated in Chart I-16. There have been periods over the past 10 years when EM risk assets and currencies have performed poorly, despite an accelerating pace of QE programs worldwide (Chart I-16). The true and critical driver for EM equity and currency performance has been EM’s own domestic fundamentals and China’s business cycle (please refer to Chart I-11 on page 7). To be sure, we are not suggesting that DM central bank policies have not affected global and EM financial markets at all. They have done so in spades. By purchasing and withdrawing about $9 trillion in high-quality securities from the marketplace, the monetary authorities have shrunk the stock of available financial assets. Consequently, even though QE programs have expanded broad money supply only modestly,2 the upshot has been that more money has been chasing fewer financial assets. Also, low interest rates reduce the opportunity cost of owning risk assets. These two phenomena have led investors to bid up prices of various securities, including EM ones. Nevertheless, despite the ongoing and indiscriminate global search for yield, EM share prices in US dollar terms and EM ex-China currencies (including carry, i.e. on a total-return basis) are still below their 2010 levels. Such poor performance of EM risk assets has been a corollary of just how bad EM fundamentals have been. Bottom Line: EM corporate profits will improve on a rate-of-change basis in the coming months. However, forward-looking indicators do not yet point to a robust recovery in EM corporate profits as occurred in 2017. Investment Conclusions We are maintaining our long EM equities position with a stop point at 1050 for the MSCI EM stock index (7% below the current level). If EM share prices, credit markets and currencies outperform their DM peers during a correction/consolidation phase, we will upgrade EM allocations to overweight in global equity and credit portfolios. At the moment, EM is confronting a resilience test. Within the EM equity universe, our overweights are Russia, Korea, Thailand, Mexico, UAE, Pakistan and central Europe. Our recommended equity underweights include Indonesia, the Philippines, Hong Kong domestic stocks, South Africa, Turkey and Colombia. In sovereign credit and local bond markets, our overweights are Mexico, Russia, Thailand, Malaysia, Pakistan and Ukraine. In turn, South Africa, Turkey, Philippines and Indonesia warrant an underweight stance. Today we are upgrading Indian bonds from neutral to overweight (see page 17). In the currency space, we continue holding a short position versus the US dollar in the following basket of currencies: BRL, ZAR, CLP, COP, IDR, PHP and KRW. As always, the full list of our positions is presented at the end of report (please refer to pages 18-19 and on our website). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com India: Beware Of Private Banks And Consumer Perils Indian private banks and consumer staple stocks have been holding up the Indian equity market at a time when the rest of the bourse has been sluggish. Both sectors, however, are extremely expensive and thus tremendously sensitive to minor profit disappointments. Remarkably, private banks now trade at a price-to-earnings (P/E) ratio of 31 and price-to-book value (PBV) ratio of 4. Indian consumer staple stocks, on the other hand, trade at a P/E ratio of 41 (Chart II-1 and Chart II-2). Chart II-1Indian Private Bank Stocks Are Expensive Chart II-2Indian Consumer Staple Stocks Are Very Pricey Chart II-3A Credit Boom Among Indian Private Banks Given that private banks have been specializing in both mortgages and non-mortgage consumer lending, the call on both private bank and consumer staple stocks is contingent on consumer financial health. The loan book of private banks has expanded tremendously: since 2010 it has grown at a compounded annual growth rate (CAGR) of 20% and 14% in nominal and real (inflation-adjusted) terms, respectively (Chart II-3).3 In turn, the share of household loans is reasonably large at around 52% of private banks total loan book. Unfortunately, India’s consumer sector appears to be fragile at the moment. Employment and wage growth have downshifted – the Manpower employment index is at a 14-year low (Chart II-4). Consequently, household disposable income growth has decelerated to 9% in nominal terms (Chart II-5). Critically, households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs, i.e., bank lending rates (Chart II-5). This development is precarious not only because it makes it more difficult for consumers to service their debt – causing NPLs to rise – but it also dampens consumer credit demand. Consequently, private banks’ considerable exposure to consumers could reverse the fortunes of the former as consumers face increasing difficulties servicing their debt. Moreover, with borrowing costs above nominal income growth, banks in India could face adverse selection problem. The latter is a phenomenon when loan demand primarily comes from riskier borrowers who are in desperate need for funding. In such a case, non-performing loans are bound to mushroom. Chart II-4India's Labor Market Is In Doldrums Chart II-5India: Household Nominal Income And Lending Rate Overall, household spending is in the doldrums. Two- and three-wheeler and passenger car unit sales have all been contracting. In the meantime, consumer demand for non-durable goods has also weakened, as reflected by stalling non-durable consumer goods production. Residential property demand has plummeted. According to the Reserve Bank of India’s December Financial Stability Report – quoting data from PropTiger DataLabs – housing sales units contracted by 20% in September from a year ago. In turn, growth in house prices has been anemic (Chart II-6). Prices are now growing below core inflation, i.e. property prices are deflating in real terms. Households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs. Going forward, odds are that employment and wage growth will remain weak in India. The basis is the corporate sector is also struggling and still reluctant to invest and hire. Chart II-7 illustrates that the number of investment projects has collapsed, while capital goods production and capital goods imports are both shrinking (Chart II-7). Chart II-6India: Housing Market Is Feeble Chart II-7India: Companies Are Not Investing Overall, the entire Indian economy is suffering from high borrowing costs in real (adjusted for inflation) terms (Chart II-8, top panel). Chart II-8Lending Rates Have Not Declined Despite Monetary Easing Importantly, the monetary policy transmission mechanism has not been working effectively in India. Even though the central bank has cut its policy rate by 135 basis points in 2019, prime borrowing did not budge (Chart II-8, middle panel). Consequently, loan growth has decelerated sharply (Chart II-8, bottom panel). On the whole, for the economy to recover, it requires considerably lower borrowing costs or a substantial fiscal boost. Indian central and state fiscal aggregate budget deficit is already wide at 6% of GDP. With public debt-to-GDP ratio at 68%, there is some but not enormous room for boosting government expenditures drastically. This makes reducing commercial bank lending rates the most feasible mechanism to jump-start the economy. Consequently, the authorities will become more aggressive in forcing commercial banks to cut their lending rates. This seems to be taking place as in September 2019 the RBI asked Indian commercial banks to link lending rates on certain types of loans more closely to the central bank’s policy rate to ensure more effective monetary policy transmission. Yet doing so will squeeze down commercial banks’ net interest rate margins – which have widened – and will hit banks’ profits. Alternatively, if lending rates do not fall, non-performing loans (NPLs) will increase because only risky borrowers will be willing to borrow while existing debtors will struggle to service their debt at current elevated interest rates. This will also depress bank profits. These two negative scenarios are probably reflected in low valuations of public bank share prices, but they are not yet priced in among private banks stocks. Given the latter’s exuberant valuations, only a small drop in net interest rate margins or a small rise in NPLs, will be enough to drag their share prices lower. Investment Conclusions Chart II-9India Vs. EM Relative Equity Performance Is Often About Oil Travails of the Indian economy will persist for now. Much more policy support is required to turn the business cycle around. EM equity investors should keep a neutral allocation to Indian stocks within an EM equity portfolio. Indian share prices often outperform their EM peers when oil prices drop and lag when crude prices rally (Chart II-9). Given our negative view on oil prices,4 we are reluctant to downgrade this bourse to underweight. Private banks are susceptible to a drawdown as either their net interest rate margins will drop or they will face rising non-performing loans. Consumer staples stocks are expensive and, hence, are vulnerable to marginal profit disappointments. We are upgrading our allocation to Indian domestic bonds from neutral to overweight within an EM local bond portfolio. Consistently, we are closing our yield curve steepening trade in India. This position has produced a 30 basis points gain since July 2016. Low inflation, weak real growth, a struggling credit system and ineffective transmission of monetary easing argue for even lower interest rates in India. The surge in food prices should be viewed as a relative price shock, not inflation. Higher food prices will curb the spending power of consumers and weaken their expenditures on non-food items. In addition, core inflation remains very low. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 Please click on the link to access EM: Perception versus Reality report. 2 Commercial banks’ reserves at central banks do not constitute and are not a part of narrow or broad money supply. 3 The calculation is based on the annual reports of four large Indian private banks: HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and Axis Bank. 4 This is the Emerging Markets Strategy team’s view and it differs for BCA’s house view on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights The bank credit 6-month impulse is likely to drop sharply in Europe, drop modestly in the US, but remain positive in China. Hence, the momentum of first-half economic data is likely to be worse in Europe than in China – albeit the Wuhan coronavirus scare is an unknown risk to this view. Initiate long CNY/GBP on a 6-month horizon. Underweight banks and the cyclical-heavy Eurostoxx 50 versus other markets, again on a 6-month horizon. There will be a better time to enter these positions later in the year when 6-month impulses are improving. Long-term investors seeking value in Europe should focus on the main currencies and not on the main equity indexes. Fractal trade: long EUR/GBP. Europe And China Play A Role-Reversal In recent dispatches we have highlighted that the euro area bond yield 6-month impulse stands near +100 bps, posing the strongest headwind to growth for three years. To make matters worse, the impulse has flipped from a strong -100 bps tailwind last summer into the current strong headwind, equating to a marked deterioration in the weather. But in China, it is the opposite story. Last summer, the China bond yield 6-month impulse constituted a strong +80 bps headwind; today the headwind has disappeared. Indeed, it has morphed into a tailwind, albeit a very mild tailwind at just -10 bps. In this sense, Europe and China are now playing a role-reversal. The momentum of first-half economic data is likely to be worse in Europe than in China – albeit with the caveat that the Wuhan coronavirus scare is an unknown risk to this view (Chart of the Week). Chart of the WeekBond Yields In Europe And China Play A Role-Reversal For the sake of completeness, we should address the world’s other large economy, the United States. Just as in the euro area, the US bond yield 6-month impulse has flipped from a strong -100 bps tailwind last summer into a current headwind. But the headwind, at +50 bps, is not as strong as it is in the euro area (Chart I-2). Chart I-2Headwind Impulses In The Euro Area And The US, But Not In China The Four Impulse Framework For Short-Term Growth The bond yield 6-month impulse is the first component of our proprietary ‘four impulse framework’ for short-term growth. The bond yield 6-month impulse is important because it usually leads the framework’s second component, the bank credit 6-month impulse, by a few months. This relationship makes perfect sense as, at the margin, it is the price of credit that drives credit demand. Indeed, to the extent that monetary policy drives growth, this is the main mechanism by which it operates, albeit with a slight delay. The bond yield impulse usually leads the credit impulse. On this compelling theoretical and empirical evidence, the bank credit impulse is now likely to drop sharply in the euro area (Chart I-3), drop modestly in the US (Chart I-4), but remain positive in China (Chart I-5). Chart I-3The Credit 6-Month Impulse Is Likely To Drop Sharply In The Euro Area... Chart I-4...Drop Modestly In ##br##The US... Chart I-5...But Remain Positive In China But we must also consider the other two impulses in our four impulse framework. In the case of the euro area, the third important impulse is the oil price 6-month impulse. This is because the euro area relies on oil imports whose volumes tend to be price inelastic. Hence, when the oil price falls it subtracts from imports, thereby adding to net exports and growth – and vice-versa when the oil price rises. In the middle of 2019, the oil price impulse constituted a very strong headwind which helps to explain the midyear sharp slowdown in Germany. Subsequently, the headwind eased, even reversing into a modest tailwind which facilitated a recovery. But the tailwind is now fading (Chart I-6). Chart I-6A Fading Tailwind From The Oil Price 6-Month Impulse The fourth and final component of our four impulse framework is geopolitical risk. This is not an impulse in the strict mathematical sense, but it is the same broad idea applied to the flow of geopolitical tail-events, both negative and positive. Europe’s positive events came several months ago: first in early-August when Italy ousted the firebrand Matteo Salvini from government; then in early-October when the UK parliament legislated against a no-deal Halloween Brexit. The tailwind from these positive events has now likely faded. For China, a positive geopolitical event and potential mild tailwind has come more recently, with the signing of the phase one trade deal with the US. Against this, the Wuhan coronavirus scare is a new risk – though based on the latest information it is unlikely to impact a 6-month view. The tailwind from the oil price impulse is now fading. On the four impulse framework, the momentum of first-half economic data is likely to favour China over Europe. We have found that the best way of playing this is through the exchange rate (Chart I-7), though given recent moves our preferred expression is versus the pound rather than the euro. Hence, on a 6-month horizon, initiate long CNY/GBP. Chart I-7Play Relative Impulses Through Currencies More generally, can the mild tailwind in China counter the headwinds in the West? No. Despite the improvement in China, the aggregate global bond yield impulse still constitutes a +50 bps headwind, which is almost certain to weigh down the global credit impulse through the early months of 2020 (Chart I-8). Chart I-8The Global Credit 6-Month Impulse Will Weaken In Early 2020 Therefore, as discussed last week in Strong Headwind Warrants Caution In H1, we recommend an underweight stance to banks and to the cyclical-heavy Eurostoxx 50 versus other markets, again on a 6-month horizon. This is not to say that these positions cannot do better on a 12-month view, as per the BCA house view. But if so, any outperformance will be back-end loaded, and there will be a better time to enter these positions later in the year when 6-month impulses are improving. Where Is The Value In Europe? One of the most common questions we get is: are European equities cheaper than US equities? Usually, this question comes from our US clients who are aware that their own stock market is expensive and wish that Europe might be less so. Unfortunately, the wishful thinking won’t make it come true! Major stock market indexes comprise multinational companies with global footprints. For these multinationals, there is no such thing as a ‘European’ company or a ‘US’ company. They are simply global companies that could list their shares on any major stock market. Now ask yourself this: is it really plausible that such a multinational would be cheaper if its primary listing was in Frankfurt as opposed to New York? Of course not. The valuation depends on the industry and company specifics, but it is highly unlikely to depend on whether the company is listed in Frankfurt or New York. It is not European equities that are cheap, it is European currencies that are cheap. But then why do companies with dual listings in Europe and outside Europe trade at a valuation discount in their European listing? For example, Carnival Cruises trades around 8 percent dearer in New York than in London (Chart I-9); and BHP Billiton trades around 15 percent dearer in Sydney than in London (Chart I-10). The answer is that the London listing is quoted in pounds, the New York listing is quoted in US dollars, the Sydney listing is quoted in Australian dollars, but Carnival’s and BHP’s sales and profits are denominated in a mix of international currencies. Chart I-9Carnival Cruises Trades Dearer In New York Than In London Chart I-10BHP Trades Dearer In Sydney ##br##Than In London Hence, Carnival and BHP are trading dearer in New York and Sydney because the market is expecting their mixed currency earnings to appreciate more in US dollar and Australian dollar terms respectively than in pound terms. Put another way, the market is expecting the pound to appreciate structurally versus the major non-European currencies. Therein lies the important message. It is not European equities that are cheap, it is European currencies that are cheap. For those of you still in doubt, just visit the ECB website. The central bank’s own currency valuation indicator admits that the trade-weighted euro is 10 percent undervalued (Chart I-11). Chart I-11The ECB Admits That The Euro Is 10 Percent Undervalued Hence, investors seeking value in Europe should not focus on the main equity indexes. Instead, they should focus on the main currencies. That said, valuation based investing only works if you have a long enough time horizon, meaning at least two years. For shorter horizons, economic momentum and technical factors dominate. In this regard, the pound’s strong rally faces resistance once post-Brexit trade deal negotiations begin in earnest after January 31. As a tactical trade, go long EUR/GBP (see next section). Fractal Trading System* The Brexit deal unleashed a strong rally in the pound, but this is vulnerable to a countertrend setback once the trade deal negotiations begin in earnest. Accordingly, this week's recommendation is long EUR/GBP. Set a profit target at 2 percent with a symmetrical stop-loss. In other trades, long tin achieved its 5 percent profit target at which it was closed. The rolling 1-year win ratio stands at 62 percent. Chart I-12EUR/GBP When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Please note that next week’s US Bond Strategy Weekly Report will be replaced by a Special Report on Commercial Real Estate that was produced jointly with our US Investment Strategy team. That report will be published on Monday instead of Tuesday. Highlights Duration: Financial markets have taken the Fed’s dovish guidance on board, and the asset prices that are most sensitive to monetary policy are rallying strongly. If we follow the typical pattern, as was the case in 2015/16, accommodative policy will soon lead to a rebound in our preferred global growth indicators and higher bond yields. Keep portfolio duration low. Credit: The macro environment for corporate bonds remains attractive, but investors should favor high-yield bonds – particularly Caa-rated and energy debt – where spreads still have room to narrow. Yield Curve: Barbelled Treasury portfolios still make sense in the current macro environment. Specifically, we recommend that investors overweight a duration-matched 2-year/30-year barbell and underweight the 5-year bullet. Feature Bond yields have mostly trended sideways during the past few weeks, even as the S&P 500 surged. The result is that a wide gulf has opened up between the equity and bond markets (Chart 1). At times like this it becomes popular to ask whether the stock market or bond market is “right”. That is, are equities bound to sell off and re-converge with bonds? Or, will the stock market pull bond yields higher? We agree with our Global Investment Strategy team that the risk of a near-term equity sell-off is high.1 But we also think that both the equity and bond markets are responding rationally to an economic environment characterized by abundant central bank liquidity and global growth that has yet to convincingly rebound. Tech stocks are responsible for the bulk of the recent rally. To see why, we can take a look at the relative performance of different equity sectors. Technology stocks are responsible for the bulk of the recent rally, while defensive sectors have performed in-line with the benchmark index and cyclical sectors have lagged (Chart 2). This is consistent with an environment of depressed global growth and plentiful central bank liquidity. Chart 1Stocks Versus##br## Bonds Chart 2Cyclical (or Growth Sensitive) Sectors Have Lagged ... Many technology firms trade off the promise of large cash flows that will only be delivered in the distant future. In a sense, we can think of these stocks as long duration assets whose prices are very sensitive to the discount rate. The Fed’s highly accommodative interest rate guidance is the main reason for the tech sector’s outperformance. In contrast, cyclical equity sectors – like materials, industrials and energy – are less sensitive to Fed policy and more geared toward global economic growth. These sectors have lagged because global growth has yet to put in a decisive bottom. Like cyclical equity sectors, Treasury yields are also most sensitive to trends in global growth. In fact, the 10-year Treasury yield closely tracks the relative performance of cyclical versus defensive equity sectors (Chart 3). Commodity prices are also consistent with this picture (Chart 4). Gold has rallied sharply, something that often results from a shift toward more dovish monetary policy, while the growth-sensitive CRB Raw Industrials commodity index has only just begun to hook up. Historically, bond yields only rise when gains in the CRB index start to outpace gains in gold (Chart 4, bottom panel). Chart 3... Consistent With Bond Yields Chart 4The CRB/Gold Ratio But we can’t think of monetary policy and global growth as completely separate issues. They tend to follow each other in a pattern explained by our Fed Policy Loop (Chart 5). Applying the Loop to the current environment, we see that the Fed eased policy after growth weakened last year and financial markets are currently responding to this shift in monetary conditions. The most interest rate sensitive assets – e.g. tech stocks and gold – are rallying. This represents an easing of financial conditions that will eventually lead to a rebound in global growth indicators. It is only when those global growth indicators increase that US bond yields will rise. Chart 5The Fed Policy Loop On that note, we also see signs that the economy is transitioning from the ‘Asset Price Inflation’ section of the Loop to the ‘Stronger Economic Growth’ section. The US ISM Manufacturing PMI is currently downbeat at 47.2, but it should be at 50.8 according to a model based on regional Fed manufacturing surveys (Chart 6). Further, the ISM non-Manufacturing index is well above 50 and moving higher (Chart 6, panel 2). Finally, industrial production growth is nowhere near as weak as it was in 2016, even though the PMI is lower (Chart 6, bottom panel). Chart 6ISM Will Soon Trough Bottom Line: Financial markets have taken the Fed’s dovish guidance on board, and the asset prices that are most sensitive to monetary policy are rallying strongly. If we follow the typical pattern, as was the case in 2015/16, accommodative policy will soon lead to a rebound in our preferred global growth indicators and higher bond yields. Keep portfolio duration low. Stay Long Junk It’s still early, but corporate bonds have so far not joined in with this year’s equity rally. Year-to-date, the investment grade corporate bond index is only up 8 bps versus Treasuries (Chart 7). High-yield bonds have fared better. They have outperformed duration-matched Treasuries by 48 bps so far this year, and the segments of the junk market that were most beaten down in 2019 are leading the charge. Caa-rated junk bonds have outperformed Treasuries by 108 bps so far in 2020. The energy sector has also fared well since December, and is up a decent 43 bps versus Treasuries in January. Chart 7Corporate Bond Returns Chart 8Favor HY Over IG We see the divergence between investment grade and high-yield returns continuing during the next few months, due to large differences in valuation. The investment grade corporate index spread is well below our cyclical target, while the high-yield index spread still looks cheap (Chart 8).2 High-yield’s attractiveness is mostly due to Caa-rated securities which underperformed dramatically in 2019 even as junk bonds overall delivered solid returns (Chart 8, bottom panel). As we discussed in a recent report, the underperformance of Caa-rated debt was in large part due to weakness in the shale oil sector.3 The yield curve is no longer deeply inverted out to the 5-year maturity point. Bottom Line: Corporate bonds will deliver solid returns as the economy transitions from the ‘Asset Price Inflation’ stage to the ‘Stronger Economic Growth’ stage of our Fed Policy Loop. However, relative valuation dictates that returns will concentrated in high-yield, especially Caa-rated and energy debt. Finding The Best Spot On The Yield Curve We have been recommending that investors run barbelled Treasury portfolios for some time, favoring the long and short ends of the curve at the expense of the belly (5-year/7-year). However, the shape of the curve has changed a lot since the 2/10 slope briefly inverted last August. Specifically, the curve is no longer deeply inverted out to the 5-year maturity point (Chart 9A). In light of this shift, it is worth considering whether our recommended curve positioning still makes sense. First, we take a look at the 12-month rolling yield for each point on the Treasury curve (Chart 9B). The 12-month rolling yield equals each security’s coupon return plus rolldown return. It is essentially the return you would earn in each maturity if the yield curve stayed completely unchanged during the next 12 months. Despite recent curve shifts, we still see a significant pick-up in rolling yield beyond the 5-year maturity point, as was the case last August. Chart 9APar Coupon Yield Curve Chart 9B12-Month Rolling Yield Curve But yield pick-up is just one consideration. We also need to think about how the shape of the curve will change during the next 6-12 months. One way to do this is to look at a sample of recent data – we use the past six months – and calculate how sensitive each point on the Treasury curve has been to changes in our 12-month Fed Funds Discounter.4 That is, if the market moves to price-in fewer Fed rate cuts during the next 12 months, as we expect, how should we expect each point on the Treasury curve to respond? To answer this question, Chart 10 shows how sensitive weekly changes in each Treasury yield have been to changes in our Discounter during the past six months. Chart 10Risk & Reward Along The Treasury Curve The first thing we notice is that the 5-year yield is the most sensitive to changes in our Discounter and the 2-year yield is the least sensitive. The 20-year and 30-year yields are relatively insulated from changes in the Discounter, and offer the greatest rolling yields. The second and third panels of Chart 10 show how these sensitivities change if we consider increases and decreases in our Discounter differently. Here we see that maturities from 5-20 years have been similarly sensitive to increases in the Discounter during the past six months. Meanwhile, the 5-year yield has been most sensitive to declines in the Discounter. The 2-year yield is not sensitive at all to a rising Discounter, but is fairly exposed to a falling Discounter. In general, since we expect the Discounter to move up during the next 6-12 months, the 2-year note looks like the safest place to camp out. Meanwhile, the 30-year bond looks attractive in terms of its yield pick-up per unit of sensitivity. The 2-year yield is least sensitive to changes in our Fed Funds Discounter. Another approach we can take is to look at how different parts of the yield curve respond to “risk on” and “risk off” market environments. To do this, we classify months as “risk on” if both the stock-to-bond total return ratio rises and the high-yield index spread tightens. Conversely, we classify months as “risk off” if both the stock-to-bond total return ratio falls and the high-yield index spread widens. Chart 11A shows the cumulative changes in different yield curve slopes since 2010 during “risk on” months only. The chart shows that, recently, “risk on” financial market behavior has coincided with the yield curve steepening out to the 7-year/10-year part of the curve, and then flattening beyond the 10-year point. Similarly, Chart 11B shows that “risk off” months have recently coincided with yield curve flattening out to the 7-year/10-year part of the curve, and steepening beyond that. Chart 11ASlope Changes In "Risk On" Environments Chart 11BSlope Changes In "Risk Off" Environments In other words, if recent correlations hold, a “risk on” environment during the next few months would cause the 7-year and 10-year yields to rise the most, while the 2-year and 30-year yields would have less upside. Investment Conclusions We expect economic growth to strengthen during the next 6-12 months, leading to “risk on” financial market behavior and a rising Fed Funds Discounter. Based on this view and our analysis of rolling yields and curve sensitivities, we conclude that a barbelled Treasury portfolio still makes the most sense. We want to be overweight the 2-year note because it should have less upside in a “risk-on” environment, and overweight the 30-year bond to get some extra yield pick-up while taking less risk than in the 5-year, 7-year or 10-year notes. In general, we want to avoid the 5-year, 7-year and 10-year maturities. According to our yield curve models, all three of those maturities look expensive relative to a duration-matched 2/30 barbell (Chart 12).5 Chart 12Butterfly Spread Fair Value Models If we wanted to get even more precise, we could note that a duration-matched 2/30 barbell offers 5 bps of yield pick-up compared to the 5-year note, only 1 bp of yield pick-up relative to the 7-year note and about the same yield as the 10-year note. To split hairs, those extra few basis points give us a slight preference for being short the 5-year bullet compared to the 7-year and 10-year notes, though we would prefer to avoid all three. Bottom Line: Barbelled Treasury portfolios still make sense in the current macro environment. Specifically, we recommend that investors overweight a duration-matched 2-year/30-year barbell and underweight the 5-year bullet. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Time For A Breather”, dated January 10, 2020, available at gis.bcaresearch.com 2 For details on how we arrive at 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 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4 Our 12-month Fed Funds Discounter measures the 12-month change in the fed funds rate that is currently priced into the overnight index swap curve. 5 For details on our yield curve models please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights We continue to have a positive view on global equities over the next 12 months, but see heightened risks of a near-term correction. Despite dwindling spare capacity, government bond yields are still lower today than they were shortly after the financial crisis. Many investors argue that bond yields cannot rise much because asset values would plunge if yields rose sharply, while debt burdens would quickly become unsustainable. We disagree. We think there is greater scope for yields to rise than is widely believed. Investors should maintain below-benchmark duration in fixed-income portfolios, favoring inflation-linked over nominal bonds and positioning for steeper yield curves. Gold should also do well next year. As long as bond yields are rising in response to stronger growth, as will be the case for the next two years, equities will fare well. The stock market will buckle, however, once stagflation sets in around 2022. Stocks Need To Work Off Overbought Conditions Before Moving Higher Again In last week’s report, entitled “Time For A Breather,” we downgraded our tactical three-month view on global equities from overweight to neutral on the grounds that stocks had run up too hard, too fast. Net long positions in equity futures among asset managers and levered funds are now at levels that have historically preceded corrections (Chart 1). Chart 1Stocks Are At A Heightened Risk Of A Correction Chart 2Breadth Is Quite Narrow Chart 3The Equity Risk Premium Is Fairly High, Especially Outside The US The rally has been lopsided, characterized by very narrow breadth. The top five stocks in the S&P 500 (Apple, Microsoft, Alphabet, Amazon, and Facebook) now comprise 18% of market cap, a higher share than in the late 1999/early 2000s (Chart 2). As my colleague, Anastasios Avgeriou, has pointed out, Apple’s $30 billion one day market cap gain on January 9th was greater than the market cap of the median stock in the S&P 500 index. Despite our near-term concerns, we continue to maintain a positive 12-month view on global equities. Easier financial conditions, a turn in the global inventory cycle, modestly looser fiscal policy in the UK and euro area, and re-upped fiscal/credit stimulus in China should all support global growth this year. Faster growth, in turn, will lift corporate earnings. The equity risk premium also remains quite high, particularly outside the US (Chart 3). A Fragile Trade Truce A de-escalation in the trade war should provide a further tailwind to equities. The “phase one” agreement signed on Wednesday features a commitment by China to purchase an additional $200 billion in US goods and services over the next two years relative to 2017 levels. In return, the US will halve tariffs, to 7.5%, on the $120 billion tranche in Chinese imports and suspend any further tariff hikes. No firm schedule exists to begin “phase two” talks, and at this point, it is quite likely that no negotiations will take place until after the US presidential election. Nevertheless, the tail risk of an out-of-control trade war has receded for the time being, which is positive for stocks. Better Chinese Trade Data Adding to growing optimism over the global economy and diminished trade tensions, Chinese trade data surprised on the upside this week. Exports rose 7.6% in December, well above the consensus estimate of 2.9%. Imports surged 16.3%, easily surpassing the consensus estimate of 9.6%. While base effects explain some of the improvement, the overall tone of the trade data is consistent with the strengthening Chinese PMIs and improvement in industrial production and retail sales (Chart 4). Chart 4Chinese Trade Data Is Improving Chart 5Better News Out Of China Has Propelled The Yuan Higher Versus The US Dollar Better news out of China has pushed the yuan to the strongest level against the US dollar since last summer (Chart 5). The Chinese currency is the most important driver of other EM currencies. If the yuan continues to strengthen, as we expect, EM assets – particularly EM stocks and local-currency bonds – should do well this year. How High Can Bond Yields (Realistically) Go? Despite rising over the past few months, global government bond yields are lower today than they were shortly after the financial crisis ended (Chart 6). The decline in yields has occurred alongside dwindling spare capacity. In most countries, the unemployment rate today is below 2007/08 lows (Chart 7). Many investors argue that bond yields cannot rise much from current levels because asset values would plunge if yields rose sharply, while debt burdens would quickly become unsustainable. If such an unfortunate turn of events were to occur, central bankers would have to shelve any tightening plans, just as Jay Powell had to do in late 2018. Chart 6Bond Yields Are Lower Today Than They Were After The Great Recession Chart 7Unemployment Rates Are Below Their Pre-Recession Lows In Most Economies Convexity Fears One argument often heard these days is that asset prices have become hypersensitive to changes in interest rates. There is some basis for thinking this. As Box 1 explains, the relationship between asset returns and interest rates tends to be “convex,” meaning that any given change in interest rates will have a bigger effect on returns if rates are low to begin with, as they are today. The effect is particularly pronounced for long duration assets such as long-term bonds, equities, or real estate. Nevertheless, while the theoretical presence of convexity in asset returns is crystal clear, many commentators overstate its practical importance. As Chart 8 shows, the average maturity of government debt stands at seven years. At that level of maturity, the effects of convexity tend to be quite small.1 Chart 8Average Debt Maturity Is Below 10 Years In Most Countries Granted, the overall stock of debt has increased in relation to GDP. However, much of that additional debt has been absorbed by central banks, reducing the amount of government debt available for the private sector. What about equities? The ratio of stock market capitalization-to-GDP has risen to 59%, up from a low of 24% in 2009, and close to its 2000 highs (Chart 9). Does that mean that stocks will sink if yields rise from current levels? Not necessarily. Remember that the discount rate is not the only thing that affects the present value of a stream of income. The expected growth rate of that income also matters. In fact, in the standard dividend discount model, it is simply the difference between the discount rate and the growth rate of dividends that determines how much a stock is worth. If higher bond yields coincide with rising growth expectations, stock prices do not need to fall at all. Chart 9Equity Market Cap Is Approaching Previous Highs Chart 10 shows that the monthly correlation between equity returns and bond yields remains as high as ever. This suggests that favorable economic news, to the extent that it leads investors to revise up the expected growth rate for earnings, usually more than compensates for a rising discount rate (Chart 11). Chart 10Correlation Between Equity Returns And Bond Yields Remains High Chart 11Earnings Estimates Tend To Move In Sync With Swings In Bond Yields So why are so many investors worried that higher bond yields will undercut stocks? The answer has less to do with convexity and more to do with the fear that bond yields will reach a level that chokes off growth. The combination of a rising discount rate and a falling growth rate would be toxic for equities and other risk assets. Debt Worries Likewise, it is not so much that corporate bond investors are worried that rising yields will cause interest payments to swell. After all, interest costs are still quite low as a share of cash flows for most firms (Chart 12). Rather, the fear is that higher yields will imperil growth, causing those cash flows to evaporate. Government debt is also much less of a problem than often assumed, at least in countries that issue bonds in their own currencies. The standard rule for debt sustainability says that the debt-to-GDP ratio will always converge to a stable level if the interest rate is below the growth rate of the economy.2 This is easily the case in almost all economies today (Chart 13). Chart 12US Corporate Sector: Interest Payments Are Not A Worry Chart 13Bond Yield Minus GDP Growth: Please Mind The Gap The only places where central banks are severely constrained in raising rates are in economies such as Canada, Sweden, and Australia where debt-financed housing bubbles have formed (Chart 14). However, even in these countries, the quality of mortgage underwriting has generally been strong, implying that a banking crisis would likely be avoided. Chart 14Canada, Sweden, And Australia Stand Out As Having Very Frothy Housing Markets It’s Really About The Neutral Rate The discussion above suggests that the main constraint to higher bond yields is the economy itself. If bond yields rise enough, the interest rate-sensitive sectors of the economy will weaken, and a recession will ensue. As long as bond yields are rising in response to stronger growth, as will be the case for the next two years, equities will be fine. Unfortunately, no one knows where the neutral rate – the interest rate demarcating the boundary between expansionary and contractionary monetary policy – really lies. Chart 15Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Slower trend growth has probably reduced the neutral rate, as has the shift to a more “capital-lite” economy. On the flipside, other forces have probably raised the neutral rate over the past few years. A tighter labor market has increased workers’ share of national income (Chart 15). Since workers spend more of every dollar of income than companies, this has raised aggregate demand. Fiscal policy has also been loosened, while elevated asset prices have likely incentivized some spending that would otherwise not have taken place. Even though we do not know the exact value of the neutral rate, we do know that the unemployment rate has been falling in most countries for the past 10 years, a period during which bond yields were generally higher than today. This suggests that monetary policy remains in expansionary territory. True, global growth did slow in 2018, just as the Fed was raising rates. However, this probably had more to do with the natural ebb and flow of the global manufacturing cycle, exacerbated by the Chinese deleveraging campaign and the brewing trade war. If global growth recovers this year, as we expect, estimates of the neutral rate will rise. This will allow equity prices to increase even in an environment of modestly higher bond yields. Inflation Is Coming… Eventually While stronger economic growth will lift bond yields this year, the big move in yields will only come when inflation breaks out. Core inflation tends to track unit labor costs (Chart 16). Unit labor cost inflation has remained range-bound for most of the recovery in the United States, which explains the failure of inflation to take flight. Unit labor cost inflation has been even more moribund elsewhere. Chart 16Core Inflation Tends To Track Unit Labor Costs Chart 17Correlation Between Labor Market Slack And Wage Growth Remains Intact Looking out, barring a major surge in productivity, rising wage growth should lead to accelerating unit labor cost inflation, first in the US and then in the rest of the world, which will translate into higher price inflation. We doubt that such a price-wage spiral will erupt this year. If anything, US wage growth has leveled off recently, with the year-over-year change in average hourly earnings falling back below the 3% mark. Nevertheless, the long-term correlation between labor market slack and wage growth remains intact (Chart 17). As wage growth reaccelerates, unit labor cost inflation will drift higher, setting the stage for a period of rising price inflation. Investors should maintain below-benchmark duration in global fixed-income portfolios, favoring inflation-linked over nominal bonds and positioning for steeper yield curves. Gold should also do well next year. As long as bond yields are rising in response to stronger growth, as will be the case for the next two years, equities will be fine. The stock market will buckle, however, once stagflation sets in around 2022. Box 1 Asset Prices And Interest Rates: The Role Of Convexity Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Assuming semi-annual compounding, the price of a 10-year bond with a 5% coupon rate falls by 7.9% if the yield increases from 1% to 2%, which is only slightly higher than the 7.6% decline that would be incurred if the yield increases from 4% to 5%. 2One might add that if the interest rate is below the growth rate of the economy, a higher starting point for the debt stock will allow for more debt issuance without leading to a higher debt-to-GDP ratio. As we have shown before, the steady-state debt-to-GDP ratio can be expressed as p/(r-g), where r is the interest rate, g is trend GDP growth, and p is the primary (i.e., non-interest) budget balance. Thus, for example, if the government wanted to achieve a stable debt-to-GDP ratio of 50% and r-g is -2%, it would need to run a primary budget deficit of 0.5*0.02=1% of GDP. However, if the government targeted a stable debt-to-GDP ratio of 200%, it could run a primary budget deficit of 2*0.02=4% of GDP. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades