Financial Markets
Highlights The world remains mired in a manufacturing recession. As such, it is still too early to put on fresh pro-cyclical trades. Focus on the crosses rather than outright U.S. dollar bets. Two new trade ideas: sell EUR/NOK and buy GBP/JPY. Also consider selling the gold/silver ratio. Feature Currency markets tend to trade into and out of various regimes. This means that to be an effective FX manager, you have to be extremely fluid. For example, interest rate differentials might dominate FX moves during a particular period, pivoting your job to a central bank monitor. Other times, flows dominate, perhaps even equity flows, like when a disruptive technology is developed in a specific market. The outperformance of U.S. equities, specifically technology stocks, is a case in point. Balance-of-payments dynamics usually matter mostly at critical turning points, making them not very useful as timing indicators. The exorbitant privilege of the U.S. dollar we discussed a fortnight ago is also a case in point. But more often than not, being able to identify whether the investment climate is about to become more hostile or not could be the key difference between being a successful FX manager or a relic. There has been no shortage of news for investors to digest over the last few days, from the Brexit imbroglio, to the Fed, to the drone attacks in Saudi Arabia and finally to U.S. President Donald Trump’s possible impeachment. But the most perplexing (and perhaps the most important) has been the German manufacturing flash PMI print for the month of September of 41.4, the lowest in over a decade (Chart I-1). If the country with the “cheapest currency” cannot manage to pull itself out of a manufacturing recession, then the message to the periphery is clearly that they have an impending problem. In short, our contention that the euro was close to a bottom might be offside by a few months, based on the latest manufacturing data release (Chart I-2). Chart I-1A Eurozone Manufacturing Recession Chart I-2The Euro Needs Stronger Growth Which FX Regime? Chart I-3A Recession Will Be Dollar Bullish The performance of the dollar since the 10/2 yield curve inverted is instructive. So far, we are tracking both the 2005 and 1998 roadmaps, meaning the window for cautious optimism on risk assets could still pan out (Chart I-3). Specifically, the dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long. In both 2006 and 1998, the dollar eventually catapulted higher, but it took longer than 12 months. Having an accurate recession probability-timing model is therefore crucial for strategy. Historically, domestic flows have been a very timely indicator, since repatriation by residents occurs during episodes of severe capital flight. In 2005, domestic individuals were deploying funds outside the U.S., which suggested patience before positioning for dollar strength. This made sense, since the return on capital was higher outside the U.S. with the EM and commodity bull market in full swing. More often than not, FX markets tend to favor regions with the highest return on capital. These tend to be the most difficult to bet against, but potentially the most potent blindside at turning points. If economic data continues to deteriorate due to much larger endogenous factors, a defensive strategy is clearly warranted. One way to tell will be an emerging divergence between our leading indicators and actual underlying data as is occurring so far in September. On the flip side, any specter of positive news could light a fire under sectors, currencies and countries that have borne the brunt of the slowdown. Both are highly risky bets. For now, we prefer to focus on the crosses rather than outright U.S. dollar bets. Sell EUR/NOK Sometimes, the best ideas are the simplest ones. The Norges bank is the most hawkish G-10 central bank, while the European Central Bank restarted QE at its latest meeting. This is a powerful catalyst for a short EUR/NOK trade: The dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long. The slowdown in the euro zone has been concentrated in the manufacturing sector, but the deflationary impulse is starting to shift to other parts of the economy. Euro area overall core CPI continues to blast downwards, which has historically been a bad omen for the euro (Chart I-4). We expect euro zone inflation expectations to eventually rise, in part helped by the recovery in oil prices (Chart I-5), but this will also benefit the Norwegian krone. EUR/NOK has historically tracked the performance of relative stock prices between Europe and Norway, but a gaping wedge opened up in 2018 (Chart I-6). This divergence is unsustainable. In short, it is a bet on oil fields in Norway versus European banks. The ECB’s tiering of reserves might prevent euro zone banks from teetering over the edge, but unless the manufacturing recession ends soon and firms start to borrow to invest, banks will continue to have a demand problem. Meanwhile, the flareup in the Middle East means that oil prices will remain bid in the near term. This should favor Norwegian equities over those in the euro zone, and be negative for EUR/NOK (Chart I-7). 10-year German bunds are yielding -0.57% while the yield pickup on Norwegian bonds is a positive carry of 1.8%, despite liquidity concerns. In their latest policy meeting, Central Bank Governor Øystein Olsen stressed that Norway had much more fiscal room to maneuver in the event of a downturn, meaning the supply of Norwegian paper could increase, easing the liquidity premium. Chart I-4Deflation Remains Predominant In The Eurozone Chart I-5A Rise In Oil Prices Will Help Inflation Expectations Chart I-6Stocks And Currencies: An Unsustainable Divergence Chart I-7Higher Oil is Negative ##br##For EUR/NOK Bottom Line: Sell EUR/NOK at 9.937. Buy GBP/JPY Last week’s Special Report made the case for a cyclical recovery in the U.K., even though structural factors remain a headwind. This week, we are re-attempting to buy cable versus the yen: Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance. Real interest rate differentials favor a stronger pound. Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance (Chart I-8). Chart i-8A Tactical Bounce In GBP/JPY Is Likely Chart I-9The Benefit Of A Weaker Pound Speculators are very short the pound while they have been covering their short bets on the yen, as the investment environment has become more uncertain. The fall in the pound should begin to improve the U.K.’s balance-of-payment dynamics relative to Japan (Chart I-9). Bottom Line: Buy GBP/JPY at 132.6. Concluding Thoughts We continue to track various indicators for the dollar, from interest rate differentials, balance-of-payment dynamics, valuations, portfolio flows and positioning – and none of them are sending a bullish signal at the moment. Global growth remains in a funk, which has been supercharging dollar bulls. However, long-dollar bets remain susceptible should global growth stabilize. Our strategy is to continue focusing on the crosses until categorical evidence emerges that global growth has bottomed. In our trading portfolio, we continue to favor the NOK, SEK, petrocurrencies and the AUD. So far, these trades have been implemented at the crosses to limit downside risk, should our view on the dollar be offside. We intend to eventually start placing outright dollar bets once evidence emerges that global growth has bottomed and the world has skidded a recession. 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 U.S. have been relatively strong: The Markit flash manufacturing PMI rebounded to 51 in September from 50.3. Flash services PMI increased to 50.9. The Chicago Fed national activity index increased to 0.1 from -0.4 in August. The Richmond Fed manufacturing index fell to -9 in September from 1. The Conference Board consumer confidence fell to 125.1 in September from 135.1. On the housing front, home prices grew by 0.4% month-on-month in July. Mortgage applications decreased by 10% for the week ended September 20th, but new home sales increased by 7% month-on-month in August. Initial jobless claims increased to 213,000 for the week ended September 20th. Annualized GDP growth was unchanged at 2% quarter-on-quarter in Q2. Trade deficit of goods was little changed at $72.8 billion. Headline and core PCE increased to 2.4% and 1.9% quarter-on-quarter, respectively in Q2. The DXY index appreciated by 0.6% this week. The recent data from the U.S. have been holding up quite well compared with the rest of the world. Net speculative positions on the greenback remain elevated due to U.S. relative strength. While we see dollar resilience in the near term, declining net foreign purchases of U.S. securities, diminishing interest rate differentials and the plunging bond-to-gold ratio all suggest the path of least resistance for the dollar is down. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area continue to deteriorate: The Markit flash manufacturing and services PMIs for the euro area both fell to 45.6 and 52, respectively in September. In France, the Markit flash manufacturing PMI fell to 50.3; services PMI decreased to 51.6. In Germany, the manufacturing PMI collapsed to 41.4; services PMI fell to 52.5. German IFO current assessment increased to 98.5 in September. However, the IFO expectations fell to 90.8. Monetary supply (M3) grew by 5.7% year-on-year in August. German Gfk consumer confidence nudged up to 9.9 in October. The EUR/USD fell by 0.8% this week. The recent data from the euro area has unfortunately showed no signs of global growth bottoming. The manufacturing PMI in Germany is now at its lowest level since the Great Financial Crisis. A major concern faced by investors is that weak activity in manufacturing may have already begun to infiltrate the service sectors. That said, the services PMIs in major economies, though falling, still remain in expansionary territory above 50. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japense Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: National headline inflation fell from 0.5% year-on-year to 0.3% year-on-year in August. Core inflation was unchanged at 0.6% year-on-year. The Markit flash manufacturing PMI fell to 48.9 in September from 49.3. Services PMI also fell to 52.8 from 53.3. The leading index and coincident index were both little changed at 93.7 and 99.7, respectively, in July. The USD/JPY has been flat this week. Japanese exports have been weak, weighed by the global trade war and manufacturing slowdown. However, accordingly to the BoJ, domestic demand has remained firm, and capex also continues to increase. Moreover, the consumption tax hike next month will probably have a marginal impact compared with previous tax hikes. In a speech this week, BoJ Governor Haruhiko Kuroda emphasized that the central bank will ease without hesitation if the economy loses momentum. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There is little data from the U.K. this week: Mortgage approvals decreased slightly to 42,576 in August from 43,303 in July. The GBP/USD fell by 1.4% this week. British Prime Minister Boris Johnson has now lost his majority in Westminster after large profile defections from the so-called rebels, thus another election is highly likely by year-end. Besides, a further delay of Brexit is almost certain. We have downgraded the probability for a no-deal Brexit. We remain positive on the pound and are buying GBP/JPY this week. Report Links: United Kingdon: Cyclical Slowdown Or Structural Malaise? - September 20, 2019 Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The preliminary commonwealth manufacturing PMI fell to 49.4 in September from 50.9 in August. On the other hand, the services PMI rebounded to 52.5 from 49.1, back to above-50 expansionary territory. Consumer confidence increased to 110.1 from 109.3 this week. The AUD/USD fell by 1% this week. Reserve Bank of Australia Governor Philip Lowe commented on Tuesday that the Australian economy is picking up, and is now at a “gentle turning point.” The previous rate cuts have allowed the property markets in big cities like Sydney and Melbourne to regain some strength, but will likely take longer to flow through the whole economy. In terms of monetary policy, Governor Lowe reiterated his commitment to ease monetary conditions when needed, though he did not signal an imminent move for next week. Australia has a large beta to global shifts as a small, open economy. Should the global manufacturing recession come to an end, the positive fundamentals will continue to lift the Australian economy through the rest of the year and into 2020. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Imports increased by NZ$30 million to NZ$5.69 billion in August, while exports fell by NZ$830 million to NZ$4.13 billion. The total trade deficit widened from NZ$700 million to NZ$1.57 billion. The NZD/USD appreciated by 1% initially, then plunged after the Reserve Bank of New Zealand’s policy meeting, returning flat this week. As widely expected, the RBNZ kept its official cash rate unchanged at 1% this Wednesday while signaling that there is more scope to ease if necessary amid a global slowdown. The market is currently pricing an 80% probability of a rate cut for the next policy meeting in November, reflecting weak business confidence. We are playing the kiwi weakness through the Australian dollar and Swedish krona, which are 1.9% and 1.95% in the money, respectively. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been resilient: Bloomberg Nanos confidence increased to 57.4 this week from 56.7. Retail sales increased by 0.4% month-on-month in July, lower than the expectations of a 0.6% monthly growth. The USD/CAD has been flat this week. Oil prices have been on a wild ride this year. Since the drone attack a fortnight ago, Saudi Arabia has claimed that it is recovering faster than expected, beating its own targets. Brent crude oil spot prices have fallen by 6% from their September 16th peak, while Western Canada Select (WCS) oil prices have dropped by 12.3%, dampening the loonie’s upside potential. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: The trade balance narrowed to CHF 1.2 billion in August from CHF 2.6 billion in July. Credit Suisse survey expectations came in at -15.4 in September, up from the last reading of -37.5 in August. The USD/CHF has been flat this week. As a small, open economy, Switzerland belongs to those countries with highest foreign trade-to-GDP share. The trade balance in August has been the lowest since January 2018, with lower exports of main goods including chemical and pharmaceutical products. Among trading partners, exports to Germany, Italy, and France all declined, reflecting the recent manufacturing slowdown in Europe. That said, we remain positive on the safe-haven Swiss franc during the risk-off period amid trade war uncertainties, Brexit chaos, Middle-East tensions, and more recently, the Trump Impeachment imbroglio. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There is scant data from Norway this week: The unemployment rate increased to 3.8% in July, 0.6 percentage points higher than in April, accordingly to the recent Labour Force Survey. The USD/NOK appreciated by 0.5% this week. The Norges Bank, the one and only hawkish central bank among the G-10, raised its interest rate by 25 basis points to 1.5% last week. Since last September, the Norges Bank has hiked rates four times in total, resulting in a one-percentage-point increase in rates. The central bank stated that “the Norwegian economy has been solid; Employment has risen; Capacity utilization appears to be somewhat above a normal level; Inflation is close to target.” A higher interest rate would also help take the wind out of skyrocketing house prices and household debt levels. In addition, the central bank lowered its projection path for the krone, stating that the factors it outlined, including weaker activity in the petroleum sector, would probably keep weighing on the krone in the years ahead. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Consumer confidence fell to 90.6 in September. PPI yearly growth fell from 2% in July to 1.4% in August. Trade balance shifted to a deficit of SEK 5.4 billion in August. USD/SEK has been flat this week. We are closely monitoring the Swedish foreign trade as a leading indicator for global growth. The Swedish trade balance has shifted to a deficit for the first time this year. However, compared to last August, the deficit was narrowed by SEK 2.6 billion. Year to date, the Swedish trade surplus amounted to SEK 27 billion. Notably, the trade in goods with non-EU countries resulted in a surplus of SEK 6.6 billion, while the trade with EU resulted in a deficit of SEK 12 billion. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Please note that this abbreviated weekly report complements today’s Special Report titled China’s Foreign Debt, And A Secret Weapon published in collaboration with BCA’s China Investment Strategy service. Feature A major rotation has commenced in recent days in global financial markets: beaten-down value companies have begun outperforming richly-priced U.S. growth stocks. This has cogently coincided with the rise in U.S. bond yields. Further, U.S. small caps have also begun outpacing U.S. large caps. Do these signals mean that EM will start outperforming DM in general and U.S. in particular? We do not think it is likely to occur on a sustainable basis. We agree that certain trends in global financial markets have become over-extended and a mean-reversion is overdue. U.S. bond yields have probably dropped much more than justified by U.S. economic strength. Although U.S. manufacturing, exports and capex have been extremely week/contracting, consumer spending is expanding at a decent clip. We believe fears of a full-blown U.S. recession are presently exaggerated. It is also critical to gauge what is the underlying cause of this financial market rotation. Is it receding fears of U.S. recession or China’s recovery or both? We believe that the rotation is caused by unwinding of recessionary fears in the U.S., not a revival in the Chinese economy or a recovery in global trade and manufacturing. Unwinding U.S. recessionary fears will not be sufficient to produce a strong and lasting rally in EM risk assets and currencies even if it leads to a breakout in DM share prices in absolute terms. EM risk assets and currencies are much more sensitive to China and global growth rather than to the U.S. economy. Watch The Dollar For Clues Chart I-1EM Relative Equity Performance Correlates With U.S. Dollar Whether the sell-off in global safe-haven bonds and outperformance of global cyclical vs. defensive equity sectors is due to a genuine recovery in China or the U.S. will be revealed in the trend of the U.S. dollar (Chart I-1). If the dollar continues grinding higher, it would entail that the recent financial markets rotation is due to amelioration in U.S. growth expectations and that there is little recovery in the Chinese economy as well as global manufacturing and trade. In this scenario, EM risk assets will underperform. On the contrary, if the greenback begins exhibiting persistent and broad weakness, it would signify that the reversal in global safe-haven bond yields and global cyclical stocks is due to a revival in Chinese demand. In such a case, a lasting recovery in global manufacturing and trade are likely. This would be consistent with a durable EM rally and outperformance. Chart I-2Bullish Technicals For U.S. Dollars So far, the greenback has remained well bid (Chart I-2). In addition, industrial commodities prices remain weak and have failed to rebound (Chart I-3). These entail that the recent spike in U.S. bond yields and outperformance of cyclical equity sectors is primarily due to unwinding of pessimism on U.S. growth rather than a reflection of growth amelioration in China. Notably, cyclical data out of China and global trade/manufacturing remain dismal. Chinese overall imports are contracting (Chart I-4). Chart I-3Breakdown Remains In Play Chart I-4Shrinking Chinese Imports Global semiconductor sales and car purchases continue shrinking at a rapid pace (Chart I-5). China’s credit and money growth and impulses appear to be rolling over, having failed to rise as much as in the previous stimulus episodes (Chart I-6). Finally, the pace of EM corporate EPS contraction is accelerating (Chart I-7). Any rally in EM share prices will be unsustainable without a bottom in EM EPS growth. Chart I-5No Improvement In Global Growth Chart I-6Chinese Credit Impulse Is Weak Chart I-7EM EPS & Share Prices Bottom Line: The U.S. dollar has failed to sell off despite the optimism in global equity markets. This entails that any rebound and outperformance in EM risk assets and currencies will prove to be short-lived. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Portfolio Strategy The contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. It no longer pays to be overweight gold mining equities as sentiment is stretched, the restarting of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on global gold miners. EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Recent Changes Trim the Global Gold Mining index to neutral, today. Downgrade the S&P Materials sector to underweight, today. Table 1 Feature Equities broke out of their trading range last week, but in order for this short-covering rally to become durable, and for volatility to subside, either global growth needs to turn the corner and alleviate recession fears or the trade war needs to de-escalate materially. On the recession front Central Banks (CBs) are doing their utmost to reflate their respective economies, but the early stages of looser monetary policy have been insufficient to change the global growth trajectory. With regard to the trade war, markets cheered the news that talks between the U.S. and China will resume in September and October. The dates for talks are conveniently chosen to follow the September FOMC meeting and the October 1 70th anniversary of the People's Republic of China. The latter date implies that Washington is considering delaying the October 1 tariff hike – and it could imply that Washington does not anticipate any violent suppression of Hong Kong protesters by that time. However, the harsh reality is that the two sides are just “kicking the can down the road”. The longer the Sino-American trade war takes to conclude, the more likely it will serve as a catalyst for a repricing of risk significantly lower (top panel, Chart 1). A technical correction may be necessary to force Trump to reduce the trade pressure significantly. Even if the October 1 tariff hike is postponed it will remain a source of uncertainty ahead of the final tariff tranche slated for December 15. The bond market may offer some clues as to the extent that the escalating trade war will eventually get reflected into stocks (bottom panel, Chart 1). The equity transmission mechanism is through the earnings avenue. Simply put, rising trade uncertainty deals a blow to global trade that boosts the U.S. dollar which in turn makes U.S. exports uncompetitive in global markets, deflates the commodity complex and with a lag weighs on SPX earnings. Chart 1Tracking Trade Uncertainty Speaking of the economically hypersensitive manufacturing sector, last week’s ISM release made for grim reading, further fueling recession fears (the New York Fed now pegs the recession probability just shy of 38% by next August). Not only did the overall survey fall below the boom/bust line (middle panel, Chart 2), but also new orders collapsed. In fact, the drubbing in new orders is worrying and it signals that the economy is going to get worse before it gets better (top panel, Chart 2). Tack on the simultaneous rise in inventories, and the sinking new orders-to-inventories ratio (not shown) warns of additional manufacturing ills in the coming months. Importantly, export orders suffered the steepest losses plunging to 43.3. The last three times that this trade-sensitive survey subcomponent was in such a steep freefall were in 1998, 2001 and 2008, when the SPX suffered peak-to-trough losses of 20%, 49% and 57%, respectively. In fact, since the history of the data, ISM manufacturing export orders have never been lower with the exception of the GFC (Chart 3). Such a retrenchment will either mark the bottom for equities or is a harbinger of a steep equity market correction. We side with the latter as the odds of President Trump striking a real trade deal (including tech) with China any time soon are low. Chart 2Like Night Follows Day Similar to the ISM manufacturing/non-manufacturing divergence (bottom panel, Chart 2), business confidence is trailing consumer conference by a wide mark. Historically this flaring chasm has been synonymous with a sizable loss of momentum in the broad equity market (Chart 4). One plausible explanation is that as business animal spirits suffer a setback, CEOs are quick to prune/postpone capex plans and, at the margin, corporations retrench and short-circuit the capex upcycle. Chart 3Export Carnage Chart 4Mind The Gap Circling back to last week’s capex update, national accounts corroborate the financial statement data deceleration, and in some cases contraction, in capital outlays (Chart 5). As a reminder our thesis is that the EPS-to-capex virtuous upcycle is morphing into a vicious down cycle.1 This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Crucially, tech investment, that comprises almost 30% of total investment according to national accounts, is decelerating, R&D and other intellectual property investment have also hooked down, non-residential structures are on the verge of contraction, and industrial, transportation and other equipment –that have the largest weight in U.S. capex – are also quickly losing steam (Chart 6). Chart 5Capex Blues Chart 6All Capex Segments… In more detail, Charts 7 & 8 further break down capital outlays in the respective categories and reveal that worrisomely the investment spending slowdown is broad based. Chart 7…Have Rolled Over… Chart 8…Except For One Adding it all up, the contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. As a reminder, this is U.S. Equity Strategy service’s view and it contrasts with BCA’s sanguine equity market house view. This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Downgrade Materials To Underweight… Heightened economic and trade policy uncertainty has claimed the S&P materials sector as one of its victims (Chart 9). Given that our Geopolitical Strategy service’s base case remains that there will be no Sino-American trade deal by the U.S. November 2020 election, there is more downside for materials stocks and we are downgrading this niche deep cyclical sector to a below benchmark allocation.2 Beyond the U.S./China trade war inflicted wounds that materials stocks have to nurse, there are four major headwinds that they will also have to contend with in the coming months. Chart 9Trade Uncertainty Sinking Materials First, the emerging markets (EM) in general and China in particular are in a prolonged soft patch that predates the Sino-American trade war. EM stocks and EM currencies are both deflating at an accelerating pace warning that relative share prices will suffer the same fate (Chart 10). Nothing epitomizes the infrastructure spending/capex cycle more than China’s insatiable appetite for commodities and the news on that front remains dire. The Li Keqiang index continues to emit a distress signal and that is negative for materials top line growth (bottom panel, Chart 10). Second, global inflation is in hibernation and select EM producer price inflation growth series are on the verge of contraction or already outright contracting. Chinese raw materials wholesale prices are in the deflation zone and warn that U.S. materials sector profits will underwhelm (Chart 11). Chart 10Bearish EM… Chart 11…And China Backdrops Base metal prices are a real time indicator of the wellness of the S&P materials sector. Currently, base metals are deflating both on the back of a firming U.S. dollar and contracting global manufacturing. Such a commodity price backdrop is dampening prospects for a profit-led materials sector relative share price recovery (top & middle panels, Chart 12). Third, the materials exports outlook is darkening. Apart from the deflating effect the appreciating U.S. dollar has on commodities it also clips basic materials companies’ exports prospects. How? It renders materials related exports uncompetitive in international markets leading to market share losses. Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Chart 12Weak Pricing Power And Declining Exports In addition, the latest ISM export order subcomponent plunged to multi-year lows reflecting trade war pessimism and falling global end-demand. The implication is that the export relief valve is closed for materials equities (bottom panel, Chart 12). Finally, materials sector financial statement metrics are moving in the wrong direction. Net debt-to-EBITDA is rising anew and interest coverage has likely peaked for the cycle at a time when free cash flow generation has ground to a halt (Chart 13). U.S. Equity Strategy’s S&P materials sector profit growth model encapsulates all these moving parts and warns that a severe profit contraction phase looms (Chart 14). Chart 13Financial Statement Red Flags Chart 14Model Says Sell Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Bottom Line: The time is ripe to downgrade the S&P materials sector to underweight. …Via Trimming Gold Miners To Neutral The way we are executing this downgrade in the materials sector to an underweight stance is by trimming the global gold mining index to a benchmark allocation. Our thesis that gold stocks serve as a sound portfolio hedge remains intact and underpinned when: economic and trade policy uncertainty are on the rise (top panel, Chart 15) global CBs start cutting interest rates and in some cases doubling down on negative interest rates currency wars are overheating Nevertheless, what has changed is the price, and we deem that global gold miners that have gone parabolic are in desperate need of a breather. The top panel of Chart 16 shows that gold stocks have rallied 58% since the May 5, 2019 Trump tweet. This outsized four-month relative return is remarkable and likely almost fully reflects a very dovish Fed and melting real U.S. Treasury yields (TIPS yield shown inverted, bottom panel, Chart 15). A much needed pause for breath is required before the next leg of the relative rally resumes, and we opt to move to the sidelines. Chart 15Positive Backdrop… Chart 16…But Reflected In Prices Moreover, on the eve of the ECB’s September meeting, were President Mario Draghi to re-commence QE in the form of sovereign and corporate bond purchases as markets participants expect, counterintuitively a selloff in the bond markets would confirm that QE and its signaling is working (bottom panel, Chart 16). Ergo, this would likely exert upward pressure on global interest rates including the U.S., especially given the one-sided positioning in the respective global risk free assets. The implication is that the shiny metal and global gold miners would suffer a setback as real yields would rise further. As a reminder, gold bullion yields nothing and gold mining equities next to nothing, thus when competing safe haven assets at the margin start yielding higher, investors flee gold and gold miners and flock to risk free assets. Sentiment toward gold and global gold miners is stretched. Gold ETF holdings are at multi-year highs (second panel, Chart 17) and gold net speculative positions are at a level that has marked previous reversals. In addition, bullish consensus on gold is near 72%, a percentage last reached in 2012 (third & bottom panels, Chart 17). Similarly, relative share price momentum is also warning that global gold mining equities are currently extended (bottom panel, Chart 18). Chart 17Extreme… Chart 18…Sentiment Finally, while the bond market’s view of 100bps in Fed cuts in the next 12 months should have undermined the trade-weighted U.S. dollar, it has actually defied gravity and slingshot to fresh cycle highs. This is a net negative both for gold and gold mining equities as the underlying commodity is priced in U.S. dollars and enjoys an inverse correlation with the greenback. The implication is that the multi-decade inverse correlation will hold and will likely pull down gold and gold mining equities at least in the short-run (U.S. dollar shown inverted, Chart 19). In sum, the exponential rise in global gold miners is in need of a breather. Sentiment is stretched, the restating of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on relative share prices Chart 19Gold Miners/Dollar Correlation Re-establishment Risk Bottom Line: Downgrade the global gold mining index to neutral, but stay tuned. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see U.S. Equity Strategy Weekly Report, “Capex Blues” dated September 3, 2019, available at uses.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report, “Big Trouble In Greater China” dated August 29 , 2019, available at bca.bcaresearch.com Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps
Highlights The fundamental backdrop continues to be mixed, but last week’s key data releases were encouraging on balance: While the U.S. manufacturing ISM survey entered contraction territory, and European manufacturing PMIs remained moribund, the services surveys were quite strong, and services contribute much more to developed economies’ total output. The U.S. economy should be able to grow at trend for the next six to twelve months: Consumption is underpinned by a robust labor market, federal government spending will not flag ahead of the 2020 elections, and state and local revenues are well supported. Investment is unlikely to sabotage the other two pillars of the U.S. economy. The view that inflation is deader than New York Mayor de Blasio’s presidential ambitions is widespread and entrenched: Participating on a panel at an inflation-themed conference last week, we were struck by the conviction that inflation is going nowhere over the next few years. The risk-reward of taking the other side of that debate may be quite attractive. Feature Another week, another mixed set of data releases. Last Tuesday, the bears’ most cherished fantasies seemed to be within reach as the ISM Manufacturing Index slid below the boom-bust line in a print that fell well short of consensus expectations. The S&P 500, which had probed around August’s 2,945 resistance level in the final pre-Labor Day session, quickly shed more than a percentage point in response. The U.S. data confirmed the message from the previous day’s European manufacturing PMIs: global manufacturing remains in a deep funk, and a turnaround is not yet at hand. It’s hard to get a recession without tight monetary policy, and it’s hard to get a bear market without a recession, ... Wednesday’s European services PMI releases gave the bulls a lift. Though manufacturing activity truly stinks (Chart 1), it shows no signs of contaminating the services sector, which is still expanding at a solid clip (Chart 2). The U.S. ISM Non-Manufacturing Index surged in August, beating consensus expectations by the same two-point margin by which manufacturing fell short. U.S. equities were already trading higher on the back of an imminent resumption of U.S.-China negotiations when the series was released Thursday morning, and the combination helped the S&P 500 decisively break through the level that had held it in check for a month (Chart 3). Chart 1Global Manufacturing ##br##Is Ailing ... Chart 2... But The Service Sector Is Expected To Expand Chart 3Breakout Taking a step back from the consistently mixed data, recessions don’t occur when monetary conditions are easy. Equity bear markets rarely occur outside of recessions, so our default position is to remain at least equal weight equities in a balanced portfolio. We estimate that the equilibrium fed funds rate is somewhere in the neighborhood of 3 to 3.25%, so the monetary backdrop remains comfortably accommodative with fed funds at 2.25% and seemingly heading to 2% or lower in the coming months. Our estimate of equilibrium is no more than an estimate, however, so we are reprising our analysis of where consumption, investment and government spending are headed over the next six to twelve months. We remain constructive on the basis of that analysis. The GDP Equation GDP is the sum of consumption, investment, government spending and net exports. Rendered as an equation, GDP = C + I + G + (X-M). Net exports are not terribly meaningful for the comparatively closed U.S. economy, and we take a small fixed trade deficit as a given, so we reduce the equation to GDP = C + I + G. Ex-trade, consumption accounts for two-thirds of output, and fixed investment and government spending for one-sixth each. At four times each of the other components’ weight, consumption is the dominant driver of U.S. activity. Investment is considerably more variable, however, making it more likely to wipe out trend growth from the other drivers (Chart 4). As we showed the first time we performed the (C+I+G) analysis, investment would only have to fall to 0.83 standard deviations below its long-run mean to zero out 2% growth in consumption and government spending.1 Chart 4Investment Is The Wild Card In a normal distribution, events 0.83 or more standard deviations below the mean are expected to occur randomly about 20% of the time. It would take a -1.31-sigma consumption event (probability ≈ 10%) to zero out 2% growth in the rest of the economy. An expansion-killing decline in government spending would be a -1.86-sigma event (probability ≈ 3%). Investment is most likely to be the swing factor tilting the economy in the direction of a recession. Consumption Both retail sales and personal consumption expenditures have accelerated since early April (Chart 5). A robust labor market should continue to support consumption spending, as our payroll model projects a pickup in hiring (Chart 6, top panel), thanks to more ambitious NFIB hiring plans (Chart 6, second panel) and falling initial unemployment claims (Chart 6, bottom panel). Job openings are at their highest level in the 19-year history of the series, indicating that demand for new employees is high, and an elevated quits rate indicates that employers are paying up to poach workers from each other to satisfy that demand. We reiterate that more Americans will be working at the end of 2019 than at the end of 2018, and that all of them will be getting paid more, on average. A robust labor market will give household incomes a boost, and solid balance sheets will give them leave to spend it. Households don’t have to spend income gains, however. If they choose instead to save them, or divert them to paying down debt, consumption won’t get much of a near-term boost. The state of household balance sheets is also a driver of consumption’s direction, and they’ve improved at the margin since our last review. The savings rate moved sharply higher in the interim (Chart 7, top panel) and household debt as a share of GDP ticked lower (Chart 7, second panel), while the burden of servicing existing debt remains light (Chart 7, bottom panel). Chart 5Consumption Is Healthy Chart 6Hiring Is Poised To ##br##Tick Higher, ... Chart 7... And Households Are In A Position To Spend Bottom Line: Consumption remains well supported and will likely continue to be over a six- to twelve-month horizon. Investment Despite hopes that the reduction in corporate income tax rates and immediate expensing of qualified investments would promote capital expenditures, growth in nonresidential fixed investment has been uninspiring. Looking ahead, surveys of corporate investment intentions are decent coincident indicators of capex, and their monthly releases provide some leading insights into quarterly GDP investment. Capital spending plans in the NFIB small business survey have bounced since early April (Chart 8, top panel), but capex plans in the regional Fed surveys have weakened (Chart 8, bottom panel). Although both surveys have turned down, they remain at fairly elevated levels, suggesting that an investment plunge capable of negating trend growth in consumption and government spending is unlikely. Chart 8Neither Here Nor There Residential investment is less than a quarter of nonresidential investment and therefore typically only has a marginal impact on investment. It remains in a slump, with momentum in starts and permits sputtering (Chart 9, top panel); existing home sales running in place (Chart 9, middle panel); and inventories of homes for sale up since April, albeit still at low levels relative to history (Chart 9, bottom panel). Despite a sharp decline in mortgage rates since the end of last year, housing activity has failed to revive. Conversations with various market participants lead us to believe that zoning restrictions, sparse quantities of affordable land, difficulty in assembling construction crews, and a general idling of smaller developers in the wake of the crisis have all contributed to insufficient supplies of the entry-level and first-move-up homes for which there is ample demand. Chart 9Housing Is Weaker Than It Should Be, But It Doesn't Mean The Economy Is In Trouble Bottom Line: Neither nonresidential nor residential investment appears vulnerable enough to spark a decline in investment that could cause the economy to stall out. Government Spending All systems are go from a fiscal perspective. The federal spending taps will surely be open in a hotly contested presidential election year. State income and sales tax revenues have improved since our last review in April (Chart 10, top two panels), and should be well supported by a strong labor market. Solid home price appreciation will nudge the appraisals underpinning property taxes higher (Chart 10, third panel), supporting municipal tax receipts. Government spending will continue to hold up its end. Chart 10State And Local Revenues Will Hold Up Is Inflation Dead? Chart 11Another Upleg Is Coming We participated in a panel discussion last week at an inflation-linked products conference. The panel included Fed researchers and a veteran inflation-products trader turned investment manager. After a wide-ranging discussion that touched on U.S. economic prospects, the message from the yield curve, the impact of trade tensions and the continuing relevance of the Phillips Curve, each panelist was asked if inflation has already peaked for the cycle. The response was a resounding unanimous yes until we got our turn. The other panelists were not laypeople, traders, bottom-up analysts, or anyone else with only a passing interest in macroeconomics. They were experts, and we were struck by the conviction with which they dismissed the possibility that inflation could yet break out in the current cycle. Judging by the shrinking scale of the annual conference (this year’s edition was half the size of the previous two years’), the idea that inflation is dead for the foreseeable future has found a wide following. We do not think that inflation, and bond yields, will go anywhere in the immediate future, but it is far from assured that they will remain moribund for the rest of the expansion (Chart 11). Taking the other side looks attractive to us, given the preponderance of inflation-is-dead opinions. It is not terribly surprising that wide output gaps opened following an especially job-destructive downturn. With economic capacity considerably ahead of aggregate demand across the major economies, inflation had little chance of taking hold at an economy-wide level. The picture is changing, however, with the IMF estimating that the U.S. output gap closed in 2017 and in the advanced economies as a whole sometime last year (Chart 12). Goods inflation is primarily a global phenomenon, and with the IMF estimating that output gaps persist in Australia, Canada, Japan and the U.K., international slack can still mitigate domestic price pressures, though new tariff barriers would bind inflation more closely to domestic conditions. Services inflation, which is much more domestically driven, could begin to perk up now that unemployment is below NAIRU in the Eurozone as well as the U.S. (Chart 13). Finally, while central banks are hardly omnipotent, Milton Friedman’s always-and-everywhere admonition leaves little doubt that the monetary authorities can boost inflation expectations if they really want to. Chart 12Demand Has Caught Up To Capacity Chart 13Mind The Gap Investment Implications The investing backdrop is hardly ideal. Spreads are tight, stocks aren’t cheap, the two largest standalone economies are trying to inflect pain on each other, the U.K. can’t agree on how to get divorced from the EU, and the fate of the longest U.S. expansion on record is in doubt. The risks are well known, however, and save-haven assets have gotten pretty crowded. While the danger that shaky confidence could become self-fulfilling is real, our base case is that the expansion will trundle along, allowing stocks to rise as the worst-case scenarios fail to come to pass. It is at least possible that rumors of inflation’s demise have been greatly exaggerated. We continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond allocations. We enthusiastically endorse our bond colleagues’ overweight TIPS recommendation. When nearly everyone agrees that a particular outcome cannot happen, it is often worth carving out some space in a portfolio in the event it actually does. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see Table 1 of the April 8, 2019 U.S. Investment Strategy Weekly Report, “If We Were Wrong,” available at usis.bcaresearch.com
Highlights Global bond yields have closely tracked the trajectory of global growth. While the global economy remains fragile, some positive signs are emerging: Our global leading economic indicator has moved off its lows; global financial conditions have eased significantly; U.S. household spending remains resilient; and China is set to further increase stimulus. Neither a severe escalation of the trade war nor a hard Brexit is likely. A simple comparison between current dividend yields and bond yields implies that global equities would need to fall by an outsized amount over the next decade for bonds to outperform stocks. As global growth stabilizes and then begins to recover over the coming months, bond yields will rebound from depressed levels. Investors should overweight stocks versus bonds for now, and look to upgrade EM and European equities later this year. Feature Global Growth Driving Bond Yields Chart 1Global Bond Yields: How Low Will They Go? Global bond yields rose sharply yesterday on word that U.S. and Chinese trade negotiators will meet in October. The announcement by China’s State Council of additional stimulus measures and better-than-expected data on the health of the U.S. service sector also drove the bond sell-off. The jump in yields follows a period of almost unrelenting declines. After hitting a high of 3.25% last October, the U.S. 10-year yield fell to 1.43% this Tuesday, just shy of its all-time low of 1.34% reached on July 5, 2016. The 30-year Treasury yield broke below 2% for the first time in history on August 15, falling to as low as 1.91% this week. It now stands at 2.07%. In Japan and across much of Europe, bond yields remain firmly in negative territory (Chart 1). The large movements in bond yields can be attributed to both the state of the global economy as well as to changes in how central banks are reacting to economic uncertainty. Just as stronger global growth pushed yields higher between mid-2016 and early-2018, the deceleration in growth since then has pulled yields lower. Chart 2 shows that there has been a close correlation between changes in the U.S. 10-year yield and the ISM manufacturing index. The release on Tuesday of a weaker-than-expected ISM manufacturing print for August was enough to push the 10-year yield down by seven basis points within a matter of minutes. Chart 2The Deceleration In Growth Has Pulled Yields Down The forward-looking new orders component of the ISM manufacturing index sunk to a seven-year low. The export orders component fell to the lowest level since 2009. Export volumes track ISM export orders quite closely (Chart 3). Not surprisingly, the ISM press release noted that trade remains “the most significant issue” for U.S. manufacturers. Chart 3Export Volumes Track The ISM Export Component The only redeeming feature in the report was that the customers’ inventories index dropped a notch from 45.7 in July to 44.9 in August. A reading below 50 for this subindex indicates that manufacturers believe that their customers are holding too few inventories, which is positive for future production. Global Manufacturing PMI Not Looking Much Brighter The Markit global manufacturing PMI remained below 50 for the fourth month in a row in August. While the global PMI did edge up slightly from July’s reading, this was largely due to a modest rebound in the Chinese PMI, which rose from 49.9 to 50.4. The improvement in the China Markit-Caixin PMI stands in contrast to the further deterioration observed in the “official” National Bureau of Statistics PMI. The former is more heavily geared towards private-sector exporting companies, and hence may have been influenced by the front-loading of exports ahead of the planned tariff increase on Chinese exports to the United States. Some Positive Signs Chart 4Global LEI Has Moved Off Its Lows In light of the disappointing manufacturing data, it is too early to call a bottom in the global industrial cycle. Nevertheless, there are some hopeful signs. Our Global Leading Economic Indicator (LEI) has moved off its lows (Chart 4). It usually leads the PMIs by a few months. Sterling will probably be the best performing currency in the G7 over the next five years. Despite ongoing weakness in the manufacturing sector, household spending has held up in most economies. In the U.S., the nonmanufacturing ISM index jumped to 56.4 in August from 53.7 in July. Real personal consumption is still on track to grow by 2.8% in Q3 according to the Atlanta Fed (Chart 5). The euro area services PMIs have also been resilient (Chart 6). In Germany, where the manufacturing PMI stood at 43.5 in August, the services PMI rose to 54.8. Chart 5Inventories And Net Exports Have Subtracted From U.S. Growth In Q2 And Q3 Chart 6AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 6BThe Service Sector Has Softened Much Less Than Manufacturing (II) Global financial conditions have eased significantly, mainly thanks to the steep decline in bond yields. The current level of financial conditions implies that global growth could rebound swiftly (Chart 7). The Chinese government is also likely to step up fiscal/credit stimulus over the coming months in an effort to shore up growth. In a boldly worded statement released on Wednesday, the Chinese State Council promised to further increase bond issuance to finance infrastructure projects, while cutting interest rates and reserve requirements. A stronger Chinese economy should benefit global growth (Chart 8). Chart 7Easier Financial Conditions Will Benefit Global Growth Chart 8Stronger Chinese Growth Should Benefit The Global Economy The Trade War: Moving Towards A Détente? The announcement that the U.S. and China will resume trade negotiations on October 5th is a step in the right direction. As we noted last week, both parties have an incentive to de-escalate the trade conflict. President Trump wants to prop up the stock market and the economy in order to improve his re-election prospects. China also wants to bolster growth.1 Chart 9Would China Really Be Better Off Negotiating With A Democrat As President? As difficult as it has been for China to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would be especially the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more palatable to deal with on trade matters. Does the Chinese government really want to negotiate over labor standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 9)? While Republicans in Congress would be able to restrain a Democratic president on domestic issues, the president would still enjoy free rein over trade policy. Brexit Uncertainty Adding To Investor Angst Two weeks before the Brexit vote on June 23, 2016, I wrote that “Just like my gut told me last August that Trump would do much better at the polls than almost anyone thought possible, I increasingly feel that come June 24th, the EU may find itself with one less member.”2 Chart 10Brexit Opposition Has Been Growing Soon after the shocking verdict, we argued that a hard Brexit would prove to be politically infeasible, meaning that the U.K. would either end up holding another referendum or be forced to negotiate some sort of customs union with the EU. Our view that a hard Brexit will not happen has not changed. Chart 10 shows that opposition to Brexit has only grown since that fateful day. Boris Johnson does not have enough votes in Westminster to force a hard Brexit. Another election would not change this outcome, given that it would almost certainly produce a hung parliament. In any case, it is not clear that Johnson actually wants a hard Brexit. The Times of London recently reported that the government’s own contingency plans for a hard Brexit, weirdly code-named “Operation Yellowhammer,” predicted a crippling logjam at British ports leading to shortages of fuel, food and medicine.3 Boris Johnson is all hat and no cattle. He will be forced to make a deal with the EU. Buy the pound on any dips. Sterling will probably be the best performing currency in the G7 over the next five years. Central Banks: Cut First, Ask Questions Later Chart 11Inflation Expectations Are Low Across The Globe Despite a few glimmers of good news, central banks are in no mood to take any chances. St. Louis Fed President James Bullard said it bluntly last week: “Our job is to get the yield curve uninverted.”4 If history is any guide, global growth will stabilize and begin to recover over the coming months. Inflation expectations are below target in most economies (Chart 11). Central banks know full well that if the current slowdown morphs into a full-blown recession, they will be out of monetary ammunition very quickly. In such a setting, it does not make sense to hold your punches. Much better to generate as much inflation as possible, and as soon as possible, so that real rates can be brought deeper into negative territory if economic circumstances later warrant it. What If The Medicine Works? The risk of easing monetary policy too much is that economies will eventually overheat, producing more inflation than is desirable. It is easy to forget that the aggregate unemployment rate in the G7 is now below its 2007 lows (Chart 12). True, inflation has yet to take off, but this may simply be because inflation is a lagging indicator (Chart 13). Chart 12Unemployment Rates Keep Trending Lower Chart 13Inflation Is A Lagging Indicator For all the talk about how the Phillips curve is dead, the empirical evidence suggests it is very much alive and well (Chart 14). Ironically, this means that lower interest rates today could set the stage for much higher rates in the future if hyperstimulative monetary policies ultimately generate a bout of inflation. Chart 14The Phillips Curve Is Alive And Well Chart 15The Dollar Is A Countercyclical Currency Investment Conclusions Like most economic forecasters, central banks tend to extrapolate recent trends too far into the future. Global growth has been weakening since early 2018 so it seems reasonable to assume that this trend will persist into next year. However, as we have documented, global industrial cycles tend to last about three years – 18 months of rising growth followed by 18 months of falling growth.5 If history is any guide, global growth will stabilize and begin to recover over the coming months. Should that occur, we will enter an environment where the lagged effects of easier monetary policy are hitting the economy just when the manufacturing cycle is taking a turn for the better. Stocks are likely to fare well in such a setting, while long-term bond yields will move higher. As a countercyclical currency, the dollar will also start to weaken anew (Chart 15). Granted, an intensification of the trade war or some other major adverse shock would upset this rosy forecast. Nevertheless, current market pricing offers a fairly large cushion against downside risks. Thanks to the drop in bond yields, the equity risk premium is quite high globally (Chart 16). Even if one were to assume that nominal dividend payments remain unchanged for the next ten years, the S&P 500 would still need to fall by more than 20% in real terms over the next decade for bonds to outperform stocks (Chart 17). Euro area stocks would need to drop by more than 42%. U.K. stocks would need to plummet by at least 60%! Chart 16AEquity Risk Premia Remain Quite High (I) Chart 16BEquity Risk Premia Remain Quite High (II) Chart 17AStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Chart 17BStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Investors should remain overweight stocks versus bonds over the next 12 months. We intend to upgrade EM and European equities once we see a bit more evidence that global growth has troughed. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “A Psychological Recession?” dated August 30, 2019. 2Please see Global Investment Strategy Weekly Report, “Worry About Brexit, Not Payrolls,” dated June 10, 2016. 3Rosamund Urwin and Caroline Wheeler, “Operation Chaos: Whitehall’s Secret No-Deal Brexit Preparations Leaked,” The Times, August 18, 2019. 4“Fed’s Bullard Sees ‘Robust Debate’ Over Half-Point Cut,” Bloomberg, August 23, 2019. 5Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights The lingering global manufacturing recession and the substantial drop in U.S. bond yields have been behind the decoupling between both EM stocks and the S&P 500, and cyclical and defensive equities. Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to indicate either further bifurcation in global markets or a risk-off period. We review some of our long-standing themes and associated recommendations. Feature Global financial markets have become bifurcated. On one hand, numerous segments of global financial markets leveraged to global growth, including EM stocks, have already sold off (Chart I-1). On the other hand, share prices of growth companies, defensive stocks and global credit markets have remained resilient. Chart I-2 shows that a similar divergence has taken place within EM asset classes: EM share prices have plummeted while EM corporate credit excess returns have not dropped much. Chart I-1Bifurcated Equity Markets Chart I-2Bifurcated Markets In EM How to explain this market bifurcation? Financial markets sensitive to global trade and manufacturing cycles have been mirroring worsening conditions in global trade and manufacturing. Some of the affected segments include: Global cyclical equity sectors. Emerging Asia manufacturing-related currencies (KRW, TWD and SGD) versus the U.S. dollar (Chart I-3). EM and DM commodity currencies (Chart I-4). Chart I-3Total Return (Including Carry): KRW, TWD And SGD Vs. USD Chart I-4EM And DM Commodity Currencies Industrial and energy commodities prices. U.S. high-beta stocks as well as U.S. small caps (Chart I-5). Chart I-5U.S. High-Beta Stocks DM bond yields. Crucially, the current global trade and manufacturing downturns have taken place despite robust U.S. consumer spending. In fact, our theme for the past several years has been that a global business cycle downturn would occur despite ongoing strength in American household spending. The rationale has been that China and the rest of EM combined are large enough on their own to bring down global trade and manufacturing, irrespective of strength in U.S. consumer spending. At the current juncture, one wonders whether such a market bifurcation is justified. It is not irrational. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Corporate bonds have also done well, given the background of a falling risk-free rate. Will the current market bifurcation continue? Or will these segments in global financial markets recouple and in which direction? What To Watch China rather than the U.S. has been the epicenter of this slowdown, as we have argued repeatedly in the past. Hence, a major rally in global cyclical equities and EM risk assets all hinge on a recovery in the Chinese business cycle. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Even though Caixin’s PMI for China was slightly up in August, many other economic indicators remain downbeat: The latest hard economic data out of Asia suggest that global trade/manufacturing continues to contract. Korea’s total exports in August contracted by 12.5% from a year ago, and its shipments to China plunged by 20% (Chart I-6). The import sub-component of China’s manufacturing PMI is not showing signs of amelioration (Chart I-7). The mainland’s import recovery is very critical to a revival in global trade and manufacturing. Chart I-6Korean Exports: No Recovery Chart I-7Chinese Imports To Remain Weak Chart I-8German Manufacturing Confidence German manufacturing IFO business expectations and current conditions both suggest that it is still early to bet on a global trade recovery (Chart I-8). Newly released August data points reveal that U.S., Taiwanese, and Swedish manufacturing new export orders continue to tumble. To gauge whether bifurcated markets will recouple and whether it will occur to the downside or the upside, investors should watch the relative performance of China-exposed markets, global cyclicals and high-beta plays – the ones that have already sold off substantially. The notion is as follows: These markets’ relative performance will likely bottom before their absolute performance recovers. If so, their relative performance will likely foretell the outlook for their absolute performance. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. In other words, they could sell off even if a global recession is avoided. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. To assess the outlook for global cyclicals and China-related plays, we are monitoring the following financial market indicators: The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. This ratio is making a new cyclical low (Chart I-9). Hence, it presently warrants a negative view on global growth, China’s industrial sector and commodities. Global cyclical equity sectors seem to be on the edge of breaking down versus defensives (Chart I-10). This ratio does not signal ameliorating global growth conditions. Chart I-9The Risk-On/Safe-Haven Currency Ratio Chart I-10Global Cyclicals Versus Defensives Chart I-11U.S. High-Beta Stocks Versus S&P 500 Finally, U.S. high-beta stocks continue to underperform the S&P 500 (Chart I-11). This is consistent with overall U.S. growth deceleration. Bottom Line: Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to foreshadow either further bifurcation in global markets or a risk-off period. Continue trading EM stocks and currencies on the short side, and underweighting EM risk assets versus DM. Our Investment Themes And Positions Some of our open positions often run for years because they reflect our long-standing themes. Our core theme has for some time been that a global trade/manufacturing recession will be generated by a growth relapse in China. To capitalize on this theme, we have been recommending a short EM stocks / long 30-year U.S. Treasurys strategy since April 2017. This recommendation has produced a 25% gain since its initiation (Chart I-12). Continue betting on lower local interest rates in emerging economies where the central bank can cut rates despite currency depreciation. To implement this theme, we have been recommending receiving swap rates in Korea and Chile for the past several years. Our reluctance to recommend an outright buy on local bonds stems from our bearish view on both currencies – the Korean won and Chilean peso. In fact, we have been shorting both the KRW and the CLP against the U.S. dollar. Chart I-13 shows that swap rates in Korea and Chile have dropped substantially since our recommendations to receive rates in these countries. More rate cuts are forthcoming in these economies, and we are maintaining these positions. Chart I-12EM Stocks Have Massively Underperformed U.S. Bonds Chart I-13Continue Receiving Rates In Korea And Chile We have been bearish on EM banks in general and Chinese banks in particular. We have expressed these themes in a number of ways: Short EM and Chinese / long U.S. bank stocks. Short EM banks / long EM consumer staples (Chart I-14). Within Chinese banks, we have been short Chinese medium and small banks / long large ones. All these strategies remain valid. In credit markets, we have been favoring U.S. corporate credit versus EM sovereign and corporate credit. Ability to service debt is better among U.S. debtors than EM/Chinese borrowers. We have been playing this theme in the following ways: Underweight EM sovereign and corporate credit / overweight U.S. investment-grade corporates (Chart I-15). Chart I-14Short EM Banks / Long EM Consumer Staples Chart I-15Underweight EM Credit / Overweight U.S. Investment-Grade Corporates Underweight Asian high-yield corporate credit / overweight emerging Asian investment-grade corporates. As a bet on a deteriorating political and business climate in Hong Kong, in our Special Report on Hong Kong SAR from June 27, we reiterated the following positions: Short Hong Kong property stocks / long Singapore equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Mexico: Crying Out For Policy Easing The Mexican economy is heading into a full-blown recession. Most segments of the economy are in contraction, and leading indicators point to further downside. Both manufacturing and non-manufacturing PMIs are well below 50 (Chart II-1). Monetary policy remains too restrictive: Nominal and real interest rates are both very high and plunging narrow money (M1) growth is signaling further downside in economic activity (Chart II-2). Chart II-1The Economy Is Deteriorating Chart II-2Narrow Money Points To Negative Growth An inverted yield curve signifies that the central bank is behind the curve and foreshadows growth contraction (Chart II-3). Fiscal policy has tightened as the government has remained committed to achieving a primary fiscal surplus of 1% of GDP in 2019 (Chart II-4, top panel). Consequently, nominal government expenditures have been curbed (Chart II-4, bottom panel). The government’s fiscal stimulus has not been large and has been implemented too late. Chart II-3A Message From The Inverted Yield Curve Chart II-4Fiscal Policy Has Tightened A Lot Finally, business confidence is extremely low due to uncertainty over President Andrés Manuel López Obrador’s (AMLO) policies towards the private sector. The president is attempting to revive business confidence, but it will take time. Chart II-5Mexico Versus EM: Domestic Bonds And Sovereign Credit Our major theme for Mexico has been that both monetary and fiscal policies are very tight. Consequently, we have been recommending overweight positions in Mexican domestic bonds and sovereign credit relative to their respective EM benchmarks. (Chart II-5). Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Meanwhile, we have been favoring the Mexican peso relative to other EM currencies due to the fact that AMLO is not as negative for the country as was initially perceived by markets. With inflation falling and the Federal Reserve cutting rates, Banxico will ease further. Yet, it will likely cut rates slower than warranted by the economy. The longer the central bank takes to ease, the lower domestic bond yields will drop. Concerning sovereign credit, investors should remain overweight Mexico within an EM credit portfolio. Mexico’s fiscal position is healthier, and macroeconomic policies will be more prudent relative to what the market is currently pricing. We continue to believe concerns about Pemex’s financing and its impact on government debt are overblown, as we discussed in detail in our previous Special Report. In July, the government released an action plan for Pemex financing. We view this plan as marginally positive. To supplement this plan, the government can use the $14.5 billion federal budget stabilization fund to fill in financing shortfalls in the coming years. Importantly, the starting point of Mexican public debt is quite low, which will allow the government to finance Pemex in the years to come by borrowing more from markets. Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Lastly, our overweight recommendation in Mexican stocks has not played out. However, we are maintaining it for the following reasons: Chart II-6 illustrates that when Mexican domestic bond yields decline relative to EM ones (shown inverted on Chart II-6), Mexican share prices usually outperform their EM counterparts in common currency terms. Consistent with our view that Mexican local currency bonds will outperform their EM peers, we expect Mexican stocks to outpace the EM equity benchmark. The Mexican bourse’s relative performance against EM often swings with the relative performance of EM consumer staples versus the EM equity benchmark. This is due to the large share of consumer staples stocks in Mexico (34.5%) compared to that in the EM benchmark (7%). Consumer staples stocks are beginning to outpace the EM equity index, raising the odds of Mexican equity outperformance versus its EM peers (Chart II-7). Chart II-6Local Bond Yields And Relative Stocks: Mexico Versus EM Chart II-7Consumer Staples Have A Large Weight In Mexican Bourse We do not expect a major rally in this nation’s stock market given the negative growth outlook. Our bet is that Mexican share prices - having already deflated considerably - will drop less in dollar terms than the overall EM equity index. Bottom Line: We continue to recommend an overweight stance on Mexican sovereign credit, domestic bonds and equities relative to their respective EM benchmarks. The main risk to the Mexican peso stems from persisting selloff in EM currencies. Traders’ net long positions in the MXN are elevated posing non-trivial risk (Chart II-8). We have been long MXN versus ZAR but are taking profit today. This trade has generated a 9.7% gain since March 29, 2018. A plunging oil-gold ratio warrants a caution on this cross rate in the near term (Chart II-9). Chart II-8Investors Are Long MXN Chart II-9Take Profits On Long MXN / Short ZAR Trade Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations