Energy
Highlights Portfolio Strategy Recovering energy related capex and upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Augment positions to overweight. A diverging crude/refined product inventory backdrop, narrowing Brent-WTI crude oil spread, and extreme analyst optimism warn that the easy money has been made in refiners. Lock in profits and downgrade to a benchmark allocation. Recent Changes S&P Integrated Oil & Gas - Upgrade to overweight. S&P Oil & Gas Refining & Marketing - Book profits of 9% and downgrade to neutral today. Table 1 Feature Chart 1Vertigo Alert Equities have been rising at a dizzying speed year-to-date, as investors have extrapolated the tax reform EPS tailwind far into the future in a very short time span. The risk of a tactical, and likely short lived, 5-10% pullback is very high. Putting this potential correction in perspective is in order. A drop in the SPX to near its 50-day moving average would set the market back 6%, to near the 2,700 mark. As a reminder, the S&P 500 crossed 2,700 on January 3, 2018. A 10% drawdown would push the market below 2,600, a level first surpassed on Black Friday (Chart 1). While steep stock price increases are not unprecedented, at the current juncture all of our tactical indicators suggest that caution is warranted (please refer to the January 22 and January 29 Weekly Reports for more details). The way we recommend defending against such exuberance is to book gains in high-beta pair trades, institute trailing stops to the high-conviction list high flyers (see page 19) and make some subsurface changes to intra-sector positioning. From a cyclical perspective we remain constructive on the broad market and given our view of no recession in the coming 9-12 months our investment strategy is to "buy the dip". Chart 2 shows our S&P 500 EPS model using trailing EPS data directly from Standard & Poor's. Calendar 2017 profit growth is on track to hit 17% year-over-year. Chart 3 shows our S&P 500 EPS model using IBES trailing EPS data. We decided to regress the same variables on the IBES trailing EPS dataset since the market trades on the forward EPS from IBES. According to IBES, calendar 2017 EPS growth will hit 12%, so there is a 5% delta between the two datasets. Our understanding of the difference between the two numbers is what each provider considers one time I/S items. Currently, IBES bottom-up forecasts pencil in 18% growth in calendar 2018 and our model suggests that 21% is possible (Chart 3). S&P forecasts call for a 23% calendar 2018 increase and our model is pointing toward 24% (Chart 2). Chart 2No Matter The Data Set... Chart 3...EPS Will Shine In 2018 Irrespective of what data one uses the signal is clear: EPS will have a blowout year in 2018. Studying such EPS reacceleration phases is very interesting. Since the mid-1980s there have been four other periods where EPS exhibited breakneck growth (excluding the GFC, Chart 3). Importantly, we analyzed what the prevalent macro conditions were in all four iterations and Charts A1-A4 in the Appendix on page 16 detail the results. In all iterations, the 10-year Treasury yield was rising, the ISM manufacturing survey was well above the 50 boom/bust line, the U.S. dollar was falling, and crude oil prices were increasing. Currently, we believe reaching and even surpassing the 20% EPS growth rate number in 2018 is likely, given the similarities between the current macro backdrop and these four prior periods (Chart 4). However, this does not necessarily mean that there will be no stock market volatility and equites will increase uninterruptedly in a straight line. Chart 5 shows how the S&P 500 performed in these four periods and in all of them short-term tactical pullbacks occurred. We think 2018 will prove no different. This week we update our view on a deep cyclical sector and tweak our intra-sector positioning. Chart 4Favorable Macro Conditions... Chart 5...But Don't Get Carried Away Stay Long Energy... We put the S&P energy sector on our high-conviction overweight list in late-November as a key beneficiary of our synchronized global capex theme.1 Since then, the broad energy complex has bested the S&P 500 by over 3%, and our macro indicators suggest that more gains are in store for this deep cyclical sector. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit the highest level in a decade. Similarly, capex intentions in the coming six months are also probing multi-year highs and signaling that the budding recovery in energy capital budgets will likely gain steam (middle panel, Chart 6). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (bottom panel, Chart 6). Indeed, rising oil prices are providing a much needed assist. Higher crude prices make more global projects economical and coupled with the steadily lower breakeven costs of shale oil suggest that EPS and sales growth normalcy is likely to return to this commodity complex. Moreover, the indiscriminate selling of the U.S. dollar explains part of the oil price rise, but other macro forces are also at play (Chart 7). Chart 6Capex Theme Beneficiary Chart 7Catch Up Phase Looming Chart 8Levered To Global Growth##BR## And Rising Inflation Similar to "Dr. Copper", crude oil prices are an excellent global growth barometer. In fact, oil price swings move in lockstep with the ebb and flow of global output growth and the current message is positive (Chart 8). Not only is our proprietary measure of global Industrial Production rising, but the multi-year high in the forward looking global manufacturing PMI survey also suggests that more good news on the global economic front lies ahead. As unemployment gaps close around the world, with more and more countries following in the U.S.'s footsteps toward full employment, inflation is bound to reaccelerate. Recently, the 10-year U.S. Treasury yield has been on a tear driven mostly by rising inflation expectations. Higher interest rates is another key BCA theme for 2018 and energy stocks also stand to benefit from this rising interest rate backdrop. Historically, relative share prices have been positively correlated both with bond yields and inflation expectations and the current message is to expect a catch up phase in the former (bottom panel, Chart 8). Beyond an enticing macro backdrop, favorable industry supply/demand dynamics are a harbinger of sunnier energy days. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. The implication is that relative share prices will remain well bid (oil inventories shown inverted, middle panel, Chart 9). OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew roughly by 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 9). Our energy profit model does an excellent job capturing all of these different forces and is signaling that energy EPS will easily outpace the SPX and continue to capture a larger share of the broad market's earnings pie (Chart 10). Chart 9Favorable Supply/Demand Backdrop Chart 10EPS Model Flashing Green Bottom Line: We reiterate our high-conviction overweight call in the S&P energy index. ...Boost The Integrated Oil & Gas Index To Overweight, But... Factors are falling into place for the heavyweight S&P integrated oil & gas index to generate outsized returns in the coming year, and we are compelled to lift this beaten-down energy sub-index to an above benchmark allocation. Investment spending and relative performance are one and the same for this capital-outlay-reliant group. The time to buy these capital intensive high-operating leverage stocks is during a capex upcycle when a virtuous EPS cycle takes root. The opposite is also true. Earlier this decade, the energy sector's share of the U.S. stock market reported capex pie got halved to 16% (top panel, Chart 11). While we are not calling for a return to the heyday of triple digit oil, even a modest renormalization of capital spending would go a long way. Recent news that Exxon Mobil would bump domestic capital spending to $50bn over the next five years is a step in the right direction. New projects/investments comprise 70% of this figure. The company cited the new U.S. tax law as a reason behind the announcement, and tax reform has the potential to drive industry capex plans/budgets. Our sense is that more announcements like the Exxon Mobil one may be brewing and could serve as a catalyst to unlock excellent value in the S&P integrated oil & gas index. Meanwhile, higher oil prices will result in a pickup in global energy project outlays. The top panel of Chart 12 shows that the global oil & gas rig count is rebounding from an extremely depressed level. Encouragingly, these investments will likely pay dividends and translate into cash flow growth extending the virtuous upcycle (bottom panel, Chart 12). Chart 11Buy Oil Majors Chart 12Prime Beneficiary Of Rising Capex As we mentioned earlier in the energy section, BCA still has a sanguine 2018 oil view, and if it pans out, it will continue to underpin not only the broad energy space, but also oil majors. Action in the commodity pits corroborates that the path of least resistance is higher both for the underlying commodity and relative share prices. Crude oil net speculative positions just hit a record high as a percent of open interest (bottom panel, Chart 13). Similarly, consensus on oil just breached the 50 line and is now in bullish territory, signaling that momentum in the relative share price ratio will gain steam in the coming months (middle panel, Chart 13). Adding it up, recovering energy related capex coupled with upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Under such a backdrop a valuation rerating phase is looming (Chart 14). Chart 13Encouraging Oil Market Dynamics Chart 14Cheap With A 150bps Dividend Carry Bottom Line: Boost the S&P integrated oil & gas index to overweight. This index also sports a 150bps positive dividend carry. The ticker symbols for the stocks in this index are: XOM, CVX & OXY. ...Take Profits In Refiners While we recommend upgrading the S&P integrated oil & gas index to overweight, we are booking gains of 9% in the niche S&P oil & gas refining & marketing index and downgrading to a benchmark allocation. We upgraded refiners to overweight in early September, as a way to capitalize on the havoc that hurricane season dealt to refining capacity. Since then, our portfolio has benefited handsomely from the run up in refining stocks, but we do not want to overstay our welcome in this niche space as refinery runs have now returned to normal (Chart 15). Moreover, a number of headwinds signal that the easy gains are already behind this group. First, refining margins are under pressure as the Brent-WTI crude oil spread is steadily narrowing. Historically, refining margins and this oil price spread have been joined at the hip and the current message is negative for margins. A diverging inventory backdrop also points toward margin trouble ahead. Refined product inventories are outpacing crude oil supplies, warning that a further softening in crack spreads is in the cards (bottom panel, Chart 16). In fact, crude oil inventories are whittled down, whereas gasoline and distillate fuel stocks are built up (middle panel, Chart 15). This inventory accumulation represents, at the margin, a challenging pricing outlook for refiners. Chart 15Return To Normalcy... Chart 16...But Cracks Are Forming Worrisomely, sell side analysts have been extrapolating a euphoric EPS backdrop far into the future with five year profit forecasts pushing all-time highs. While tax reform represents a one-time boost to EPS in 2018, we cannot comprehend how this highly cyclical industry with razor thin margins can attain 34% EPS growth for the next 3-5 years, outpacing the overall market by a staggering 20 percentage points (Chart 17). Putting this sky-high long-term EPS growth number in perspective is instructive. Typically, relative share prices hit a wall when such analyst optimism reigns. The tech sector in the late 1990s, biotech stocks twice in 2001 and 2014, and semi equipment stocks late last year all suffered a major setback when long-term profit forecasts catapulted near the 25% mark (Chart 17). (As a reminder chip equipment stocks are a high-conviction underweight and have benefitted our portfolio by 17.2% since the November 27th inception, please see page 19.) Finally, from a technical perspective, a bearish pennant formation with lower highs has formed and is warning that a breakdown is possible in the relative share price ratio in the coming quarters (top panel, Chart 16). Nevertheless, we refrain from turning outright bearish on refiners as there is a sizeable offset. Refined product consumption is as firm as ever. Gasoline demand remains upbeat and this indicator has historically been positively correlated with relative share prices, relative 12-month forward EPS and relative valuations (Chart 18). Chart 17Watch Out Down Below Chart 18Consumption Is A Positive Offset Any let-up in demand or a further jump in refined product inventories could prove deflationary for refiners and were that to take place we would not hesitate to further prune exposure to a below benchmark allocation. Bottom Line: Lock in profits of 9% in the S&P oil & gas refining & marketing index and downgrade to neutral. The ticker symbols for the stocks in this index are: PSX, VLO, MPC and ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Appendix Chart A1 Chart A2 Chart A3 Chart A4 Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).
Overweight In a welcome reversal of fortunes, the S&P energy services index caught a bid last month, lifted by rising oil prices, healthy earnings and bullish 2018 forecasts. We think this is just the beginning for the beleaguered sector. OPEC crude oil production remains firmly in contraction territory with the mantle being taken up by non-OPEC producers (second panel), the key customer group for the energy services index. However, the increases have not been enough to offset the declines and OECD oil stocks have fallen for the past year, a trend that has sparked the biggest revival in oil patch capex in the last five years (third panel). In the context of the valuation pounding the sector has taken during the oil downturn, the rebound has a very long runway. We reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5ENRE- SLB, HAL, FTI, NOV, BHGE, HP.
Highlights A thorough audit of our trade book highlights that our country and sector allocation recommendations have been quite profitable for investors. Of the 12 active trades in our book, 11 have generated a positive return, including one with a 32% annualized rate of return. A review of the original basis and subsequent performance of our trades suggests that investors should close 6 out of 12 of our active positions, predominantly related to resource & construction and domestic stock market themes. We will be looking for opportunities to add new trades to our book over the coming weeks and months that have broad, "big-picture" relevance. Watch this space. Feature In this week's report we conduct a thorough audit of our trade book, by revisiting the original basis and subsequent performance of all 12 of our active trades. While these trades have been initiated at different points over the past five years, they can be broadly grouped into five different themes: Core Equity Allocation & General Pro-Risk Trades (4 Trades) Reform-Oriented Trades (2 Trades) Resource & Construction Plays (2 Trades) Domestic Stock Market Trades (2 Trades) Trades Linked To Hong Kong (2 Trades) Overall, our trade book performance has been excellent. Of the 12 active trades in our book, 11 have generated a positive return, including one with a 32% annualized rate of return (since December 2015). As a result of our trade book review, we recommend that investors close six trades and maintain six over the coming 6-12 months. The closed trades predominantly fall into the resource & construction and domestic stock market categories, although we also recommend closing our long China H-share / short industrial commodity trade as well as our long Hong Kong REITs / short Hong Kong broad market trade. We present our rationale for retaining or closing each trade below. Over the coming weeks and months we will be looking for opportunities to add new trades to our book. Stay tuned. Core Equity Allocation & General Pro-Risk Trades We have four open core equity allocation and pro-risk trades: Overweight MSCI China Investable stocks versus the emerging markets benchmark, initiated on May 2, 2012 Long China H-shares / short industrial commodities, initiated on March 16, 2016 Short MSCI Taiwan / Long MSCI China Investable, initiated on February 2, 2017 and Long China onshore corporate bonds, initiated on June 22, 2017 We recommend that investors stick with three of these trades, but close the long China H-shares / short industrial commodities position for the following reasons: Chart 1Be Overweight China Vs EM In This Environment Overweight MSCI China Investable Stocks Versus The EM Benchmark (Maintain) This trade represents one of the most important equity allocation calls for Chinese stocks, and is one of the ways that BCA expresses a view on the Chinese economy in our House View Matrix.1 While it hasn't always been the case, we noted in a recent Special Report that Chinese stocks have become a high-beta equity market versus both the global aggregate and the emerging market benchmark, even when excluding the technology sector.2 China's high-beta nature, the fact that EM equities remain in an uptrend (Chart 1), and our view that China's ongoing slowdown is likely to be benign and controlled all suggest that investors should continue to overweight Chinese stocks vs their emerging market peers. Long China H-Shares / Short Industrial Commodities (Close) We initiated this trade in March 2016, one month after Chinese stock prices bottomed following the significant economic slowdown in 2015. At that time it was not clear to global investors that a mini-cycle upswing in the Chinese economy had begun, and this pair trade was a way of taking a limited pro-risk bet. Given our view of a benign, controlled economic slowdown in China, this hedged trade is no longer needed, especially given the uncertain impact of ongoing supply side constraints in China on global commodity prices. As such, we recommend that investors close the trade, locking in an annualized return of 15.7%. Short MSCI Taiwan / Long MSCI China Investable (Maintain) Chart 2If The TWD Declines Materially, ##br##Upgrade Taiwan (From Short) We initiated our short MSCI Taiwan / long MSCI China investable trade last February, when the risk of protectionist action from the Trump administration loomed large. While there have been no negative trade actions levied against Taiwan this year, macro factors, particularly the strength of the currency, continue to argue for an underweight stance within the greater China bourses (China, Hong Kong, and Taiwan). We reviewed the basis of this trade in a report last month,3 and recommended that investors stick with the call despite significantly oversold conditions (Chart 2). A material easing in pressure on Taiwan's trade-weighted exchange rate appears to be the most likely catalyst to close the trade and to upgrade Taiwan within a portfolio of greater China equities. Long China Onshore Corporate Bonds (Maintain) Chinese corporate bond yields have risen materially since late-2016, largely in response to expectations of tighter monetary policy. These expectations have been validated, with 3-month interbank rates having risen over 200bps since late-2016. We argued last summer that the phase of maximum liquidity tightening was likely over, and that quality spreads and government bond yields would probably drop over the coming three to six months. While this clearly did not occur (yields and spreads rose), the total return from this trade has remained in the black owing to the significant yield advantage of these bonds versus similarly-rated bonds in the developed world. Chart 3 highlights that Chinese 5-year corporate bond spreads are also considerably less correlated with equity prices than their investment-grade peers in the U.S. This underscores that the rise in yields and spreads over the past year has reflected expectations of tighter monetary policy, not rising default risk. Our sense is that barring a significant improvement in China's growth momentum, significant further monetary policy tightening is improbable, meaning that corporate bond yields are not likely to rise much further. As a final point, as of today's report we are changing the benchmark for this trade from a BCA calculation based on a basket of 5-year AAA and AA-rated corporate bonds to the ChinaBond Corporate Credit Bond Total Return Index. Chart 3Chinese Corporate Spreads Aren't A Risk ##br##Barometer Like In The U.S. Reform-Oriented Trades We have two open trades related to China's rebooted reform initiative, both of which were initiated on November 16, 2017: Long China investable consumer staples / short consumer discretionary stocks and Long China investable environmental and social governance (ESG) leaders / short investable broad market These trades were recently opened, and we continue to recommend that investors maintain both positions: Long China Investable Consumer Staples / Short Consumer Discretionary Stocks (Maintain) The basis for the first trade stems from the current limitations of China's investable consumer discretionary index as a clear-cut play on retail-oriented consumer spending. We argued in our November 16 Weekly Report that Chinese investable consumer staples would be a better play on Chinese consumer spending owing to the material weight of the automobiles & components industry group in the discretionary sector, which may fare poorly over the coming year due to the environmental mandate of President Xi's proposed reforms. We argued in the report that this trade would likely be driven by alpha rather than beta, and indeed Chart 4 illustrates that staples continue to rise relative to discretionary against a backdrop of a rising broad market. Long China Investable ESG leaders / Short Investable Broad Market (Maintain) In the same report we recommended that investors overweight the China investable ESG leaders index, based on the goal of favoring firms that are best positioned to deliver "sustainable" growth in an era of heightened environmental reforms. The index overweights firms with the highest MSCI ESG ratings in each sector (using a proprietary MSCI ranking scheme), and maintains similar sector weights as the investable benchmark, which limits the beta risk of the trade. Chart 5 highlights that the trade is progressing in line with our expectations, suggesting that investors stick with the position over the coming 6-12 months. Chart 4Staples Vs Discretionary Isn't A Low Beta Trade Chart 5Likely To Continue To Outperform Resource & Construction Plays We have two open trades related to the resource sector: Long China investable oil & gas stocks / short global oil & gas stocks, initiated on April 26, 2014 and Long China investable construction materials sector / short investable broad market, initiated on December 9, 2015 We recommend that investors close both of these positions, based on the following rationale: Chart 6Similar Earnings Profile, ##br##But Weaker Dividend Payouts Long China Investable Oil & Gas Stocks / Short Global Oil & Gas Stocks (Close) This trade was initiated based on the view that the valuation gap between Chinese and global oil & gas companies is unjustifiable given that the earnings off both sectors are globally driven. Indeed, Chart 6 shows that the trailing EPS profiles of both sectors in US$ terms have been broadly similar over the past few years, and yet China's oil & gas sector trades at a 40% price-to-book discount relative to its global peers. However, panel 2 of Chart 6 highlights that this discount may represent investor concerns about earnings quality and/or state-owned corporate governance. The chart shows that while the earnings ROE for Chinese oil & gas companies is higher than that of the global average, the dividend ROE (dividends per share as a percent of shareholders equity) is considerably lower. While China's oil & gas dividend ROE has recently been rising, the gap remains wide relative to global oil & gas companies, suggesting that there is no significant re-rating catalyst that is likely to emerge over the coming 6-12 months. Close for an annualized return of 1.4%. Long China Investable Construction Material Stocks / Short China Investable Broad Market (Close) The relative performance of Chinese investable construction material stocks has been positive over the past two years, with the trade having generated an 8.1% annualized return since initiation. There are two factors contributing to our view that it is time for investors to book profits on this trade. The first is that China's investable construction materials are dominated by cement companies, which may suffer in relative terms from China's rebooted reform initiative this year.4 The second is that the relative performance of construction materials stocks is closely correlated with, and led by, the growth in total real estate investment (Chart 7). Residential investment makes up a significant component of total real estate investment, and Chart 8 highlights that a significant gap between floor space sold and completed has narrowed the inventory to sales ratio over the past three years. But the ratio remains somewhat elevated relative to its history which, when coupled with the ongoing growth slowdown in China and the deceleration in total real estate investment growth, implies a poor risk/reward ratio over the coming 6-12 months. Chart 7Cement Producers Trade Off Of Real Estate Investment Chart 8No Clear Construction Boom Is Imminent Domestic Stock Market Trades We have two open trades related to China's domestic stock market: Long China domestic utility sector / short domestic broad market, initiated on January 22, 2014 and Long China domestic food & beverage sector / short domestic broad market, initiated on December 9, 2015 Similar to our resource & construction plays, we recommend that investors close both of our recommended domestic stock market trades: Long China Domestic Utility Sector / Short Domestic Broad Market (Close) We initiated this trade in early-2014, following a comprehensive reform plan released in late-2013 by the Chinese government. The plan called for allowing market forces to play a decisive role in allocating resources, which we argued would grant utilities more pricing power, reduce their earnings volatility associated with policy risks, and lead to a structural positive re-rating. Chart 9 illustrates that this trade gained significant ground in 2014 and early-2015, even prior to the significant melt-up in domestic stock prices that began in Q2 2015. However, the trade has underperformed significantly since the middle of last year, which has been driven by a sharp deterioration in ROE. This decline in ROE appears to have been cost-driven, as coal is an important feedstock for Chinese utility companies and has risen substantially in price over the past two years. While domestic utilities are now significantly oversold in relative terms, we recommend that investors close this trade because the original reform-oriented basis has shifted significantly. The priorities that emanated from October's Party Congress were decidedly environmental in nature, meaning that coal prices may very well remain elevated over the coming 6-12 months (due to restricted supply). This means that a recovery in ROE would rest on the need to raise utility prices, which is a low-visibility event that will be difficult to predict. Close for an annualized return of 3%. Long China Domestic Food & Beverage Sector / Short Domestic Broad Market (Close) We initiated this trade in December 2015, based on this sector's superior corporate fundamentals and undemanding valuation levels. We argued that the anti-corruption campaign since late-2012 was likely the cause of prior underperformance, given that the group is dominated by a few high-end alcohol producers. The market overacted to the high-profile crackdown, and ultimately the fundamentals of the sector did not deteriorate materially. Our view has panned out spectacularly, with the trade having earned a 32% annualized return since inception5 (Chart 10 panel 1). While the group's ROE remains significantly above that of the domestic benchmark, valuation measures suggest that investors have more than priced this in (Chart 10 panel 2). The trade has mostly played out and we would not like to overstay our welcome. In addition, panel 3 illustrates that technical conditions are extremely overbought, suggesting that investors are being presented with an excellent opportunity to exit the position. Chart 9Sidelined By A Major Hit To ROE Chart 10Time To Book Profits Trades Linked To Hong Kong We have two open trades related to Hong Kong: Long U.S. / short Hong Kong 10-Year government bonds, initiated on January 15, 2014 and Short Hong Kong property investors / long Hong Kong broad market, initiated on January 21, 2015 We recommend that investors stick with the first and close the second, based on the following perspectives: Long U.S. / Short Hong Kong 10-Year Government Bonds (Maintain) Hong Kong has an open capital account and an exchange rate pegged to the U.S. dollar, meaning that its monetary policy is directly tied to that of the U.S. Yet, Hong Kong's 10-year government bond yield is non-trivially below that of the U.S., which argues for a short stance versus similar maturity U.S. Treasurys. While it is true that the Hong Kong - U.S. 10-year yield spread does vary and can widen over a 6-12 month horizon, Chart 11 highlights that the relative total return profile of the trade (in unhedged terms) trends higher over time due to the carry advantage. Short Hong Kong REITs / Long Hong Kong Broad Market (Close) There are cross-currents facing the outlook for Hong Kong REITs vs the broad market, arguing for a neutral rather than an underweight stance. Close this trade for an annualized return of 3.6%. While the relative performance of global REITs is typically negatively correlated with bond yields, Chart 12 shows that the relationship with Hong Kong property yields has been positive and lagging (i.e. falling yields lead declining relative performance, and vice versa). Under this regime, a rise in U.S. government bond yields, as we expect, would suggest an improvement in the relative performance of Hong Kong REITs. Chart 11A Straightforward Carry Pick Up Trade Chart 12Rising Bond Yields Implies ##br##Positive HK REIT Performance Chart 13 highlights that periods of positive yield / REIT performance correlation have tended to occur when Hong Kong property prices are rising significantly relative to income, as they have been for the past several years. One interpretation of this dynamic is that when house prices are overvalued and potentially vulnerable, REIT investors react positively to an improvement in economic fundamentals (which tends to push yields up due to higher interest rate expectations). The risk of an eventual collapse of Hong Kong property prices is clear, but we cannot identify an obvious catalyst for this to occur over the coming 6-12 months. Importantly, the fact that property prices have continued to rise during a period of tighter mainland capital controls suggests that only a significant economic shock will be enough to derail the uptrend in prices, circumstances that we do not expect over the coming year. Finally, Chart 14 highlights that Hong Kong REITs are deeply discounted relative to book value when compared against the broad market. This suggests that at least some of the risks associated with the property market have already been priced in by investors. Chart 13Yields & REITs Positively Correlated ##br##When House Prices Are Overvalued Chart 14Hong Kong REITs Are Cheap Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 https://www.bcaresearch.com/trades 2 Please see China Investment Strategy Weekly Report, "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report "Taiwan: Awaiting A Re-Rating Catalyst", dated December 14, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 5 Please note that the total return from this trade had been erroneously reported for some time due a data processing error on BCA's part. The return since inception now properly sources the China CSI SWS Food & Beverage index from CHOICE. We sincerely regret the error and any confusion it may have caused. Cyclical Investment Stance Equity Sector Recommendations
Highlights Slower global demand growth, coupled with surging production from the U.S. shales and higher OPEC 2.0 production, risks reversing the progress made in draining global commercial oil storage and tanking prices in 2019.1 Our updated balances modelling is in agreement with the backwardation in forward Brent and WTI curves, but, if anything, indicates the backwardation should be more pronounced: We are forecasting Brent and WTI prices next year will average $55 and $53/bbl, respectively, vs. $62.80/bbl and $57.40/bbl average prices for 2019's forward curves. For 2018, we are maintaining our $67 and $63/bbl expectation for Brent and WTI, although our modelling indicates higher prices are a distinct possibility, given our fundamental assumptions of falling supply and rising demand this year (Chart of the Week). Energy: Overweight. We liquidated our May and July Brent and WTI $55 vs. $60/bbl call spreads last week with gains of 110.1% and 129.0%. We will be liquidating our Dec/18 Brent and WTI $55 vs. $60/bbl call spreads at tonight's close; they were up 62.3% and 82.1% as of Tuesday. We remain long Jul/18 vs. Dec/18 WTI (up 47.4%), and long the S&P GSCI (up 8.5%), expecting backwardation. We will get long $55 Brent Puts vs. short $50 Brent Puts in 4Q19 at tonight's close. Base Metals: Neutral. We continue to expect base metals to remain well supported in 1H18 by environmental reforms in China, and supply uncertainty around contract renegotiations at the copper mines. The global expansion underpinning demand will compensate for slower Chinese growth in 2H18. Precious Metals: Neutral. Our long gold portfolio hedge is up 8.5% since inception in May/17. Ags/Softs: Underweight. Soybean markets rallied following last week's USDA WASDE report, but grains fell amid data indicating these markets will remain oversupplied. Feature If there is one truth in commodity markets it is this: The best cure for high prices is high prices, and vice versa. This is being dramatically demonstrated by OPEC 2.0 in its collective action to remove 1.8mm b/d of production from the market following disastrously low prices in 2015 - 16. Higher prices in 4Q17 and 1H18 oil futures are incentivizing a surge in U.S. shale output, and will give OPEC 2.0 comfort in slowly feeding output taken offline at the beginning of 2017 back into the market in 2H18 and 2019 (Chart 2). Higher prices and tightening monetary conditions globally will slow the rate of growth in demand next year (Chart 3). Chart of the WeekFundamentals##BR##Support Oil In 2018 Chart 2Non-OPEC Production##BR##Will Surge Chart 3Strong Consumption Growth In 2018,##BR##Tempered By Higher Prices In 2019 Given these fundamental inputs, we expect to see Brent averaging $55/bbl next year, and WTI averaging $53/bbl next year. Our forecast is highly uncertain, given the actual evolution of prices will, once again, depend on actions taken by OPEC 2.0 and the forward guidance provided by its leadership, KSA and Russia. Our forecast for 2018 - $67/bbl for Brent and $63/bbl for WTI - remains unchanged. If anything, our unconstrained models (Chart of the Week) have more upside risk than our forecast suggests, largely from falling production and surging demand - not to mention unplanned production outages. Looking to the end of 2019 from today, the backwardation we expect is greater than what is being priced into the Brent and WTI forward curves presently. Growth In U.S. Shales Dominates Non-OPEC Gains We are expecting U.S. crude oil production growth will dominate the increase in non-OPEC output in 2018 and 2019 (Chart 2, top panel). U.S. shale-oil output rises by 970k b/d and another 1.18mm b/d, respectively, this year and in 2019. By our reckoning, this will lift total U.S. crude oil production to 10.22mm b/d this year, a record level of output, and to 11.44mm b/d on average next year. Total U.S. crude and liquids output therefore rises from just under 17mm b/d in 2018 to 18.5mm b/d by the end of 2019. If our estimates are correct, the U.S. will join Russia in producing more than 11mm b/d of crude oil next year, and may even exceed it. Russia is expected to raise production slightly. As one of the putative leaders of OPEC 2.0, we expect Russia to maintain its 300k b/d production cut in 1H18, which will keep its overall liquids production steady at ~ 11.17mm b/d through June. In 2H18, Russia will gradually restore production to an average of 11.24mm b/d, reaching 11.4mm b/d by December. For 2019, we expect total Russian liquids production to average 11.35mm b/d, up ~ 140k b/d yoy. OPEC's return will be led by the Cartel's Gulf producers, which are expected to raise crude production 450k b/d this year and 350k b/d next year (Chart 2, bottom panel). Total production in Gulf OPEC states will reach 25.25mm b/d on average in 2019. This will, of course, be dominated by KSA, which we expect will lift crude production to ~ 10.36mm b/d in 2H18 after holding crude output steady at ~ 10mm b/d in 1H18 over-delivering vs. its quota under the OPEC 2.0 Agreement. For 2019, we expect KSA to maintain production above 10.1mm b/d.2 Non-Gulf OPEC producers, on the other hand, will see their production fall 140k b/d this year, and another 240k b/d next year, leaving it at 7.49mm b/d on average in 2019, in our estimation. The contribution of these states to the OPEC 2.0 production cuts has been "managing" their respective decline curves. It is highly unlikely they will see production surge following the expiration of the OPEC 2.0 agreement at the end of this year. Overall, we expect global crude and liquids production to reach 100mm b/d this year, and 102.2mm b/d next year (Table 1). Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Demand Surges This Year, But Slows In 2019 The global economic expansion will lift oil demand above 100mm b/d this year to 100.3mm b/d. This will be led, as always, by non-OECD growth, which we expect to increase 1.24mm b/d this year to 52.8mm b/d (Chart 3, top panel). DM demand - i.e., OECD consumption - will increase 440k b/d this year, to 47.5mm b/d, based on our estimates. Overall global demand rises 1.68mm b/d this year, by our reckoning (Chart 3). We expect tighter financial conditions this year and next will, with the lags typical of monetary policy, slow the rate of growth in oil demand next year. This will be delivered by tightening monetary policy, led by the U.S. Fed, and a mild recession next year, most likely in 2H19. We expect global demand to grow 1.57mm b/d next year, rising to just under 102mm b/d. EM demand will grow 1.21mm b/d, while DM demand will be up 360k b/d next year. Tightening Balances Will Reverse In 2H18 The yeoman effort put forth by OPEC 2.0 in reducing output and draining commercial inventories globally will reach its apotheosis by the end of 1H18 (Charts 4). Thereafter, as production grows and demand begins to slow, our balances indicate inventories will start to grow again (Chart 5). Chart 4Supply-Demand Balances##BR##No Longer Tightening In 2019 ... Chart 5... Leading To##BR##Inventory Accumulation Markets likely will start focusing on the implications of OPEC 2.0 returning production to the market and the surge in shale in 2H18 and during 2019. Non-forecastable events notwithstanding - e.g., a breakdown in Venezuela's production and exports - markets will be looking to OPEC 2.0 leadership for guidance on how the coalition will manage member-state production from 2H18 forward. If the OPEC 2.0 coalition is allowed to dissolve - something we do not expect - and a production free-for-all resumes similar to that of 2015 - 16, another round of supply destruction, brought about by lower prices, likely will ensue. This would greatly restrict E&P and services companies' access to capital, should it occur, and would, once again, imperil the economies of OPEC 2.0. In addition, because such volatility would discourage investment once again, it would set up a powerful price rally in the early 2020s following the attendant collapse in capex and E&P spending, as occurred in the previous down-cycle. We doubt this is the desired outcome of the OPEC 2.0 leadership, particularly KSA, as the Kingdom will be looking to IPO Saudi Aramco later this year to fund its Vision 2030 diversification efforts. We also doubt this is the desired outcome of Russia, given the economic pain it endured in the 2015 - 16 episode. More Frequent OPEC 2.0 Guidance Expected Given these considerations, we expect KSA and Russia to increase the frequency of forward guidance, directing market participants toward a preferred price band. Right now, this looks like a $50 to $60/bbl range - the 2018 forecast given by Russia's Energy Minister Alexander Novak earlier this week.3 It would be incumbent on OPEC 2.0 leadership to guide markets to expect production and inventory responses consistent with such guidance. We think the combination of OPEC 2.0 production restraint and the powerful synchronized global growth already in place puts Energy Minister Novak's guidance out of range for this year, and we are sticking with our forecasts for Brent and WTI. However, beginning in 2H18, a 2019 Brent forecast in Novak's range appears reasonable, based on the fundamentals discussed above. And, our WTI forecast of $53/bbl also is reasonable, given the average marginal cost of producing in the most prolific fields in the U.S. are at or below $50/bbl, according to the Dallas Fed's periodic Energy Survey.4 We believe the massive drawdown in global oil inventories to be the first step in a longer-term strategy by OPEC 2.0 countries. Lower OECD commercial inventory levels will diminish their shock-absorbing capacity, leading to a higher responsiveness of oil prices to supply-demand shocks. This will allow the coalition to exert greater control over oil prices via rapid, flexible storage adjustments and spare capacity management. Therefore, this year's out-of-range prices will be tolerated by Russia and KSA to achieve their optimal level of global inventories. A $50-to-$60/bbl Brent range for OPEC 2.0 would be consistent with a longer-term strategy to maximize the period of time hydrocarbons are the primary transportation fuel in the world. This is the only way to achieve the development goals set out by leaders of various oil-exporting states seeking to diversify the economic underpinnings of these economies. To do so, they have to keep oil-based transportation competitive for decades. Too much volatility - i.e., frequent excursions between very high and very low prices - will severely limit the access to capital these societies need to pull off this diversification. Managing production in a way that limits this volatility and keeps oil competitive in transport markets therefore is critical. Bottom Line: High prices will cause crude oil production to surge this year and next, particularly in the U.S. shales, and demand growth to slow. We expect Brent prices to average $67/bbl this year and $55/bbl next year. WTI prices will average $63/bbl this year and $53/bbl next year. We expect OPEC 2.0 to increase the frequency of its forward guidance - and to follow through on production and inventory adjustment in a manner that supports a desired price range for Brent prices in 2019 and into the 2020s. Right now, that range looks like $50 to $60/bbl. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is a name we coined to describe the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed at the end of 2016 to rein in out-of-control global oil production by cutting production some 1.4 to 1.5mm b/d last year (vs. a target of 1.8mm b/d). The coalition has been remarkably successful in maintaining production discipline in 2017 and extending their deal to the end of 2018 with an option to review quotas in June. We expect OPEC 2.0 to gradually return production taken off the market over the course of 2H18, which will, by next year, most likely reverse the draws seen in global inventories. 2 KSA's production should lift next year as pipeline repairs at its giant Manifa field are completed. Corrosion problems took some 300k of 900k b/d total production offline. In addition, there is another 500k b/d of capacity offline in the Neutral Zone shared with Kuwait. KSA's capacity likely will remain ~ 11.7mm b/d, versus its historical 12.5mm level, but as Energy Intelligence notes, it will have to balance actual production with spare capacity for the next year or so. Please see "A Headache for Aramco," published July 2017 by Energy Intelligence on its website. 3 Please see "CORRECTED-UPDATE 5-Brent oil falls by $1 but demand underpins near $70/barrel," published by uk.reuters.com on January 16, 2018. 4 In its December 2017 Dallas Fed Energy Survey, the Federal Reserve Bank of Dallas reported the WTI price shale operators needed to profitably drill a new well in Texas and Oklahoma averaged $49/bbl (simple, unweighted survey average). The lowest cost was in the Permian Midland formation ($46/bbl) and the highest costs was in so-called Other U.S. (shale) at $55/bbl. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights Duration: Economic fundamentals indicate that U.S. TIPS breakeven inflation rates have further cyclical upside and this will drive nominal bond yields higher on a 6-12 month horizon. In the near term, however, positioning data suggest that the uptrend in U.S. bond yields is due for a pause. Maintain a below-benchmark duration stance. Oil & U.S. Bonds: The cost of inflation compensation is an important driver of U.S. bond yields and the oil price is an important driver of the cost of inflation compensation. This will continue to be true until long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%. At that point the oil price will become a less important driver of U.S. bond yields. Australia: Maintain an overweight position in Australian government debt. Economic data are still mixed and the RBA will stay on hold for the foreseeable future. Against a backdrop of Fed rate hikes, Australian debt should outperform. Feature Chart of the WeekHigher Yields, Driven By Inflation There was certainly no shortage of possible catalysts for last week's bond rout (Chart of the Week). The Bank of Japan (BoJ) reduced its buying of long-dated JGBs, there was a rumor that China plans to slow or stop its purchases of U.S. Treasury debt, and U.S. inflation expectations started to ramp back up - driven by a combination of higher oil prices and a strong December core CPI print. But of all these factors we think it is only the third that merits much attention. Once the BoJ started targeting the level of the yield curve in September 2016, its quantity targets became irrelevant. A reduction in the pace of BoJ buying only matters if it foreshadows a shift to a higher yield curve target. Our foreign exchange strategists don't think such a move is likely in the next 12-18 months.1 China, for its part, still has a highly managed currency and now that capital is no longer flowing out of the country it will start to rebuild its foreign exchange reserves. Given that the U.S. Treasury market remains the world's most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States (Chart 2). The compensation for 10-year U.S. inflation protection broke above 2% last week, after having been as low as 1.66% as recently as last June. This 34 basis point increase in inflation compensation coincided with a 36 basis point increase in the nominal U.S. 10-year yield and a Brent crude oil price that rose from $45 per barrel last June to $70 per barrel as of last Friday. We think these correlations will continue to be the most important factors driving bond yields during the next 6-12 months, and the bulk of this report is dedicated to disentangling the linkages between oil prices, inflation, inflation expectations and nominal bond yields. But first we reiterate our cyclical investment stance. Last week's U.S. CPI report provided further evidence that U.S. core inflation is in the process of bottoming-out (Chart 3). The 10-year U.S. TIPS breakeven inflation rate will settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's target. By that time the nominal 10-year yield will be in a range between 2.8% and 3.25%. Likewise, our energy strategists anticipate that an ongoing steady decline in commercial inventories will keep crude prices well supported on a 6-12 month horizon. Chart 2China's Forex Reserves Are Rising Chart 3U.S. Inflation Turns The Corner However, on a shorter time horizon (3 months or less), recent shifts in speculative positioning signal that the uptrends in bond yields and the oil price might be due for a pause (Chart 4). After having been solidly "net long" since the middle of last year, net speculative positions in the 10-year U.S. Treasury futures contract have just dipped into "net short" territory. Historically, net speculative positions have been a decent indicator of 3-month changes in the 10-year U.S. Treasury yield, and at current levels they signal that the 10-year yield could decline modestly during the next three months (Chart 5). Similarly, speculators in the oil futures market are now more "net long" than at any time since last February. While this positioning indicator does not work quite as well for the oil market as for the Treasury market, net longs at more than 20% of open interest (most recent reading is 26%) have more often than not been met with 3-month price declines since 2010 (Chart 6). Chart 4Net Speculative Positioning##BR##For Oil And Bonds Chart 5Net Speculative Positions &##BR##10-Year Treasury Yield (2010 - Present) Chart 6Net Speculative Positions &##BR##WTI Oil Price (2010 - Present) Bottom Line: The outlook for U.S. inflation suggests that TIPS breakeven rates have further cyclical upside and this will drive nominal bond yields higher. However, positioning data in both bond and oil markets suggest that the recent run-up in yields might be due for a near-term pause. Maintain a below-benchmark duration stance on a 6-12 month horizon. Oil, TIPS, Inflation And U.S. Bond Yields: Sorting Out The Mess During the post-financial crisis period two relationships have been both (i) incredibly robust and (ii) unlike relationships observed in prior periods. They are: The cost of inflation protection has been an unusually important determinant of nominal U.S. bond yields. The oil price has shown a very strong correlation with the cost of inflation protection. Both relationships can be explained by the Federal Reserve's asymmetric ability to control inflation. We consider each relationship in turn. The Importance Of Inflation Chart 7TIPS Beta Declines When##BR##Breakevens Are Low A common rule of thumb is to estimate the TIPS beta - the proportion of movement in U.S. nominal bond yields that is explained by movement in TIPS (real) yields - at around 0.8. In other words, this assumes that 80% of the movement in nominal bond yields is explained by the real component. However, we observe that since the financial crisis the 10-year TIPS beta has been a much lower 0.68, and at times it has been closer to 0.5 on a 12-month rolling basis (Chart 7). We also observe that the TIPS beta tends to be lower when TIPS breakeven inflation rates are un-anchored to the downside. There is a very good reason for this. The reason is that the Fed's ability to influence inflation is asymmetric. The Fed has a strong track record of successfully tightening to bring inflation down, but has been less successful at easing to drive it up. This asymmetric ability to influence prices is due in no small part to the zero-lower bound on interest rates. Because the Fed's ability to ease policy is constrained while its ability to tighten is not, bond market participants may at times question the Fed's ability to ease and revise their inflation expectations lower. It is also during these periods that inflation expectations become more volatile and a more important determinant of nominal bond yields. This is because they are increasingly driven by the swings in the economic data and less by the Fed's policy bias. The Importance Of Oil This is where the oil price comes in. Oil and other commodities are crucial inputs to the production process. As such, not only do these prices rise in response to stronger aggregate demand, but higher prices also signal mounting cost-push inflationary pressures. But despite this obvious truth, there is not always a strong correlation between oil prices and inflation expectations. This is because the Fed's reaction function influences the relationship. Consider the pre-crisis (2004-2008) period. Long-maturity TIPS breakeven inflation rates stayed range-bound between 2.4% and 2.5% even as the oil price increased dramatically (Chart 8). Since investors perceived that the Fed would simply tighten policy to tamp out any inflationary pressures that might arise, there was no desire to demand greater compensation for inflation. However, this logic does not work in reverse. When commodity prices fell in 2014, inflation expectations declined alongside. In fact we observe that the correlations between long-maturity TIPS breakeven inflation rates and both oil and commodity prices have been much stronger in the post-crisis period, when inflation expectations have been un-anchored (Table 1). Chart 8The Unstable Correlation: Breakevens & Oil Table 1Correlations Between TIPS Breakeven Inflation & Commodities Investment Conclusions The Fed's asymmetric reaction function leads to two crucial investment conclusions. First, long-maturity inflation expectations (as measured by the U.S. TIPS breakeven inflation rate) can fall when deflationary pressures mount, but their upside is capped in the 2.4% to 2.5% range. This is because the market has no reason to question the Fed's ability to lower inflation by lifting rates. The upside limit of 2.4% to 2.5% will remain in place unless the Fed changes its inflation target. A change to the inflation target that allows for higher inflation is an idea that is quickly gaining traction among policymakers, but is unlikely to be implemented this year. Second, when long-maturity inflation expectations are below their 2.4% to 2.5% upper-bound they become both (i) a more important driver of nominal yields - as evidenced by the lower TIPS beta - and (ii) more sensitive to swings in commodity prices. For this reason, the oil price will continue to be an important driver of inflation expectations and nominal U.S. bond yields for the next few months, but will decrease in importance as TIPS breakevens move back to their 2.4% to 2.5% range. Once inflation expectations are re-anchored, nominal bond yields will once again be predominantly driven by the real component and swings in the price of oil will be less important for bond markets. The dynamics described above are not merely theoretical. Consider the evidence from five developed countries presented in Charts 9 & 10. Chart 9 shows that the oil price is tightly correlated with inflation expectations in the U.S., Eurozone and Japan, but also that inflation expectations in the U.K. and Australia did not respond to the recent increase in oil prices. The reason is that core inflation in the U.K. and Australia is already relatively close to the central bank's target (Chart 10). It is only where core inflation is far below target (in the U.S., Eurozone and Japan) that the oil price remains an important driver of bond yields. Chart 9Oil & Inflation Expectations Highly Correlated... Chart 10...But Only When Inflation Is Low The U.K. in particular presents an interesting case study. U.K. core inflation was quite far below target throughout 2015 and 2016, and during this time period U.K. inflation expectations were tightly linked with the oil price. It is only in the past few months that U.K. core inflation has moved back above target, and not surprisingly the correlation between the U.K. 10-year CPI swap rate and the price of oil has started to break down. Bottom Line: At present, the cost of inflation compensation is an important driver of U.S. bond yields and the oil price is an important driver of the cost of inflation compensation. Both of these dynamics will continue to be true for the next few months, but will decline in importance as TIPS breakeven inflation rates rise. When long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%, then the oil price will become a less important driver of U.S. bond yields. Australia: Too Soon To Expect A Hike Chart 11Australia: A Solid Rebound In Growth... Over the last quarter much of the economic data from Australia have improved. Real GDP growth rebounded sharply to 2.8% YoY in Q3 from 1.9% the previous quarter (Chart 11). Iron ore prices have been rising since mid-October. Employment growth is robust and the unemployment rate is well below its estimated natural level. This begs the question - with so much going right is it time for the Reserve Bank of Australia (RBA) to lift rates? Our answer is an emphatic "no." First, most data improvements have been relatively minor and the overall economic picture remains mixed. As we mentioned in our recent Special Report,2 the RBA is stuck between conflicting forces. Booming house prices and rising household indebtedness on the one hand, and an economy still working off excess capacity on the other. Nevertheless, our expectation is that the RBA will allow the economy to recover further for the following reasons: Consumer health is fragile. Policymakers left cash rates unchanged at the last monetary policy meeting in December, and Governor Philip Lowe expressed concerns about household consumption. Consumption is a significant driver of economic growth and the combination of declining savings, elevated debt levels and weak income growth is worrisome (Chart 12). Since then, real income growth has dipped back into positive territory, but only barely so. Meanwhile, house prices are still surging, despite macro-prudential measures aimed at tightening lending standards, thereby supporting consumer spending through the wealth effect. Given an extreme household debt to income ratio, consumption would be very vulnerable if the RBA were to curb house price gains by raising rates. Labors markets have plenty of slack. The unemployment rate has fallen to a four year low and other labor market statistics show a broad-based improvement over the last quarter. However, the unemployment rate is still significantly higher than it was in the previous cycle and other improvements in the labor market have also occurred from extremely weak levels. In 2017Q1, the underemployment rate and part-time workers as a percentage of total workers both reached all-time highs. Those numbers have dipped slightly in Q3, with underemployment falling to 8.3% and part-time workers as a percentage of total declining to 31.7%, but those elevated levels suggest there still needs to be significant improvement before spare capacity is worked off and real wage growth starts to move higher (Chart 13). Chart 12...But Consumers Can't Afford A Rate Hike Chart 13Still Plenty Of Slack In Australian Labor Markets Inflation is still too low. Headline and core inflation readings came in at 1.8% and 1.9% respectively in Q3 (Chart 14). While headline slowed, core inflation recovered over the last quarter. Tradeable goods inflation collapsed into negative territory at -0.9%, as a result of currency strength and increased competition among retailers. Going forward, we expect consumer price growth to be muted given the lack of inflationary pressures. The output gap is wide, despite rebounding growth, and the IMF forecasts that it will be years before the Australian economy reaches capacity. The trade-weighted Aussie dollar index has risen almost 5% since it bottomed in early December, while the AUD/USD has broken above its 40-week moving average. Continued currency strength would exert even further deflationary pressure. As stated above, the labor market also requires significant improvement to work off excess capacity. All of these factors caused the RBA to dial back its inflation forecast in the November statement. It now expects that inflation will remain quite flat for the next two years, only touching the lower-end of its 2%-3% target range at the end of 2019. Consequently, inflation will not be forcing the RBA's hand in the foreseeable future. One of our key themes for 2018 is that global growth will be less synchronized. Central banks will therefore employ diverging monetary policies, presenting cross-country bond market investment opportunities. As such, we recently shifted to a slight overweight position in Australian debt within our model portfolio, arguing that it would outperform global government bond benchmarks during a year expected to be driven by Fed tightening and ECB/BoJ tapering concerns. Historically, relative yield moves have closely tracked relative shifts in monetary policy (Chart 15). In the U.S., above-trend growth, a tight labor market and the continued recovery in inflation will force the Fed to become more aggressive. If the RBA stays inactive as we expect, then this gap should continue to move in favor of Australian debt. Additionally, there is still a modest yield pickup in Australian debt relative to the global index and as we expect global bond yields to rise, low-beta Australian government bonds should offer considerable protection. Chart 14Australia: Lacking Inflationary Pressures Chart 15Australian Relative Yields Track Relative Policy This also leads us to continue holding our tactical Long Dec 2018 Australian Bank Bill futures trade from last October. We initially entered into this trade as a more focused way of expressing that the RBA will stay on hold. The trade is currently 6 bps in the money and with markets still pricing about 30 bps of rate hikes during the next 12 months, there is plenty of room for further profit as market expectations are revised down. Bottom Line: Maintain an overweight position in Australian government debt. Economic data are still mixed and the RBA will stay on hold for the foreseeable future. Against a backdrop of Fed rate hikes, Australian debt should outperform. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com 1 Please see BCA's Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com. 2 Please see BCA's Global Fixed Income Strategy Special Report, "Australia: Stuck Between A Rock And A Hard Place", dated July 25, 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: Economic fundamentals indicate that TIPS breakeven inflation rates have further cyclical upside and this will drive nominal bond yields higher on a 6-12 month horizon. In the near term, however, positioning data suggest that the uptrend in bond yields is due for a pause. Maintain a below-benchmark duration stance. Oil & Bonds: The cost of inflation compensation is an important driver of bond yields and the oil price is an important driver of the cost of inflation compensation. This will continue to be true until long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%. At that point the oil price will become a less important driver of yields. Fed: The Fed will start actively discussing alternative monetary policy frameworks in 2018. While we think the Fed will eventually adopt a policy framework that tolerates higher inflation, this shift probably won't occur this year. Feature There was certainly no shortage of possible catalysts for last week's bond rout (Chart 1). The Bank of Japan (BoJ) reduced its buying of long-dated JGBs, there was a rumor that China plans to slow or stop its purchases of U.S. Treasury debt, and U.S. inflation expectations started to ramp back up - driven by a combination of higher oil prices and a strong December core CPI print. But of all these factors we think it is only the third that merits much attention. Once the BoJ started targeting the level of the yield curve in September 2016 its quantity targets became irrelevant. A reduction in the pace of BoJ buying only matters if it foreshadows a shift to a higher yield curve target. Our foreign exchange strategists don't think such a move is likely in the next 12-18 months.1 China, for its part, still has a highly managed currency and now that capital is no longer flowing out of the country it will start to rebuild its foreign exchange reserves. Given that the U.S. Treasury market remains the world's most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States (Chart 2). Chart 1Higher Yields, Driven By Inflation Chart 2China's Forex Reserves Are Rising The compensation for 10-year U.S. inflation protection broke above 2% last week, after having been as low as 1.66% as recently as last June. This 34 basis point increase in inflation compensation coincided with a 36 basis point increase in the nominal 10-year yield and a Brent crude oil price that rose from $45 per barrel last June to $70 per barrel as of last Friday. We think these correlations will continue to be the most important factors driving bond yields during the next 6-12 months, and the bulk of this report is dedicated to disentangling the linkages between oil prices, inflation, inflation expectations and nominal bond yields. But first we reiterate our cyclical investment stance. Last week's CPI report provided further evidence that core inflation is in the process of bottoming-out (Chart 3). The 10-year TIPS breakeven inflation rate will settle into a range between 2.4% and 2.5% by the time that core inflation returns to the Fed's target. By that time the nominal 10-year yield will be in a range between 2.8% and 3.25%. Likewise, our energy strategists anticipate that an ongoing steady decline in commercial inventories will keep crude prices well supported on a 6-12 month horizon. Chart 3U.S. Inflation Turns The Corner Chart 4Net Speculative Positioning For Oil And Bonds However, on a shorter time horizon (3 months or less), recent shifts in speculative positioning signal that the uptrends in bond yields and the oil price might be due for a pause (Chart 4). After having been solidly "net long" since the middle of last year, net speculative positions in the 10-year U.S. Treasury futures contract have just dipped into "net short" territory. Historically, net speculative positions have been a decent indicator of 3-month changes in the 10-year U.S. Treasury yield, and at current levels they signal that the 10-year yield could decline modestly during the next three months (Chart 5). Similarly, speculators in the oil futures market are now more "net long" than at any time since last February. While this positioning indicator does not work quite as well for the oil market as for the Treasury market, net longs at more than 20% of open interest (most recent reading is 26%) have more often than not been met with 3-month price declines since 2010 (Chart 6). Chart 5Net Speculative Positions & 10-Year Treasury Yield Chart 6Net Speculative Positions & WTI Oil Price Bottom Line: The outlook for U.S. inflation suggests that TIPS breakeven rates have further cyclical upside and this will drive nominal bond yields higher. However, positioning data in both bond and oil markets suggest that the recent run-up in yields might be due for a near-term pause. Maintain a below-benchmark duration stance on a 6-12 month horizon. Oil, TIPS, Inflation And Bond Yields: Sorting Out The Mess During the post-financial crisis period two relationships have been both (i) incredibly robust and (ii) unlike relationships observed in prior periods. They are: The cost of inflation protection has been an unusually important determinant of nominal U.S. bond yields The oil price has shown a very strong correlation with the cost of inflation protection Both relationships can be explained by the Federal Reserve's asymmetric ability to control inflation. We consider each relationship in turn. The Importance Of Inflation Chart 7TIPS Beta Declines When ##br##Breakevens Are Low A common rule of thumb is to estimate the TIPS beta - the proportion of movement in U.S. nominal bond yields that is explained by movement in TIPS (real) yields - at around 0.8. In other words, this assumes that 80% of the movement in nominal bond yields is explained by the real component. However, we observe that since the financial crisis the 10-year TIPS beta has been a much lower 0.68, and at times it has been closer to 0.5 on a 12-month rolling basis (Chart 7). We also observe that the TIPS beta tends to be lower when TIPS breakeven inflation rates are un-anchored to the downside. There is a very good reason for this. The reason is that the Fed's ability to influence inflation is asymmetric. The Fed has a strong track record of successfully tightening to bring inflation down, but has been less successful at easing to drive it up. This asymmetric ability to influence prices is due in no small part to the zero-lower bound on interest rates. Because the Fed's ability to cut rates is constrained by the zero-bound while its ability to lift rates is not, bond market participants may at times question the Fed's ability to ease and revise their inflation expectations lower. It is also during these periods that inflation expectations become more volatile and a more important determinant of nominal bond yields. This is because they are increasingly driven by the swings in the economic data and less by the Fed's policy bias. The Importance Of Oil This is where the oil price comes in. Oil and other commodities are crucial inputs to the production process. As such, not only do these prices rise in response to stronger aggregate demand, but higher prices also signal mounting cost-push inflationary pressures. But despite this obvious truth, there is not always a strong correlation between oil prices and inflation expectations. This is because the Fed's reaction function influences the relationship. Consider the pre-crisis (2004-2008) period. Long-maturity TIPS breakeven inflation rates stayed range-bound between 2.4% and 2.5% even as the oil price increased dramatically (Chart 8). Since investors perceived that the Fed would simply tighten policy to tamp out any inflationary pressures that might arise, there was no desire to demand greater compensation for inflation. However, this logic does not work in reverse. When commodity prices fell in 2014, inflation expectations declined alongside. In fact we observe that the correlations between long-maturity TIPS breakeven inflation rates and both oil and commodity prices have been much stronger in the post-crisis period, when inflation expectations have been un-anchored (Table 1). Chart 8The Unstable Correlation Breakevens & Oil Table 1Correlations Between TIPS Breakeven Inflation And Commodities Investment Conclusions The Fed's asymmetric reaction function leads to two crucial investment conclusions. First, long-maturity inflation expectations (as measured by the TIPS breakeven inflation rate) can fall when deflationary pressures mount, but their upside is capped in the 2.4% to 2.5% range. This is because the market has no reason to question the Fed's ability to lower inflation by lifting rates. The upside limit of 2.4% to 2.5% will remain in place unless the Fed changes its inflation target. A change to the inflation target that allows for higher inflation is an idea that is quickly gaining traction among policymakers, but is unlikely to be implemented this year (see section titled "The Fed In 2018: Contemplating A Major Change" below). Second, when long-maturity inflation expectations are below their 2.4% to 2.5% upper-bound they become both (i) a more important driver of nominal yields - as evidenced by the lower TIPS beta - and (ii) more sensitive to swings in commodity prices. For this reason, the oil price will continue to be an important driver of inflation expectations and nominal bond yields for the next few months, but will decrease in importance as TIPS breakevens move back to their 2.4% to 2.5% range. Once inflation expectations are re-anchored, nominal bond yields will once again be predominantly driven by the real component and swings in the price of oil will be less important for bond markets. The dynamics described above are not merely theoretical. Consider the evidence from five developed countries presented in Charts 9 & 10. Chart 9 shows that the oil price is tightly correlated with inflation expectations in the U.S., Eurozone and Japan, but also that inflation expectations in the U.K. and Australia did not respond to the recent increase in oil prices. The reason is that core inflation in the U.K. and Australia is already relatively close to the central bank's target (Chart 10). It is only where core inflation is far below target (in the U.S., Eurozone and Japan) that the oil price remains an important driver of bond yields. Chart 9Oil & Inflation Expectations Highly Correlated... Chart 10...But Only When Inflation Is Low The U.K. in particular presents an interesting case study. U.K. core inflation was quite far below target throughout 2015 and 2016, and during this time period U.K. inflation expectations were tightly linked with the oil price. It is only in the past few months that U.K. core inflation has moved back above target, and not surprisingly the correlation between the U.K. 10-year CPI swap rate and the price of oil has started to break down. Bottom Line: At present, the cost of inflation compensation is an important driver of bond yields and the oil price is an important driver of the cost of inflation compensation. Both of these dynamics will continue to be true for the next few months, but will decline in importance as TIPS breakeven inflation rates rise. When long-maturity TIPS breakeven inflation rates settle into a range between 2.4% and 2.5%, then the oil price will become a less important driver of bond yields. The Fed In 2018: Contemplating A Major Change? As was alluded to in the prior section, the biggest potential change for bond markets in 2018 would be if the Fed changed its monetary policy framework to one that tolerated higher levels of inflation. For example, let's imagine that the Fed suddenly lifted its inflation target from 2% to 3%. This would likewise shift the upper-bound range for long-maturity TIPS breakeven inflation rates to approximately 3.4% to 3.5%. It would mean that nominal bond yields have further upside over the course of the cycle, and also that oil and commodity prices would play an important role in bond markets for much longer. It would also lengthen the period where spread product can outperform Treasuries since the Fed would not be so quick to choke off the recovery. We still think it is unlikely that such a change will be implemented this year, but recent weeks have seen a marked increase in the number of Fed policymakers either advocating for a different policy framework or saying that the Fed should start researching alternative frameworks. What's crucial to remember is that the reason policymakers are unsatisfied with the current 2% inflation target is that it brings the zero-lower bound on interest rates into play too often. So any potential change in policy framework would be to one that tolerates higher inflation rates. Bernanke's Idea Chart 11The Implications Of A Price Level Target One potential new policy approach was put forward by ex-Fed Chairman Ben Bernanke in a recent blog post.2 Bernanke made the case for "Temporary Price Level Targeting", a policy where the Fed continues to use a 2% inflation target when the fed funds rate is sufficiently far from zero, but then switches to a price-level target when the fed funds rate is close to the zero bound. In his own words, the strategy would be communicated as follows: The Committee therefore agrees that, in future situations in which the funds rate is at or near zero, a necessary condition for raising the funds rate will be that average inflation since the date at which the federal funds rate first hit zero be at least 2 percent. Chart 11 provides an illustration of this example. Under the current framework the Fed targets 2% PCE inflation and forecasts that it will achieve this target sometime in 2019. In Bernanke's proposed framework the Fed would not target 2% inflation, but rather a price level that is consistent with 2% trend growth in prices since the zero-lower bound was hit in December 2008. In order to achieve this goal by the end of 2019 the Fed would need to tolerate a significant overshoot of inflation during the next two years (bottom panel). Who's On Board? The Appendix to this report is a list of all Fed Governors and Regional Fed Presidents. It also shows our own assessment of each committee member's policy bias. We noted from the most recent Summary of Economic Projections that 6 FOMC participants expect three rate hikes in 2018, 6 expect fewer than three rate hikes and 4 expect more than three hikes. From recent speeches we attempted to discern which member owns which forecast and then we attributed a "dovish" policy bias to those with a forecast for fewer than three hikes, a "neutral" bias to those expecting three hikes, and a "hawkish" bias to those expecting more than three hikes. We also show which FOMC participants are voters in 2018, although we do not think that distinction carries much practical importance. The Committee tends to arrive at decisions by consensus anyways, and all participants voice their opinions at every meeting whether or not it is their turn to vote. But it is the "notes" column of the Appendix that is most striking. There we highlighted all the FOMC participants who have recently made comments regarding the exploration of alternative policy frameworks. A general consensus seems to be forming that alternative frameworks should be studied this year, and a few policymakers (San Francisco Fed President John Williams, in particular) have strongly made the case that the Fed should switch to some sort of price level targeting regime. The Appendix also identifies the biggest source of uncertainty for the Fed this year. Namely that there are four vacant Governor positions that need to be filled. The New York Fed will also need a new President when William Dudley retires later this year. Who is nominated to fill those vacant positions will go a long way toward determining how aggressively the Fed pursues alternative policy frameworks. Bottom Line: The Fed will start actively discussing alternative monetary policy frameworks in 2018. While we think the Fed will eventually adopt a policy framework that tolerates higher inflation, this shift probably won't occur this year. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com 2 https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ Appendix Table 2Composition Of The FOMC Fixed Income Sector Performance Recommended Portfolio Specification
Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Chart 15...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Overweight - High Conviction A cyclical over defensive sector preference is consistent with a capex upcycle and a simultaneous bond market selloff (please see the next Insight), both of which are our key 2018 investment themes. Our overweight recommendation on the S&P energy index is predicated on our cyclical preference, aided by much better fundamentals. The index has caught fire recently, lifted by a recovery in the price of oil (second panel) which has, in turn, been responding to a revving global economy and a sell-off in the US$ (top panel). However, the index has been diverging sharply from falling oil stocks (third panel), which are typically a harbinger of much better performance. This has created a buying opportunity as the energy index still sports a below-market valuation (a hard to find criteria in these heady times) that we expect to mean revert, driven by ongoing improvements in operating fundamentals. We reiterate our high conviction overweight recommendation.
Highlights Before re-capping the performance of our recommendations last year - up 77%, led by oil calls, which posted an average gain of 111% - we take a look at what the re-emergence of financial and monetary factors will mean for commodities this year. Fundamentals - supply, demand, inventories - drove the evolution of industrial commodity prices over the past two years, and will remain supportive for oil and, to a lesser degree, base metals in 1H18. Thereafter, in 2H18, we believe financial and monetary variables will begin to re-assert their importance in the evolution of commodity prices. Forecasting commodity prices becomes more difficult, as a result, as it is not clear the Fed or other systematically important central banks, understand what is driving their principal policy variables - particularly inflation - or how they are evolving. Despite these central-bank uncertainties, we remain long broad commodity exposure via the S&P GSCI (up 6.4% since it was recommended in Dec/17), long call spreads in Brent and WTI across 2018 deliveries (up 78%); and long gold (up 6.7%). 2018 Weightings Energy: Overweight. WTI and Brent crude oil forward curves will become more backwardated as the combination of OPEC 2.0 production discipline and continued strength in demand draws inventories lower. This will boost S&P GSCI returns.1 Base Metals: Neutral. Base metals will continue to be supported through 1Q18 by China's environmental reforms, which are reducing supply in the face of continued strength in global demand. Strong demand ex-China will offset weaker Chinese growth, supporting metals prices. Precious Metals: Neutral. While we expect four rate hikes by the Fed this year, we are wary of policy errors at systemically important central banks, which makes forecasting monetary policy highly uncertain. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Still-high supplies outside the corn market; policy uncertainty re NAFTA; and uncertainty over Fed policy likely keep grain prices weak. A stronger USD would weaken demand for U.S.-sourced grains and softs. Feature Chart of the WeekFundamentals Continue To##BR##Support Commodities That was quick! Oil prices are closely hewing to fundamentals as the year opens. We revised our Brent forecast to $67/bbl in early December (up from a $65/bbl forecast in mid-October 2017), based on our fundamental assessment of the market - supply, demand and inventories - and, voilà, contracts for Mar/18 delivery got there by the end of 2017. Our $63/bbl forecast for WTI is still ~ $2.50/bbl from being realized, but we continue to expect this gap to close. At the moment, fundamentals for industrial commodities - oil and, to a slightly lesser extent, base metals - will support firmer prices in 1H18 (Chart of the Week). For oil, this will be an extension of the fundamental realignment initiated by OPEC 2.0 at the end of 2016. The producer coalition agreed to remove ~ 1.1mm b/d from the market, which, along with another 300k to 400k barrels of natural declines, tightened the supply side considerably. On the demand side, the synchronized global economic upturn that powered consumption up by 1.65mm b/d last year, by our estimation, will push demand higher by 1.67mm b/d this year. Supply-side adjustments in base metals, particularly copper, where strikes and natural disasters combined to tighten markets, will be augmented by the ongoing environmental reforms in China (Chart 2). These supply-side effects in industrial commodities occurred against a backdrop of stronger-than-expected economic growth worldwide last year - the first such upturn since the Global Financial Crisis (GFC) in 2008 (Chart 3). Chart 2Fundamentals Supported Metals Chart 3Global Upturn Powers Commodity Demand We expect this to continue. Part of the recovery in aggregate demand worldwide can be attributed to the massive monetary stimulus by systematically important central banks - led by the Fed, the ECB and BoJ. Lower energy prices last year, which acted like a tax cut, put more discretionary income in consumers' hands and also boosted aggregate demand.2 Monetary Policy Will Re-Assert Itself Chart 4The USD Will Re-Emerge As A##BR##Driver Of Commodity Prices The influence of monetary policy - chiefly how the Fed's actions affect the USD - has been de minimis over the past two years relative to fundamentals, which have driven price formation in industrial commodities (Chart 4). While the Fed raised its policy rate 3 times last year, monetary conditions remained relatively loose in the U.S., which was supportive of commodity prices. Looser monetary conditions kept the USD better offered than other major currencies in 4Q17, which allowed gold prices to recover late in the year. A weaker USD also supported grain markets, which also have staged a somewhat subdued recovery following a mid-2017 sell-off. For at least 1H18, we see commodities generally continuing to be supported by strong fundamentals and relatively accommodative monetary policy globally, even with the Fed lifting its policy rate as many as four times this year, per our House view. Inflation Pressures Could Start Building By 2H18, inflationary pressures could start to build: In the U.S., tax cuts coupled with fiscal stimulus from the federal government in the form of disaster relief and higher discretionary spending - could add ~ 0.5% to GDP growth this year, based on calculations by BCA's Global Investment Strategy team (Chart 5).3 This should, all else equal, increase demand for labor and push the U.S. unemployment rate lower, lifting wages, inflation and inflation expectations in turn (Chart 6). At least that's how it's supposed to work. Our colleagues in BCA Research's U.S. Bond Strategy note, the "dichotomy between stronger growth and a tight labor market on the one hand and low inflation on the other gets to the heart of the first big challenge that incoming Fed Chairman Jay Powell will face next year. Specifically, how much faith should the Fed have in its framework for forecasting inflation? Chart 5U.S. Inflation Is Ticking Higher Chart 6Still Waiting On The Phillips Curve "... Janet Yellen's Phillips Curve model of core inflation does not explain this year's decline.1 It also shows that inflation is close to 0.5% below fair value, almost the largest deviation since 1995."4 We're inclined to agree with former Fed Chair Ben Bernanke on this. In 2016, he noted that, given the years-long stretch of errors in forecasting key economic variables - output, unemployment and the Fed funds rate - "Fed-watchers should probably focus on incoming data and count a bit less on Fed policymakers for guidance."5 This is a mixed blessing (or curse) for commodity markets: Increased economic activity raises demand for commodities, so at least in 1H18, and most likely for the second half as well, commodity demand will remain well supported globally. If we do get higher inflation, the Fed likely would feel it could lean into its rate-normalization with greater vigor, and start guiding to more frequent or bigger rate hikes. If we don't see higher inflation - if, as Chicago Fed President Charles Evans fears, inflation expectations have been marked down in a meaningful way - and the Fed cannot justify further rate hikes, we could see the real side of the global economy take another leg higher, lifting commodity demand in the process.6 This is the big issue for the coming year. We cannot say at this point how it plays out, which is why we recommend commodity investors remain in tactical mode, as we did a year ago. Recapping 2017's Recommendations Our trade recommendations were up an average of 77% last year, led by a 111% gain in our oil calls. This was a touch better than the 95% average gain we posted on our oil recommendations in 2016 (Table 1). Table 1Average Quarterly Returns 2017 Without a doubt, most of our recommendations were in the oil markets, as the accompanying tables show, and we maintained an exposure of one sort or another in oil throughout the year (Table 2). Table 2Trades Closed In 2017 The big drivers of our view in oil markets were fundamentals: On the supply side, we maintained the view OPEC 2.0 would not waver in its commitment to draining global storage levels, particularly in the OECD commercial inventories via supply reductions. On the demand side, by mid-2017, it became apparent to us the big data providers - the U.S. EIA and the IEA in Paris - and most of the sell-side analysts were underestimating demand. Information flows during 1H17 were often contradictory, which injected enormous volatility in crude-oil spread markets - particularly the calendar spreads trading markets employ to take a view on the shape of the forward curve (e.g., long a near-term futures contract like Dec/17 Brent, vs. short a deferred delivery contract like Dec/18). This intense volatility drove us toward the relative safety of call-option spreads in 2H17, where the risk of loss is limited to the net premium paid for the call spread. As we did last year, we constructed an information ratio (IR) to determine whether the additional volatility produced by our recommendations was adequately compensated for by the returns (simple percent changes of the opening level for a recommendation vs. the closing level). Our IR uses the S&P GSCI as a benchmark, given it has a relatively high weight in energy-related exposures. Our ratio looks at the average excess return of the active portfolio against this benchmark. This average excess return is divided by its standard deviation (also referred to as the tracking error volatility) in order to generate a risk-adjusted metric to measure returns on our recommendations relative to the risk we took to generate them. BCA's IR thus is calculated as: The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: High returns in the portfolio; low returns in the benchmark, or low tracking error volatility. Hence, this measure provides a numeric value to analyze the risk-reward trade-off; it tells us whether or not the risk assumed in our trades was compensated for by larger returns. Viewing our energy recommendations as a portfolio over the course of 2017, our average return was 111%, while the GSCI return was 5.8%. The tracking error volatility was 112%.7 Using these inputs, the IR of our recommendations was 0.94. While not as stellar as our 2016 IR of 1.47, this risk-adjusted return is still stout, and indicates the consistent positive excess returns of our portfolio relative to passive GSCI exposure compensated for the high volatility of those returns. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is the name we've given the OPEC + non-OPEC producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 For a summary of our 2018 outlooks, please see BCA Research's Commodity & Energy Strategy Weekly Report "Oil Fundamentals Remain Bullish Heading Into 2018," published on December 21, 2017, and "Opposing Forces: Stay Neutral Metals In 2018" in the same issue. It is available at ces.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," published December 22, 2017. It is available at gis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Ill Placed Trust?," published December 19, 2017. It is available at usbs.bcaresearch.com. 5 Please see "The Fed's shifting perspective on the economy and its implications for monetary policy," by Ben S. Bernanke, published by the Brookings Institution on its website August 8, 2016. 6 Please see "All Talk, Few Answers From FOMC for Yellen's Long Inflation Miss," published by bloomberg.com on January 3, 2018. 7 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 224 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking-error volatility. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017