Financial Markets
Highlights OPEC 2.0 production discipline and the capital markets’ parsimony in re funding US shale-oil producers will restrain oil supply growth. Monetary and fiscal stimulus will revive EM demand. These fundamentals will push inventories lower, further backwardating forward curves. Base metals demand will pick up as EM income growth revives. Demand also will get a boost from the ceasefire in the Sino-US trade war. Gold will remain range-bound for most of next year: A weaker USD and rising inflation expectations are bullish, but rising bond yields and reduced trade tensions will be headwinds. Grain markets will drift, although dry conditions in Argentina and the trade-war ceasefire could provide short-term price support, along with a weaker USD. Risk to our view: Continued elevated global policy uncertainty would support a stronger USD and stymie central bank efforts to revive global growth in 2020. Feature Dear Client, We present our key views for 2020 in this issue of Commodity & Energy Strategy. This will be our last publication of 2019, and we would like to take the opportunity to thank you for your on-going interest in the commodity markets and in our publication. It has been our privilege to serve you. We wish you and your loved ones all the best of this beautiful Christmas season and a prosperous New Year in 2020! Robert Ryan Chief Commodity & Energy Strategist Going into 2020, policy uncertainty again will be a key driver of commodity demand, the Sino-US trade-war ceasefire and UK election results notwithstanding.1 As uncertainty has increased, demand for safe havens like the USD and gold have increased. The principal impact of this uncertainty shows up in FX markets. As uncertainty has increased, demand for safe havens like the USD and gold has increased. Indeed, the Fed’s Broad Trade-Weighted USD index for goods (TWIBG) has become highly correlated with the Global Economic Policy Uncertainty index (GEPU). The three-year rolling correlation between these indexes reached a record high in November 2019 (Chart of the Week).2 Individually, the record for the TWIBG was posted in September 2019, while the GEPU record was hit in August 2019. Chart of the WeekGlobal Economic Policy Uncertainty Highly Correlated With USD A strong USD affects commodity demand directly, because it slows income growth in EM economies – the engine-house of commodity demand. A stronger USD raises the local-currency cost of consuming commodities – an important driver of EM demand – and reduces the local-currency cost of producing commodities. So, at the margin, demand is pressured lower and supply growth is incentivized – together, these effects combine to push prices lower. Economic policy uncertainty likely will diminish in early 2020, following the Sino-US trade-war ceasefire, the decisive UK election results and continued central-bank signaling – particularly from the Fed – that rates policy will remain accommodative for the foreseeable future. That said, the ceasefire does not mark the end of the Sino-US trade war, and many issues – ongoing US-China tensions, US election uncertainty, global populism and nationalism, rising geopolitical tensions in the Persian Gulf, ad hoc monetary policy globally – still are to be resolved. Terra Incognita The GEPU index does not measure uncertainty per se, as uncertainty per se cannot be measured.3 The index picks up word usage connected with the word “uncertainty.” So, it is more the perception of uncertainty that is being reported by Economic Policy Uncertainty in its data. Nonetheless, this is a good way to measure such sentiment, as research from the St. Louis Fed found: “Increases in the economic uncertainty index tend to be associated with declines (or slower growth) in real GDP and in real business fixed investment.” In past three years, increased policy uncertainty also has been fueling demand for safe havens, chiefly the USD and gold. This is a highly unusual coincidence – i.e., a rising USD accompanied by a rising gold price. Typically, a weaker USD puts a bid under gold prices. Indeed, this relationship is one of the primary drivers of our gold model, which suggests the effect of the heightened policy uncertainty dominates the USD impact on gold prices in the current environment (Chart 2). Chart 2Gold Typically Rallies When the USD Weakens The flip-side of the deleterious effects of higher economic policy uncertainty is its resolution: Growing cash balances and a higher capacity to lever balance sheets of households, firms and investor accounts means there is a lot of dry powder available to recharge growth in the real and financial economies globally.4 Chart 3BCA's Grwowth Gauges Indicate Global Economy Rebounding Our commodity-driven economic activity gauges are picking up growth impulses, most likely in response to the global monetary stimulus that has been deployed this year (Chart 3). In addition, systemically important central banks have given no indication they are going to be reversing this stimulus. A meaningful reduction in uncertainty could turbo-charge global growth prospects. Below, we provide our key views for each of the commodity complexes we cover. Oil Outlook Energy: Overweight. The oil market is poised to move higher on the back of OPEC 2.0’s deepening of production cuts to 1.7mm b/d, mostly because of actions by the Kingdom of Saudi Arabia (KSA) to cut output deeper, to a total of close to 900k b/d vs. its October 2018 production levels.5 Combined with the loss of ~ 1.9mm b/d of production in Iran and Venezuela due to US sanctions, the supply side can be expected to tighten next year (Chart 4). The Vienna meeting – which ended December 6, 2019 – demonstrated commitment to OPEC 2.0’s production-restraint strategy, and we expect member states will deliver. At least they will reduce the incidence of free riding at KSA’s expense – there were subtle hints from the Saudis they will not tolerate such behavior. KSA’s threats in this regard are credible, given its follow-through in 1986 when they surged production and briefly drove WTI prices below $10/bbl to send a message to free riders in the OPEC cartel. The Saudis acted similarly during the 2014 – 2016 market share war. US shale-oil production growth will slow next year to 800k b/d y/y, vs. the 1.35mm b/d we expect for this year. US lower 48 crude production will increase to 10.7mm b/d in 2020, taking total US production to 13.1mm b/d, a ~ 850k b/d increase y/y. On the demand side, we lowered our expectation for 2019 growth to 1.0mm b/d, given the continued downgrades of historical consumption estimates this year from the EIA, IEA and OPEC. Nonetheless, we continue to expect 2020 growth of 1.4mm b/d, on the back of continued easing of global financial conditions, led by central-bank accommodation. Given our view, we remain long oil exposures in several ways. First, we remain long WTI futures outright going into 2020; this position is up 30% from January 3, 2019 when it was initiated. Second, we recommended getting long 2H20 vs. short 2H21 Brent futures, expecting crude oil forward curves to backwardate further as tighter supply and stronger demand force refiners to draw inventories harder next year (Chart 5). Chart 4Markets Will Tighten In 2020 Chart 5Oil Inventories Will Draw Harder In 2020 We expect Brent crude oil to average $67/bbl next year, given the fundamentals outlined above. We also expect a weaker dollar to be supportive of demand ex-US. WTI will trade at a $4/bbl discount to Brent next year, based on our modeling (Chart 6). Chart 6Brent, WTI Will Trade Higher We remain overweight energy, crude oil in particular, given our expectation markets will tighten on the supply side and demand growth, particularly in EM economies, will revive. Bottom Line: We remain overweight energy, crude oil in particular, given our expectation markets will tighten on the supply side and demand growth, particularly in EM economies, will revive. This expectation will be challenged by continued economic policy uncertainty. On the flip side, however, a meaningful resolution to this uncertainty could turbo-charge growth as real economic activity picks up and the USD weakens. Base Metals Outlook Base Metals: Neutral. We remain strategically neutral base metals going into 2020, but tactically bullish, carrying a long LMEX and iron-ore spread position into the new year.6 The behavior of base metals prices – used by economists as proxies for EM growth – is indicating industrial demand is picking up (Chart 7). This aligns well with our proprietary indicators of commodity demand and global industrial activity (Chart 8). Base metals prices are more sensitive to changes in global growth than other commodities. For this reason, we use these prices to confirm the signals coming from the proprietary models we use to gauge EM growth. Chart 7Base Metals Prices Signaling EM Growth Revival The so-called phase-one agreement to reduce tariffs in the Sino-US trade war will support global demand at the margin for base metals. This is a ceasefire in the trade war not a resolution, so we are not expecting a surge in demand. Chart 8BCA Proprietary Indicators Also Signaling Growth Revival That said, base metals – aluminum and copper, in particular – have a tailwind in the form of global monetary accommodation by central banks. This was undertaken to reverse the negative effect on global financial conditions brought about by the Fed’s rates normalization policy last year and China’s 2017-18 deleveraging campaign. In addition, our China strategists expect modest fiscal and monetary stimulus from Beijing, which also will be supportive of demand.7 Aluminium and copper comprise 75% of the LMEX index. These are primary industrial markets, in which China accounts for ~ 50% of global demand, and EM ex-China demand remains stout. Even with a trade war raging for most of 2019, the supply and demand of aluminum and copper – the largest components of the LMEX index – was diverging: Consumption outpaced production – a multi-year trend – which forced inventories to draw hard (Charts 9A and 9B). Chart 9AGlobal Aluminum Markets Getting Tighter … Chart 9B… As Are Copper Markets Bottom Line: Inventories in industrial-metals markets have been drawing hard for years – particularly in aluminum – as metals' demand remained above supply. Given this, we are long the LMEX index: Even a marginal growth pick-up could rally prices. Precious Metals Outlook Precious Metals: Neutral. Going into 2020, gold’s outlook could be volatile – especially in 1H20 – as the metal’s key drivers will send conflicting signals (Table 1). Table 1Fundamental And Technical Gold-Price Drivers Gold prices are holding up above $1,450/oz. Our latest fair-value estimate indicates gold will hover around $1,475/Oz over the short-term (Chart 10). We break next year’s gold forecast into two parts: Phase 1: Growth revival and uncertainty respite. These two factors are closely intertwined; the magnitude of global growth’s rebound is conditional on a reduction of global economic policy uncertainty. We expect this relief will come from a ceasefire in the US-China trade war. Combined, accelerating economic activity – mainly driven by EM economies – and falling uncertainty will push the US dollar lower.8 For gold prices, this phase will be characterized by two contrasting forces: A falling USD (bullish gold) vs. lower safe-haven demand and rising US interest rates (bearish gold). US rates will increase early next year as global uncertainty is reduced and bond markets price-out Fed rates cuts. The current unusually high correlation between gold and US rates implies gold will face selling pressures during this period (Chart 11). Nonetheless, we expect the Fed will stay on hold and not start raising rates next year, which will cap price risks to gold. Chart 10High USD Correlation Throws Off Fair-Value Model Gold Prices Will Rise 4Q20 Chart 11US Rates Could Hurt Gold Prices In 1H20 Phase 2: EM wealth effect and inflation rebound. As income growth accelerates, EM households will slowly accumulate jewelry, coins, and bars – of which China and India are the largest consumers. Demand pressure from these consumers will manifest itself in 2H20, adding to buoyant central-banks purchases of gold. The upside in bond yields will be limited by major central banks’ dovish stance until inflation is well-established above target. Closely monitoring the evolution of inflation will become increasingly important in 2020, given inflation pressures are building in the US and globally (Chart 12). A lower USD – supporting stronger commodity demand – will magnify global inflation trends (Chart 13). There is a very real risk inflation shoots up in 4Q20, keeping real rates low. This differs from our BCA House view, which does not see inflation pressures building until 2021. Chart 12Inflationary Pressures Are Building Up In The US And Globally Political uncertainty likely will return ahead of the 2020 US election. A resurgence in popular support for one of the progressive Democratic candidates – Elizabeth Warren or Bernie Sanders – could disrupt US stock markets. Gold would advance in such an environment. Chart 13No Inflation Without A Weaker USD Progressive populists would lead to domestic policy uncertainty and larger budget deficits, yet would not remove the threat of trade protectionism. We expect the Fed will stay on hold and not start raising rates next year, which will cap price risks to gold. Bottom Line: Gold prices will move sideways in 1H20 and will drift higher in 4Q20 supported by depressed real rates, a lower dollar, and US election uncertainty. Silver Market Chart 14Silver Prices Will Move Higher With Gold Prices Silver prices have traded closely with gold since the Global Financial Crisis (GFC), moreso than with industrial metals (Chart 14). Prior to the GFC, silver traded like a base metal, owing to the high growth rates in EM economies undergoing rapid industrialization. Post-GFC, the evolution of silver’s price more closely tracked gold prices, following the massive injections of money and credit by central banks globally. Thus, we expect it will continue to follow the evolution of gold prices outlined above. Nonetheless, industrial applications still represent ~ 50% of silver’s physical demand and its supply-demand balance is estimated to have been tight this year. Silver likely will outperform gold next year as global growth and industrial activity rebound. PGM Markets The palladium market will remain tight in 2020. According to Johnson Matthey, the 10-year-long supply deficit is expected to widen massively this year, when all’s said and done. Prices surpassed $1,900/oz in December, forcing inventory liquidation (Chart 15). We believe the platinum-to-palladium ratio is at a level that would incentivize substitution in the pollution-control technology in gasoline-powered engines, and supports higher platinum content in diesel catalyzers (Chart 16).9 Nonetheless, swapping palladium for platinum is complex and requires a redesign of the production process. A lot will depend on how much the added cost of the more expensive palladium affects new-car buyers’ demand.10 To date, there are no signs car makers have already – or are willing to – initiate this process on a significant scale. Chart 15Palladium Inventories Are Depleted A few factors need to align to incentivize substitution of palladium for platinum. The price ratio between the two metals should reach extreme levels; the price divergence should be expected to last for a prolonged period of time, and concerns over supply security of platinum should be low. Chart 16Relative Inventory levels Drive The Palladium To Platinum Price Ratio In today’s context, this last condition could slow substitution. South African platinum supply – which represents close to 73% of the world primary supply – is projected to fall by close to 3% next year. Automakers need stable platinum supplies as they increase their demand for the metal and with persistent power-supply issues in South Africa – exacerbated by recent flooding – this condition will be hard to meet. No market has been harder hit by the Sino-US trade war than grains and ags generally. Thus, palladium holds an advantage over platinum on that front. Its supply sources are more diversified, and with 15% comes from stable North American countries and 40% comes from Russia. We believe substitution will commence, but this is a gradual process and will only slowly affect the metals’ price ratio.11 For 2020, we expect palladium prices to continue increasing due to stricter pollution regulation in China, India, and Europe.12 Ag Outlook Chart 17Sino-US Trade War, USD Hammer Grain Prices Ags/Softs: Underweight. The final form of the ceasefire in the Sino-US trade war – i.e., the “phase one” deal between China and the US to roll back tariffs – has yet to show itself. Last Friday, US Trade Representative Robert Lighthizer stated China has agreed to buy $32 billion – over the next two years – of US ag products as part of a “phase one” deal. This news moved corn, wheat and beans prices up 6.3%, 3.2%, and 3.4% respectively as of Tuesday’s close. Another positive news for US farmers was an announcement from the USDA that the final $3.6 billion of the $14.5 billion budgeted for farm subsidies this year to offset the trade war impact on US farmers most likely would be made in the near future by the Trump administration.13 No market has been harder hit by the Sino-US trade war than grains and ags generally. Severe weather across much of the US Midwest should have produced a rally, as offshore demand competed for available supply, which likely would have been lower at the margin last year absent a trade war. Instead, corn, wheat and beans are going into 2020 pretty much at the same price levels they went into 2019. In addition to the deleterious effect of the US-China trade war, ag markets have been particularly hard hit by the strong USD, which makes exports from the US expensive relative to alternative suppliers – e.g., Argentina and Brazil, which are posing serious challenges to US farmers (Chart 17). Global inventories are, nonetheless, being whittled away, which is good news for farmers generally (Chart 18). And, this likely will continue in 2020, given the physical deficits expected this year (Chart 19). Chart 18GLOBAL GRAIN STOCKS BEING WHITTLED DOWN ... Chart 19... Physical Deficits Will Whittle Stocks Further Next Year Markets are still awaiting final details of the ceasefire in the Sino-US trade war. The deal is expected to be signed in the first week of January. 2020 could be the year the global ag markets come more into balance, with stocks-to-use levels falling and normal trade resuming. We are not inclined to take a view on this possibility and are therefore remaining underweight the ag complex. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 Our outlook last year was entitled 2019 Key Views: Policy-Induced Volatility Will Drive Markets. It was published December 13, 2018, and is available at ces.bcaresearch.com. This year’s outlook again reflects our House view, which was published in the Bank Credit Analyst on November 28, 2019, entitled OUTLOOK 2020: Heading Into The End Game. It was sent to all clients last month and is available at bca.bcaresearch.com. 2 Uncertainty is measured using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. GEPU is a monthly GDP-weighted index of newspaper headlines containing a list of words related to three categories – “economy,” “policy” and “uncertainty.” Newspapers from 20 countries representing almost 80% of global GDP (on an exchange rates-weighted basis) are scoured monthly to create the index. Please see Economic Policy Uncertainty for additional information. We use the Fed's USD broad trade-weighted index for goods (TWIBG) reported by the St. Louis Fed to track the USD. Please see the St. Louis Fed’s FRED website at Trade Weighted U.S. Dollar Index: Broad, Goods. 3In a June 2011 interview with the Minneapolis Fed, Ricardo Caballero, a professor of economics at MIT, provided a succinct description of risk and uncertainty, paraphrasing former US Defense Secretary under President George W. Bush Donald Rumsfeld: “(W)hen he talked about the difference between known unknowns and unknown unknowns. The former is risk; the latter is uncertainty. Risk has a more or less well-defined set of outcomes and probabilities associated with them. Uncertainty does not—things are much less clear.” Kevin L. Kliesen of the St. Louis Fed explores the link between rising uncertainty and slower economic growth in Uncertainty and the Economy (April 2013), observing, “If the business and financial community believes the near-term outlook is murkier than usual, then the pace of hiring and outlays for capital spending projects may be unnecessarily constrained, thereby slowing the overall pace of economic activity.” 4The Wall Street Journal reported investors have accumulated a $3.4 trillion cash position, a decade-high level; this is consistent with the risk aversion that can be expected when economic uncertainty is high. Please see Ready to Boost Stocks: Investors’ Multitrillion Cash Hoard, published by The Wall Street Journal November 5, 2019. 5 Accounting for Saudi Arabia's 400k b/d of additional voluntary cuts. 6 The LMEX no long trades on the LME, but we are using the index as a proxy for a position. In iron ore, we are long December 2020 65% Fe futures vs. short 62% Fe futures on the Singapore Exchange, expecting steelmakers will favor the high-grade material in the new mills they’ve brought on line. 7 Our China strategists expect “Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the domestic economy and exports to only modestly accelerate.” Please see 2020 Key Views: Four Themes For China In The Coming Year, published by BCA Research’s China Investment Strategy December 11, 2019. It is available at cis.bcareserach.com. 8 The US dollar is a countercyclical – i.e. it is inversely correlated with the global business cycle – due to the fact that the US economy is driven more by services than manufacturing. 9 Palladium is used mostly in pollution-abatement catalysts in gasoline-powered cars, while Platinum is favored in diesel-engine cars (along with a small amount of palladium). Catalysts production represents close to 80% and 45% of palladium's and platinum's total demand. 10 Considering there’s ~ 3.5g of palladium in a new car and palladium trades at ~ $1,900/oz, close to $240 is added to the cost of a new gasoline-powered car by using this metal in pollution-abatement technology. 11 Please see South African Mines Grind To Halt As Floods Deepen Power Crisis, published by reuters.com on December 10, 2019. 12 Stricter emissions standards in the car industry – mainly in China where China 6 emissions legislation is taking effect – are increasing the PGMs loadings in each car, supporting demand growth. 13 Please see China May Agree to Buy U.S. Ag Exports, But a Final Tranche of Cash to Farmers is Still Likely, published by agriculture.com’s Successful Farming news service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed
Dear Clients, In our final publication of the year, we bring you a recap of this past week’s significant events in Sino-US relations and the key messages from the Central Economic Work Conference. Accordingly, we are upgrading our tactical stance towards Chinese stocks from neutral to overweight. Our publishing schedule will resume on January 9, 2020 with our monthly Macro and Market Review. Our China Investment Strategy team wishes you a happy holiday season and a prosperous New Year! Best regards, Jing Sima, China Investment Strategist Highlights We are upgrading our tactical call on Chinese stocks from neutral to overweight. Recent developments in the Chinese investable equity market point to a risk-on sentiment. The fact the US and China have reached an agreement likely marks the beginning of a truce, which could potentially last through the US presidential election in November 2020. The CEWC statement from last week reinforces our view that China's leadership feels the urgency to stabilize the economy now outweighs the desire to continue financial deleveraging. Feature Signals from the Chinese investable equity market have titled in a bullish direction. This shift is accompanied by two modestly bullish developments: First, the annual China Economic Work Conference (CEWC) concluded on December 12 with support for a more reflationary stance for the coming year. Then, a day later, the US and Chinese officials confirmed they have agreed on a Phase One trade deal. The combination of these developments provides a sufficient basis to upgrade our tactical (0-3 month) stance on Chinese stocks from neutral to overweight (within a global equity portfolio), to be consistent with our bullish cyclical (6-12 month) stance. Equity Market Signals Have Become Bullish In our previous reports, we highlighted that the relative performance of some sectors in the Chinese investable equity market reflects China’s policy direction and financial market conditions, supporting our bullish/bearish calls on Chinese stocks. Recently, two of the three equity market telltale signs that we have been watching have turned favorable for a bullish view on Chinese stocks (Chart 1A and 1B): Chart 1ACountercyclical Sector Stock Performance Points To Improvement In Economic Activity Chart 1BThe Breakdown Of Defensive Stocks Suggests A Return Of Risk-On Sentiment Chart 1A (top panel) shows that the relative performance of investable utility stocks have broken down, signifying that market participants anticipate the slowdown in China’s economy will soon bottom. Investable healthcare stocks have not breached their 200-day trend, but are headed in that direction (Chart 1A, bottom panel). Key equity market signs have turned supportive for a bullish tactical call on Chinese stocks. Cyclical stocks are outperforming defensives in both China’s onshore and offshore markets, reflecting improved investor sentiment towards China’s economic outlook (Chart 1B). Bottom Line: Key equity market signs have turned supportive for a bullish call on Chinese stocks for the next 0 to 3 months. Phase One Trade Deal: Unimpressive But Pragmatic Adding to this bullish shift in equity market signals was the first of two positive fundamental improvements over the past week. The US and China reached agreement on a Phase One deal just a few days before the 15% tariff increase on $160 billion of Chinese export goods to the US was scheduled to come into effect. Reportedly, the two sides agreed to pause the 15% tariff scheduled for December 15 and lower the tariff on about $120 billion of Chinese imports to 7.5%. However, the 25% tariffs on the first $250 billion of Chinese imports will remain in place (Chart 2). Chart 2Tariff Rollbacks Unimpressive... Chart 3...But China's Promise To Buy American Goods Helps Trump Claim Victory In return, China agrees to, in the next two years, boost imports of American goods and services by a total of $200 billion from their levels in 2017 (Chart 3). While no specific number has been confirmed from the Chinese side, in a news conference, Chinese officials said that China “will expand imports of some agriculture products currently in urgent need, such as pork and poultry.” Given that both sides picked low hanging fruit in the Phase One deal, the tougher issues to be discussed in Phase Two could lead to a breakdown in negotiations, which potentially could unravel the Phase One tariff rollbacks. Nevertheless, the agreement serves an interim purpose for both President Trump and President Xi: it allows Trump to claim a short-term political victory on his trade negotiations with China, and gives Xi some breathing space to focus on domestic economic challenges. Bottom Line: While the Phase Two negotiations, when commencing, will be a risk to the Phase One trade deal, the current agreement likely marks the beginning of a truce, which could potentially last through the November’s presidential election in 2020. CEWC: Reinforcing Reflationary Bias For 2020 In addition to the trade deal, another bullish factor for stocks is the fact that Chinese policymakers will proactively fine-tune economic policy to mitigate the impact from the US tariffs that remain in effect and to ensure stable economic growth in the coming year. President Xi at last week’s Central Economic Work Conference (CEWC) urged that Chinese policymakers must “make contingency plans” to combat challenges from both domestic and external environment. At the three-day annual CEWC this year, Chinese central and local government officials set the direction and strategy of China’s economic policy for the coming year. The meeting also reveals the challenges Chinese policymakers are facing, and the areas they will likely mobilize monetary resources to tackle. Investors can therefore benefit from insights into both the direction and constraints of China’s near-term policy framework. We highlight four investment-relevant messages from this year’s CEWC: A Greater Emphasis On Growth Stability The tone from this year’s CEWC reflects an urgency to stabilize the economy and meet growth targets. The tone from this year’s CEWC reflects an urgency to stabilize the economy and meet growth targets. The statement from the meeting mentioned “stability” 31 times, compared with 22 in 2018.1 The statement also reiterated the importance of doubling GDP and per capita income by 2020. This suggests that a growth imperative remains the top priority and reinforces the leadership’s reflationary policy stance for next year. We previously projected that the Chinese government would allow a lower GDP growth target for 2020, between 5.5 and 6.0%. However, we think growth targets to be set at next March’s National People’s Congress (NPC) are more likely to be in a “reasonable range” (verbiage used in the CEWC statement) between 5.8 and 6.2%. As noted in our December 11 report,2 the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms. While China’s real GDP statistics are suspiciously smooth and largely invalid when it comes to equity market pricing, the deviation between market expectations and the actual GDP growth target range set at NPC can help investors gauge how much more (or less) ammunition Chinese policymakers are willing to deploy to support the economy in that year. China is falling short of its target to double real urban per capita income next year from 10 years ago (Chart 4). Nominal wage and salary per capita growth has experienced a sharp drop since the third quarter of 2018 and probably contributed to the subdued appetite for consumption (Chart 5). Chart 4Household Income: Rural Overshooting; Urban Falling Short Chart 5Wage Growth Only Started Stabilizing Recently To meet the target, urban per capita income will need to grow at an above-real GDP rate of 10% in 2020, almost doubling the growth in 2018 and 2019. Given the still weak domestic economic conditions, we are not optimistic that China will be able to double the growth rate of urban income per capita in 2020 from 2019. Additionally, income typically lags economic activity. Even if China’s economic slowdown bottoms in the first quarter of 2020, it is unlikely we will see significant improvement in income until a few quarters later. Therefore, we think policymakers will likely focus on overall economic and employment growth stability, and poverty reduction through improving rural income in 2020 (Chart 4, top panel). A Shift In Policy Priorities The new year marks the final year of the “Three Major Battles” against financial deleveraging, poverty elimination, and pollution. In this year’s CEWC statement, for the first time in three years, the order of the battles has been rearranged with financial deleveraging ranked behind poverty reduction and environment protection. The PBoC will stay on a mild rate-cutting cycle throughout next year. The shift in policy priorities suggests that the pressure to deleverage has greatly eased. Banks’ asset balance sheets will expand at a faster rate, while the pace of reduction in shadow banking will likely continue to moderate (Chart 6). The description of monetary policy stance was amended to “maintaining a flexible and appropriate monetary policy” from last year’s “appropriately loose or tight.” The change points to a more dovish tone, confirming our assessment that the PBoC will stay on a mild rate-cutting cycle to lower corporate funding costs throughout the next year3 (Chart 7). Chart 6In 2020, Expect Faster Bank Balance Sheet Expansion Chart 7The PBoC's Rate-Cutting Cycle Will Continue Next Year At this stage, we do not anticipate the Chinese policymakers will entirely abandon financial risk containment or significantly loosen financial regulations. Rather, we think the reduced pressure on deleveraging and lowering of funding costs will provide moderate support for the private sector, specifically small- and medium-sized enterprises. A slew of new policies announced before the CEWC, including an adjustment to some of the parameters in the Macro-Prudential Assessment (MPA) framework to encourage lending to the private sector,4 will help strengthen the impact of PBoC’s countercyclical measures. A Bigger Fiscal Push This year’s CEWC statement indicated policymakers will continue to fine-tune a proactive fiscal policy, but unlike last year, the meeting did not specify further cuts to taxes. The statement suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year. Chart 8Local Governments Have Borrowed More Than They Spent In 2019, infrastructure investment was subdued, despite increased quotas for local government special-purpose bond issuance. Our research shows that local government infrastructure expenditures in 2019 have consistently lagged behind their borrowing (Chart 8). The gap between local government infrastructure funding deficit and borrowing has only started flattening in the third quarter of this year. The delayed conversion from borrowing to spending means local governments have accumulated more spending power for 2020. In order to encourage local governments to speed up spending, the central government is also likely to further loosen up project restrictions. A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019.5 More robust fiscal stimulus will lead to an increase in the debt load of local governments, but Chinese policymakers are caught between a rock and a hard place and therefore must choose the least risky tools to stimulate the economy. In our view, local government bonds are still a better option over local government financing vehicles (LGFVs) or other illicit channels. Social Housing Gets Another Boost Surprisingly,6 last week’s CEWC statement again emphasized the importance of shantytown renovation (Chart 9). While this implies there would likely be a significant monetary boost to social housing in the coming year, the statement also indicated that policymakers would not want property prices to dramatically change in either direction. Even though local governments have been granted more flexibility to fine-tune their local housing policies, we think the possibility of a broad-based regulatory easing in the housing market remains low in 2020. Therefore, government subsidies in social housing in 2020 will unlikely to lead to another property market boom like that of 2016. Chart 9Social Housing Gets Another Fiscal Boost If the scale of the cyclical policy support in 2020 is still moderate, then we think the stimulus may delay, but not entirely derail China’s progress in structural rebalancing, particularly if the current financial regulations remain in place. The CEWC statement also mentioned deepening reforms of state-owned enterprises (SOEs), and a “three-year SOE reform executive plan”, which we will be closely monitoring in the coming year. Last year’s reference to “striving for stronger, better and larger state assets” was replaced this year by “accelerating the reform of SOEs and optimization of SOE resource allocation”, implying there will be a greater emphasis on the quality and efficiency of SOEs’ assets. These plans can potentially impact SOE profit margins and accelerate the pace of industry consolidation among SOEs. The statement also dedicated a lengthy and detailed segment to "promoting high-quality development", covering topics ranging from the reform of the agricultural supply side to accelerating the implementation of regional development strategies. Further details are expected after next March’s NPC in Beijing. At that time, we will have a Special Report to consider some of the strategic and regional planning initiatives discussed at the meeting and their market implications. Bottom Line: The past week’s CEWC reinforces our view, that the Chinese leadership’s urgency to stabilize the economy has shifted to overweigh the desire to continue financial deleveraging. Monetary policy will only moderately loose further, but fiscal stimulus may overshoot in the first half of 2020. Investment Conclusions We have been cyclically overweight Chinese stocks on the basis of a bottoming in the economy in the first quarter of 2020, and the likelihood of an eventual trade deal. Tactically however, we have been more cautious because of the potential for further near-term downside in the economic data, and the uncertainty surrounding the timing and nature of a trade deal. While the tariff reduction in the trade deal announced last week is somewhat disappointing, the combination of a trade agreement, bullish equity market signals, and the positive messages from last week’s CEWC warrant an upgrade to our tactical stance on Chinese stocks from neutral to overweight. As such, our cyclical and tactical calls are now both aligned in favor of Chinese stocks within a global equity portfolio. As a final point, we noted in last week's report that there are decent odds that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. In the new year, we look forward to providing an ongoing assessment of whether Chinese economic growth has more or less potential upside than we currently expect, along with the attendant investment implications of our analysis. Stay tuned! Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 http://www.gov.cn/xinwen/2019-12/12/content_5460670.htm http://www.xinhuanet.com/english/2019-12/12/c_138626531.htm 2 Please see China Investment Strategy Weekly Report "2020 Key Views: Four Themes For China In The Coming Year," dated December 11, 2019, available at cis.bcaresearch.com 3, 5 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 4 http://www.gov.cn/premier/2019-12/14/content_5461147.htm 6 In our last week’s China Investment Strategy 2020 Outlook report, we had projected less monetary support to this sector in 2020. Cyclical Investment Stance Equity Sector Recommendations
Highlights 2019 was a good year for our constraint-based method of political analysis. Trump was impeached, the trade war escalated, and China (modestly) stimulated – all as predicted. Nevertheless Trump caught us by surprise in Q2, with sanctions on Iran and tariffs on China. Our best trades were long defense stocks, gold, and Swiss bonds. Our worst trade was long rare earth miners. Feature Jean Buridan’s donkey starved to death because, faced with equal bundles of grain on both sides, it could not decide which to eat. So the legend goes. Investors face indecision all the time. This is especially the case when a geopolitical sea change is disrupting the global economy. Two or more political outcomes may seem equally plausible, heightening uncertainty. What is needed is a method for eliminating the options that require the farthest stretch. That’s what we offer in these pages, but we obviously make mistakes. The purpose of our annual report card is to identify our biggest hits and misses so we can hone our ability to combine fundamental macro and market analysis with the “art of the possible,” delivering better research and greater returns for clients. This is our last report for 2019. Next week we will publish a joint report with Anastasios Avgeriou of BCA Research’s US Equity Strategy. We will resume publication in early January. We wish all our clients a merry Christmas, happy holidays, and a happy new year! American Politics: Unsurprising Surprises Chart 1Our 2019 Forecast Held Up On the whole our 2019 forecast held up very well. We argued that the global growth divergence that began in 2018 would extend into 2019 with the Fed hiking rates, a lack of massive stimulus from China, and an escalation in the US-China trade war. The biggest miss was that the Fed actually cut rates three times – addressed at length in our BCA Research annual outlook. But the bulk of the geopolitical story panned out: the US dollar, US equities, and developed market equities all outperformed as we expected (Chart 1). Geopolitical risk in the Trump era is centered on Trump himself. Beginning in 2017, we argued that the Democrats would take the House of Representatives in the midterm elections and impeach the president. Congress would not be totally gridlocked: while we argued for a government shutdown in late 2018, we expected a large bipartisan budget agreement in late 2019 and always favored the passage of the USMCA trade deal. Still, Congress would encourage Trump to go abroad in pursuit of policy victories, increasing geopolitical risks. We also argued that, barring “smoking gun” evidence of high crimes, the Republican-held Senate would acquit Trump – assuming his popularity held up among Republican voters themselves (Chart 2). These views either transpired or remain on track. The implication is that Trump-related risk continues and yet that Trump’s policies are ultimately constrained by the guardrails of the election. The latter factor helped propel the equity rally in the second half of the year. We largely sat out that rally, however. We overestimated the chances that Senator Bernie Sanders would falter and Senator Elizabeth Warren would swallow his votes, challenging former Vice President Joe Biden for the leading position in the early Democratic Party primary. We expected a significant bout of equity volatility via fears of a sharp progressive-populist turn in US policy (Chart 3). Instead, Sanders staged a recovery, Warren fell back, Biden maintained his lead, and markets rallied on other news. Chart 2Trump Will Be Acquitted Chart 3Fears Of A Progressive Turn Did Not Derail The H2 Rally Warren could still recover and win the nomination next year. But the Democratic Primary was not a reason to remain neutral toward equities, as we did in September and October. China’s Tepid Stimulus In recent years China first over-tightened and then under-stimulated the economy – as we predicted. But we misread the credit surge in the first quarter as a sign that policymakers had given up on containing leverage. In total this year’s credit surge amounts to 3.4% of GDP, about 1.2% short of what we expected (based on half of the 9.2% surge in 2015-16) (Chart 4). China’s credit surge was about 1.2% short of what we expected, but the direction was correct. While the government maintained easy monetary policy as expected, its actions combined with negative sentiment to snuff out the resurgence in shadow banking by mid-year (Chart 5). Chart 4China's Credit Surge Was Underwhelming Still, China’s policy direction is clear – and fiscal policy is indeed carrying a greater load. The authorities are extremely unlikely to reverse course next year, so global activity should turn upward (Chart 6). Our “China Play Index” – iron ore prices, Swedish industrials, Brazilian stocks, and EM junk bonds, all in USD terms – has appreciated steadily (Chart 7). Chart 5China's Shadow Banking Remained Under Pressure Chart 6Global Activity Should Turn Upward In 2020 Chart 7Our 'China Play Index' Performed Well US-China: Underestimating Trump’s Risk Appetite We have held a pessimistic assessment of US-China relations since 2012. We rejected the trade truces agreed at the G20 summits in December 2018 and June 2019 as unsustainable. Our subjective probabilities of Trump achieving a bilateral trade agreement with China have never risen above 50%. Since September we have expected a ceasefire but not a full-fledged deal. Nevertheless we struggled with the timing of the trade war ups and downs (Chart 8). In particular we accepted China's new investment law as a sufficient concession and were surprised on May 5 when talks collapsed and Trump increased the tariffs. The lack of constraints on tariffs prevailed in 2019 but in 2020 the electoral constraint will prevail as long as Trump still has a chance of winning. Our worst trade recommendation of the year emerged from our correct view that the June G20 summit would lead to trade war escalation. We went long rare earth miners based outside of China. We expected China to follow through on threats to impose a rare earth embargo on the US in retaliation for sanctions against Chinese telecom giant Huawei. Not only did the US grant Huawei a reprieve, but China’s rare earth companies outperformed their overseas rivals. The trade went deeply into the red as global sentiment and growth fell (Chart 9). Only with global growth turning a corner have these high-beta stocks begun to turn around. Chart 8Expect A Ceasefire, Not A Full-Fledged Trade Agreement Chart 9Our Worst Call: Long Rare Earth Miners Chart 10North Korean Diplomacy Has Not Collapsed (Yet) Our sanguine view on North Korea was largely offside this year. Setbacks in US negotiations with North Korea have often preceded setbacks in US-China talks. This was the case with the failed Hanoi summit in February and the inconsequential summit at the demilitarized zone in June. This could also be the case in 2020, as Washington and Pyongyang are now on the verge of breaking off talks with the latter threatening a “Christmas surprise” such as a nuclear or missile test. It is not too late to return to talks. Beijing is the critical player and is still enforcing crippling sanctions on North Korea (Chart 10). Beijing would benefit if North Korea submitted to nuclear and missile controls while the US reduced its military presence on the peninsula. We view this year as a hiccup in North Korean diplomacy but if talks utterly collapse and military tensions break out then it would undermine our view on US-China talks, Trump’s reelection odds, and US Treasuries in 2020. Hong Kong, rather than Taiwan, became the site of the geopolitical “Black Swan” that we expected surrounding Xi Jinping’s aggressive approach to domestic dissent. We have never downplayed Hong Kong. The loss of faith in the governing arrangement with the mainland began with the Great Recession and shows no sign of abating (Chart 11). We shorted the Hang Seng after the protests began, but closed at the appropriate time (Chart 12). The problem is not resolved. Also, Taiwan can test its autonomy much farther than Hong Kong and we still expect Taiwan to become ground zero of Greater China political risk and the US-China conflict. Chart 11Hong Kong Discontent Is Structural Chart 12Our Hang Seng Short Is Done Chart 13Trump Needs A Trade Ceasefire Trump is unlikely to seek another trade war escalation given the negative impact it would have on sentiment and the economy (Chart 13). He could engage in another round of “fire and fury” saber-rattling against North Korea, as the economic impact is small, but he will prefer a diplomatic track. Taiwan, however, cannot be contained so easily if tempers flare. As we go to press it is not clear if Trump will hike the tariff on China on December 15. Some investors would point to his tendency to take aggressive action when the market gives him ammunition (Chart 14). We doubt he will, as this would be a policy mistake – possibly quickly reversed or possibly fatal for Trump. Trump’s electoral constraint is more powerful in 2020 than it was in 2019. Chart 14Trump Ceasefire Will Last As Long As Economy Is At Risk Chart 15Our 'Doomsday Basket' Captured Trump's First Three Years Our best tactical trade of the year stemmed from the geopolitical risk in Asia (and the Fed’s pause): we recommended a long gold position this summer that gained 16%. We also closed out our “Doomsday Basket” of gold and Swiss bonds, initiated in Trump’s first year, for a gain of 14% (Chart 15). Now that the market has digested Trump’s tactical retreat, we have reinitiated the gold trade as a long-term strategic hedge against both short-term geopolitical crises and the long-term theme of populism. Iran: Fool Me Once, Shame On You … This is the second year in a row that we are forced to explain our analysis of Iran – we were only half-right. Our long-held view is that grand strategy will push the US to pivot to Asia to counter China while scaling back its military activity in the Middle East. Two American administrations have confirmed this trend. That said, there is still a risk that President Trump will get entangled in Iran and that risk is growing. Global oil volatility – which spiked during the market share wars of 2014 – declined through the beginning of 2018, until the Trump administration took clearer steps toward a policy of “maximum pressure” on Iran. The constraints on Trump are obvious: the US economy is still affected by oil prices, which are set globally, and Iran can damage supply and push up prices. Therefore Trump should back down prior to the 2020 election. Yet Trump imposed sanctions, waivered on them, and then re-imposed them in May 2019 – catching us by surprise each time (Chart 16). Chart 16Trump Flip-Flopped On Iran Policy Chart 17Iran Tensions Backwardated Oil Markets This saga is not resolved – we are witnessing what could become a secular bull market in Iran tensions. True, a Democratic victory in 2020 could lead to an eventual restoration of the 2015 nuclear deal. True, the Trump administration could strike a deal with the Iranians (especially after reelection). But no, it cannot be assumed that the US will restore the historic 2015 détente with Iran. Within Iran the regime hardliners are likely to regain control in advance of the extremely uncertain succession from Supreme Leader Ali Khamenei and this will militate against reform and opening up. We went long Brent crude Q1 2020 futures relative to Q1 2021 to show that tensions were not resolved (Chart 17) – the attack on Saudi Arabia in September confirmed this view. And yet the oil price shock was fleeting as global supply was adequate and demand was weak. Our current long Brent spot trade is not only about Iran. Global growth is holding up and likely to rebound thanks to monetary stimulus and trade ceasefire, OPEC 2.0 has strong incentives to maintain production discipline (driven by both Saudi Arabian and Russian interests), and the Iranian conflict has led to instability in Iraq, as we expected. The UK: Not Dead In A Ditch British Prime Minister Boris Johnson proclaimed this year that he would "rather be dead in a ditch” than extend the deadline for the UK to leave the EU. The relevant constraint was that a disorderly “no deal” exit would have meant a recession, which we used as our visual illustration of why Johnson would not actually die in a ditch (Chart 18). The test was whether parliament could overcome its coordination problems when it reconvened in September, which it immediately did, prompting us to go long GBP-USD on September 6 (Chart 19). This trade was successful and we remain long GBP-JPY. Chart 18The Reason We Rejected Chart 19UK Parliament Voted Down No-Deal Brexit Populism faltered in Europe, as expected. As we go to press, the UK Christmas election is reported to have produced a whopping Conservative majority. This year Johnson mounted the most credible threat of a no-deal Brexit that we are ever likely to see and yet ultimately delayed Brexit. The Conservative victory will produce an orderly Brexit. The trade deal that needs to be negotiated next year will bring volatility but it does not have a firm deadline and is not harder to negotiate than Brexit itself. The UK has passed through the murkiest parts of Brexit uncertainty. Moreover, our high-conviction view that more dovish fiscal policy would be the end-result of the Brexit saga is now becoming consensus. Europe: Not The Crisis You Were Looking For The European Union was a geopolitical “red herring” in 2019 as we expected. Anti-establishment feeling remained contained. Italy remains the weakest link in the Euro Area, but the political “turmoil” of 2018-19 is the populist exception that mostly proves the rule: Europeans are not as a whole rebelling against the EU or the euro. On France, Italy, and Spain our views were fundamentally correct. Even in the European parliament, where anti-establishment players have a better chance of taking seats than in their home governments, the true Euroskeptics who want to exit the union only make up about 16% of the seats (Chart 20). This is up from 11% prior to the elections in May this year. Chart 20Euroskepticism Was Overstated Yet the European political establishment is losing precious time to prepare for the next wave of serious agitation, likely when a full-fledged recession comes. Chart 21Trump Did Not Pile Tariffs Onto Auto Sector Germany is experiencing a slow transition from the long reign of Angela Merkel, whose successor has plummeted in opinion polls. The shock of the global slowdown – particularly heavy in the auto sector (Chart 21) – hastened Germany’s succession crisis. Chart 22Overstated EU Political Risk, Understated Chinese Risk There is a silver lining: this shock is forcing the Germans to reckon with de-globalization. Attitudes across the country are shifting on the critical question of fiscal policy. Even the conservative Christian Democrats are loosening their belts in the face of the success of the Green Party and a simultaneous change in leadership among the Social Democrats to embrace bigger spending. The Trump administration refrained from piling car tariffs onto Europe amidst this slowdown in the automobile sector and overall economy. We expected this delay, as there is little support in the US for a trade war with Europe, contra China, and it is bad strategy to fight a two-front war. But if the US economy recovers robustly and Trump is emboldened by a China deal then this risk could reignite in future. With European political risk overstated, and Chinese mainland risk understated, we initiated a long European equities relative to Chinese equities trade (Chart 22), as recommended by our colleagues at BCA Research European Investment Strategy. And now we are initiating the strategic long EUR/USD recommendation that we flagged in September with a stop at 1.18. Japan: Shinzo Abe Has Peaked Japanese Prime Minister Shinzo Abe is still in power and still very popular, whether judged by the average prime minister in modern memory or his popular predecessor Junichiro Koizumi. But he is at his peak and 2019 did indeed mark the turning point – it is all downhill from here. First, he lost his historic double super-majority in the Diet by falling to a mere majority in the upper house (Chart 23). He is still capable of revising the constitution, but now it is now harder – and the high water mark of his legislative power has been registered. Chart 23Abe Lost His Double Super Majority Chart 24Consumption Tax Hike Shows Limits Of Abenomics Second, he proceeded with a consumption tax from 8% to 10% that predictably sent the economy into a tailspin given the global slowdown (Chart 24). We thought the tax hike would be delayed, but Abe opted to hike the tax and then pass a stimulus package to compensate. This decision further supports the view that Abe’s power will decline going forward. It is now incontrovertible that the Liberal Democrats are eschewing a radical plan of debt monetization in which they coordinate ultra-dovish fiscal policy with ultra-dovish monetary policy. “Abenomics” has not necessarily failed but it is a fully known quantity. Abe will next preside over the 2020 summer Olympics and prepare to step down as Liberal Democratic party leader in September 2021. It is conceivable he will stay longer, but the likeliest successors have been put into cabinet positions, including Shinjiro Koizumi, son of the aforementioned, whom we would not rule out as a future prime minister. Constitutional revision or a Russian peace deal could mark the high point of his premiership, but the peak macro consequences have been felt. Japan suffered a literal and figurative earthquake in 2011. Over the long run Tokyo will resort to more unorthodox economic policies and redouble its efforts at reflation. But not until the external environment demands it. This suggests that the JPY-USD is a good hedge against risks to the cyclically bullish House View in 2020 and supports an overweight stance on Japanese government bonds. Emerging Markets: Notable Mentions India: We were correct that Narendra Modi would be reelected as prime minister, but we did not expect that he would win a single-party majority for a second time (Chart 25). The risk is that this result leads to hubris – particularly in foreign policy and domestic social policy – rather than accelerating structural reform. But for now we remain optimistic about reform. Chart 25 East Asia: We are optimistic on Southeast Asia in the context of US-China competition. But we proved overly optimistic on Malaysia and Indonesia this year, while we missed a chance to close our long Thai equity trade when it would have been very profitable to do so. Turkey: Domestic political challenges to President Recep Tayyip Erdoğan have led to a doubling down on unorthodox monetary policy and profligate fiscal policy, as expected. Early in the year we advised clients that Erdoğan would delay deployment of the Russian S-400 air defense system in deference to the US but it quickly became clear that this was not the case. Thus we correctly anticipated the sharp drop in the lira over the autumn (Chart 26). The US-Turkey relationship continues to fray and additional American sanctions are likely. Russia: President Vladimir Putin focused on maintaining domestic stability amid tight fiscal and monetary policy in 2019. This solidified our positive relative view of Russian currency and equities (Chart 27). But it also highlighted longer-term political risks. We expect this trend to continue, but by the same token Russia is a potential “Black Swan” risk in 2020. Chart 26The Lira's Autumn Relapse Chart 27Russia's Eerie Quiet In 2019 Venezuela: Venezuela’s President Nicolas Maduro eked out another year of regime survival in 2019 despite our high-conviction view since 2017 that he would be finished. However, the economy is still collapsing and Russian and Chinese assistance is still limited (Chart 28). Before long the military will need to renovate the regime, even if our global growth and oil outlook for next year is positive for the regime on the margin. Chart 28Maduro Clung To Power Chart 29Our 2019 Winner: Global Defense Stocks Brazil: We were late to the Brazilian equity rally. While we have given the Jair Bolsonaro administration the benefit of the doubt, a halt to structural reforms in 2020 would prove us wrong. Our worst trade of the year was long rare earth miners, mentioned above. Our best trade was long global defense stocks (Chart 29), a structural theme stemming from the struggle of multiple powerful nations in the twenty-first century. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Jingnan Liu Research Associate jingnan@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com
Dear Client, In lieu of our regular report next week, I will be hosting a webcast on Wednesday, December 18th at 10:00 AM EST, where I will discuss the major investment themes and views I see playing out for 2020. This will be the last Global Investment Strategy report of 2019, with publication resuming early next year. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Overall Investment Strategy: Global growth should accelerate in 2020. Favor stocks over bonds. A more defensive stance will be appropriate starting in late 2021. Equities: Upgrade non-US equities to overweight at the expense of their US peers. Cyclical stocks, including financials, will outperform defensives. Fixed Income: Central banks will stay dovish, but bond yields will nevertheless rise modestly thanks to stronger global growth. Favor high-yield corporate credit over investment grade and sovereigns. Currencies: The US dollar will weaken in 2020 against EUR, GBP, CAD, AUD, and most EM currencies. The dollar will be flat against the yen and the Swiss franc. Commodities: Oil and industrial metals prices will move higher. Gold prices will be range-bound next year, but should rally in 2021 once inflation finally breaks out. GIS View Matrix I. Global Macro Outlook Stronger Global Growth Ahead We turned bullish on global equities last December after temporarily moving to the sidelines in the summer of 2018. Last month, we increased our procyclical bias by upgrading non-US stocks within our recommended equity allocation at the expense of their US peers. The decision to upgrade non-US equities stems from our expectation that global growth will strengthen in 2020. Global financial conditions have eased sharply this year, largely due to the dovish pivot by many central banks. Monetary policy affects the economy with a lag. This is one reason why the net number of central banks cutting rates has historically led global growth by about 6-to-9 months (Chart 1). Chart 1The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy In addition, there is mounting evidence that the global manufacturing cycle is bottoming out (Chart 2). The “official” Chinese PMI produced by the National Bureau of Statistics rose above 50 in November for the first time since May. The private sector Caixin manufacturing PMI has been improving for five consecutive months. The euro area manufacturing PMI increased over the prior month, led by gains in Germany and France. Chart 2A Fairly Regular Three-Year Manufacturing Cycle Chart 3The Auto Sector Is Showing Signs Of Life (I) The PMI data for the US has been mixed. The ISM manufacturing index weakened in November. In contrast, the Markit PMI rose to a seven-month high. Despite its shorter history, we tend to give the Markit PMI more credence. It is based on a larger sample of companies and has sector weights that closely match the actual composition of US output. As such, the Markit PMI is better correlated with hard data on manufacturing production, employment, and factory orders. The auto sector has been particularly hard hit during this manufacturing downturn. Fortunately, the industry is showing signs of life. The Markit euro area auto sector PMI has rebounded, with the new orders-to-inventory ratio moving back into positive territory for the first time since the autumn of 2018. US banks stopped tightening lending standards for auto loans in the third quarter. They are also reporting stronger demand for vehicle financing (Chart 3). In China, vehicle production and sales are improving on a rate-of-change basis (Chart 4). Both automobile ownership and vehicle sales in China are still a fraction of what they are in most other economies, suggesting further upside for sales (Chart 5). Chart 4The Auto Sector Is Showing Signs Of Life (II) Chart 5China: Structural Outlook For Autos Is Bright Trade War Uncertainty The trade war remains the biggest risk to our sanguine view on global growth. As we go to press, rumors are swirling that the US and China have reached a “Phase One” trade deal that would cancel the scheduled December 15th tariff hike and roll back as much as half of the existing tariffs. If this were to occur, it would be consistent with our expectation of a trade truce. Nevertheless, it is impossible to be certain about how things will unfold from here. The best we can do is think through the incentives that both sides face and assume they will act in their own self-interest. For President Trump, the key priority is to get re-elected next year. Trump generally gets poor grades from voters on most issues. The one exception is the economy. Rightly or wrongly, the majority of voters approve of his handling of the economy (Chart 6). An escalation of the trade war would hurt the US economy, especially in a number of Midwestern states that Trump needs to win to remain president (Chart 7). Chart 6Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 7Economic Health Of The US Midwest Matters For Trump A resurgence in the trade war would also hurt Trump’s credibility. The point of the tariffs was not simply to raise revenue; it was to get China to the negotiating table. As a self-described master negotiator, President Trump now has to produce a “great” deal for the American people. If he had finalized an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than face him after the election when he will no longer be constrained by re-election pressures. China would also like to avoid facing someone like Elizabeth Warren or Bernie Sanders, who may insist on including stringent environmental and human rights provisions in any trade deal. At least with Trump, the Chinese know that they are getting someone who is focused on commercial issues. Contrary to most media reports, there is a fair amount of overlap between what Trump wants and what the Chinese themselves would like to achieve. For example, as China has moved up the technological ladder, many Chinese companies have begun to complain about intellectual theft by their domestic rivals. Thus, strengthening intellectual property protection has become a priority for Chinese officials. Along the same vein, China aspires to transform the RMB into a reserve currency. A country cannot have a reserve currency unless it also has an open capital account. Hence, financial market liberalization must be part of China’s long-term reform strategy. These mutual interests between the US and China could provide the basis for a trade truce. The Changing Nature Of Chinese Stimulus Chart 8China: Credit Growth Is Only A Few Percentage Points Above Nominal GDP Growth If a détente in the trade war is reached, will this prompt China to go back to its deleveraging campaign? We do not think so. For one thing, there can be no assurance that a trade truce will last. Thus, China will want to maintain enough stimulus as an insurance policy. In addition, credit growth is currently running only a few percentage points above nominal GDP growth (Chart 8). With the ratio of credit-to-GDP barely rising, there is little need to bring credit growth down much from current levels. This does not mean that the Chinese authorities will allow credit growth to increase significantly further. Instead, the authorities will continue shifting the composition of credit growth from the riskier shadow banking sector to the safer formal banking sector, while increasingly leaning on fiscal policy to buttress growth. One of the developments that has gone largely unnoticed by investors this year is that China’s general government deficit has climbed from around 3% of GDP in mid-2018 to 6.5% of GDP at present (Chart 9). Some of this stimulus has been used to finance tax cuts for households. Some of it has also been used to finance infrastructure spending, which requires imports of raw materials and capital goods. As a result of this fiscal easing, the combined Chinese credit/fiscal impulse has risen to a two-year high. It leads global growth by about nine months (Chart 10). Chart 9China Has Been Stimulating, Fiscally Chart 10Chinese Stimulus Should Boost Global Growth Europe On The Upswing Chart 11Euro Area Growth: The Good, The Bad, And The Ugly Chart 12German Economy: Some Green Shoots The weakness in euro area growth this year has been concentrated in Germany and Italy. France and Spain have actually grown at a trend-like pace (Chart 11). Germany should benefit from stronger global growth and a recovery in automobile production next year. The recent rebound in the German PMI, as well as improvements in the expectations components of the IFO, ZEW, and Sentix surveys are all encouraging in this regard (Chart 12). Italy should also gain from an easing in financial conditions and receding political risks (Chart 13). The Italian 10-year government bond yield has fallen from a high of 3.69% in October 2018 to 1.23% at present. Chart 13Easing Financial Conditions And Less Political Uncertainty Will Help Italy Chart 14Euro Area Fiscal Thrust Fiscal policy across the euro area is also turning more stimulative. The fiscal thrust in the euro area rose to 0.4% of GDP this year mainly due to a somewhat larger budget deficit in France (Chart 14). The thrust should remain positive in 2020. Even in Germany, fiscal policy should loosen. Faster wage growth in Germany is eroding competitiveness relative to the rest of the euro area (Chart 15). That could force German policymakers to ratchet up fiscal stimulus in order to support demand. Already, the Social Democrats are responding to poor electoral performance by adopting a more proactive fiscal policy, hoping to stop the loss of votes to the big spending Greens. Chart 15Germany: Faster Wage Growth Eroding Competitiveness Relative To The Rest Of The Euro Area Chart 16Boris Johnson Won't Pursue A No-Deal Brexit The UK economy should start to recover next year as Brexit uncertainty fades and fiscal policy turns more stimulative. Exit polls suggest that the Conservatives will command a majority government following today's election. There is not enough appetite within the Conservative party for a no-deal Brexit (Chart 16). As such, today's victory will allow Prime Minister Boris Johnson to push his proposed deal through Parliament. It will also allow him to fulfill his pledge to pass a budget that boosts spending. Japan: Own Goal Japan has been hard hit by the global growth slowdown, given its close ties to its Asian neighbors, namely China. Add on a completely unnecessary consumption tax hike, and it is no wonder the economy has been faltering. Despite widespread weakness, there have been some very preliminary signs of improvement of late: The manufacturing PMI ticked up in November, while the services PMI rose back above 50. Consumer confidence also moved up to the highest level since June. Furthermore, Prime Minister Abe announced a multi-year fiscal package worth approximately 26 trillion yen. The headline number grossly overstates the size of the stimulus because it includes previously announced measures as well as items such as land acquisition costs that will not directly benefit GDP. Nevertheless, the package should still boost growth by about 0.5% next year, offsetting part of the drag from higher consumption taxes. US: Chugging Along Despite the slowdown in global growth, a stronger dollar, and the trade war, US real final demand is on track to grow by 2.5% this year (Chart 17). This is above the pace of potential GDP growth of 1.7%-to-2%. Chart 17Underlying US Growth Remains Above Trend The Fed’s 75 basis points of rate cuts has moved monetary policy even further into accommodative territory. Not surprisingly, residential housing – the most interest rate-sensitive part of the economy – has responded favorably (Chart 18). While the tailwind from lower mortgage rates will dissipate by next summer, we do not anticipate much weakness in the housing market. This is because the inventory levels and vacancy rates remain near record-low levels (Chart 19). The shortage of homes should buttress both construction and prices. Chart 18US Housing: On Solid Ground (I) Chart 19US Housing: On Solid Ground (II) Strong labor and housing markets will support consumer spending, which represents nearly 70% of the economy. Business capital spending should also benefit from lower rates, receding trade tensions, and rising wages which are making firms increasingly eager to automate. II. Financial Markets Global Asset Allocation We argued in the section above that global growth should rebound next year thanks to easier financial conditions, an upturn in the global manufacturing cycle, a detente in the trade war, and modest Chinese stimulus. Chart 20 shows that stocks usually outperform bonds when global growth is accelerating. This occurs partly because corporate earnings tend to rise when growth picks up. BCA’s US equity strategy team expects S&P 500 EPS to increase by 5% next year if global growth merely stabilizes. An acceleration in global growth would surely lead to even stronger earnings growth. On the flipside, investors also tend to price out rate cuts (or price in rate hikes) when growth is on the upswing, resulting in lower bond prices (Chart 21). Chart 20Stocks Usually Outperform Bonds When Global Growth Is Accelerating Chart 21Improving Global Growth Boosts Earnings Growth...And Expectations Of Rate Hikes Relative valuations also favor stocks over bonds. Despite the stock market rally this year, the MSCI All-Country World Index currently trades at a reasonable 15.8-times forward earnings. This is below the forward PE ratio of 16.7 reached in January 2018 and even below the forward PE ratio of 16.4 hit in May 2015. Analysts expect global EPS to increase by 10% next year, below the historic 12-month expectation of 15% (Chart 22). In contrast to most years when analyst forecasts prove to be wildly overoptimistic, the current EPS forecast is likely to be met. Chart 22Analyst Expectations Are Not Wildly Optimistic Chart 23Equity Risk Premium Remains Quite Elevated If one inverts the PE ratio, one can calculate an earnings yield for global equities of 6.3%. One can then calculate the implied equity risk premium (ERP) by subtracting the real long-term bond yield from the earnings yield. As Chart 23 illustrates, the ERP remains quite elevated by historic standards. Some observers might protest that the ERP is elevated mainly because bond yields are so low. If low bond yields are discounting very poor economic growth prospects, perhaps today’s PE ratio should be lower than it actually is? The problem with this argument is that growth prospects are not so bad. The IMF estimates that global growth will be slightly above its post-1980 average over the next five years (Chart 24). While trend growth is falling in both developed and emerging economies, the rising share of faster-growing emerging markets in global GDP is helping to prop up overall growth. Chart 24The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM Sector And Regional Equity Allocation US stocks have outperformed their overseas peers by 10% year-to-date and by 137% since 2008. About half of the outperformance of US equities since the Great Recession was due to faster sales-per-share growth, a third was due to stronger margin growth, and the rest was due to relative PE expansion (Chart 25). Chart 25Faster Sales Growth, Rising Margins, And Relative PE Expansion Helped Drive US Outperformance Over The Past Decade It is worth noting that the outperformance of US stocks is a fairly recent phenomenon. Between 1970 and 2008, European equity prices and EPS actually rose slightly faster than in the US (Chart 26). EM stocks also outperformed the US in the decade leading up to the Global Financial Crisis. Chart 26US Earnings Have Not Always Outpaced Their Peers We expect US stocks to rise in 2020 by about 5%-to-10%, but to lag their foreign peers in common-currency terms. There are four reasons for this: Sector skews favor non-US equities. Cyclical stocks tend to outperform defensives when global growth is strengthening and the US dollar is weakening (Chart 27). Cyclical sectors are overrepresented outside the US. We would include financials in our definition of cyclicals. Faster global growth next year will lift long-term bond yields. Since central banks are unlikely to raise rates, yield curves will steepen. Steeper yield curves will boost net interest margins, thus helping bank shares (Chart 28). European banks are more dependent on the spread between lending and borrowing rates than US banks, since the latter derive more of their profits from fees. Non-US stocks are quite a bit cheaper than their US peers. The forward PE for US equities currently stands at 18.1, well above the forward PE of 13.6 for non-US equities. Other valuation measures reveal an even bigger premium on US stocks (Chart 29). Differences in sector weights account for about a quarter of the valuation gap between the US and the rest of the world. The rest of the gap is due to cheaper valuations within sectors. Financials, for example, are notably less expensive in the rest of the world, particularly in Europe (Chart 30). The valuation gap between the US and the rest of the world is even starker if we compare earnings yields with bond yields. Since bond yields are lower outside the US, the implied equity risk premium is significantly higher for non-US stocks. Profit margins have less scope to rise in the US than in the rest of the world. According to MSCI data, net operating margins currently stand at 10.3% in the US compared to 7.9% abroad. Unlike in the US, margins in Europe and EM are still well below their pre-recession peaks (Chart 31). While US margins are unlikely to fall next year thanks to stronger global growth, rising wage growth will negatively impact profits in some labor-intensive industries. Labor slack is generally greater abroad, which should limit cost pressures. Uncertainty over the US election is likely to limit the gains to US equities. All of the Democratic frontrunners have pledged to roll back the 2017 Tax Cuts and Jobs Act to one degree or another. A full repeal of the Act would reduce S&P 500 EPS by about 10%. While such a dramatic move is far from guaranteed – for starters, it would require that the Democrats gain control of both the White House and the Senate – it does pose a risk to investors. The same goes for increased regulatory actions, which Senators Sanders and Warren have both vocally championed. Chart 27Cyclicals Do Well Versus Defensives When Global Growth Is Strengthening And The US Dollar Is Weakening Chart 28Steeper Yield Curves Help Financials Chart 29US Equities Are More Expensive Than Stocks Abroad Chart 30European Financials Trade At A Substantial Discount To Their US Peers Chart 31Profit Margins Have Less Scope To Rise In The US Than In The Rest Of The World Within the non-US universe, euro area stocks have the most upside potential. In contrast, we see less scope for Japanese stocks to outperform the global benchmark because of uncertainties over the impact of the consumption tax hike on domestic demand. In addition, a weaker trade-weighted yen next year will annul the currency translation gains that unhedged equity investors can expect to receive from other non-US stock markets. Lastly, the passage of a new investment law that requires investors wishing to “influence management” to receive prior government approval could cast a pall over recent efforts to improve corporate governance in Japan. Fixed Income Chart 32Inflation Excluding Shelter Has Been Muted Chart 33Long-Term Bond Yields Will Move Higher As Faster Growth Pushes Up Estimates Of The Neutral Rate Central banks will remain on the sidelines next year. Inflation is still running well below target in most economies. Even in the US, where slack has largely been absorbed and wage growth has risen, core inflation excluding housing has averaged only 1.2% over the past five years (Chart 32). Nevertheless, long-term bond yields will still move higher next year as investors revise up their estimate of the neutral rate in response to faster growth (Chart 33). On a regional basis, BCA’s fixed-income experts favor low-beta bond markets (Chart 34). Japanese bonds have a very low beta to the overall Barclays Global Treasury index because inflation expectations are quite depressed and the Bank of Japan will actively intervene to prevent yields from rising. On a USD currency-hedged basis, the Japanese 10-year yield stands at a relatively decent 2.38%, above the yield of 1.79% on comparable maturity US Treasurys (Table 1). Chart 34Favor Lower-Beta Government Bond Markets In 2020 Table 1Bond Markets Across The Developed World In contrast to Japan, the beta of US Treasurys to the overall global bond index is relatively high, implying that Treasurys will underperform other sovereign bond markets in a rising yield environment. The beta for Germany, UK, Australia, and Canada lie somewhere between Japan and the US. Consistent with our bullish view on global equities, we expect corporate bonds to outperform sovereign debt in 2020 (Chart 35). Despite the weakness in manufacturing, US banks further eased terms on commercial and industrial loans in Q3, according to the Fed’s Senior Loan Officer Survey. Chart 35Stronger Growth Causes Corporate Spreads To Tighten At the US economy-wide level, neither interest coverage nor debt-to-asset ratios are particularly stretched (Chart 36). Admittedly, the picture looks less flattering if we focus solely on high-yield issuers (Chart 37). That said, a wave of defaults is very unlikely to occur in 2020, so long as the Fed is on hold and economic growth is on the upswing. Chart 36Corporate Debt: A Benign Top-Down View Chart 37Corporate Debt: More Concerning Picture Among High-Yield Issuers Chart 38US Corporates: Focus On High-Yield Credit Moreover, despite narrowing this year, high-yield spreads still remain above our fixed-income team’s estimate of fair value (Chart 38). They recommend moving down the credit curve and increasing the weight in Caa-rated bonds. These have underperformed this year largely because of technical factors such as their large exposure to the energy sector and relatively short duration. As oil prices rise next year, energy sector issuers will feel some relief. Moreover, unlike this year, rising long-term government bond yields in 2020 should also make shorter-duration credit more attractive. In contrast to high-yield spreads, investment-grade spreads have gotten quite tight. Investors seeking high-quality bond exposure should shift towards Agency MBS, which still carry an attractive spread relative to Aa- and A-rated corporate bonds. European IG bonds should also outperform their US peers thanks to faster growth in Europe next year and ongoing support from the ECB’s asset purchase program. Looking beyond the next 12-to-18 months, there is a strong chance that inflation will increase materially from current levels. The unemployment rate across the G7 has fallen to a multi-decade low, while the share of developed economies reaching full employment has hit a new cycle high (Chart 39). Chart 39ADeveloped Markets: Unemployment Rates Keep Trending Lower... And Full Employment Reaching New Cycle Highs Chart 39BDeveloped Markets: Unemployment Rates Keep Trending Lower... And Full Employment Reaching New Cycle Highs Chart 40The Phillips Curve Is Alive And Well For all the talk about how the Phillips curve is dead, wage growth remains well correlated with labor market slack (Chart 40). Rising wages will boost real disposable incomes, leading to more spending. If economies cannot increase supply to meet higher demand, prices will rise. It simply does not make sense to argue that the price of apples will increase if the demand for apples exceeds the supply of apples, but that overall prices will not increase if the demand for all goods and services exceeds the supply of all goods and services. It will take at least until mid-2021 for inflation to rise above the Fed’s comfort zone. It will take even longer for rates to reach restrictive territory, and longer still for tighter monetary policy to make its way through the economy. However, at some point in 2022, the interest-rate sensitive sectors of the US economy will buckle, setting off a global economic downturn and a deep bear market in equities and credit. Enjoy it while it lasts. Currencies And Commodities The US dollar is a countercyclical currency, meaning that it usually moves in the opposite direction of the global business cycle (Chart 41). This countercyclicality stems from the fact that the US, with its large service sector and relatively small manufacturing base, is a “low beta economy.” Strong global growth does help the US, but it benefits the rest of the world even more. Thus, capital tends to flow out of the US when global growth strengthens, which puts downward pressure on the dollar. As global growth picks up in 2020, the dollar will weaken. EUR/USD should increase to around 1.15 by end-2020. GBP/USD will rise to 1.40. USD/CNY will move to 6.8. The Australian and Canadian dollars, along with most EM currencies, will strengthen as well. However, the Japanese yen and Swiss franc are likely to be flat-to-down against the dollar, reflecting the defensive nature of both currencies. Today's rally in the pound has raised the return on our short EUR/GBP trade to 10.5%. For now, we would stick with this position. Chart 42 shows that the pound should be trading near 1.30 against the euro based on real interest rate differentials, which is still well above the current level of 1.20. Chart 41The Dollar Is A Countercyclical Currency Chart 42Interest Rate Differentials Suggest More Upside For The Pound The trade-weighted dollar will continue to depreciate until late-2021, and then begin to strengthen again as the Fed turns more hawkish and global growth starts to falter. Commodity prices tend to closely track the global growth/dollar cycle (Chart 43). Industrial metal prices will fare well next year. Oil prices will also move up. Globally, the last of the big projects sanctioned prior to the oil-price collapse in late 2014 are coming online in Norway, Brazil, Guyana, and the US Gulf. Our commodity strategists expect incremental oil supply growth to slow in 2020, just as demand reaccelerates. Gold is likely to be range-bound for most of next year reflecting the crosswinds from a weaker dollar on the one hand (bullish for bullion), and receding trade war risks and rising bond yields on the other hand. Gold will have its day in the sun starting in 2021 when inflation finally breaks out. Our key market charts are shown on the following page. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 43Dollar Weakness Is A Boon For Commodities Key Financial Market Forecasts MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights An analysis on Thailand is available below. In all scenarios of global market performance, EM will underperform DM in the first half of 2020. Absolute return investors should be mindful of downside risks in EM financial markets. The principal drivers for EM corporate profits are domestic demand in both China and EM ex-China. US and European demand are not particularly relevant. We do not expect a recovery in domestic demand in China and the rest of EM in the early months of 2020. EM corporate profit growth is unlikely to turn positive in H1 2020. Volatility Is A Coiled Spring Chart I-1EM Stocks And Profits: An Unsustainable Divergence EM share prices and currencies have been range-bound in 2019, despite the strong rally in DM share prices. On one hand, growing hopes of a US-China trade deal, global monetary easing and expectations of a global growth recovery have put a floor under EM (Chart I-1, top panel). On the other hand, a lack of actual growth recovery in EM/China, a deepening contraction in EM corporate profits and lingering structural malaises in many EM economies have capped upside potential (Chart I-1, bottom panel). Consistent with this sideways market action, implied volatility measures for EM equities and currencies have dropped to record lows (Chart I-2, top and middle panels). Similarly, implied volatility measures for commodities currencies – which tend to be strongly correlated with EM risk assets – have plummeted close to their historic lows (Chart I-2, bottom panel). Remarkably, DM currency markets’ implied volatility has also collapsed to the all-time lows recorded in 2007 and 2014 (Chart I-3, top panel). Chart I-2EM Vol Is A Coiled Spring Chart I-3DM Currency Vol Is At Record Low Nevertheless, past performance does not guarantee future performance. The fact that global financial market volatility has been very low over the past 12 months does not imply that it will remain subdued going forward. On the contrary, when DM currency volatility was this low in 2007 and 2014, it was followed by a bear market in EM risk assets (Chart I-3, bottom panel). Both EM and DM market volatility resemble a coiled spring. As such, it is quite likely these coiled springs will snap sometime in the first half of 2020. If this is indeed the case, it will be accompanied by a selloff in EM risk assets. We devote this report to discussing the reasons why such dynamics are likely to play out. An urge on the part of investors to deploy capital in EM has supported EM financial markets despite shrinking corporate profits. Hence, investment portfolios should be positioned for a resurgence in financial market volatility in general and currency volatility in particular in H1 2020. As we argued in our November 14 report, the US dollar is still enjoying tailwinds, especially versus EM and commodities currencies. All in all, asset allocators should continue to underweight EM stocks, credit markets and currencies relative to their DM counterparts. In all scenarios of global market performance, EM will underperform DM in the first half of 2020. Absolute return investors should be mindful of downside risks in EM financial markets. As always, the list of our recommended country allocations across EM equities, currencies, credit markets and domestic bonds is presented in the tables at the end of our report – please refer to pages 18-19. An Urge To Deploy Capital Amid Poor EM Fundamentals Investors’ unrelenting urge to deploy capital in EM financial markets put a floor under EM equities and currencies in 2019. Yet poor fundamentals have prevented EM equities and currencies from rallying. Such a battle between two opposing forces has produced a stalemate in EM financial markets. The same is true for commodities and many global market segments sensitive to global growth. Chart I-4Global Industrials: A Rally Without Profit Amelioration This stalemate is unlikely to last forever. Next year will likely be a year of either an EM breakout or breakdown. EM corporate earnings hold the key, and China’s domestic demand is of paramount importance to the EM profit cycle. We discuss our outlook for both the China and EM business cycles below. Following are the reasons why we believe market expectations of a rebound in global growth are too optimistic, and that EM risk assets are at risk: First, there is a widening gap between share prices and corporate profits. Not only are EM per-share earnings shrinking at a double-digit rate, as shown in Chart I-1 on page 1, but also EM EPS net revisions have not yet turned positive. This widening gap between share prices and net EPS revisions is also striking for global industrials (Chart I-4). If corporate profits stage an imminent recovery, stocks will continue to advance. Alternatively, investor expectations will not be met, and a selloff will ensue. As the top panel of Chart I-5 illustrates, the annual growth rate of EM EPS will at best begin bottoming – from double-digit contraction territory – only in the second quarter of 2020. Odds are that investor patience might run out before that occurs and EM markets will sell off in such a scenario. Second, improvement in US and European growth is not in and of itself a sufficient reason to be positive on EM/China growth. In fact, neither US nor euro area consumer spending have been weak (Chart I-5, middle and bottom panels). Yet, EM growth and corporate profits have plunged. Hence, EM growth is by and large not contingent on consumer spending in the US and Europe. As we have repeatedly argued, EM profit growth and risk assets are driven by China/EM domestic demand, rather than by US or European growth cycles. Third, EM financial markets are not cheap. Our composite valuation indicators based on 20% trimmed-mean and equal-weighted multiples indicate that stocks are trading close to their fair value (Chart I-6). These indicators are composed based on the trailing and forward P/E ratios, price-cash earnings, price-to-book value and price-to-dividend ratios for 50 EM equity subsectors. Chart I-5EM Profits Are Driven By China Not US Or Europe Chart I-6EM Equities Are Fairly Valued When valuations are neutral, stock prices can rise or drop depending on the outlook for corporate profits. Provided we believe EM corporate profits will continue to contract for now, risks to share prices are skewed to the downside. Finally, several markets are still conveying a cautious message regarding EM assets. Specifically: There are cracks forming in EM credit markets. EM sovereign credit spreads are widening. Remarkably, emerging Asian high-yield corporate bond yields – shown inverted in Chart I-7 – are beginning to rise. Rising borrowing costs for high-yield borrowers in emerging Asia have historically heralded lower share prices in the region (Chart I-7). Chains often break in their weak links. Similarly, selloffs commence in the weakest segments and then spread from there. Hence, the budding weakness in emerging Asian junk corporate bonds and EM sovereign credit could be signals of a forthcoming selloff in EM/China plays. Remarkably, emerging Asian and Chinese small-cap stocks have failed to stage a rally in the past three months – despite global risk appetite having been strong (Chart I-8). This also signifies the lack of a meaningful recovery in emerging Asia in general and China in particular. Chart I-7A Canary In A Coal Mine? Chart I-8No Rally In Chinese And Emerging Asian Small Caps Chart I-9Semiconductor Prices Are Still Subdued Last but not least, cyclical currencies and commodities markets are not signaling a global business cycle recovery. Neither industrial metals nor oil prices have been able to rally meaningfully. EM currencies have also failed to appreciate versus the dollar. In addition, semiconductor prices – both DRAM and NAND – remain weak (Chart I-9). Bottom Line: An urge on the part of investors to deploy capital in EM has supported EM financial markets despite a poor growth background, in general, and shrinking corporate profits, in particular. China: Structural Malaises To Delay A Cyclical Recovery Recent macro data, particularly PMIs, have once again raised hopes of a business cycle recovery in China. While it is reasonable to infer that the industrial cycle in China has recently stabilized, sequential improvements will be hard to achieve in the coming months for the following reasons: The credit and fiscal spending impulse has historically led the manufacturing cycle in China on average by about nine months. However, this time gap has varied – from three months in the first quarter of 2009 to about 20 months in 2017 (Chart I-10). Chart I-10China Credit/Fiscal Impulse And Business Cycle: Varying Time Lags There are several reasons why the time lag could be longer than nine months in the current cycle: (1) The US-China confrontation is dampening sentiment among both enterprises and households in China. Marginal propensity to spend among households and enterprises is low and has not improved (Chart I-11). A Phase One deal is unlikely to reverse this. The fact remains that the US and China have failed to reach an even small and limited accord in the past year of negotiations. With this in mind, even if there is a Phase One deal, businesses both in China and around the world are unlikely to alter their investment plans substantially. (2) Regulatory pressures on banks and on the shadow banking sector to deleverage remain acute. Although the People’s Bank of China has reduced interest rates and is providing ample liquidity, the regulatory tightening measures from 2016-2018 have not been reversed. Consistently, commercial banks’ assets and broad bank credit growth are rolling over anew (Chart I-12). Chart I-11China: Lack Of Appetite To Spend For Enterprises And Households Chart I-12Banking System Is Now More Restrained Compared With Previous Stimulus Episodes (3) There has been no stimulus targeting the real estate market. Without a recovery in the property market – both strong price appreciation and construction activity – it will be difficult to achieve a business cycle recovery. The basis is that real estate – not exports to the US – has been the key pillar driving China’s growth over the past 10 years. Even if there is a Phase One deal, businesses both in China and around the world are unlikely to alter their investment plans substantially. In the onshore bond market, government bond yields do not confirm the sustainability of the improvement in the national manufacturing PMI (Chart I-13). China’s local currency government bond yields have generally been a good coincident indicator for the industrial cycle, and they are not flashing green. Chart I-13Chinese Local Bond Yields Doubt The Sustainability Of A Stronger PMI November Asian and Chinese trade data have been somewhat mixed. Korea’s total exports and exports to China still show double-digit contraction (Chart I-14, top panel). Similarly, Japanese foreign machine tool orders – both total and from China – remain in deep contraction (Chart I-14, middle panel). In contrast, Taiwanese exports to China and to the world ex-China have improved (Chart I-14, bottom panel). The recuperation in Taiwanese exports to China could be attributed to stockpiling of semiconductors by mainland companies. Odds are that China has decided to stockpile semiconductors from Taiwan, given the lingering uncertainty over the China-US relationship, especially regarding China’s access to semiconductors. Real estate – not exports to the US – has been the key pillar driving China’s growth over the past 10 years. Infrastructure spending remains lackluster, despite a surge in special bond issuance by local governments over the past 12 months (Chart I-15, top panel). Chart I-14Asian Trade Was Still Very Weak In November Chart I-15China: Domestic Demand Is Lackluster Chart I-16EM Ex-China: No Recovery In Domestic Demand The reason is that special bond issuance accounts for a small share of infrastructure investment. Bank loans, corporate bond issuance by LFGVs and land sales are still the main source of funding for capital expenditures on infrastructure. Finally, on the consumer side, auto sales are contracting for a second straight year, while smartphone sales are flat-to-down for a third year in a row (Chart I-16, middle and bottom panels). EM Ex-China: Mind The Deflationary Forces In EM ex-China, Korea and Taiwan, not only are their exports weak, but their domestic demand trajectory is also downbeat (Chart I-16). Despite rate cuts by EM central banks, their interest rates remain elevated in real terms (adjusted for inflation). The basis is that inflation has dropped as much as policy rate cuts. In fact, in many economies, inflation is flirting with all-time lows (Chart I-17). Furthermore, lending rates by banks have not been adjusted sufficiently low in line with the declines in policy rates. Consequently, local borrowing costs in EM remain elevated. Not surprisingly, broad money growth is close to a record low (Chart I-18). Chart I-17EM Ex-China: Inflation Is At A Record Low Chart I-18EM Ex-China: More Aggressive Monetary Easing Is Necessary Table I-1EM Corporate Profits Across Sectors Without recognizing non-performing loans and recapitalizing banks, a sustainable credit cycle - and hence domestic demand recovery - is implausible in many EM countries. This will impede the corporate profit recovery, especially for banks that account for 28% of MSCI EM corporate profits (Table I-1). As we argued in our November 14 report, such deflationary tendencies in many EM economies warrant a weaker currency. Bottom Line: The principal drivers for EM corporate profits are domestic demand in China and EM ex-China, rather than the ones in the US or Europe. We do not expect a recovery in domestic demand in both China and the rest of EM in the early months of 2020. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Thailand: Bet On More Monetary Easing Chart II-1Thailand Is Flirting With Deflation Deflationary pressures are mounting in Thailand. This will lead the central bank to cut interest rates much further. We therefore recommend to continue overweighting Thai domestic bonds within an EM local bond portfolio, currency unhedged. Thailand’s economy is flirting with deflation and needs lower interest rates, a cheaper currency and a fiscal boost: Core inflation has fallen to a mere 0.5%. Likewise, headline inflation has plunged to 0.2%, which is far below the central bank’s lower-bound target of 1% (Chart II-1). Further, nominal GDP growth has dropped below the prime lending rate (Chart II-2). Adjusted for core inflation, real lending rates are too high for the economy to handle. If lending rates are not brought down, credit demand will decline further and non-performing loans will mushroom (Chart II-3). Chart II-2Thailand: Nominal GDP Growth Is Below Prime Lending Rate Chart II-3Thailand: Decelerating Domestic Credit High borrowing costs are especially detrimental for the non-financial private sector – households in particular. Consumer debt currently stands at 125% of disposable income. The central bank is set to deliver more rate cuts and will probably begin intervening in the foreign exchange market to weaken the baht. Thailand’s economic growth has decelerated and more downside is likely. Business sentiment is deteriorating, companies’ book orders are falling and manufacturing production is contracting (Chart II-4, top panel). Overall, corporate earnings are shrinking 8% from a year ago in local currency terms (Chart II-4, bottom panel). Declining corporate profitability is beginning to hurt capex and employment. In turn, slower employment and wage growth have hit consumer confidence. Private consumption volume has decelerated decisively (Chart II-5, top panel) and passenger vehicle sales are falling (Chart II-5, bottom panel). Chart II-4Thailand: Business Sentiment Is Falling Chart II-5Thailand: Consumer Spending Has Been Hit Chart II-6Thailand's Real Estate Market Is Weak The real estate market is also slowing down. Chart II-6 shows various types of residential property prices. Specifically, house price appreciation has either decelerated or turned into deflation. Accordingly, construction activity has been weak. Overall, the Thai economy needs significant monetary and fiscal easing. Yet the 2020 fiscal budget entails only a 6% increase in expenditures in nominal terms, which is insufficient to halt the economy’s downtrend momentum. With the budget already set, aggressive monetary easing - in the form of generous rate cuts and foreign exchange interventions to induce some currency depreciation – is the only tool available to the authorities at the moment. Bottom Line: The Thai economy is facing strong deflationary forces and requires lower interest rates and a cheaper currency. The central bank is set to deliver more rate cuts and will probably begin intervening in the foreign exchange market to weaken the baht. Investment Recommendations Local interest rates will drop further and the Bank of Thailand (BoT) will keep cutting interest rates next year in the face of mounting deflationary trends in the economy. For dedicated EM fixed-income portfolios, we recommend keeping overweight positions in Thai local currency bonds and sovereign credit within their respective EM portfolios. While the Thai baht could depreciate because of monetary easing, the currency will still perform better than many other EM currencies. Thailand carries a very robust current account surplus of 6% of GDP. This will provide a cushion for the baht. Furthermore, foreign ownership of local currency bonds is low at 18%. This limits potential foreign outflows from local bonds in case the currency depreciates. In addition, Thailand’s foreign debt obligations - which are calculated as the sum of short-term claims, interest payments and amortization over the next 12 months - are small, accounting for 14% of exports. This limits hedging needs by Thai debtors with foreign currency liabilities and, hence, the currency’s potential downside. We recommend EM equity investors to keep an overweight position in Thai equities. First, Thai bourse is defensive in nature – with utilities, consumer staples and healthcare accounting for 27% of the MSCI Thailand market cap – and will begin outperforming as EM share prices come under renewed stress (Chart II-7, top panel). Second, net EPS revision in Thailand vs. EM has plummeted to a 16-year low (Chart II-7, bottom panel). This entails that a lot of bad news has already been priced in relative terms. Finally, narrow money (M1) growth seems to be bottoming. This is occurring because the central bank has begun accumulating foreign exchange reserves. While it might take some time before monetary easing leads to an economic recovery, Thai share prices will benefit from it early on (Chart II-8). Chart II-7Thailand vs. EM: Relative Stock Prices And Earnings Revisions Chart II-8Thailand: Narrow Money And Share Prices Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Global growth will rebound in 2020, led by the US and China, putting upward pressure on global bond yields. Maintain below-benchmark overall duration exposure. Central banks will stay dovish until policy reflation has clearly turned into inflation, limiting how high bond yields can climb in 2020 but sowing the seeds for a far more bond-bearish backdrop in 2021. Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. Accommodative monetary policy and faster growth will delay the peak in the aging global credit cycle. Stay overweight global corporate debt versus sovereign bonds. Returns on global fixed income will be far lower in 2020 than in 2019, given rich valuation starting points. Country and sector selection will be more important in driving fixed income outperformance. For sovereign bonds, favor countries where yields are less sensitive to change in overall global yields; for credit, favor sectors with lower interest rate durations and lower spread volatility. Feature BCA Research’s Outlook 2020 report, outlining the main investment themes for next year from the collective mind of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2020. In a follow-up report to be published in the first week of the new year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2020 Outlook Chart 1Expect A Cyclical Rise In Global Yields In 2020 The main conclusions from the Outlook 2020 report were cyclically bullish looking out over the next twelve months, but more cautious beyond that. The downturn in global growth seen in 2019 is projected to end in response to several headwinds that have become tailwinds: a small wave of Chinese stimulus and reflation; more stimulative global monetary policies; the substantial easing of global financial conditions as risk assets have rallied worldwide; a fading drag on global manufacturing from inventory destocking; both China (weak growth) and the US (the 2020 US election) have good reasons to de-escalate the trade war in 2020. This backdrop should push global bond yields moderately higher in 2020, while maintaining a backdrop that is once again favorable for risk assets on a relative basis versus government debt (Chart 1). A critical element to this story is the supportive monetary policy backdrop. Central banks worldwide, led by interest rate cuts from the US Federal Reserve and a resumption of asset purchases from the European Central Bank (ECB), are now running more stimulative policies in response to this year’s global manufacturing slump and elevated level of political uncertainty. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy. A repeat of the spectacular total return numbers seen across the majority of asset classes in 2019 is unlikely, but global equity and credit markets should solidly outperform government bonds. Yet all that monetary stimulus does not come without a price. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy. A revival of inflationary pressures in 2021 will force central banks to raise rates much more aggressively. Combined with a China that remains wary of promoting excess leverage, this will drive the current prolonged global business cycle expansion to its recessionary endgame, taking equity and credit markets down with it. This will eventually trigger a new decline in global bond yields as policymakers shift back to easing mode, but from much higher levels than today. Our Four Main Key Views For Global Fixed Income Markets In 2020 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall duration exposure. The pickup in global growth that we expect in 2020 has its roots in two locations: China and the US. For China, policymakers are keenly aware that the current growth slowdown cannot continue, as it has already pushed nominal GDP growth below 8% (Chart 2). For an economy as highly leveraged as China, slowing nominal growth is lethal and must be avoided to prevent a surge in private sector defaults and rising unemployment. Already, China has delivered significant policy stimulus in 2019: the reserve requirement ratio has been cut by 400bps; taxes have been cut by 2.8% of GDP; capital spending at state-owned enterprises has increased; the currency has depreciated; and, more recently, monetary policy has been eased via traditional interest rate cuts. These measures have eased our index of Chinese monetary conditions and triggered a surge in the China credit impulse, which leads Chinese import growth (i.e. China’s most direct impact on the global economy) by nine months. There are signs that Chinese growth is already bottoming out, as evidenced by the recent pickup in the China manufacturing PMI. Expect more signs of improvement in the first half of 2020. The BCA global leading economic indicator (LEI) has been rising since January of this year, and the global LEI diffusion index is signaling that the upturn will continue in 2020 (Chart 3). With global financial conditions at highly stimulative levels thanks to the robust performance of risk assets in 2019, the backdrop is already conducive to faster global growth. BCA’s geopolitical strategists are of the view that a “détente” in the US-China trade war is still the most likely base case scenario, which would go a long way in reducing the growth-inhibiting effects of elevated uncertainty (bottom panel). Chart 2A Boost To Global Growth From China In 2020 Chart 3Lower Uncertainty + Easy Financial Conditions = Faster Growth As for the US, the lagged impact of the Fed’s 75bps of rate cuts this year has boosted domestic liquidity conditions in a pro-growth fashion. The BCA US Financial Liquidity Indicator, which leads not only US growth but also leads the BCA global LEI and commodity prices by 18 months, is already signaling that US economic momentum is set to bottom out in early 2020 (Chart 4). This signal is in addition to the leading properties of US financial conditions (middle panel), which suggests a reacceleration of real GDP growth back above trend is about to unfold. Chinese policy reflation has typically been a good leading indicator for US capex and is heralding a rebound in investment spending (bottom panel). The pickup in global growth would also help revive the dormant euro zone economy, which has been hit hard though plunging export demand and overall weakness in the manufacturing sector. The entire slump in euro area real GDP growth since the start of 2018 can be attributed to plunging net exports, while domestic demand has held steady (Chart 5). The increase in the China credit impulse and our global LEI diffusion index – both leading indicators of euro area export growth – are signaling that euro area export demand is already in the process of bottoming out (bottom two panels) and should gain momentum in the first half of 2020. Chart 4US Growth Is Poised To Accelerate Chart 5The Drag On European Growth From Trade Will Soon End This better growth backdrop will put moderate upward pressure on global bond yields in 2020. This better growth backdrop will put moderate upward pressure on global bond yields in 2020. Key View #2: Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. While we expect bond yields to drift higher in the next 6-12 months, the upside will be capped with central banks likely to stay dovish until policy reflation has clearly turned into higher inflation. Interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up. The Fed, ECB, Bank of Japan and other central banks have all stated publicly that they will maintain current accommodative policy settings until realized inflation has sustainably returned to target levels, typically around 2%. This would be a major change in the modus operandi of these policymakers, who have typically signaled rate hikes based simply on forecasts of higher inflation. The implication is that interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up (Chart 6). Chart 6Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates A critical ingredient for global inflation to begin moving higher again is a softer US dollar (USD). The year-over-year growth rate of the trade-weighted USD is correlated to global export price inflation and commodity price inflation, more generally (Chart 7). The typical drivers of the USD are all pointing in a more bearish direction: Chart 7The USD Is Critical For Global Reflation Chart 8Global Real Yields & Inflation Expectations Will Drift Higher In 2020 the Fed has cut interest rates multiple times since the summer and is expanding its balance sheet via repo operations and treasury bill purchases; global (non-US) growth is bottoming out, and capital tends to flow out of the USD into more cyclical currencies in Europe and EM when global growth is accelerating; elevated policy uncertainty, which tends to attract inflows into the safety of the USD, is starting to diminish. The combination of improving global growth and a softer USD would normally be enough to generate a significant increase in global bond yields. Yet we do not expect the sort of move higher in the real component of bond yields signaled by our global LEI diffusion index in 2020 (Chart 8, top panel). While real yields should move higher alongside faster growth, if there is no expected tightening of monetary policy as well, the move in real yields will be more limited. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. This suggests that inflation-linked bonds should perform reasonably well in countries where inflation is likely to accelerate the fastest, like the US. Faster inflation expectations will also result in some bear-steepening of global government bond yield curves in the first half of 2020 (Chart 9). There is very little curve steepening discounted in bond forward rates in the developed markets – a consequence of the general flatness of yield curves – which suggests that yield curve steepening trades could prove to be profitable in 2020. Chart 9Expect A Mild Bear-Steepening Of Global Yield Curves Chart 10The Fed Has Dis-Inverted The Treasury Curve In the case of the US, the Fed’s recent easing actions have pushed short-term interest rates below longer-term Treasury yields, removing the yield curve inversion that sparked recession fears among investors during the summer of 2019 (Chart 10). With the Fed likely to sit on its hands for most of next year, even as US growth and inflation are likely to improve, this will put additional bear-steepening pressure on the US Treasury curve. In Europe, bond markets have already discounted a very significant impact from the ECB restarting its Asset Purchase Program, which only began last month. Investment grade corporate bond spreads, as well as Italy-Germany government bond spreads, have narrowed substantially despite a weak euro area economy (Chart 11, bottom panel). Meanwhile, the term premium on 10-year German bunds is back to the deeply negative levels middle panel) seen when the ECB was expanding its balance sheet at a 30-40% pace, rather than the 5% pace implied by the current announced pace of purchases of 20 billion euros per month (top panel). This potentially leaves longer-term European yields exposed to the same bear-steepening pressures seen in other bond markets, even within the context of a renewed ECB bond-buying program. Chart 11European Bonds Already Discount A Very Dovish ECB Chart 12The Wild Card For Bonds Markets In 2020: Fiscal Policy A potentially big wild card for global bond markets next year will be fiscal policy, which can also exacerbate yield curve steepening pressures. Any sign of a push toward more government spending, particularly in Europe where there has been such reluctance to open the fiscal taps, would result in a sharper upward move in global bond yields than we are expecting. This is not because of a supply effect related to more government bond issuance that would require higher yields to attract buyers. It is because fiscal stimulus (Chart 12) would push growth to an even faster pace that would bring forward the date when inflation returns to policymaker targets and tighter monetary policy could commence. This would follow a similar path to the curve steepening dynamics described earlier, with a fiscal boost to growth pushing up longer-term inflation expectations before starting to push up short-term interest rate expectations. Key View #3: Stay overweight global corporate debt versus sovereign bonds. Investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. The combination of faster global growth, somewhat higher inflation and accommodative monetary policies laid out in the BCA Outlook 2020 report will delay the peak in the aging global credit cycle. This means investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. Low borrowing rates are already helping to extend the credit cycle by making it easier for highly indebted borrowers to service their debts. This can be seen in the US, where interest coverage ratios (using top-down data for the non-financial corporate sector) remain above the levels that have preceded previous recessions (Chart 13). Low borrowing rates are also helping indebted borrowers in Europe, particularly in Italy and Spain where the banking system is now far less exposed to non-performing loans than during the peak years of the 2011-12 European Debt Crisis (Chart 14). Chart 13Low Rates Helping Extend The US Credit Cycle Chart 14Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Chart 15A Cyclically Positive Backdrop For Global Corporates According to our checklist of indicators to watch for an end of the corporate credit cycle in the US – tight monetary policy, deteriorating corporate sector financial health, and tightening bank lending standards – only corporate financial health is flashing a warning signal according to our Corporate Health Monitor as we discussed in a recent report.2 In fact, our global Corporate Health Monitor is rolling over – a trend that should continue as growth improves in 2020 – which should support global corporate bond outperformance versus government debt next year (Chart 15). Key View #4: Returns on global fixed income will be far lower in 2020 than in 2019. Country and sector selection will be more important in driving fixed income outperformance in 2020. The start of 2020 looks far different in terms of fixed income valuations compared to the beginning of 2019. For example, the 10yr US Treasury yield started the year at 2.72% and is now 1.83%, while the 10yr German bund yield started this year at 0.24% and is now MINUS-0.31%. These lower yields reflect the slower pace of global economic growth and monetary policy easing delivered by the Fed and ECB. Yet at the same time, corporate credit spreads have narrowed in both the US (the high-yield index OAS is down from 526bps to 360bps) and the euro area (the investment grade index OAS is down from 152bps to 100bps). These massive rallies in global bond markets this year resulted in both lower government bond yields and tighter credit spreads - even with slower global growth that would normally be a trigger for wider spreads/higher risk premiums. Looking at the current valuation of government bond yields in the major developed markets from a long-run perspective, it is difficult to make the case that it is attractive. Medium-term real bond yields remain well below potential GDP growth rates, a consequence of central banks keeping policy rates well below neutral levels suggested by measures like the Taylor Rule (Chart 16). Chart 16Global Government Bonds Are Expensive Without the initial starting point of cheap valuations, fixed income return expectations for 2020 should be tempered. This means that rather than loading up on maximum duration risk and/or credit risk to capture big yield and spread moves, bond investors should be more selective in country, maturity and credit exposure to generate outperformance in 2020. Chart 17Favor Lower-Beta Government Bond Markets In 2020 For government bonds, that means focusing country exposures on lower-beta markets where yields are less correlated to moves in the overall level of global bond yields. Our preferred way to measure this is to look at the beta of monthly yield changes for the benchmark 10-year government yields of the major developed market countries to the overall Bloomberg Barclays Global Treasury index yield for the 7-10 year maturity bucket, over a rolling three-year window. We define a “high-beta” bond market as having a yield beta of 1.25 or higher, and a “low-beta” bond market as having a yield beta of 0.75 or lower. Under that definition, global bond investors should underweight higher-beta Canada, the US and Italy, and overweight low-beta Japan and Spain (Chart 17). Bond markets with betas between 1.25 and 0.75 (Germany, Australia, Sweden, the UK) can also be considered on their own fundamental merits. Of that list, we see Germany and Australia having a better chance of outperforming the UK and Sweden, given the greater odds that the Bank of England or Riksbank could signal a need to hike rates in 2020 compared to the ECB or Reserve Bank of Australia. Chart 18Stay Overweight Global Spread Product In 2020, But Be Selective For spread product, that means focusing exposure on sectors that are less risky, either defined by interest rate duration or spread volatility (i.e. spread duration). With credit spreads remaining near the low end of long-run historical ranges for nearly all major markets (Chart 18), it is hard to find examples of spread product being cheap in absolute terms. On a risk-adjusted basis, however, negatively-convex spread product like US and euro area high-yield debt and US agency MBS actually look more interesting in the rising yield environment we expect in 2020, since the interest rate durations of those fixed income sectors fell as bond yields declined in 2019. Thus, we recommend owning high-yield corporates over higher-duration investment grade corporates in the US and euro area, while also favoring US agency MBS over higher-quality credit tiers of US investment grade corporate credit. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, “The Lowdown On Low-Rated High-Yield”, dated November 27, 2019, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns