Financial Markets
Highlights The key risk to a dollar bearish view is a US-led rebound in global growth. This would allow the Federal Reserve to tighten monetary conditions much faster than other central banks, supporting the dollar in the process. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for this risk. Feature We were on the road last week, visiting clients in South Africa. The biggest preoccupation was what could put a dollar bearish view offside, especially vis-à-vis the rand. Many understand that the dollar is a countercyclical currency and tends to depreciate when global growth is rebounding. Yet there was still a good amount of trepidation on the totality of this argument. The dollar has been in a bull market since 2011, but there have been a couple of growth cycles during that period. One of our last meetings was in the beautiful city of Stellenbosch, a university town lined with majestic landscapes and rooted deep in South African history. A multi-asset fund manager had just met with two FX strategists before meeting with us. One of them was a dollar bull, and the other a bear. We could sense from his demeanor that indecisiveness was not part his ‘modus operandi,’ and he definitely wanted some clarity from our meeting. What transpired was an honest conversation on currencies, especially vis-à-vis our bearish dollar view. The conversation embodied the sentiment we had been getting from most other fund managers, which is that the view on the dollar is highly polarized. As we went through a swathe of charts, I noted his insightful questions, many of which drilled to the core of where the view could go wrong. Is The Dollar That Countercyclical? The observation that the dollar is a countercyclical currency rests on two pillars. The first is that the US economy is driven more by services than manufacturing. As such, when global growth is rebounding, more cyclical economies benefit most from this growth dividend, and as such, capital tends to gravitate to their respective economies. This is aptly illustrated by the fact that whenever global cyclical sectors (higher concentration outside the US) are outperforming defensive ones, the dollar is in a bear market (Chart I-1). In the US, a wider fiscal deficit tends to be partly financed by new money creation. More importantly, the Fed tends to be the lender of last resort to the global economy, not least because the US dollar remains a reserve currency. In times of crises, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. In the US, a wider fiscal deficit tends to be partly financed by new money creation. Part of the feedback loop in this mechanism is that it leads to a flow of greenbacks outside US borders. This eases offshore rates while greasing the international money supply chain (Chart I-2). Chart I-1The Dollar Tends To Weaken When Cyclicals Are Outperforming Chart I-2An Increasing Supply##br## Of Dollars Where can this view go wrong? If the Fed’s mandate is vis-à-vis the domestic US economy rather than maintaining international financial stability, then the biggest risk to a bearish dollar view is one in which global growth rebounds (or decelerates), but the US economy holds up well, allowing the Fed to pursue a relatively tighter monetary stance. This week, we got the US Markit and ISM PMIs, and the gaping wedge between the two is the highest since the 2015 manufacturing recession. Given sampling differences, where the Markit PMI surveys more domestically oriented firms, it is fair to assume it is also a barometer of US domestic growth relative to global output. Put another way, whenever the US services PMI is outperforming its manufacturing component, the dollar tends to appreciate (Chart I-3). If global growth rebounds but the US is leading the rebound (the Fed has been one of the most dovish central banks after all), the dollar can continue to rally. Our view is that this remains a tail risk. The slowdown in the global economy has been driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. Not to mention, cyclical swings in most economies tend to be driven by manufacturing and exports rather than services. Meanwhile, on the services front, the US economy appears to be rolling over relative to global. Even relative to China, the US appears to remain victim to the repercussions of the trade war (Chart I-4). This divergence is likely to keep the Fed on the sidelines, at least relative to other central banks. Meanwhile, on the political spectrum, our geopolitical strategists observe that historically, it has been extremely rare for the Fed to raise interest rates a few months ahead of an election cycle. Chart I-3The Risk To A Bearish Dollar View Chart I-4Conflicting Messages A source of support for this view arises from the German bund versus US Treasury spread. In short, it is a battle of manufacturing versus services. Ever since the European debt crisis, the velocity of money in the euro area has collapsed relative to that of the US. In the financial world, relative long bond yields have followed suit in tight correlation (Chart I-5). If this reverses, it will be a key sign that the neutral rate of interest in the Eurozone is rising relative to that of the US, albeit from a low starting point. The message from bond markets is that such a shift is already taking place. Chart I-5R-Star For The Euro Area Could Move Higher There have been two powerful disinflationary forces for the velocity of money in the US. The first is the lagged effect from the Fed’s tightening policies in 2018. This is especially important given that the fed funds rate was eerily close to the neutral rate of interest, providing little incentive for firms to borrow and invest. Inflation is a lagging indicator, and it will take a sustained rise in economic vigor to lift US inflation expectations. This will not be a story for 2020 (Chart I-6A). Second, the recent rise in the dollar and fall in commodity prices is likely to continue to anchor US inflation expectations downward (Chart I-6B). This should keep the Fed on the sidelines. Chart I-6AVelocity Of Money Versus Inflation Chart I-6BVelocity Of Money Versus Inflation Bottom Line: The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. This would be an environment in which US inflation would also surprise to the upside. So far, the move in bond markets suggests this remains a tail risk (Chart I-7). Chart I-7Stalemate Equity (And Bond) Capital Flows The nascent upturn in a few growth indicators is also coinciding with a positive signal from financial variables. Global cyclical stocks have started to outperform defensives, and the traditional negative correlation with the dollar appears to be holding (previously referenced Chart I-1). Correspondingly, flows into more cyclical ETF markets are accelerating. These are usually a small portion of overall FX flows, but the information coefficient is directionally quite good. The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. The S&P 500 has been the best performing market for a few years now, so a crucial part of the dollar call lies in international equity markets outperforming the US. Markets such as the Swedish OMX, the Swiss Market Index and the TSX, among others, have broken out – indices with large international exposure and which are very much tied to the global cycle. Such market breakouts also tend to correspond with a weaker dollar, especially when the return on capital appears marginally higher outside the US. In a nutshell, the performance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to both the South African rand and other emerging and developed market currencies (Chart I-8A and Chart I-8B). The catalyst will have to be rising relative returns on the capital outside the US, but the starting point is also extremely attractive valuations. Chart I-8ACapital Flows And Exchange Rates Chart I-8BCapital Flows And Exchange Rates Over a shorter horizon, sentiment might drive stock market performance, but valuations matter a lot for the longer term. Chart I-9A shows the composite valuation indicator for the US relative to other developed markets. The message is quite clear: Any investor deploying fresh capital into the US today is doing so with the prospect of much lower longer-term returns, at least compared to the euro area and Japan. With inflows into US assets having rolled over, this will likely remain a source of concern for longer-term investors. This is compounded by the fact that expectations for the US technology sector going forward are likely to be hampered by regulatory concerns and lofty valuations. For South African investors, structural reforms will be needed for much more juicy long-term equity returns, beyond a terms-of-trade benefit (Chart I-9B). Chart I-9AReturns To US Equities Look Dire Chart I-9BReturns To US Equities Look Dire On the fixed-income front, international investors may still find US bond markets attractive in an absolute sense due to higher interest rate spreads. However, the currency risk is just too big a potential blindside to bear. Markets with the potential for currency appreciation such as Australia, Canada, Norway or even Sweden might be better bets. Flow data also highlight just how precarious it is to be long US dollars. As of September, overall flows into the US Treasury market have been negative, which may have contributed to the bottom in bond yields. Net foreign purchases by private investors are still positive, but the momentum in these flows is clearly rolling over. This is more than offset by official net outflows that are running at $350 billion (Chart I-10). As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Chart I-10A Growing Dearth Of Treasury Buyers Bottom Line: Flows into US assets are rapidly dwindling. This may be partly because as the S&P 500 makes new highs amid lofty valuations, long-term investors are slowly realizing that future expected returns will pale in historical comparison. Given that being long Treasurys and the dollar remains a consensus trade, international investors run the risk of being potentially blindsided by a sharp drop in the dollar. Rebuy NOK/SEK We were stopped out of our long NOK/SEK position last week. We are reinstating this trade as relative fundamentals, especially from an interest rate perspective, still favor the cross. We are reinstating long NOK/SEK as relative fundamentals, especially from an interest rate perspective, still favor the cross. We remain oil bulls on the back of a pickup in global demand and OPEC production discipline. This should lead to the outperformance of energy stocks, benefiting inflows into Norway (Chart I-11). Chart I-11No Near-Term Replacement For Oil Chart I-12Interest Rates Favor NOK/SEK Interest rate differentials continue to favor NOK over SEK. The Riksbank will probably – at the margin – be more hawkish than the Norges Bank in an attempt to exit negative interest rates, but the carry will remain wide (Chart I-12). Meanwhile, Norway mainland GDP growth continues to outpace that of Sweden (Chart I-13). Finally, the cross has approached an important technical level, with our intermediate-term indicator signaling oversold conditions. Should the NOK/SEK pattern of higher lows and higher highs in place since the 2015 bottom persist, we should be on the cusp of a powerful rally (Chart I-14). Chart I-13Growth Favors NOK/SEK Chart I-14Rebuy NOK/SEK Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM and Markit data are sending conflicting signals: the Markit manufacturing PMI edged up to 52.6, while the ISM number dipped towards 48.1 in November. On the services front, the Markit PMI was unchanged at 51.6, while the ISM PMI fell to 53.9. ADP employment recorded an increase of 67K jobs in November, well below expectations. The jobs report on Friday will be especially important. The trade deficit narrowed by $4 billion to $47.2 billion in October. The DXY index fell by 0.9% this week. Incoming data have been consistent with our base case view that global growth has bottomed and will rebound in 2020. Along with a manufacturing sector recovery, pro-cyclical, or higher-beta currencies are poised to outperform the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 201 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area signal a tentative recovery: Preliminary headline and core inflation both rebounded to 1% and 1.3% year-on-year, respectively in November. The Markit manufacturing PMI increased to 46.9 in November. The Services PMI also edged up to 51.9. Retail sales grew by 1.4% year-on-year in October, lower than the 2.7% yearly growth from the previous month. GDP growth was unchanged at 1.2% year-on-year in Q3. EUR/USD appreciated by 0.6% this week. The recent rebound in both inflation and PMI has brightened the outlook for the euro area and boosted investor confidence. Our Global Investment Strategy upgraded euro area equities to overweight recently. We continue to remain positive on the euro against the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: Construction orders soared by 6.4% year-on-year in October. Manufacturing PMI increased to 48.9 from 48.6 in November. Consistently, the services PMI also increased to 50.3. Vehicle sales fell by 14.6% year-on-year in November. This series is extremely volatile, especially given the front-loading of purchases ahead of the consumption tax hike. USD/JPY fell by 0.8% this week. Sluggish growth in Asia, together with the consumption tax hike have weighed on the Japanese economy through 2019. However, the Japanese yen remained resilient due to its safe-haven nature. The Abe government has revealed a sizeable fiscal stimulus, but the potential impact on the economy is still being digested. At the margin, fiscal stimulus reduces the scope for the BoJ to adopt more experimental monetary policies, which is bullish the yen. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been upbeat: On the PMI front, both Markit manufacturing and services PMIs increased to 48.9 and 49.3, respectively in November. The construction PMI also rebounded to 45.3 from 44.2. Consumer credit increased by £1.3 billion in October. The British pound has appreciated by nearly 2% against the US dollar this week, making it the best performing G10 currency over the past few weeks. Our Geopolitical strategists believe that the UK election will not reintroduce a no-deal Brexit risk, either in the short-term or long-term. This is positive for the UK economy overall, and bullish for the British pound especially given it is still trading well below its long-term real effective exchange rate. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been robust: GDP growth soared to 1.7% from 1.4% year-on-year in Q3. On the PMI front, both AiG manufacturing and services PMIs fell to 48.1 and 53.7, respectively in November. The Commonwealth manufacturing PMI was little changed at 49.9, while the services PMI increased to 49.7. The current account balance increased to 7.9 billion from 4.7 billion in Q3. AUD/USD increased by 0.8% this week. On Monday, the RBA kept interest rates unchanged at 0.75%. Governor Lowe implied that after 3 rate cuts this year, the current low cash rate is already boosting Australian asset prices and household spending. Combined with government spending and a growing population, this should help underpin the Australian economy and the Aussie dollar in the long run. We remain overweight the Aussie dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data from New Zealand this week: Terms-of-trade increased by 1.9% quarter-on-quarter in Q3. NZD/USD increased by 1.7% this week. As a small open economy, New Zealand should benefit once global growth stabilizes. Moreover, rising terms-of-trade, mainly in dairy and meat prices, are lifting New Zealand exports and the trade balance this year. We remain positive on the kiwi against the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 201 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: Annualized GDP increased by 1.3% quarter-on-quarter in Q3, well below the 3.5% quarterly growth in the second quarter. The Markit manufacturing PMI slightly increased to 51.4 in November. The Ivey PMI also soared to 60 from 48.2 on a seasonally-adjusted basis in November. Imports slightly increased to C$51 billion in October. Exports also increased to C$49.9 billion. The trade deficit, as a result, narrowed to C$1.1 billion. USD/CAD fell by 1% this week. On Wednesday, the BoC held interest rates unchanged at 1.75%. A catalyst was probably early signs of a global growth recovery. The BoC is one of the few central banks that haven't eased monetary policy this year amid the trade war and a manufacturing sector slowdown. Going forward, we are positive on energy prices, and believe that the loonie is primed for a breakout. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been soft: The KOF leading indicator fell to 93 from 94.8 in November. Real retail sales increased by 0.7% year-on-year in October, from 1.6% the previous month. Headline inflation increased from -0.3% to -0.1% year-on-year in November. The Swiss franc increased by 1.2% against the US dollar this week, amid broad dollar weakness. Inflation has been negative for a second consecutive month in November, and a strong franc does not offer any help. While we remain positive on the Swiss franc, the biggest risk to an appreciating franc is intervention from the central bank. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Retail sales fell by 0.8% month-on-month in October. The current account surplus narrowed by NOK 2.6 billion to NOK 23.9 billion in Q3. The Norwegian krone increased by 0.8% this week against the US dollar, supported by rising oil prices and a brightened outlook for global growth. The EIA reported a decrease of crude oil stocks by 4.9 million barrels for the week ended November 29th. Combined with a revival in oil demand, this is bullish for the oil prices and the Norwegian krone. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly positive: GDP increased by 1.6% year-on-year in Q3, an improvement from 1% the previous quarter. The manufacturing PMI fell to 45.4 from 46 in November. This was in contrast to other euro area countries. The current account surplus improved to SEK 69 billion from SEK 37 billion in Q3. USD/SEK decreased by 1% this week. Typically, a weak krona helps the manufacturing sector by a lag of about 12 months. Moreover, the weak krona is also improving balance of payments dynamics in Sweden. Going forward, we remain bullish on the Swedish krona, and are playing krona strength via the New Zealand dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights The Fed is the usual culprit for killing business cycles — but the Fed is on hold. This makes geopolitics the likeliest candidate to kill the cycle. The key geopolitical risks are US political turmoil, China’s economic policy, and the US-Iran confrontation. Nevertheless, policymakers are adjusting to the threat of recession, which points to a continuation of this long-in-the-tooth expansion. The US-China talks will be driven by Trump’s need for an economic boost ahead of the US election. If the economy or Trump’s approval rating fails anyway, then all bets are off. Go long gold as a strategic hedge. Feature Great power struggle, or “multipolarity,” continues to be our mega-theme in 2020. The world does not operate like a normal society, with a single government that possesses a monopoly on the use of force and ensures stability. Nations are individualistic, armed, and dangerous, creating what scholar Hedley Bull once called “The Anarchical Society.” This is not pure chaos, but rather a community of nations that lacks a clear and undisputed leader. Hence, quarrels break out often. Updating our geopolitical power index shows that the rise of China remains the most disruptive trend in global politics (Chart 1). The gap between the US and China has closed until recently, with China’s downshift in growth rates, but American fear is just being awakened (Chart 2). Given that Beijing threatens the US’s military and technological dominance over the long run, Washington will continue to develop a containment policy. Chart 1China's Geopolitical Rise Is Disruptive Chart 2China-US Power Gap Is Narrowing China is too big to quarantine, especially for a relatively unpopular first-term American president who eschews international coalition-building. The European Union’s decline in relative power is more marked than that of the United States, but China does not pose as much of a security threat to Europe. This trend exacerbates the already serious divergence in the trans-Atlantic alliance – which will worsen if Trump wins on November 3, 2020. Hence, globalization faces persistent challenges, as indicated by the falling import share of global output (Chart 3). This multi-decade process has peaked, creating a headwind for trade-exposed firms over the long run. What about the next 12 months? Will geopolitics kill the bull market? Not necessarily. Just as central bankers have cut interest rates to guard against deflationary risks (Chart 4), so the key governments are adjusting policies to avoid recessionary risks, especially with the memory of 2008 still fresh. Simply put: The Fed is on pause, Trump wants to be reelected, and China cannot afford a hard landing. Chart 3Globalization Faces Challenges Chart 4Policymakers Are Reacting To Deflationary Risks Clearly the risks to this view are elevated. The chief ones: (1) President Trump becomes a lame duck, cannot run on an economic platform, and thus makes a desperate attempt to win as a “war president” (2) Xi Jinping overestimates his advantage, in domestic or foreign policy, and makes a policy mistake (3) the US-Iran conflict spirals out of control due to Iran’s economic vulnerability. Other risks, such as Brexit, pale by comparison. Fear And Loathing On The Campaign Trail It is too soon to declare that Trump’s presidency is finished. On the contrary he is slightly favored to win reelection: • The Senate is unlikely to remove him from office. Republican support for the president is well above average despite evidence that Trump tried to get Ukrainian officials to investigate his political rival (Chart 5). The implication is that a year from now Democrats will have suffered a policy failure while Trump will have been cleared of charges. Chart 5Trump Still Popular Among Republicans • The odds of recession in the coming year are low. The US voter is buffered by rising real incomes and wages and high net wealth (Chart 6). To unseat a sitting president requires a recessionary backdrop that fundamentally discredits him and his party – not just slowing growth. Chart 6Pocketbook Voter Theory To The Test • Trump’s low approval rating does not prohibit him from reelection. While historically low, it is also historically stable. Our quantitative election model – which predicts Trump will win the Electoral College with 279 votes by clinging onto Pennsylvania – shows that Trump’s victory margin would increase if we looked not at the average level of his approval but at its change, momentum, or low range (i.e. stability). Table 1 shows the results of all four variations of his approval rating, with ascending chances of winning key swing states. Table 1All Measures Of Trump’s Approval Rating Get Him 270 Electoral College Votes Trump’s odds of winning will affect the US equity market throughout the year. As long as he remains competitive, i.e. neither scandal nor the economy cause his approval rating to break down, he will have reason to temper his policies to cater to US financial markets. Foreign and trade policies are Trump’s only ways to improve the economy and voter support. Trump’s only remaining way to boost the economy and improve voter support lies in foreign policy and trade policy. Specifically, he will stop increasing tariffs on China – and maybe even roll back tariffs to August 2019 or even April 2019 levels (Chart 7) – at least as long as the manufacturing recession persists. Chart 7Some Tariff Rollback Is Possible China is unlikely to implement painful structural changes when Trump could be gone in 12 months’ time. Strategic tensions outside of trade will undermine any ceasefire. Hence economic policy uncertainty will remain elevated even though it will drop off from recent peaks. Assuming the electoral constraint prevents Trump from levying sweeping tariffs on China or Europe, he will be limited to other foreign and trade policies to try to boost his approval rating or fire up his base: • We expect a third summit with Kim Jong Un of North Korea. Trump is rumored to be considering some troop reduction in exchange for progress on denuclearization (neither of which would be irreversible). • Otherwise Trump could turn to saber-rattling, since Pyongyang is threatening to resume long-range tests and the economic consequences of another round of “fire and fury” would be limited. • Trump could also rattle the saber against Iran, Venezuela, or other rogue states. If Trump becomes uncompetitive in the election, then the market will sell off. The market will have to price not only policy discontinuity (e.g. higher taxes), but also the chance of a progressive-populist taking the White House. Moreover, if a Democrat is able to unseat an incumbent president, the Democrats will take the Senate as well. Trump is a known unknown; this scenario would be an unknown unknown. The Democratic Party’s primary election will consume the first half of the year. It culminates in the Democratic National Convention, strategically chosen to take place in Milwaukee, Wisconsin on July 13-16. Wisconsin is one of three critical swing states. Will former Vice President Joe Biden win the nomination? A high conviction is not warranted. Biden is clearly the frontrunner, but we think a progressive can pull it off. A simulation of the Democratic Convention “pledged delegates,” based on November polling in the first four primary elections, shows Biden far short of a majority (Chart 8). He needs to outperform his polls, but this will be difficult given that he is well-known, has not performed well in debates, and will have Mayors Pete Buttigieg and Michael Bloomberg nipping at his heels in the Midwest and Northeast, respectively. Chart 8Do Not Discount A Progressive Win Over time, candidates will drop out, so it is more informative to look at the “centrist” candidates as a whole compared to the “progressives.” Here the early primary polling suggests that the progressives will come closest to victory (Chart 9). Chart 9Progressives Come Closest To Victory The trend within the party is to move to the left. Senators Elizabeth Warren and Bernie Sanders are tied as voters’ second choice – even Buttigieg supporters are split between Biden and Warren (Chart 10). What is unknown is whether Warren (or Sanders) can consolidate the progressive vote faster than Biden (or Buttigieg) consolidates the centrist vote. Chart 10If Biden Falters, Progressives Are Next In Line Chart 11Structural Imbalances Give Rise To Populism Trends pointing toward a progressive victory may not at first trouble the market, but any signs that a progressive is pulling ahead decisively will force investors to sharply upgrade the probability that he or she will win the White House. This will cause equity volatility, which could become self-reinforcing. A progressive nominee would force investors to recognize that populism and political risk are here to stay – which is our expectation given that they are motivated by polarization, inequality, and other structural imbalances in the United States (Chart 11). Left-wing or progressive populism is far more negative for corporate earnings than Trump’s right-wing or “pluto-populism.” Sanders or Warren present the worst case for investors because they favor trade protectionism in addition to higher taxes and minimum wages. Most presidents achieve their chief legislative priority in their first term and there is no reason to assume a progressive presidency would be any different. The implication is higher corporate taxes as well as individual taxes to pay for a sweeping expansion of the social safety net – positive for the economy perhaps but negative for corporate earnings. Chart 12A Progressive Win Threatens Key Sectors An extensive re-regulation of the US economy would occur regardless, since it falls under executive authority. It would affect the key equity sectors in the US bourse, technology and health (Chart 12), as well as energy and financials. The choice of a centrist Democrat like Biden (or Buttigieg) would be the least negative outcome for US equities of all the Democrats. The market would probably cheer a Trump versus Biden matchup for this reason. Biden favors higher taxes and regulation but is an establishment politician and known quantity. However, even Biden will be pulled to the left by the current within his party once in office; and Buttigieg will govern to the left of Biden. Trump’s reelection would spur a relief rally in US equities, but it would be short-lived. He would solidify low taxes and deregulation and would have a real chance of passing an infrastructure package. But he would also curtail labor force growth with his border wall and double down on trade protectionism – likely against Europe as well as China this time. His unpredictable and aggressive tendencies would be turbo-charged by a new popular mandate. We expect to cut back on risk exposure upon Trump’s reelection, assuming the bull market has survived to return him to office. A Democratic victory would mark another reversal in US policy orientation. Given our view that the White House call is also the Senate call, this would be the third time since 2008 that the country has witnessed a total reversal. Domestic American political risk will not end with the election: a legitimacy crisis could follow a narrow election, and institutional erosion continues regardless. It is too soon to call peak polarization, as the election will result in either a left-wing government bent on redistributing wealth or a right-wing Trump administration that exacerbates inequality. A centrist "return to normalcy" is possible with a Biden or Buttigieg victory. This reinforces our constructive cyclical view. Bottom Line: The chief risk from US politics in 2020 is Trump becoming a lame duck and resorting to belligerent foreign policy to try to win back voters through a rally around the flag. The chief risk of the Democratic nomination, and the general election, is a left-wing populist winning the White House. Any Democratic victory would likely bring the Senate, removing a key constraint. Over time the median voter is moving to the left. The Man Who Changed China Chart 13Xi Is Purging Misallocated Capital Xi Jinping undoubtedly represents a “new era” in China – a reassertion of Communist Party rule. The party faced a crisis of legitimacy amid the Great Recession and Arab Spring and was determined to regain political, economic, and social control. Xi had previously been anointed but was all too happy to take on the role of neo-Maoist strongman. Yet Xi’s playbook is close to that of President Jiang Zemin’s: centralize the party, repress dissent, modernize the military, restructure banks and the economy, upgrade the country’s science and technology, and expand China’s global influence. The difference is that while Jiang rode the high tide of globalization, Xi is riding the receding tide. Jiang culled two-thirds of the country’s state-owned enterprises, laying off over 40 million people, confident that a surge of new growth would ensue. Xi is also cracking down – allowing bankruptcies to purge misallocated capital (Chart 13) – but with a large debt load and shrinking labor force, he needs the state sector to put a floor under growth rates. The takeaway is that Xi will act pragmatically to boost growth when China’s stability is threatened, as he did in 2015-16. The trade war has already forced him to backtrack on the 2017-18 deleveraging campaign and stimulate the economy. The combined fiscal and credit impulse amounts to 6.6% of GDP from trough to now, and it hasn’t peaked. The implication is that Chinese growth – and global growth – will pick up from here (Chart 14). Chinese authorities are still trying to contain the growth in leverage, which has kept this year’s stimulus in check. But the chief banking regulator has also stated that as long as the macro-leverage ratio is not growing faster than 10%, this goal is met (Chart 15). Chart 14Chinese Growth Will Pick Up Chart 15China Says Leverage Already Contained The economy has not yet durably bottomed, so the state will continue adding support. The coming year is the third and final year of the “Three Battles” – against poverty, pollution, and systemic risk – as well as the final year of the thirteenth five-year plan. Beijing is falling short on its targets for real urban per capita income (Chart 16) and poverty elimination (Chart 17). A last-minute rush to meet these targets is likely and will require more fiscal stimulus. Chart 16Beijing Falls Short Of Urban Income Target... Chart 17...And Poverty Target This is not an argument for a blowout credit splurge. China is saving dry powder for a further escalation in the US containment strategy and a worse economic downturn. Do not expect a blowout Chinese credit splurge. The core constraint on policy is unemployment. Stimulus efforts have created a bottom in the employment component of the manufacturing PMI as well as a notable uptick in the demand for urban labor (Chart 18). To withdraw stimulus now – or tighten policy – would be to trigger a relapse in an economy that is ultimately at risk of a debt-deflation trap. Chart 18Chinese Stimulus Shows Up In Employment Chart 19A Banking Crisis Is A Risk To The Chinese Economy Tougher controls on credit and shadow banking have seen an uptick in corporate defaults and bank failures. With the government deliberately imposing pain on bloated sectors of the economy, financial turmoil could spread. Newspaper mentions of defaults, layoffs, and bankruptcies have only slightly subsided since stimulus efforts began (Chart 19). If bank failures spiral out of control, the economy will tank. The state will have to fight fires. Tariffs have accelerated the trend of firms relocating out of China, which began because of rising wages and a darkening business environment (Chart 20). A questionable trade ceasefire will not reverse the process as American and Asian companies are seeking a lasting solution, which requires them to set up shop elsewhere. China will want to mitigate the process, first by stabilizing domestic growth, and second by accepting Trump’s tactical trade retreat. Xi is also trying to avoid diplomatic isolation by courting trade partners other than the US, since the ceasefire is unreliable and the US containment strategy is presumed to continue. This involves outreach to the rest of Asia, Russia, and Europe, and even to distrustful neighbors like Japan and India. Europe is the swing player. China’s Asian neighbors, and Australia and New Zealand, have reason to fear Beijing’s growing clout and seek the US’s security umbrella. Russia and China are informal allies. But the European public is not interested in the new cold war – China does not threaten Europe from next door, like Russia does, and the Trump administration is threatening Europe with both trade war and Middle Eastern instability. European leaders are happy to take the market share that the US is leaving, as is clear from direct investment (Chart 21). Only a concentrated US diplomatic effort can address this divergence, which is not forthcoming in 2020. Chart 20Firms Are Relocating Out Of China Chart 21Europe Exploits US-China Rift A new Democratic administration, or a change in Trump strategy in the second term, could eventually produce a multilateral western coalition demanding that China open up and liberalize parts of its economy. But Europe will need to be convinced of the underlying reality that China is doubling down on the state-led industrial policies that provoked the Americans to begin with. Beijing is after economic self-sufficiency, indigenous innovation, and leadership in high-tech production and new frontiers. Its official research and development budget is not its only means for achieving this end (Chart 22) – it also has state-backed acquisitions and cyber campaigns. Germany and Europe have begun scrutinizing Chinese investment, separately from the United States. Chart 22Beijing Is After Economic Self-Sufficiency The danger to China – and the world – is that Xi Jinping might overplay his hand. He could overtighten money, credit, or property regulations and spoil the economy when global growth is vulnerable. His anti-corruption campaign is a telling reminder of his heavy hand in domestic affairs (Chart 23). Chart 23Xi Jinping Risks Overplaying His Hand Chart 24China Needs To Calm Things Down He could also suppress protesters in Hong Kong and rattle sabers over Taiwan or the South China Sea in a way that undermines the trade ceasefire. Or he could fail to bring the North Koreans to heel. These strategic tensions are significant only insofar as they undermine the trade ceasefire or provoke US-China saber-rattling. Failing to act as an honest broker in the Iran crisis would also irk Europeans and give them an excuse to side with the US. Bottom Line: China will continue modestly stimulating the economy next year to achieve a durable stabilization in growth. The risk of debt-deflation and rising unemployment ultimately necessitates this policy. Beijing can accept Trump’s tariff rollback for the sake of stability – China’s policy uncertainty relative to the rest of the world is off the charts and Beijing has an interest in calming things down (Chart 24). Yet Beijing will double down on indigenous innovation, while courting the rest of the world so as to preempt criticism and isolate the Americans. The risk is that Xi proves too heavy-handed when it comes to domestic leverage, the tech grab, strategic disputes, or trade talks with Washington. The Strait Of Hormuz Risk Chart 25US-Iran Conflict Still Unresolved In a special report earlier this year entitled “The Polybius Solution” we argued that while the US-China conflict is the major long-term geopolitical conflict, the US-Iran showdown could supersede it in the short term. This remains a risk for 2020, as the Trump administration’s confrontation with Iran is fundamentally unresolved (Chart 25). The Trump administration is still enforcing “maximum pressure” sanctions, which have reduced Iranian oil exports from 1.8 million barrels per day at their recent peak to 100,000 barrels per day in November (Chart 26). These are crippling sanctions that have sent Iran’s economy reeling. Chart 26Iran Remains Under Iran’s Supreme Leader Ayatollah Ali Khamenei has ruled out negotiations with Trump. They would be unpopular at home without a major reversal on sanctions from Trump (Chart 27). Chart 27Major US Reversal Prerequisite For Iran Talks Trump presumably aims to avoid an oil shock ahead of the election. The US and its allies have visibly shied away from conflict in the wake of Iran’s provocations, including the spectacular attack on eastern Saudi Arabia that knocked 5.7 million barrels of oil per day offline in September. However, this does not mean the odds of war are zero. The Americans or the Iranians could miscalculate. Both sides might think they can improve their standing at home by flexing their muscles abroad. Iran is a rational actor and would not normally court American airstrikes or antagonize a potentially lame duck president. Yet it is under extreme pressure due to the sanctions. It faces significant unrest both at home and in its sphere of influence (Iraq and Lebanon). Opinion polls show that the public primarily blames the government for the collapsing economy, and yet that American sanctions are siphoning off some of this anger (Chart 28). This could tempt the leaders to continue staging provocations in the Strait of Hormuz or elsewhere in the region. Chart 28Iranians Blame Tehran, Tehran Blames America Hardline military leaders and politicians currently receive the most favor in polling, while the reformist President Rouhani – undercut by the American withdrawal from the 2015 deal – is among the least popular (Chart 29). The Majlis (parliament) elections in February will likely reverse the reformist turn in Iranian politics that began in 2012. The regime stalwarts are gearing up for the supreme leader’s succession in the coming years. While a Democratic White House could restore the 2015 deal, that ship may have sailed. Chart 29Rouhani And Reformists In Trouble A historic oil supply disruption is a fatter tail risk than investors realize. Chart 30The Iranians May Take Excessive Risk Trump, under impeachment, could seek to distract the public. This was Bill Clinton’s tactic with Operations Infinite Reach, Desert Fox, and Allied Force in 1998-99. These operations were minor and not comparable to a conflict with Iran. However, Trump may be emboldened. On paper the US strategic petroleum reserve (along with OPEC and other petroleum reserves) could cover most major oil shock scenarios. According to Hugo Bélanger, Senior Analyst at BCA Research Commodity & Energy Strategy, a supply outage the size of the Abqaiq attack in September would have to persist for four months to cause enough price pressure to harm the US economy and decrease Trump’s chances of winning reelection. The simulations in Chart 30 overstate the gasoline price impact by assuming that global oil reserves remain untapped. Thus while the Iranians may take excessive risks, the Trump administration may not refrain this time from airstrikes. Bottom Line: While the Middle East is always full of risks to oil supply, Iran’s vulnerability and Trump’s status at home make the situation unusually precarious. A historic oil supply disruption is a fatter tail risk than investors realize. Europe Is A Price Taker, Not A Price Maker Just as the US and China have a shared incentive to avoid tariff-induced recession, so the UK and EU have a shared incentive to prevent a shock reversion to basic WTO tariffs. The December 31, 2020 deadline for the UK-EU trade deal, like the various deadlines for Brexit itself, can be delayed. Even Prime Minister Boris Johnson has proved unwilling to exit without a deal and even a hung parliament has proved capable of preventing him from doing so. The negotiation of a trade deal – which is never easy and always drags on – will be a lower-order risk in the wake of the past two years’ Brexit-induced volatility. Johnson will not be held hostage by hardline Brexiters given that Brexit itself will be complete. If our view on Chinese growth is correct, then Europe’s economy can recover and European political risk will be a “red herring” in 2020, as it was in 2019. Instead the EU presents an opportunity. Chart 31Euro Area Breakup Risk Has Subsided Euro Area break-up risk has subsided after a series of challenges in the wake of the sovereign debt crisis (Chart 31). There is not a basis for a reversal of this trend, at least not until a full-blown recession afflicts the continent. The rise in anti-establishment parties coincided with a one-off surge in migration that is finished – and successful populists from Greece to Italy have moderated on euro membership once in power. Germany is entering a profound transition driven by de-globalization and tensions with the United States. It is more likely to have an early election than the consensus holds. But it is fundamentally stable and supportive of European integration. In fact the great debate about fiscal policy poses an upside risk over the long run both for European equities and the European project. We remain optimistic on French structural reforms even though President Emmanuel Macron must overcome significant public opposition. An eerie quiet hangs over Russia, making it one of our “Black Swan” risks for 2020. Oil prices are not very high, which discourages foreign adventures, and President Vladimir Putin has spent his fourth term trying to consolidate international gains and improve domestic stability. But approval of the government is weak, the job market is deteriorating, and social unrest is cropping up. There is plenty of room to ease monetary and fiscal policy, but a sharp downturn could provide the basis for an aggressive foreign policy action to shore up regime support. The US election also presents the risk of renewed US-Russian tensions, whether over election interference or a Democratic victory. Investment Conclusions Geopolitics is the likeliest candidate to derail the global bull market in 2020. Nevertheless, policymakers are adjusting to their constraints. Trump and Xi are negotiating a ceasefire and a disorderly Brexit is off the table. Even Trump’s impeachment shows that the US system of checks and balances remains intact. After all, there is nothing to prevent removal from office if Trump further antagonizes public opinion and the Republican Senate. This means that policy uncertainty will decline on the margin in 2020, even as it remains elevated due to the danger of the underlying events. The nature of US economic imbalances suggests that the policy discontinuity of a Democratic victory on November 3, 2020 would be better for the economy (via household consumption) than it would be for corporate earnings. Policy continuity with the Trump administration suggests the opposite. On a sectoral basis we recommend going long US energy large cap stocks and short info-tech and communications. Energy has limited downside even if a progressive wins whereas tech has limited upside even if Trump wins. The BCA Research House View expects the US dollar to weaken as global growth rebounds, stocks to outperform bonds and cash, and developed market equities to outperform those of the United States. But a Republican victory in November would push against these trends as it is more bullish for the greenback and for US equities relative to global. As a play on the global growth rebound we expect, we recommend going long industrial metals. Like our colleagues at BCA Research Commodity & Energy Strategy, we are initiating this as a tactical trade but it may become strategic. We are reinitiating a tactical long Korea / short Taiwan equity trade. Taiwanese political risk is understated ahead of January’s election and the island is the epicenter of the US-China cold war. We are restoring our long gold trade as a strategic hedge. Populism and de-globalization are potentially inflationary, but they are also linked with great power competition which will increase the frequency of geopolitical crises. In either case, gold is the right safe haven to own. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com
Highlights A 400k b/d addition to OPEC 2.0’s official production cut of 1.2mm b/d will have little effect on actual supplies. The market already has seen ~ 2.0mm to 2.5mm b/d of output removed from the market via excess voluntary cuts (e.g., from Saudi Arabia and others) and involuntary cuts (e.g., from Iran and Venezuela). The incremental 400k b/d would just be another target for free-rider states to ignore. However, if Iraq and other states with on-and-off compliance at the margin can be persuaded to follow through on producing at lower quotas following OPEC 2.0’s meetings today and tomorrow, markets could rally as actual output falls (Chart of the Week). A rally on the back of lower OPEC 2.0 production would support the IPO of Saudi Aramco, which is expected to price while the producer coalition is meeting in Vienna. Production from the “Other Guys” – our moniker for all producers excluding Gulf OPEC, US shale and Russia – will account for a lesser and lesser share of global output. New production – much of it from the last of the big conventional projects sanctioned prior to the 2014 price collapse – from Norway, Brazil, Guyana and the US Gulf of Mexico will come on strong in 2020 – but most of this has been priced in already. The rate of growth of US shale-oil production will slow. Feature Brent crude oil prices could get a boost from OPEC 2.0, if free-rider states – specifically Iraq and states with marginal quota compliance shown in the Chart of the Week – actually were to abide by production cuts they agree to. This would be amplified if cuts are extended to end-June, from end-March. The impact would be marginal, to be sure, given most of the production cuts that matter to the market already are in place – i.e., Saudi Arabia’s overcompliance of ~ 400k b/d, and Iran and Venezuela’s involuntary production cuts of ~ 1.8mm b/d resulting from US sanctions, as of October 2019. Ahead of the Vienna meetings today and tomorrow, the putative leaders of the producer coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have been lobbying at cross purposes. KSA is seeking support for deeper cuts and an extension to mid-year of the deal. Russia is lobbying to keep the original deal’s expiry at end-March, and also is seeking to have its ultra-light crude (i.e., condensates) production excluded from its quota, as it is from OPEC members’ production calculations. Russia is creating additional volumes of condensate – ~ 800k b/d this year of its total 11.2mm b/d output – to dispose of as it ramps natural gas production to new feed markets, particularly China.1 Our expectation is the production-cutting deal will be extended to end-June with an official target of 1.6mm b/d removed from the market. Whether the new deal matters to the market will depend on the actions of heretofore free-rider OPEC 2.0 states. Prices could go up, but market share for the producer coalition will remain under pressure (Chart 2). Chart of the WeekAdditional OPEC 2.0 Cuts Could Be Bullish For Crude Oil Chart 2OPEC 2.0 Market Share Under Pressure Saudi Aramco IPO Due To Price Follow-through by all OPEC 2.0 members on additional production cuts would benefit Saudi Arabia, as it is expected to price the Saudi Aramco IPO while the producer coalition is meeting in Vienna. The Aramco IPO price is expected to value the company between $1.5 and $1.8 trillion. We recently looked at the IPO and believe Aramco will be valued closer to $2 trillion than to $1 trillion, the literal range in which the offering was being valued by banks and analysts.2 To briefly recap, in the first six months of this year, Aramco produced 10.0mm b/d of crude oil and condensates. Aramco accounted for 12.5% of global crude output in 2016 - 18 and reported in its red herring that its proved liquids reserves were ~ five times larger than the combined proved liquids reserves of the five major independent oil companies. Aramco’s 3.1mm b/d of refining capacity makes it the fourth largest integrated refiner in the world. In 2018, Aramco’s free cash flow amounted to almost $86 billion. Net income last year was $111 billion, more than the combined profits of the next six largest oil companies in the world. For its first year as a public company, Aramco has indicated it will pay an annual dividend of $75 billion. Improving compliance with the OPEC 2.0 production-cutting deal is of obvious importance for the Aramco IPO. The member states are quick to stress they support the deal and will do their part, but free riding has been a problem in terms of compliance. As we noted above, full compliance will lower OPEC 2.0 crude oil production from current levels, but Saudi Arabia’s voluntary over-compliance, coupled with the involuntary production losses from Iran and Venezuela already are doing most of the work in restraining production. The “Other Guys” Continue Treading Water Since 2010, most of the growth in world oil production came from three regions: US onshore shale-oil producers, Gulf OPEC and Russia. These regions added 14mm b/d of supply between 2010 and 2019. The “Other Guys” often are overlooked in the oil market, but they still accounted for 45% of global oil production this year on average. Production from the “Other Guys” – our moniker for all producers excluding Gulf OPEC, US shale and Russia – has been falling as a share of global production for years, due to a lack of domestic and foreign direct investment in their energy sectors. We expect their production will remain flat next year and could start falling in 2021. The “Other Guys” often are overlooked in the oil market, but they still accounted for 45% of global oil production this year on average: Their combined output was ~ 45mm b/d of crude and liquids (Chart 3). The “Other Guys’” production is mostly long-cycle projects and these countries do not possess spare capacity. Thus, they are reacting to oil prices and maximizing production now, if they can. Even so, their share of global production continues to fall (Chart 4). Chart 3The "Other Guys" Production Is Stagnant Chart 4The "Other Guys" Market Share Plummets The 3- to 5-year lag between final investment decisions and first production for projects in these states strongly suggests the global oil market is entering a period of lower supply additions from the “Other Guys,” given the last mega-projects were probably sanctioned in 2014 while prices still were above $100/bbl for both Brent and WTI. The "Other Guys’" rig count recovered, along with oil prices, since the 2016 downturn. However, this is still a low level of rigs vs. the 2010-2014 period – a period during which production from this group barely grew despite prices averaging more than $100/bbl. We expect their rig count to remain weak next year (Chart 5). Conventional production takes time to ramp up, therefore we should not expect a large increase in production over the next few years. Chart 5The "Other Guys" Rig Counts Will Remain Under Pressure Oil Supply Looks Tighter Toward 2021 Globally, the last of the big projects sanctioned prior to the oil-price collapse beginning in 2H14 and lasting to 1H16 are coming online in Norway, Brazil, Guyana and the US Gulf. Up to this year, US onshore production was the sole growing region globally. If capital discipline caps growth prospects in key US shale basins, global oil supply will grow only modestly in 2020 and 2021. For the most part, the “Other Guys” haven't been attracting the capital needed to sustain and grow their production. Given the ongoing drive by E&P companies globally to return capital to shareholders via buybacks or dividends, and the insistence of capital markets to fund only solid, profitable projects, capital likely will remain constrained for the “Other Guys.” States that were able to attract capital prior to the 2014 oil price collapse – Canada, Brazil, Norway, Guyana and the US – are expected to increase production next year; however, we believe much of this production increase already has been priced in by the market, as it has been by BCA (Chart 6). In our balances, we have oil production for Canada up 50k b/d next year vs 2019; Brazil +330k b/d and Norway +360k b/d. This is 740k b/d ex-Guyana in 2020. Guyana is still doing exploratory drilling and recently announced they expect to have their first commercial flows online this month. Oil markets are expecting initial commercial flows of ~ 120k b/d between December and 1Q20, and a ramp to 750k b/d by 2025, which would be significant. We will be updating our balances in two weeks, in our final publication of the year. Up to this year, US onshore production was the sole growing region globally. If capital discipline caps growth prospects in key US shale basins, global oil supply will grow only modestly in 2020 and 2021 (Chart 7). US shale output reaches ~ 9.35mm b/d on average next year in the Big Five basins (Permian, Eagle Ford, Bakken, Niobrara and Anadarko), in our modeling. This amounts to an 800k b/d increase in our US lower 48 production estimate for the US, vs. a 900k b/d increase we expected earlier.3 Chart 6"The New Guys" Production vs. The "Other Guys" Production Chart 7US Shale Oil Production Growth Will Slow Going forward, it is important to re-emphasize that even the prolific shales in the US are being constrained by investors demanding the shale guys either return capital to shareholders via share buybacks or steady dividends and dividend increases. If they don’t accommodate investor interests, these shale producers – and all oil producers for that matter – will simply be denied access to funding markets. Capital is, finally, the binding constraint on the growth of global oil supplies. This has not always been the case, as we’ve noted. 2020 Could See Stronger Prices Markets generally are responding as expected to more accommodative financial conditions globally, which will allow oil demand growth, particularly in the EM economies, to revive in 2020. As a result, we are maintaining our expectation for growth of 1.4mm b/d next year, which is up 300k b/d from our expectation for growth this year. The rebound in demand we expect next year will force prices higher to incentivize additional supply and the release of inventories – mostly in 2H20. This will push the entire futures curve up, especially nearby futures, which will steepen the backwardation in Brent and WTI futures. Bottom Line: Further actual production cuts by OPEC 2.0, emerging threats to US shale growth, and stagnant output from the “Other Guys” facing off against higher demand growth next year could result in higher prices than we currently expect for 2020 – i.e., $67/bbl for Brent and $63/bbl for WTI. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Market Round-Up Energy: Overweight Brent prices remain stuck between $60/bbl and $65/bbl awaiting clear signals about the US-China trade negotiations and OPEC 2.0’s decisions on its supply management beyond March 2020. Money managers are increasing their net long position, expecting bullish news on both these developments. They are increasing their Brent exposure to 414k long contracts vs. 64k short. Base Metals: Neutral SHFE copper inventories fell 11% on a week on week basis to 120k MT as of last Friday. Combined, the LME, COMEX and SHFE fell by 6%. The larger decline in Chinese inventory is partly attributed to the reduced import quotas on copper scraps, which limited the total available supply to meet domestic demand. As discussed in last week’s report, fundamentals in the two largest components of the LMEX – i.e. copper and aluminum – are tight and the rebound in demand showing up in our proprietary indicators will support prices. We remain long the LMEX tactically. Last week, we recommended getting long the LMEX index. We have subsequently learned the LME ceases trading the index. We will, nonetheless, continue to track the reported level of the index, as if it were tradeable. Precious Metals: Neutral Closing at $1479/bbl on Tuesday, gold prices broke out of the narrow range in which the metal has traded over the past month. Gold’s daily-return 1-year rolling correlation with the U.S. dollar is at its weakest level since 2011 and is below the 5th percentile of its distribution since 2004. On the other hand, the correlation with U.S. 10-year TIPS yields is strengthening and is now above the 95th percentile of its distribution. As safe-haven demand dissipates – alongside the rebound in global growth we expect – we believe these correlations will move back to their historical relationships, supporting gold as the U.S. dollar depreciates. Ags/Softs: Underweight CBOT Corn March Futures Contracts rallied at the beginning of the week on the back of a blizzard in the Midwest that stalled the already delayed corn harvest, which the USDA reported to be 89% complete as of Dec. 1, well behind the five-year average of 98%. After reaching multi-months highs last week, wheat futures fell due to profit taking and weaker than expected export figures. Soybean fell for the eighth straight day on Monday, with the most active contract closing at $8.73/Bu, the lowest in six months. A possible delay in the US-China trade deal together with expectations of a bumper crop in Brazil remain headwinds to prices. Footnotes 1 Please see Russia to press OPEC+ to change its oil output calculations published by reuters.com November 27, 2019. 2 Please see our Special Report Aramco’s IPO: The Tie That Binds KSA And China, published November 15, 2019. It is available at ces.bcaresearch.com. 3 We discuss further risks to shale oil production growth in Lingering Oil-Demand Weakness Will Fade, including the high levels of flaring in the Permian and Bakken basins. This report is available at ces.bcaresearch.com. 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 Closed Trades
Highlights We are upgrading Pakistani equities to overweight within an EM equity portfolio. Fixed-income investors should consider purchasing 5-year local currency government bonds. The balance-of-payments adjustment is probably over. Hence, the currency will be stable, allowing inflation and interest rates to drop. Feature The country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Chart I-1Pakistani Stocks: The Worst Is Over We downgraded Pakistani equities in March 2017 and put this bourse on our upgrade watch list this past May (Chart I-1). In the past two years, the country has been going through a severe balance-of-payments crisis and a correspondingly painful adjustment. In recent months, the country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Today we are upgrading Pakistani stocks to overweight within an EM equity portfolio and recommend buying 5-year local currency government bonds. The worst is over for the economy and its financial markets for the following reasons. First, the country’s balance-of-payments position will improve. In real effective exchange rate (REER) terms, the Pakistani rupee has depreciated 15% over the past two years (Chart I-2). This will boost exports and cap imports, narrowing both trade and current account deficits further (Chart I-3). Chart I-2Considerable Depreciation In Pakistani Rupee… Chart I-3…Will Boost Exports And Cap Imports We expect exports to grow 5-10% next year. The country’s competitiveness has improved considerably, with its top commodities exports all having shown impressive growth in volume terms, despite weakening global growth (Chart I-4). Besides, in order to boost exports, the government has reduced the cost of raw materials and semi-finished products used in exportable products by exempting them from all customs duties in fiscal 2020 (July 2019 – June 2020). The government has also promised to provide sales tax refunds to the export sector. Chart I-4Increasing Competitiveness In Pakistan Exports In addition, falling oil prices will help reduce the country’s import bill. Remittance inflows – currently equaling 9% of GDP – have become an extremely important source of financing for Pakistan’s trade deficit. In the past 12 months, remittances sent from overseas have risen to US$22 billion, and have covered most of the US$28 billion trade deficit. Financial inflows are also likely to increase in 2020 and will be sufficient to finance the current account deficit. The IMF will disburse roughly US$2 billion to Pakistan. Other multilateral/bilateral lending/grants and planned issuance of Sukuk or Euro bonds will provide the government with much-needed foreign funding. As the economy recovers, net foreign direct inflows are also likely to increase. Net foreign direct investment received by Pakistan has grown 24% year-on-year in the past six months, with 56% of the increase coming from China. Overall, the improvement in Pakistan’s balance-of-payments position will continue, resulting in a refill of the country’s foreign currency reserves. Odds are that the central bank will purchase foreign currency from the government as the latter gets foreign funding. This will provide the government with local currency to spend. At the same time, the central bank’s purchases of these foreign exchange inflows will boost the local currency money supply – a positive development for the economy and stock market. Chart I-5 shows that the Pakistani stock market closely correlates with swings in the nation’s narrow money growth. The Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Chart I-5Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Chart I-6Pakistan: Improving Fiscal Balance Second, Pakistan’s fiscal balance also shows signs of improvement. Pakistan and the IMF have agreed to set the target for the overall budget and primary deficits at 7.2% of GDP and 0.6% of GDP, respectively, for the current fiscal year (Chart I-6). This will be a considerable improvement from the 8.9% of GDP and 3.3% of GDP, respectively, last fiscal year. In early November, the IMF praised Pakistan for having successfully managed to post a primary budget surplus of 0.9% of GDP during the first quarter (July 1, 2019 – September 30, 2019) of its current fiscal year. The authorities are determined to maintain strict fiscal discipline. The country’s tax-to-GDP ratio is at about 12%, one of the lowest in the world, so there is room to expand the tax base. Third, the Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Both headline and core inflation seem to have peaked (Chart I-7). Headline inflation fell to 11% in October, which already lies within the central bank’s target range of 11-12% for the current fiscal year. The policy rate is currently 225 basis points higher than headline inflation. As inflation drops and the currency finds support, interest rates will be reduced to facilitate the economic recovery. In addition, there has been much less public debt monetization by the central bank. After borrowing Rs3.16 trillion from the central bank in the previous fiscal year, the federal government has curtailed such borrowing to only Rs122 billion in the first three months of this fiscal year. Diminishing debt monetization will also help ease domestic inflation. Chart I-7Inflation Has Peaked Chart I-8Manufacturing Activity Is Likely To Recover Soon Fourth, manufacturing activity in Pakistan has plunged to extremely low levels, comparable to the 2008 Great Recession (Chart I-8). With a more stabilized local currency, easing domestic inflation and interest rate reductions, Pakistan’s economic activity is set to recover soon from a very low base. Finally, Phase II of the China-Pakistan Economic Corridor (CPEC) is set to begin this month. Under Phase II of the CPEC, five special economic zones will be established with Chinese industrial relocation. Phase II will also bring forward dividends from Phase I projects. The nation’s infrastructure facilities built by China over the past several years have enhanced the productive capacity of the Pakistani economy. The significant increase in electricity supply and improved railway/highway transportation will promote higher productivity/efficiency gains. Bottom Line: We are upgrading Pakistani equities to overweight within the emerging markets space. Both absolute and relative valuations of Pakistani stocks appear attractive (Charts I-9 and I-10). Chart I-9Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Chart I-10…And Relative To EM Equities Meanwhile, we recommend going long Pakistani 5-year local currency government bonds currently yielding 11.5%, as we expect interest rates to drop quite a bit (Chart I-11). Chart I-11Go Long Pakistani 5-Year Local Currency Government Bonds Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Structurally overweight US T-bonds versus core European bonds. Our preferred expression is long T-bonds versus Swiss bonds. US yields can fall a lot more than European yields, and European yields can rise a lot more than US yields. Structurally underweight the overvalued dollar versus undervalued European currencies. Our preferred expression is long SEK/USD. Structurally underweight price-sensitive European export sectors. Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. But structurally overweight soft luxuries. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Fractal trade: The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Feature Chart of the WeekLike-For-Like, Structural Inflation Is Lower In the US Than In Europe A seemingly trivial disagreement between Europeans and Americans on how to measure inflation turns out to be the culprit for three major distortions in the world right now: Deeply divergent monetary policies across the developed economies. Huge valuation anomalies in the foreign exchange markets. President Trump’s threat of a trade war to counter the huge trade surpluses that Europe and China are running against the US. The inflation measurement disagreement wouldn’t really matter if inflation were running in the mid-single digits. But when inflation is near zero, the seemingly trivial difference in inflation measurement methodologies has ended up generating massive distortions. European And American Inflation Are Not The Same European inflation excludes the maintenance and upkeep costs associated with owning your home, whereas US inflation includes these costs at a hefty 25 percent weighting, making owner occupied housing by far the largest single item in the US inflation basket. By omitting the largest item in the US inflation basket, European inflation is subtly yet crucially different to American inflation. The European statisticians argue that unlike all the other items in the inflation basket, there is no independent market price for the ongoing cost of home ownership, and therefore this cost should be excluded. The American statisticians argue that the ongoing cost of home ownership is the single largest expense for most people and, as such, it should be ‘imputed’ from a concept known as ‘owner equivalent rent’ – essentially, asking homeowners how much it would cost to rent their own home. Different definitions of inflation will trigger very different policy responses from central banks. Both the European and American approaches have their merits and drawbacks, and it is not our intention to endorse one approach over the other. Our intention is simply to point out that the two approaches can give very different results for inflation – and therefore trigger very different policy responses from inflation-targeting central banks, with their consequent economic and political repercussions. If Americans used the European definition of inflation, then headline inflation in the US today would be running at the same sub-par rate as in the euro area, 1 percent, and well below the Fed’s 2 percent target (Chart I-2 and Chart I-3). More important, the five year annualised rate of inflation – let’s call it US structural inflation – would have been stuck below 1 percent since 2016 (Chart I-1 and Chart I-4). Under these circumstances, it would have been impossible for the Fed to hike the funds rate eight times, as it did through 2017-18. Chart I-2Like-For-Like, Headline Inflation Is Identical In The US And The Euro Area... Chart I-3...And Core Inflation Is ##br##Very Similar Chart I-4Using The European Definition Of Inflation, The Fed Couldn't Have Hiked Rates Instead, what if Europeans used the American definition of inflation? European inflation does not include owner equivalent rent, but it does include housing rent for those that do rent their homes. In the US, these two items tend to move in lockstep (Chart I-5). If we assume the same for Europe, we can deduce that a US type weighting for owner equivalent rent would have boosted the headline inflation rate in the euro area by 0.3-0.4 percent through 2014-16, and by a possible 0.5 percent in Sweden through 2013-15 (Chart I-6 and Chart I-7). Under these circumstances, it would have been very difficult for the ECB and Riksbank to take and maintain policy rates deeply in negative territory, as they did through 2015-19. Chart I-5Owner Equivalent Rent Tracks ##br##Housing Rent Chart I-6Using The American Definition Of inflation, Euro Area Inflation Would Have Been Higher... Chart I-7...And Swedish Inflation Would Have Been Much Higher The Different Definitions Of Inflation Have Created Dangerous Distortions If Europeans and Americans were using the same definition of inflation then, one way or the other, their monetary policies would not be as deeply divergent as they are now. One important implication is that European currencies would not be as undervalued as they are now. If Europeans and Americans were using the same definition of inflation then their monetary policies would not be as deeply divergent as they are now. Based on the ECB’s own analysis, the euro area is over-competitive versus its top 19 trading partners – meaning the euro is undervalued – by at least 10 percent. Moreover, the ECB admits that this sizable undervaluation only appeared after the ECB and Fed started taking their monetary policies in opposite directions in 2015 (Chart I-8). Chart I-8The Euro Is Undervalued By More Than 10 Percent Put the other way, the dollar would not be as overvalued as it is now. In turn, the stronger dollar has created its own dangerous spill-overs. As we explained last week in The Hidden Sales Recession Of 2015… And Why It Matters Now, the surging dollar in 2015 could not have come at a worse time for China. Given that the Chinese economy was already slowing sharply, and the yuan was pegged to the dollar, the resulting loss of Chinese competitiveness just exacerbated the slump. Forcing China to loosen the dollar peg in August 2015. All of which brings us neatly to the hot topic of 2019, and likely 2020 too – President Trump’s threat of a trade war to counter the huge trade imbalances that Europe and China are running against the US. As it happens, President Trump has a good point. Trade wars almost always stem from trade imbalances; and trade imbalances almost always stem from exchange rate manipulations or, at least, exchange rate distortions that advantage one economy to the detriment of another. The euro's undervaluation only happened after monetary policies diverged in 2015. Most of the euro area’s €150 billion trade surplus with the US appeared after 2015, so it cannot be a structural issue. In fact, the evolution of the trade imbalance has tracked relative monetary policy between the Fed and ECB almost tick for tick (Chart I-9), via the exchange rate channel and the over-competitiveness of the euro which the ECB fully admits. Chart I-9Excessively Divergent Monetary Policies Caused The Euro Area's Huge Trade Surplus With The US Of course, neither the ECB nor the Fed are deliberately targeting trade or the exchange rate; they are targeting inflation. But to repeat, they are targeting different definitions of inflation. Crucially, with a backdrop of near zero inflation, small definitional differences in inflation can generate huge economic and financial distortions, with dangerous political consequences. The Compelling Structural Opportunities The definitional difference between European and American inflation explain many of the economic and financial distortions we are witnessing now, as well as the dangerous political consequences. The main counterargument is that the inflation definitions are what they are; neither the ECB nor the Fed are likely to change them anytime soon. Nevertheless, there are compelling structural opportunities. Since 2015, American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices (Chart I-10 and Chart I-11). The historic evidence suggests that such a pace of outperformance is unsustainable structurally and, absent this tailwind, US and European headline inflation rates have to converge, one way or the other. Chart I-10An Unsustainable Surge In US Owner Equivalent Rent... Chart I-11...Has Lifted US Headline ##br##Inflation In this inevitable convergence, the asymmetric starting point of bond yields favours a long US T-bonds, short core European bonds structural position. Because, if the inflation convergence is downwards, T-bond yields will fall much further than European yields; whereas if the inflation convergence is upwards, European yields will likely rise more than T-bond yields. Our preferred structural expression is: long US T-bonds, short Swiss bonds. For currencies it is the opposite message. The overvalued dollar is likely to underperform, at least versus other developed market currencies. Given that Swedish inflation has been the most understated by the exclusion of owner equivalent rents, combined with the Riksbank’s intention to exit negative interest rate policy imminently, our preferred structural expression is: long SEK/USD. American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices. Lastly, European export growth – even in Germany – has been heavily reliant on a cheapening euro (Chart I-12). Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. Even those multinationals that sell their products in dollars will lose out in the accounting translation back into a strengthening domestic currency. Hence, structurally underweight price-sensitive European export sectors. Chart I-12Without A Weaker Euro, Most European Exporters Will Struggle To Outperform The one exception to this is the soft luxuries sector. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Stay structurally overweight soft luxuries. Fractal Trading System* The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Accordingly, this week’s recommended trade is to short the MSCI All Country World versus the global 10-year bond (simple average of US, euro area, and China), setting a profit target and symmetrical stop-loss at 2.5 percent. In other trades, long NZD/JPY and long SEK/JPY both achieved their profit targets of 3 percent and 1.5 percent respectively. Against this, long Poland versus World reached its 4 percent stop-loss. The rolling 1-year win ratio now stands at 65 percent. Chart I-13MSCI All-Country World Vs. Global 10-Year Bond When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights China’s PMIs continue to flash a positive signal, but the hard data trend remains negative. There has been a notable improvement in China’s cyclical sectors (versus defensives) over the past month, but broad equity market performance has been flat-to-down. China’s lackluster equity index performance in the face of rising PMIs suggests that investors can afford to wait for an improvement in the hard economic data before tactically upgrading to overweight. Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets versus the global benchmark, favoring the former over the latter. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, China’s November PMIs were clearly positive, and the rise in the official manufacturing PMI above the 50 mark is notable. However, the odds continue to favor a bottoming in the economy in Q1 rather than Q4, in large part because China’s “hard” economic data has continued to deteriorate during the time that the Caixin PMI has been signaling an expansion in manufacturing activity. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, China’s cyclical sectors have outperformed defensives, which is consistent with the positive message from China’s PMIs. But China’s broad equity markets have been flat-to-down versus the global index over the past month, suggesting that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight (from neutral). Cyclically, we continue to recommend an overweight stance towards both the investable and A-share markets, but favor the former over the latter in a trade truce scenario. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Both measures of the Li Keqiang index (LKI) that we track indicated no obvious improvement in Chinese economy activity in October. The BCA China Activity indicator, a broader coincident measure of China’s economy, also moved sideways in October and (for now) remains in a downtrend. Thus, based on the “hard data”, Chinese economic activity has not yet bottomed. Chart 1A Moderate Strength Economic Recovery Will Begin In Q1 The components of our LKI leading indicator continue to tell a story of easy monetary conditions and sluggish money & credit growth (Chart 1). The indicator itself remains in an uptrend, but it is a shallow one that does not match the intensity of previous credit cycles. While the uptrend in the indicator suggests that China’s economy will soon bottom, the shallow pace suggests that the coming rebound in growth will be less forceful than during previous economic recoveries. The uptrend in headline CPI is a notable macro development, with prices having risen 3.8% year-over-year in Oct (the fastest pace in almost eight years). This rise has been driven almost entirely by a surge in pork prices, which have risen over 60% relative to last year (panel 1 of Chart 2). While some investors have questioned whether the rise in headline inflation will cause the PBoC to tighten its stance at the margin, we argued with high conviction in our November 20 Weekly Report that this will not occur.1 Panel 2 of Chart 2 shows that periods of easy monetary policy line up strongly with periods of deflating producer prices, arguing that the PBoC will see through transient shocks to headline inflation. China’s October housing market data highlighted three points: housing sales are modestly improving, the pace of housing construction has again deviated from the trend in sales, and housing price appreciation is slowing in Tier 2 and Tier 3 markets. For now, we are inclined to discount the surge in floor space started, given previous divergences that proved to be unsustainable. The bigger question is whether investors should be concerned about slowing housing prices. Chart 3 shows that floor space sold and property prices have been negatively correlated over the past three years, in contrast to a previously positive relationship. Deteriorating affordability and tight housing regulations have contributed to this shift in correlation, which helps explain why the PBoC’s Pledged Supplementary Lending (PSL) program has been so closely related to housing sales over the past few years. While the growth in PSL injections is becoming less negative, it has not risen to the point that it would be associated with a strong trend in sales. As such, we continue to see poor affordability as a threat to further housing price appreciation, absent stronger funding assistance. Poor affordability will continue to be a headwind for China’s housing market. Chart 2The PBoC Will See Through Transient Shocks To Headline Inflation Chart 3Poor Affordability Will Continue To Weigh On Housing Demand Chart 4Investors Need To See Concrete Signs Of A Hard Data Improvement China’s November PMIs were quite positive, which legitimately increases the odds that China’s economy is beginning the process of recovery. However, we see two reasons to believe that the odds continue to favor a bottoming in the economy in Q1 rather than Q4. First, while they improved in November, several important elements of the official PMI remain in contractionary territory, particularly the new export orders subcomponent. Second, while the Caixin PMI has now been above the 50 mark for 4 consecutive months, China’s hard data has continued to deteriorate since the summer (Chart 4). Given the historical volatility of the Caixin PMI, we advise investors to wait for concrete signs of a hard data improvement before firmly concluding that China’s economy is recovering. Over the last month, China’s investable stock market has rallied roughly 1% in absolute terms, while domestic stocks have fallen about 3%. In relative terms, A-shares underperformed the global benchmark, while the investable market moved sideways. In our view, the underperformance of China’s domestic market reflects increased sensitivity to monetary conditions and credit growth compared with the investable market,2 and a weaker credit impulse in October appears to have been the catalyst for A-share underperformance. Over the cyclical horizon, earnings will improve in both the onshore and offshore markets in response to a modest improvement in economic activity, suggesting that an overweight stance is justified for both markets. But we think the investable market has more upside potential in a trade truce scenario. The outperformance of cyclical versus defensive sectors is sending a positive signal, but investors can afford to wait for better economic data before tactically upgrading. Chart 5A Positive Sign From Cyclicals Versus Defensives Within China’s investable stock market, it is quite notable that cyclicals have outperformed defensives over the past month on an equally-weighted basis (Chart 5). Interestingly, key defensive sectors such as investable health care and utilities have sold off significantly, and equally-weighted cyclicals have also outperformed defensives in the domestic market. The outperformance of cyclicals and underperformance of defensives is consistent with the positive message from China’s PMIs, but the fact that this improvement is occurring against the backdrop of flat-to-down relative performance for China’s equity market suggests that investors can afford to wait for confirmation of a hard data improvement before upgrading their tactical stance to overweight. In this vein, China’s November update for producer prices and total imports have high potential to be market-moving, and should be closely monitored. China’s government bond yields fell slightly in November, potentially reflecting expectations of further modest easing. Our view that monetary policy will likely remain easy over the coming year even in a modest recovery scenario suggests that Chinese interbank rates and government bond yields are likely to range-trade over the coming 6-12 months. We expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. Chinese onshore corporate bond spreads eased modestly over the past month. Despite continued concerns about onshore corporate defaults, the yield advantage offered by onshore corporate bonds have helped the asset class generate a 5.4% year-to-date return in local currency terms. Barring a substantial intensification of the pace of defaults, we expect onshore corporate bonds to continue to outperform duration-matched government bonds in 2020. The RMB has moved sideways versus the US dollar over the last month. USD-CNY had fallen below 7 in October following the announcement of the intention to sign a “phase one” trade deal, but the move ultimately proved temporary given the deferral of an agreement. We would expect the RMB to appreciate following a deal of any kind (a truce or something more), and it is also likely to be supported next year by improving economic activity. Still, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors. As such, we expect a modest downtrend in USD-CNY over the coming year. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated November 27, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Chart 1Manufacturing PMIs Track Bond Yields November’s manufacturing PMI data were released yesterday, giving us an update for two of our preferred global growth indicators: the Global Manufacturing PMI and the US ISM Manufacturing PMI (Chart 1). Unfortunately, the two indicators sent conflicting signals, providing us with very little clarity on the global growth outlook. On the positive side, the Global Manufacturing PMI jumped back above 50 for the first time since April. China is the largest weighting in the global index, and its PMI rose for the fifth consecutive month. Conversely, the US ISM Manufacturing PMI dipped further into contractionary territory in November – from 48.3 to 48.1. Optimistically, the index’s inventory component contracted by more than the new orders component, meaning that the difference between new orders and inventories rose to its highest level since May. The difference between new orders and inventories often leads the overall ISM index by several months. All in all, we continue to see tentative signs of stabilization in our preferred global growth indicators. But a more significant rebound will be necessary to push bond yields higher in the first half of next year, as we expect. Stay tuned. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in November, bringing year-to-date excess returns up to +494 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is high and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The third quarter’s tightening of C&I lending standards is a concern, because it suggests that monetary conditions may not be sufficiently stimulative for banks to keep the credit taps running (bottom panel). But the yield curve, another indicator of monetary conditions, has steepened significantly since Q3, suggesting that lending standards will soon move back into “net easing” territory. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 47 basis points in November, bringing year-to-date excess returns up to +671 bps. The index option-adjusted spread tightened 22 bps on the month and currently sits at 370 bps, 131 bps above our target (Chart 3). Ba and B rated junk bonds outperformed the Treasury benchmark by 79 bps and 76 bps, respectively, in November. But Caa-rated credit underperformed Treasuries by 89 bps. This continues the trend of Caa underperformance that has been in place since late last year (panel 3). We analyzed the divergence between Caa and the rest of the junk bond universe in last week’s report and came to two conclusions.3 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for this year’s Caa underperformance that make us inclined to downplay any potential negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of this year’s underperformance (bottom panel). With elevated spreads, accommodative monetary conditions and a looming recovery in global economic growth, we expect junk spreads to tighten during the next 6-12 months. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in November, bringing year-to-date excess returns up to +22 bps. The conventional 30-year zero-volatility spread tightened 3 bps on the month, as a 5 bps tightening of the option-adjusted spread (OAS) was offset by a 2 bps increase in expected prepayment losses (aka option cost). We recommend an overweight allocation to Agency MBS, particularly relative to corporate bonds rated A or higher, for three reasons.4 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 50 bps (Chart 4). This is very close to its pre-crisis average and only 3 bps below the spread offered by Aa-rated corporate bonds (panel 4). Also, spreads for all investment grade corporate bond credit tiers trade below our targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most homeowners have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 14 basis points in November, bringing year-to-date excess returns up to +197 bps. Sovereign debt outperformed duration-equivalent Treasuries by 36 bps on the month, bringing year-to-date excess returns up to +513 bps. Local Authorities outperformed the Treasury benchmark by 24 bps, bringing year-to-date excess returns up to +245 bps. Meanwhile, Foreign Agencies outperformed by 4 bps, bringing year-to-date excess returns up to +266 bps. Domestic Agencies outperformed by 11 bps in November, bringing year-to-date excess returns up to +51 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +36 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 70 basis points in November, bringing year-to-date excess returns up to +6bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 4% in November, and currently sits at 83% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Specifically, 2-year and 5-year M/T yield ratios are somewhat below average pre-crisis levels at 68% and 72%, respectively. However, M/T yield ratios for longer maturities (10 years and higher) are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 84%, 93% and 97%, respectively. Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve shifted higher in November, steepening out to the 7-year maturity and flattening beyond that. The 2/10 Treasury slope was unchanged on the month. It currently sits at 17 bps. The 5/30 slope flattened 7 bps to end the month at 59 bps (Chart 7). In a recent report we discussed the 6-12 month outlook for the 2/10 Treasury slope.8 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in November, bringing year-to-date excess returns up to -70 bps.The 10-year TIPS breakeven inflation rate rose 8 bps on the month and currently sits at 1.62%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps on the month and currently sits at 1.73%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.9 That being said, the 10-year TIPS breakeven inflation rate is currently 29 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +74 bps. Chart 9ABS Market Overview The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 34 bps; its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive US spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The is true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in November, dragging year-to-date excess returns down to +221 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month. It currently sits at 72 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer Survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +107 bps. The index option-adjusted spread tightened 2 bps on the month, and currently sits at 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 26 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 29 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 29, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 45 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 45 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 29, 2019) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of November 29, 2019. The model has not made any directional change in its allocations this month. In terms of magnitude, however, the underweight of the US and the UK are both reduced slightly at the expense of other countries, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed the MSCI World benchmark in November by 22 bps, caused by the underperformance from both the Level 1 (11 bps) and the Level 2 (27 bps) models. Four out of the five underweights worked well, especially the large underweight in Japan. However, none of the seven overweights panned out, especially the large overweight in Spain and Italy. Since going live, the overall model has outperformed by 51 bps, with 237 bps of outperformance by the Level 2 model, offset by 58 bps of underperformance from the Level 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) For more on historical performance, please refer to our website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. Chart 3GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of November 29, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The global growth proxies used in our model have turned slightly bearish, reflecting concerns about the rebound. This in turn led the model to reverse a few of the overweights it had instated last month on sectors such as Industrials and Consumer Discretionary. The valuation component remains muted across all sectors except Energy. The model is now overweight three sectors in total, one cyclical versus two defensive sectors. These are Consumer Staples, Health Care, and Information Technology. Chart 4Overall Model Performance Table 3Overall Model Performance For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates”, dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 4Current Model Allocations Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Research Associate amrh@bcaresearch.com
Highlights Portfolio Strategy Interest rates are one of the most important macro drivers of overall equity returns via valuations. BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as BCA predicts, will have significant knock on effects on sector selection. Recent Changes There are no changes to our portfolio this week. Table 1 Feature As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. We remain perplexed by the market’s euphoric rise and near total neglect of weak profit growth fundamentals. This “hope rally”, as we have characterized it in the recent past, may have some more legs with the traditional Santa Rally around the corner, but the set up for stocks could not be more treacherous for 2020. Importantly, we deem the risk of not getting a Sino-American trade deal to be significantly greater than a relief rally in case of a successful deal. Most of the positive trade-related news is already reflected into equities. This complacent backdrop is reminiscent of the early 2018 SPX catapult to 2,870 as back then the fresh fiscal easing package was all priced into stocks in the first 20 trading days of that year. Chart 1 vividly depicts this euphoric melt-up in stocks with the longest dated VIX future trouncing the squashed front month VIX future. While this ratio is not at the stratospheric level hit in late-December 2017, it hit a wall recently forewarning that equities are skating on thin ice. Chart 1VOL... Similarly, speculators are net short vol, but a snap can occur at any time. This is eerily reminiscent of February 2018. Since 2017, this vol positioning measure has consistently troughed prior to the SPX peak on three occasions and a “four-peat” likely looms (vol net spec positions shown inverted, bottom panel, Chart 2). On the profit front, sector earnings breadth is sinking like a stone confirming the negatively anchored S&P 500 net EPS revisions ratio (Chart 3). We doubt that 10% EPS growth for calendar 2020 is even plausible, especially given the looming steep deceleration in equity retirement that we highlighted recently.1 Tack on the mighty US dollar, and profit headwinds abound. Chart 2...A Coiled Spring Chart 3No Earnings Pulse Market internals are also screaming that something is off in the equity markets. Small caps are trailing large caps, transports are at stall speed, weak balance sheet stocks are underperforming strong balance sheet stocks, the median stock as per the Value Line Geometric Index is far from all-time highs and high yield bonds (especially CCC rated) are also not confirming the SPX breakout (Chart 4). Importantly, the CBOE’s S&P 500 implied correlation index, which gauges “the expected average correlation of price returns of S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX”,2 is rising again over the 40% mark, underscoring that stocks are more and more beginning to move in tandem. Historically this has been a negative omen (implied correlation index shown inverted, top panel, Chart 5). Chart 4Watch Market Internals Chart 5Reflation No More? Downtrodden M&A activity is also firing a warning shot. A steep divergence of M&A deals from stock prices is atypical at this late stage of the business cycle (middle panel, Chart 5). In fact, out Reflation Gauge comprising the greenback, oil prices and the 10-year Treasury yield has taken a turn for the worse, signaling that economic surprises will likely suffer the same fate (bottom panel, Chart 5). All of this, warns that the risks of a significant pullback in the SPX are rising. What follows is four high-conviction overweight and four underweight calls. Similar to last year, we are using BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls.3 While last year this was offside, the collapse in the 10-year US Treasury yield from 3% last December to 1.75% currently offers a better backdrop for this view to pan out. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as our BCA house view predicts, will have significant knock on effects on sector selection.4 As a reminder, interest rates are one of the most important macro drivers of overall equity returns via valuations (10-year Treasury yield shown inverted, Chart 6). Moreover on a sector basis, the ebbs and flows of the risk free asset directly influence utilities, real estate, financials, consumer discretionary and tech growth stocks or more than half of the S&P 500’s market capitalization. Chart 6Priced To Perfection What follows is four high-conviction overweight and four underweight calls. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com S&P Managed Health Care (Overweight) We upgraded the S&P managed health care group to overweight in April shortly after Bernie Sanders re-introduced his revamped “Medicare For All” bill. Despite the recent explosive run up in relative share prices – partly owing to the drop in Elizabeth Warren’s odds of winning the Democratic candidacy and partly given her watering down of her “Medicare For All” take up plan – we are adding this health care sub-group to our high-conviction overweight call list. HMOs are finally raising prices at the steepest rate of the past fifteen years and while such breakneck pace is unsustainable, profit margins are set to expand smartly (Chart 7). The profit margin backdrop is enticing for health insurers for another reason: labor cost containment. CEOs have been extremely prudent refraining from adding to headcount. One final profit margin booster is the rising 10-year Treasury yield, as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves. Thus, if BCA’s bond view materializes, it will prove a tonic to both margins and profits. With regard to technicals, relative share prices are not as oversold as they were mid-year, but remain below the neutral zone still offering investors a compelling entry point to this position (bottom panel, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG. Chart 7S&P Managed Health Care S&P Machinery (Overweight) A tentative up-tick in EM data in general and China in particular along with improving operating metrics signal that the US/China trade war wounded machinery stocks deserve a high-conviction overweight status for 2020. In more detail, the budding recoveries in the EM and Chinese manufacturing PMIs herald a brighter outlook for relative share prices. China’s fiscal and credit impulse also signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can reclaim the early-2018 highs. On the operating front, the new orders-to-inventories momentum has traced a bottom. Assuming that the Chinese manufacturing PMI reading stays on an upward trajectory, machinery demand will make a durable comeback. None of these green shoots are reflected in sell-side analysts’ bombed out relative profit and sales growth expectations (bottom panel, Chart 8). The ticker symbols for the stocks in this index are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS. Chart 8S&P Machinery S&P Banks (Overweight) The expected price of credit, still pristine credit quality, and a looming reacceleration in credit growth all argue for including the S&P banks index in our high-conviction overweight list. Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market. As the bond sell-off gained steam, the bank outperformance phase also caught on fire. BCA’s view for next year calls for a 50-75bps selloff in the 10-year Treasury yield, further boosting the allure of bank equities (top panel, Chart 9). Beyond the rising price of credit, credit growth is another key industry profit driver. Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher. The upshot is that bank credit growth will likely reaccelerate in the first half of 2020 (third panel, Chart 9). Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine. Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that there is a long runway ahead for relative bank valuations (bottom panel, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC. Chart 9S&P Banks Long Large Caps/Short Small Caps (Overweight) The large cap size bias is our sole hold out from last year’s high-conviction list despite getting stopped out and booking a handsome 9% profit. Today we recommend reinstating a large cap size bias. This call actually represents a slight hedge on BCA’s overall higher interest rates view for next year. Financials comprise 13% of the SPX, but the weight jumps to 18% in small cap indexes. Thus, if the rising interest view is off the mark, the large cap bias will provide an offset. Relative forward profit growth favors mega caps and by a wide margin. One key factor underpinning this increasing profit gap is the massive profit margin divergence (Chart 10). Tack on the fact that index providers omit negative forward profits from their index EPS calculations and the narrative that small caps have cheapened versus large caps falls flat on an adjusted basis. Why? Because a large number of small caps have negative forward EPS. Moreover, we recently created a relative employment proxy that is firing on all cylinders. Not only is the small business labor market crumbling according to the latest NFIB survey, but hard data also suggest that nonfarm private small business payroll employment has ground to a halt. Finally, small caps are debt saddled compared with large caps and small cap b/s have actually been degrading of late (Chart 10). Chart 10Long Large Caps/Short Small Caps S&P Homebuilding (Underweight) We downgraded homebuilders to underweight in late-October, and today we are adding it to our high-conviction underweight call list. Most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drubbing in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Now that interest rates are moving in reverse, more pain lies ahead for the S&P homebuilding index (Chart 11). Worrisomely, consumers’ expectations to purchase a new home plunged anew last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 11). Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 11). Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Chart 11S&P Homebuilding S&P Semi Equipment (Underweight) While year-to-date chip equipment stocks are the best performing index in the SPX, we deem them a mania, and include them in our high-conviction underweight basket for 2020. The top panel of Chart 12 shows this irrational exuberance that has permeated the semi equipment universe is similar to the dotcom era excesses. Back in the late-1990s relative profit growth was sky high, but today it is flirting with the zero line, warning that gravity will pull these stocks back down to earth (second panel, Chart 12). The contracting ISM manufacturing survey signals that relative share price momentum running at a breakneck pace is unwarranted. The same holds true for relative forward profit and revenue growth expectations, especially given the ongoing contraction in global semi sales (middle panel, Chart 12). This deficient demand for semis and therefore semi equipment manufacturers is also apparent in deflating DRAM prices, our industry pricing power proxy. Historically, relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy. Net earnings revisions have slingshot from extreme pessimism to extreme optimism during the past quarter and are vulnerable to disappointment (bottom panel, Chart 12). In sum, lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the mania in the S&P chip equipment index will likely turn into a panic next year. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. Chart 12S&P Semi Equipment S&P Utilities (Underweight) Heavily indebted utilities are a high-conviction underweight call for next year. · Relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (Chart 13). Utilities command a 19.4 forward P/E multiple representing roughly a 10% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 400bps. Our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession (Chart 13). On the operating front, natural gas prices are contracting at the steepest pace of the past four years, and electricity capacity utilization is in a multi-decade downtrend, warning that the relative profitability will remain under pressure in 2020. The implication is that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam as BCA expects. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES. Chart 13S&P Utilities S&P Real Estate (Underweight) We would refrain from chasing high yielding real estate stocks higher, and instead we are including them in our high-conviction underweight call list for 2020. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown). Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble. Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (Chart 14). Occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects. The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum (Chart 14). Finally, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the selloff in the bond market gains steam as BCA expects. (Chart 14). The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC. Chart 14S&P Real Estate Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “Gasping For Air” dated November 18, 2019, available at uses.bcaresearch.com. 2 https://www.cboe.com/micro/impliedcorrelation/impliedcorrelationindicator.pdf 3 Please see BCA The Bank Credit Analyst Monthly Report, “OUTLOOK 2020: Heading Into The End Game” dated November 22, 2019, available at bca.bcaresearch.com. 4 Ibid. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)