Equities
Dear Client, I will be discussing the economic and financial implications of the pandemic with my colleague Caroline Miller this Friday, March 27 at 8:00 AM EDT (12:00 PM GMT, 1:00 PM CET, 8:00 PM HKT). I hope you will be able to join us for this webcast. Next week, we will send you a special report prepared by BCA’s Chief Economist Martin Barnes. Martin will provide his perspective on the current crisis, focusing on some of the longer-run implications. Best regards, Peter Berezin, Chief Global Strategist Highlights The world is in the midst of a deep recession. Growth should recover in the third quarter as the measures taken to compensate for the initial slow response to the crisis are relaxed and existing measures are better calibrated to reduce economic distress. Continued monetary support and unprecedented fiscal stimulus should help drive the recovery once businesses reopen and workers return to their jobs. Investors should maintain a modest overweight to global equities. US stocks will lag their foreign peers over the next 12 months. The US dollar has peaked. A weaker dollar should help lift commodity prices and the more cyclical sectors of the stock market. High-yield credit spreads will narrow over the next 12 months, but we prefer investment-grade credit on a risk-reward basis. Investors are understating the potential long-term inflationary consequences of all the stimulus that has been unleashed on the global economy. Buy TIPS and gold. I. Macroeconomic Outlook The global economy is now in recession. The recession has occurred because policymakers saw it as the lesser of two evils. They judged, with good reason, that a temporary shutdown of most non-essential economic activities was a price worth paying to contain the virus. Outside of China, the level of real GDP is likely to be down 1%-to-3% in Q1 of 2020 relative to Q4 of 2019, and down another 5%-to-10% in Q2 relative to Q1. On a sequential annualized basis, this implies that GDP growth could register a negative print of 40% in some countries in the second quarter, a stunning number that has few parallels in history. Growth in China should stage a modest rebound in the second quarter, reflecting the success the country has had in containing the virus. Nevertheless, the level of Chinese economic activity will remain well below its pre-crisis trend, with exports increasingly weighed down by the collapse in overseas spending. A One-Two Punch The “sudden stop” nature of the downturn stems from the fact that the global economy was simultaneously hit by both a massive demand and supply shock. When households are confined to their homes, they cannot spend as much as they normally would. This is particularly the case in an environment of heightened risk aversion, which usually leads to increased precautionary savings. At times like these, businesses also slash spending in a desperate effort to preserve cash. All this reduces aggregate demand. On the supply side, production has been impaired because of workers’ inability to get to their jobs. According to the Bureau of Labor Statistics, less than 30% of US employees can work from home (Chart 1). Since modern economies rely on an intricate division of labor, disturbances in one part of the economy quickly ripple through to other parts. The global supply chain ceases to function normally. Chart 1US: Who Can Work From Home And Who Cannot? Think of this as a Great Depression-style demand shock combined with a category five hurricane supply shock. The fact that both of these shocks have been concentrated in the service sector, which represents at least two-thirds of GDP in most economies, has made the situation even worse (Chart 2). During most recessions, the service sector is the ballast that helps stabilize the economy in the face of sharp declines in the more cyclical sectors such as manufacturing and housing. This time is different. Chart 2The Service Sector Accounts For A Big Chunk Of GDP And Has Been Very Hard Hit The Shape Of The Recovery: L, U, or V? Provided that the number of new infections around the world stabilizes during the next two months, growth should begin to recover in the third quarter. What will the recovery look like? From the perspective of sequential quarterly growth rates, a V-shaped recovery is inevitable simply because a string of quarters of negative 20%-to-40% growth would quickly leave the world with no GDP at all. However, thinking in terms of growth rates is not the best approach. It is better to think of the level of real GDP. Chart 3 shows three scenarios: 1) An L-shaped profile for real GDP where the level of output falls and then remains permanently depressed relative to its long-term trend; 2) A sluggish U-shaped recovery where output slowly rebounds starting in the second half of the year; and 3) A rapid V-shaped recovery where output quickly moves back to its pre-crisis trend. Chart 3Profile Of The Recovery: L, U, or V? We had previously thought that the recovery from the pandemic would be V-shaped. Compared to the sluggish recovery following the Great Recession, that is likely still true. However, at this point, we would prefer to characterize the probable recovery as being more U-shaped in nature. This is mainly because the measures necessary to contain the virus may end up having to remain in place, in one form or another, for the next few years. Why Not L? Given the likelihood that containment measures will continue to weigh on economic activity, how can an L-shaped “recovery” be avoided? While such a dire outcome cannot be ruled out, there are three reasons to think “U” is more likely than “L”. Reason #1: We Will Learn From Experience It is almost certain that we will figure out how to fine-tune containment measures to reduce the economic burden without increasing the number of lives lost. There are still many questions that remain unanswered. For example: Are restaurants where family members sit together really more dangerous than bars or conferences where strangers are milling about talking to one another? How dangerous is air travel? Modern airplanes have hospital-grade filtration systems that recirculate all the air in the cabin every three minutes. Might this explain why there has only been a handful of flight attendants that have tested positive for the virus? How contagious are children, who often may not present any symptoms at all? Which drugs might slow the spread of the disease or perhaps even cure it? To what extent would widespread mask-wearing help? Yes, a mask may not prevent you from catching the virus, but if there is major social stigma associated with being unmasked in public, then people who have the virus and may not know it will be less of a threat to others. One study estimates that the virus could be completely eradicated if 80% of people always wore masks.1 With time, we will learn the answers to these questions. We will also be able to stockpile masks, ventilators, respirators, and test kits – all of which are currently in short supply – to better combat the virus. Reason #2: We Are NowOvercompensating For Lost Time Second, most countries are currently at the stage where they are trying not just to bring down the basic reproduction number for the virus to 1, but to drive it down to well below 1. There is merit in doing so. If you can reduce the reproduction number to say, 0.5, meaning that 100 people with the virus will pass it on to only 50 other people, then the number of new infections will fall rapidly over time. This is what China was finally able to achieve. A recent study documented that China succeeded in bringing down the reproduction number in Wuhan from 3.86 to 0.32 once all the containment measures had been implemented (Chart 4).2 Chart 4Severe Containment Measures Have Changed The Course Of The Wuhan Outbreak The critical point is that once you reduce the number of new infections to a sufficiently low level, you can then relax the containment measures by just enough so that the reproduction number rises back to 1. At that point, the number of new infections at any given point in time will be constant. One can see this point by imagining a bicycle coasting down a mountain road. Ideally, the rider should apply uniform pressure on the brakes at the outset of the descent to prevent the bicycle from accelerating too quickly. However, if the rider is too slow to apply the brakes and ends up going too fast, he or she will then need to overcompensate by pressing hard on the brakes to slow the bike down before easing off the brakes a bit. Most of the world is currently in the same predicament as the cyclist who failed to squeeze the brakes early on. We are overcompensating to get the infection rate down. However, once the infection rate has fallen by enough, we can ease off the most economically onerous measures, allowing GDP to slowly recover. Reason #3: Containment Measure Will Be Eased As More People Acquire Immunity Much of the popular discussion of the epidemiology of COVID-19 has failed to distinguish between the basic reproduction number, R0, and the effective reproduction number, Re. The former measures the average number of people a carrier of the virus will infect in an entirely susceptible population, whereas the latter measures the average number of people who will be infected after some fraction of the population acquires immunity either by surviving the disease or getting vaccinated. Mathematically, Re = R0*(1-P), where P is the proportion of the population which has acquired immunity. For example, suppose P=0.5, meaning that half the population has acquired immunity. In this case, the average number of people a carrier will infect will be only half as high as when no one has immunity. As we discuss below, there is considerable uncertainty about how fast P will increase over time, including whether it could spike upwards if a vaccine becomes widely available. Still, any increase in P will make it more difficult for the virus to propagate. Over time, this will permit policymakers to raise R0 at an accelerating rate towards the level it would naturally be in the absence of any containment measures (Chart 5). Such a strategy would allow economic activity to increase without raising Re; that is to say, without triggering an explosion in the number of new cases. Chart 5Populations Acquiring Immunity Is Key The Virus Endgame How long will it take to dismantle all the containment measures completely? This partly depends on what medical breakthroughs occur and what measures are needed to “flatten the curve” of new infections (Chart 6). Right now, most countries are trying to drive down the number of new infections to very low levels in the hopes that either a vaccine will be invented or new treatment options will become available. Chart 6Flattening The Curve We are not medical experts and will not offer an opinion on how likely a breakthrough may be. What we would say is that combating the virus has become a modern-day Manhattan project. If the project succeeds, a V-shaped recovery could still ensue. What if the virus evades the best efforts of scientists to eradicate it? In that case, the only way for life to return to some semblance of normalcy is for the population to acquire herd immunity. How many people would need to be infected? In the context of the foregoing discussion, this is equivalent to asking how high P needs to rise for Re to fall below 1. The equation above tells us this must correspond to the value of P for which R0 (1-P) <1. Solving for P yields P > 1-1/R0. In the absence of social distancing and other containment measures, most estimates of R0 for COVID-19 place it between 1.5 and 4. This implies that between one-third (1-1/1.5) to three-quarters (1-1/4) of the population would need to be infected for herd immunity to set in. Even if one allows for the likelihood that significantly more resources will be marshalled to allow hospitals to service a greater number of patients, we estimate that it would take 2-to-3 years to reach that point.3 To be clear, the virus’ ability to spread will decline even before herd immunity is achieved. An increase in the share of the population who survived and became naturally inoculated against the virus would allow policymakers to relax containment measures, perhaps to such an extent that eventually only the simplest of actions such as increased hand-washing and widespread mask-wearing would be enough to prevent hospitals from being overwhelmed. This underscores our baseline expectation of a U-shaped economic recovery. Second-Round Effects Suppose the global economy starts to recover in the third quarter of this year as the measures taken to compensate for the initial slow response to the crisis are relaxed, existing measures are better calibrated to reduce economic distress, and more younger and healthier people acquire natural immunity to the virus, thus reducing the vulnerability of the old and frail. Does that mean we are out of the woods? Not necessarily! We still have to worry about the second-round economic effects. Even if the virus is contained, there is a risk that the economy will be so scarred by the initial drop in output that it will fail to recover. A vicious circle could emerge where falling spending leads to higher unemployment, leading to even less spending. In the current environment, the tendency for unemployment to rise may be initially mitigated by the decision of a few large companies with ample financial resources to pay their workers even if they are confined to their homes. This would result in a decline in labor productivity rather than higher unemployment. That said, given the severity of the shock and the fact that many of the hardest-hit firms are in the labor-intensive service sector, a sharp rise in joblessness is still inevitable, particularly in countries with flexible labor markets such as the US. Chart 7Worries Over Job Security Abound Today’s spike in US initial unemployment claims is testament to that point (Chart 7). In fact, the true increase in the unemployment rate will probably be greater than what is implied by the claims data because many state websites did not have the bandwidth to handle the slew of applications. In addition, under existing rules, the self-employed and those working in the “gig economy” do not qualify for unemployment benefits (this has been rectified in the bill now making its way to the White House). The Role Of Policy Could we really end up in a world where the virus is contained, and people are ready and able to work, only to find that there are no jobs available? While such a sorry outcome cannot be dismissed, we would bet against it. This outcome would only arise if there is insufficient demand throughout the economy when it reopens. Unlike in 2008/09 when there was a lot of moralizing about how this or that group deserved to be punished for their reckless behavior, no one in their right mind today would argue that the workers losing their jobs and the companies facing bankruptcy somehow had it coming. What can policymakers realistically do? On the monetary side, policy rates are already close to zero in most developed economies. A number of emerging markets still have scope to cut rates, but even there, many find themselves not far from the zero bound (Chart 8). Chart 8DM Rates At The Zero Bound, With EM Rates Approaching Chart 9A Mad Scramble For Cash That said, cutting interest rates right now is not the only, and probably not the most important, way for central banks to stimulate their economies. The global economy is facing a cash shortage. Companies are tapping credit lines at a time when banks would normally be looking to increase their own cash reserves. The mad scramble for cash has caused libor, repo, and commercial paper spreads to surge (Chart 9). And not just any cash. As the world’s reserve currency, the dollar is increasingly in short supply (Chart 10). This explains why cross-currency basis spreads have soared and why the DXY index has jumped to the highest level in 17 years. Chart 10Dollars Are In Short Supply Flood The Zone Chart 11US Mortgage Spreads Have Spiked The good news is that there is no limit to how many dollars the Federal Reserve can create. The Fed has already expanded the supply of bank reserves by initiating the purchase of $500 billion in treasuries and another $200 billion in agency mortgage-backed securities (MBS) since relaunching its QE program on March 15th. Further MBS purchases will be especially useful given that mortgage rates have not come down as quickly as Treasury yields (Chart 11). The Fed has also dusted off the alphabet soup of programs created during the financial crisis to improve proper market functioning, and has even added a few more to the list, including a program to support investment-grade corporate bonds and another to support small businesses. In order to ease overseas funding pressures, the Fed has opened up swap lines with a number of central banks. We expect these lines to be expanded to more countries if the situation necessitates it. The Coming Mar-A-Lago Accord? We also think that there is at least a 50-50 chance that we could see coordinated currency interventions designed to drive down the value of the US dollar. Federal Reserve, Treasury, and IMF guidelines all permit currency intervention to counter “disorderly market conditions.” While a weaker dollar would erode the export competitiveness of some countries, this would be more than offset by the palliative effects of additional dollar liquidity stemming from US purchases of foreign securities, as well as the relief that overseas dollar borrowers would receive from dollar depreciation. Thus, on balance, a weaker dollar would result in an easing of global financial conditions. Liquidity Versus Solvency Risk Some might complain that the actions of the Fed and other central banks go well beyond their mandates. They might argue that it is one thing to provide liquidity to the financial system; it is quite another to socialize credit risk. We think these arguments are largely red herrings. For one thing, concern about credit risk can be addressed by having governments backstop central banks for any losses they incur. Moreover, there is no clear distinction between liquidity and solvency risk during a financial crisis. The former can very easily morph into the latter. For example, consider the case of Italy. Would you buy more Italian bonds if the yield rises? That depends on two competing considerations. On the one hand, a higher yield makes the bond cheaper. On the other hand, a higher yield may make it more difficult for the government to service its debt obligations, which raises the risk of default. If the second consideration outweighs the first, your inclination may be to sell the bond. To the extent that your selling causes yields to rise further, that could lead to another wave of selling. As Chart 12 illustrates, this means that there may be multiple equilibria in fixed-income markets. It is absolutely the job of central banks to try to steer the economy towards the good ”low yield” equilibrium rather than the bad “default” equilibrium. Chart 12Multiple Equilibria In Debt Markets Are Possible Without A Lender Of Last Resort In this light, ECB president Christine Lagarde’s statement on March 12th that “we are not here to close spreads” – coming on the heels of a spike in Italian bond yields and a 13% drop in euro area stocks the prior day – was one of the most negligent things a central banker has ever said. To her credit, she has since walked back her comments. The ECB has also launched the Pandemic Emergency Purchase Programme (PEPP), a EUR 750bn asset-purchase program, which gives the central bank considerable flexibility over the timing, composition, and geographic makeup of purchases. Further actions, including upsizing the PEPP, creating a “conditionality-lite” version of the ESM program, and perhaps even issuing Eurobonds, are possible. All this should help Italy. Accordingly, BCA’s global fixed-income team upgraded Italian government bonds to overweight this week. Using Fiscal Policy To Align Financial Time With Economic Time While central banks will play an important role in mitigating the crisis, most of the economic burden will fall on fiscal policy. How much fiscal support is necessary and what should it consist of? To get a sense of what is optimal, it is useful to distinguish between the concept of financial time and economic time. Financial time and economic time usually beat at the same pace. Most of the time, people have financial obligations – rent, mortgage payments, spending on necessities – that they match with the income earned from work. Likewise, companies have expenses that they match with the revenue that they derive from various economic activities. No one worries when economic time and financial time deviate in predictable ways. For example, GDP collapses around 5pm on Monday only to recover at 9am on Tuesday. The fact that many western Europeans take most of August off for vacation is also not a problem, since everyone expects this. The problem occurs when economic time and financial time deviate in unpredictable ways. That is the case at present. Today, economic time has ground to a halt as businesses shutter their doors and workers confine themselves to their homes. Yet, financial time continues to march on. This implies that in the near term, the correct course of action is for governments to transfer money to households and firms to allow them to service their financial obligations. One simple way of achieving this is through wage subsidies, where the government pays companies most of the wage bill of their employees who, through no fault of their own, are unable to work. Note that this strategy does not boost GDP. By definition, an idle worker is one who does not contribute to economic output. What this strategy does do is alleviate needless hardship, while creating pent-up demand for when businesses start to open their doors again. Once the virus is contained, traditional fiscal stimulus that boosts aggregate demand will be appropriate. How much money are we talking about? In the case of the US, suppose that annualized growth is -5% in Q1, -25% in Q2, and +10% in Q3 and Q4, respectively. That would leave the level of real GDP down 4% on the year compared to 2019. Assuming trend GDP growth of 2%, that implies an annual shortfall of income (consisting of wages and lost profits) that the government would have to cover amounting to 6% of GDP. The $2 trillion stimulus bill amounts to 10% of GDP, although not all of that will be spent during the next 12 months and about a quarter of the amount is in the form of loans and loan guarantees. Still, on size, we would give it an “A”. On composition, we would give it a “B”, as it lacks sufficient funding for state and local governments to cover the likely decline in the tax revenues that they will experience. This could result in layoffs of first responders, teachers, etc. Given that the US was running a fiscal deficit going into the crisis, all this additional stimulus could easily push the budget deficit to over 15% of GDP. While this is a huge number, keep in mind that in a world where interest rates are below the trend growth rate of the economy, a government can permanently increase its budget deficit by any amount it wants while still achieving a stable debt-to-GDP ratio over the long haul.4 Today, we are not even talking about a permanent increase in the deficit, but a temporary increase that could last a few years at most. If we end up in a depression, don’t blame the virus; blame politicians. Fortunately, given that the political incentives are aligned towards fiscal easing rather than austerity, our guess is that a depression will be averted. Appendix A summarizes the monetary and fiscal measures that have already been taken in the major economies. II. Investment Strategy As anyone who has ever watched a horror movie knows, the scariest part of the film is the one before the monster is revealed to the audience. No matter how good the makeup or set design, our imaginations can always conjure up something much more frightening than Hollywood can invent. Right now, we are fighting an invisible enemy that is ravaging the world. Victory is in sight. The number of new infections has peaked in China and South Korea. I mentioned during last week’s webcast that we should watch Italy very carefully. If the number of new infections peaks there, that would send an encouraging signal to financial markets that other western democracies will be able to get the virus under control. While it is too early to be certain, this may be happening: Both the number of new cases and deaths in Italy have stabilized over the past five days (Chart 13). Chart 13A Peak In The Number Of New COVID-19 Cases In Italy Would Send An Encouraging Signal Of course, there is still the risk that the number of new infections will rise again if containment measures are relaxed prematurely. However, as we spelled out in this report, there are good reasons to think that these measures will not need to be as severe as the ones currently in place. As such, it is likely that global growth will begin to rebound in the third quarter of this year. Equities: A Modest Overweight Is Warranted We turned more cautious on the near-term outlook for global equities earlier this year, but upgraded our recommendation on the morning of February 28th after the MSCI All-Country World Index fell by 12% over the prior week. While stocks did rally by 7% during the following three trading days, they subsequently plunged to multi-year lows. In retrospect, we should have paid more attention to our own warnings in our earlier report titled “Markets Too Complacent About The Coronavirus.” 5 For now, we would recommend a modest overweight to stocks on both a 3-month and 12-month horizon. Monetary and fiscal easing and the prospect of a peak in the number of new cases in Italy could continue to support stocks in the near term, while a rebound in growth starting this summer should pave the way for a recovery in corporate earnings over a 12-month horizon. Chart 14US Equity Valuations Are Not Yet At Bombed-Out Levels Of course, when it comes to financial markets, one should always be prepared to adjust one’s conviction level if prices either rise or fall significantly. We mentioned two weeks ago that we would move to a high-conviction overweight if the S&P 500 fell below 2250. While the index did briefly fall below this level, it has since bounced back to about 2630. At its current level, the S&P 500 is trading at 15.3-times forward earnings (Chart 14). While this is not particularly expensive, it is still well above the trough of 10.5-times forward earnings reached in 2011 during the height of the euro crisis. And keep in mind that current earnings estimates are based on the stale assumption that S&P 500 companies will earn $172 over the next four quarters, down only 3% from the peak earnings estimate of $177 reached in February. With this in mind, we are introducing a lower and upper bound for global equity prices at which we will adjust our view. To keep things simple, we will focus on the S&P 500, which accounts for over half of global stock market capitalization. If the S&P 500 falls below (and stays below) 2250, we would recommend a high-conviction overweight to global stocks. If the index rises above 2750, we would recommend a neutral equity allocation. Anything between 2250 and 2750 would justify the current stance of modest overweight. Going forward, we will adjust this range as events warrant it. Our full slate of views can be found in the table at the end of this report. Sector And Regional Equity Allocation: Favor Cyclicals and Non-US Over A 12-Month Horizon Not surprisingly, defensive equity sectors outperformed cyclicals both in the US and abroad during this month’s selloff. Financials also underperformed on heightened worries about rising defaults and the adverse effect on net interest margins from flatter yield curves (Chart 15). Chart 15Cyclicals And Financials Underperformed On The Way Down Chart 16Non-US Stocks Are Cheaper Even After Adjusting For Differences In Sector Weights Cyclicals and financials have outperformed the broader market over the past few days as risk sentiment has improved. They are likely to continue outperforming over a 12-month horizon as global growth eventually recovers and yield curves steepen modestly. To the extent that cyclicals and financials are overrepresented in stock market indices outside the US, this will give non-US equities the edge. Stocks outside the US also benefit from more favorable valuations. Even after adjusting for differences in sector weights, non-US stocks are quite a bit cheaper than their US peers as judged by price-to-earnings, price-to-book, and other valuation measures (Chart 16). The US Dollar Has Probably Peaked Another factor that should help cyclical stocks later this year is the direction of the US dollar. The greenback has been buffeted by two major forces this year (Chart 17). Chart 17The Dollar Has Been Facing Crosscurrents Chart 18USD Is A Countercyclical Currency Between February 19 and March 9, the dollar weakened as US bond yields fell more than yields abroad. This eliminated some of the yield advantage that had been supporting the dollar last year. Starting around the second week of March, however, global financial stresses escalated. Money began to flow into the safe-haven Treasury market. Global growth prospects also deteriorated sharply. As a countercyclical currency, this helped the dollar (Chart 18). Looking out, interest rate differentials are unlikely to return anywhere close to where they were at the start of this year, given that the Fed will probably keep rates near zero at least until the middle of 2021. Meanwhile, aggressive central bank liquidity injections should reduce financial stress, while a rebound in global growth will allow capital to start flowing back towards riskier foreign markets. This should result in a weaker dollar. Once Growth Bottoms, So Will Commodities Chart 19Low Prices Force US Shale Cutbacks The combination of a weaker dollar, a rebound in global growth starting this summer, and increased infrastructure stimulus spending in China should help lift resource prices. This will also buoy currencies such as the AUD, CAD, and NOK in the developed market space, and RUB, CLP, ZAR, and IDR, in the EM space. Oil prices have tumbled on the back of the sudden stop in global economic activity and the breakdown of the agreement between OPEC and Russia to restrain crude production. BCA’s commodity strategists expect the Saudis and Russians to come to an agreement to reduce output, as neither side has an incentive to pursue a prolonged price war. They see Brent prices averaging $36/barrel in 2020 and $55/barrel in 2021. However, prices are not likely to go much higher than $60/barrel because that would take them well above the current breakeven cost for shale producers, eliciting a strong supply response (Chart 19). Spread Product: Favor IG Over HY A rebound in oil prices from today’s ultra-depressed levels should help the bonds of energy companies, which are overrepresented in high-yield indices. This, together with stronger global growth and improving risk sentiment, should allow HY spreads to narrow over a 12-month horizon. Chart 20High-Yield Credit Is Pricing In Only A Moderate Recession Nevertheless, we think investment grade currently offers a better risk-reward profile. While HY spreads have jumped to more than 1000 basis points in the US, they are still nowhere close to 2008 peak levels of almost 2000 basis points. Like the equity market, high-yield credit is pricing in only a modest recession, with a default rate on par with the 2001 downturn (Chart 20). Moreover, central banks around the world are racing to protect high-quality borrowers from default. The Fed’s announcement that it will effectively backstop the investment-grade corporate bond market could be a game changer in this regard. Unfortunately for HY credit, the moral hazard consequences of bailing out companies that investors knew were risky when they first bought the bonds are too great for policymakers to bear. Government Bonds: Deflation Today, Inflation Tomorrow? As noted at the outset of this report, the current economic downturn involves both an adverse supply and demand shock. Outside of a few categories of consumer staples and medical products, we expect demand to fall more than supply, resulting in downward pressure on prices. This deflationary impulse will be exacerbated by rising unemployment. Looking beyond the next 12-to-18 months, the outlook for inflation is less clear. On the one hand, it is possible that the psychological trauma from the pandemic will produce a permanent, or at least semi-permanent, increase in precautionary savings. If budget deficits are reined in too quickly, many countries could find themselves facing a shortage of aggregate demand. This would be deflationary. On the other hand, one can easily envision a scenario where monetary policy remains highly accommodative and many of the fiscal measures put in place to support households are maintained long after the virus is eradicated. This could be particularly true in the US, where our geopolitical team now expects Joe Biden to win the presidential election. In such an environment, unemployment could fall back to its lows, eventually leading to an overheated economy. Our hunch is that the more inflationary scenario will unfold over the next 2-to-3 years. Interestingly, that is not the market’s opinion. For example, the 5-year US TIPS breakeven inflation rate is currently only 0.69% and the 10-year rate is 1.07%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.69% per year for the next five years, or 1.07% per year for the next decade. That is a bet we would be willing to take. Finally, a word on gold. Just as during the Global Financial Crisis, gold failed to be an attractive hedge against financial risk during the recent stock market selloff – bullion dropped by 15% from $1704/oz to $1451/oz, before rebounding back to $1640/oz over the past few days as risk sentiment improved. Nevertheless, gold remains a good hedge against long-term inflation risk. And with the US dollar likely to weaken over the next 12 months, gold prices should move up even if near-term inflationary pressures remain contained. As such, we are upgrading our outlook on the yellow metal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Appendix A Appendix A Table 1Central Banks Still Had Some Options When Crisis Hit Appendix A Table 2Massive Stimulus In Response To Pandemic Footnotes 1 Jing Yan, Suvajyoti Guha, Prasanna Hariharan, and Matthew Myers, “Modeling the Effectiveness of Respiratory Protective Devices in Reducing Influenza Outbreak,” U.S. National Library of Medicine, (39:3), March 2019. 2 Chaolong Wang, Li Liu, Xingjie Hao, Huan Guo, Qi Wang, Jiao Huang, Na He, Hongjie Yu, Xihong Lin, Sheng Wei, and Tangchun Wu, “Evolving Epidemiology and Impact of Non-pharmaceutical Interventions on the Outbreak of Coronavirus Disease 2019 in Wuhan, China,”medrxiv.org, March 6, 2020. 3 This calculation assumes that 5% of infected people need ICU care and each spends an average of 2 weeks in the ICU. It also assumes that hospitals are able to expand their capacity by 30 additional ICU beds per 100,000 people per year to treat COVID-19. 4 Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, available at gis.bcarearch.com. 5 Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020, available at gis.bcaresearch.com. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Equity market bloodletting likely reached a climax last Thursday as indiscriminate selling pushed correlations to the extremes of +/-1. Since then however, hypersensitive stocks have made an attempt for a comeback. These greenshoots are most visible in the highest beta areas of the market, namely chip stocks and small cap indexes. The chart shows that both the Philly SOX index and the Russell 2000 are ticking higher versus the NASDAQ 100 and S&P 500 indexes, respectively. While it is still too soon to call the ultimate trough in stocks and a retest will likely materialize, it is encouraging that investors are no longer pressing the panic sell button. Tack on the extreme short interest and lack of depth in ES futures and a significant short-covering reflex rally is likely to continue in the coming days. Bottom Line: We recommend investors with higher risk tolerance and a 9-12 month cyclical time horizon to continue nibbling on the broad equity market.
Highlights The pandemic has a negative impact on households and has not peaked in the US. But a depression is likely to be averted. Our market-based geopolitical risk indicators point toward a period of rising political turbulence across the world. We are selectively adding risk to our strategic portfolio, but remain tactically defensive. Stay long gold on a strategic time horizon. Feature I'm going where there's no depression, To the lovely land that's free from care. I'll leave this world of toil and trouble My home's in Heaven, I'm going there. - “No Depression In Heaven,” The Carter Family (1936) Chart 1The Pandemic Stimulus Versus The Great Recession Stimulus Markets bounced this week on the back of a gargantuan rollout of government spending that is the long-awaited counterpart to the already ultra-dovish monetary policy of global central banks (Chart 1). Just when the investment community began to worry about a full-fledged economic depression and the prospect for bank runs, food shortages, and martial law in the United States, the market rallied. Yet extreme uncertainty persists over how long one third of the world’s population will remain hidden away in their homes for fear of a dangerous virus (Chart 2). Chart 2Crisis Has Not Verifiably Peaked, Uncertainty Over Timing Of Lockdowns Chart 3The Pandemic Shock To The Labor Market While an important and growing trickle of expert opinion suggests that COVID-19 is not as deadly as once thought, especially for those under the age of 50, consumer activity will not return to normal anytime soon.1 Moreover political and geopolitical risks are skyrocketing and have yet to register in investors’ psyche. Consider: American initial unemployment claims came in at a record-breaking 3.3 million (Chart 3), while China International Capital Corporation estimates that China’s GDP will grow by 2.6% for the year. These are powerful blows against global political as well as economic stability. This should convince investors to exercise caution even as they re-enter the equity market. We are selectively putting some cash to work on a strategic time frame (12 months and beyond) to take advantage of some extraordinary opportunities in equities and commodities. But we maintain the cautious and defensive tactical posture that we initiated on January 24. No Depression In Heaven The US Congress agreed with the White House on an eye-popping $2.2 trillion or 10% of GDP fiscal stimulus. At least 46% of the package consists of direct funds for households and small businesses (Chart 4). This includes $290 billion in direct cash handouts to every middle-class household – essentially “helicopter money,” as it is financed by bonds purchased by the central bank (Table 1). The purpose is to plug the gap left by the near complete halt to daily life and business as isolation measures are taken. A depression is averted, but we still have a recession. Go long consumer staples. Chart 4The US Stimulus Package Breakdown Table 1Distribution Of Cash Handouts Under US Coronavirus Response Act China, the origin of the virus that triggered the global pandemic and recession, is resorting to its time-tried playbook of infrastructure spending, with 3% of GDP in new spending projected. This number is probably heavily understated. It does not include the increase in new credit that will accompany official fiscal measures, which could easily amount to 3% of GDP or more, putting the total new spending at 6%. Germany and the EU have also launched a total fiscal response. The traditionally tight-fisted Berlin has launched an 11% of GDP stimulus, opening the way for other member states to surge their own spending. The EU Commission has announced it will suspend deficit restrictions for all member states. The ECB’s Pandemic Emergency Purchase Program (PEPP) enables direct lending without having to tap the European Stability Mechanism (ESM) or negotiate the loosening of its requirements. It also enables the ECB to bypass the debate over issuing Eurobonds (though incidentally Germany is softening its stance on the latter idea). The cumulative impact of all this fiscal stimulus is 5% of global GDP – and rising (Table 2). Governments will be forced to provide more cash on a rolling basis to households and businesses as long as the pandemic is raging and isolation measures are in place. Table 2The Global Fiscal Stimulus In Response To COVID-19 President Trump has signaled that he wants economic life to begin resuming after Easter Sunday, April 12. But he also said that he will listen to the advice of the White House’s public health advisors. State governors are the ones who implement tough “shelter in place” orders and other restrictions, so the hardest hit states will not resume activity until their governors believe that the impact on their medical systems can be managed. Authorities will likely extend the social distancing measures in April until they have a better handle on the best ways to enable economic activity while preserving the health system. Needless to say, economic activity will have to resume gradually as the government cannot replace activity forever and the working age population can operate even with the threat of contracting the disease (social distancing policies would become more fine-tuned for types of activity, age groups, and health risk profiles). The tipping point from recession to depression would be the point at which the government’s promises of total fiscal and monetary support for households and businesses become incapable of reassuring either the financial markets or citizens. The largest deficit the US government has ever run was 30% of GDP during World War II (Chart 5). Today’s deficit is likely to go well beyond 15% (5% existing plus 10% stimulus package plus falling revenue). If authorities were forced to triple the lockdown period and hence the fiscal response the country would be in uncharted territory. But this is unlikely as the incubation period of the virus is two weeks and China has already shown that a total lockdown can sharply reduce transmission. Chart 5The US's Largest Peacetime Budget Deficit Any tipping point into depression would become evident in behavior: e.g. a return to panic selling, followed by the closure of financial market trading by authorities, bank runs, shortages of staples across regions, and possibly the use of martial law and curfews. While near-term selloffs can occur, the rest seems very unlikely – if only because, again, the much simpler solution is to reduce the restrictions on economic activity gradually for the low-risk, healthy, working age population. Bottom Line: Granting that the healthy working age population can and will eventually return to work due to its lower risk profile, unlimited policy support suggests that a depression or “L-shaped” recovery is unlikely. The Dark Hour Of Midnight Nearing While the US looks to avoid a depression, there will still be a recession with an unprecedented Q2 contraction. The recovery could be a lot slower than bullish investors expect. Global manufacturing was contracting well before households got hit with a sickness that will suppress consumption for the rest of the year. There is another disease to worry about: the dollar disease. The world is heavily indebted and holds $12 trillion in US dollar-denominated debt. Yet the dollar is hitting the highest levels in years and global dollar liquidity is drying up. The greenback has rallied even against major safe haven currencies like the Japanese yen and Swiss franc (Chart 6). Of course, the Fed is intervening to ensure highly indebted US corporates have access to loans and extending emergency dollar swap lines to a total of 14 central banks. But in the near term global growth is collapsing and the dollar is overshooting. This can create a self-reinforcing dynamic. The same goes for any relapse in Chinese growth. Unlike in 2008 – but like 2015 – China is the epicenter of the global slowdown. China has much larger economic and financial imbalances today than it did in 2003 when the SARS outbreak occurred, and it will increase these imbalances going forward as it abandons its attempt to deleverage the corporate sector (Chart 7). Chart 6The Greenback Surge Deprives The World Of Liquidity Chart 7China's Financial Imbalances Are A Worry The rest of emerging markets face their own problems, including poor governance and productivity, as well as the dollar disease and the China fallout. They are unlikely to lift themselves out of this crisis, but they could become the source for credit events and market riots that prolong the global risk-off phase. Bottom Line: It is too soon to sound the all-clear. If the dollar continues on its rampage, then the gigantic stimulus will not be enough, markets will relapse, and fears of deflation will grow. World Of Toil And Trouble Political risk is the next shoe to drop. The pandemic and recession are setting in motion a political earthquake that will unfold over the next decade. Almost all of our 12 market-based geopolitical risk indicators have exploded upward since the beginning of the year. Chart 8China's Political Risk Is Rising These indicators show that developed market equities and emerging market currencies are collapsing far more than is justified by underlying fundamentals. This risk premium reflects the uncertainty of the pandemic, but the recession will destabilize regimes and fuel fears about national security. So the risk premium will not immediately decline in several important cases. China’s political risk is shooting up, as one would expect given that the pandemic began in Hubei (Chart 8). The stress within the Communist Party can be measured by the shrill tone of the Chinese propaganda machine, which is firing on all cylinders to convince the world that Chinese President Xi Jinping did a great job handling the virus while the western nations are failing states that cannot handle it. The western nations are indeed mishandling it, but that does not solve China’s domestic economic and social troubles, which will grow from here. Of course, our political risk indicator will fall if Chinese equities rally more enthusiastically than Chinese state banks expand credit as the economy normalizes. But this would suggest that markets have gotten ahead of themselves. By contrast, if China surges credit, yet equity investors are unenthusiastic, then the market will be correctly responding to the fact that a credit surge will increase economic imbalances and intensify the tug-of-war between authorities and the financial system, particularly over the effort to prevent the property sector bubble from ballooning. China needs to stimulate to recover from the downturn. Obviously it does not want instability for the 100th birthday of the Communist Party in 2021. An even more important reason for stimulus is the 2022 leadership reshuffle – the twentieth National Party Congress. This is the date when Xi Jinping would originally have stepped down and the leading member of the rival faction (Hu Chunhua?) would have taken over the party, the presidency, and the military commission. Today Xi is not at risk of losing power, but with a trade war and recession to his name, he will have to work hard to tighten control over the party and secure his ability to stay in power. An ongoing domestic political crackdown will frighten local governments and private businesses, who are already scarred by the past decade and whose animal spirits are important to the overall economic rebound. It is still possible that Beijing will have to depreciate the renminbi against the dollar. This is the linchpin of the trade deal with President Trump – especially since other aspects of the deal will be set back by the recession. As long as Trump’s approval rating continues to benefit from his crisis response and stimulus deals, he is more likely to cut tariffs on China than to reignite the trade war. This approach will be reinforced by the bump in his approval rating upon signing the $2 trillion Families First Coronavirus Response Act into law (Chart 9). He will try to salvage the economy and his displays of strength will be reserved for market-irrelevant players like Venezuela. But if the virus outbreak and the surge in unemployment turn him into a “lame duck” later this year, then he may adopt aggressive trade policy and seek the domestic political upside of confronting China. He may need to look tough on trade on the campaign trail. Diplomacy with North Korea could also break down. This is not our base case, but we note that investors are pricing crisis levels into the South Korean won despite its successful handling of the coronavirus (Chart 10). Pyongyang has an incentive to play nice to assist the government in the South while avoiding antagonizing President Trump. But Kim Jong Un may also feel that he has an opportunity to demonstrate strength. This would be relevant not because of North Korea’s bad behavior but because a lame duck President Trump could respond belligerently. Chart 9Trump’s Approval Gets Bump From Crisis Response And Stimulus Chart 10South Korean Political Risk Rising We highlighted Russia as a “black swan” candidate for 2020. This view stemmed from President Vladimir Putin’s domestic machinations to stay in power and tamp down on domestic instability in the wake of domestic economic austerity policies. For the same reason we did not expect Moscow to engage in a market share war with Saudi Arabia that devastated oil prices, the Russian ruble, and economy. At any rate, Russia will remain a source of political surprises going forward (Chart 11). Go long oil. Putin cannot add an oil collapse to a plague and recession and expect a popular referendum to keep him in power till 2036. The coronavirus is hitting Russia, forcing Putin to delay the April 22 nationwide referendum that would allow him to rule until 2036. It is also likely forcing a rethink on a budget-busting oil market share war, since more than the $4 billion anti-crisis fund (0.2% of GDP) will be needed to stimulate the economy and boost the health system. Russia faces a budget shortfall of 3 trillion rubles ($39 billion) this year from the oil price collapse. It is no good compounding the economic shock if one intends to hold a popular referendum – even if one is Putin. For all these reasons we agree with BCA Research Commodity & Energy Strategy that a return to negotiations is likely sooner rather than later. Chart 11Russia: A Lake Of Black Swans However, we would not recommend buying the ruble, as tensions with the US are set to escalate. Instead we recommend going long Brent crude oil. Political risk in the European states is hitting highs unseen since the peak of the European sovereign debt crisis (Chart 12). Some of this risk will subside as the European authorities did not delay this time around in instituting dramatic emergency measures. Chart 12Europe: No Delay In Offering 'Whatever It Takes' Chart 13Political Risk Understated In Taiwan And Turkey However, we do not expect political risk to fall back to the low levels seen at the end of last year because the recession will affect important elections between now and 2022 in Italy, the Netherlands, Germany, and France. Only the UK has the advantage of a single-party parliamentary majority with a five-year term in office – this implies policy coherence, notwithstanding the fact that Prime Minister Boris Johnson has contracted the coronavirus. The revolution in German and EU fiscal policy is an essential step in cementing the peripheral countries’ adherence to the monetary union over the long run. But it may not prevent a clash in the coming years between Italy and Germany and Brussels. Italy is one of the countries most likely to see a change in government as a result of the pandemic. It is hard to see voters rewarding this government, ultimately, for its handling of the crisis, even though at the moment popular opinion is tentatively having that effect. The Italian opposition consists of the most popular party, the right-wing League, and the party with the fastest rising popular support, which is the right-wing Brothers of Italy. So the likely anti-incumbent effect stemming from large unemployment would favor the rise of an anti-establishment government over the next year or two. The result would be a clash with Brussels even in the context of Brussels taking on a more permissive attitude toward budget deficits. This will be all the worse if Brussels tries to climb down from stimulus too abruptly. Our political risk indicators have fallen for two countries over the past month: Taiwan and Turkey (Chart 13). This is not because political risk is falling in reality, but because these two markets have not seen their currencies depreciate as much as one would expect relative to underlying drivers of their economy: In Taiwan’s case the reason is the US dollar’s unusual strength relative to the Japanese yen amidst the crisis. Ultimately the yen is a safe-haven currency and it will eventually strengthen if global growth continues to weaken. Moreover we continue to believe that real world politics will lead to a higher risk premium in the Taiwanese dollar and equities. Taiwan faces conflicts with mainland China that will increase with China’s recession and domestic instability. In Turkey’s case, the Turkish lira has depreciated but not as much as one would expect relative to European equities, which have utterly collapsed. Therefore Turkey’s risk indicator shows its domestic political risk falling rather than rising. Turkey’s populist mismanagement will ensure that the lira continues depreciating after European equities recover, and then our risk indicator will shoot up. Chart 14Brazilian Political Risk Is No Longer Contained Prior to the pandemic, Brazilian political risk had remained contained, despite Brazilian President Jair Bolsonaro’s extreme and unorthodox leadership. Since the outbreak, however, this indicator has skyrocketed as the currency has collapsed (Chart 14). To make matters worse, Bolsonaro is taking a page from President Trump and diminishing the danger of the coronavirus in his public comments to try to prevent a sharp economic slowdown. This lackadaisical attitude will backfire since, unlike the US, Brazil does not have anywhere near the capacity to manage a major outbreak, as government ministers have warned. This autumn’s local elections present an opportunity for the opposition to stage a comeback. Brazilian stocks won’t be driven by politics in the near term – the effectiveness of China’s stimulus is critical for Brazil and other emerging markets – but political risk will remain elevated for the foreseeable future. Bottom Line: Geopolitical risk is exploding everywhere. This marks the beginning of a period of political turbulence for most of the major nation-states. Domestic economic stresses can be dealt with in various ways but in the event that China’s instability conflicts with President Trump’s election, the result could be a historic geopolitical incident and more downside in equity markets. In Russia’s case this has already occurred, via the oil shock’s effect on US shale producers, so there is potential for relations to heat up – and that is even more true if Joe Biden wins the presidency and initiates Democratic Party revenge for Russian election meddling. The confluence of volatile political elements informs our cautious tactical positioning. Investment Conclusions If the historic, worldwide monetary and fiscal stimulus taking place today is successful in rebooting global growth, then there will be “no depression.” The world will learn to cope with COVID-19 while the “dollar disease” will subside on the back of massive injections of liquidity from central banks and governments. Gold: The above is ultimately inflationary and therefore our strategic long gold trade will be reinforced. The geopolitical instability we expect to emerge from the pandemic and recession will add to the demand for gold in such a reflationary environment. No depression means stay long gold! US Equities: Equities will ultimately outperform government bonds in this environment as well. Our chief US equity strategist Anastasios Avgeriou has tallied up the reasons to go long US stocks in an excellent recent report, “20 Reasons To Buy Equities.” We agree with this view assuming investors are thinking in terms of 12 months and beyond. Chart 15Oil/Gold Ratio Extreme But Wait To Go Long Tactically, however, we maintain the cautious positioning that we adopted on January 24. We have misgivings about the past week’s equity rally. Investors need a clear sense of when the US and European households will start resuming activity. The COVID-19 outbreak is still capable of bringing negative surprises, extending lockdowns, and frightening consumers. Hence we recommend defensive plays that have suffered from indiscriminate selling, rather than cyclical sectors. Go tactically long S&P consumer staples. US Bonds: Over the long run, the Fed’s decision to backstop investment grade corporate bonds also presents a major opportunity to go long on a strategic basis relative to long-dated Treasuries, following our US bond strategists. Global Equities: We prefer global ex-US equities on the basis of relative valuations and US election uncertainty. Shifting policy winds in the United States favor higher taxes and regulation in the coming years. This is true unless President Trump is reelected, which we assess as a 35% chance. Emerging Markets: We are booking gains on our short TRY-USD trade for a gain of 6%. This is a tactical trade that remains fundamentally supported. Book 6% gain on short TRY-USD. Oil: For a more contrarian trade, we recommend going long oil. Our tactical long oil / short gold trade was stopped out at 5% last week. While we expect mean reversion in this relationship, the basis for gold to rally is strong. Therefore we are going long Brent crude spot prices on Russia’s and Saudi Arabia’s political constraints and global stimulus (Chart 15). We will reconsider the oil/gold ratio at a later date. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Joseph T. Wu et al, "Estimating clinical severity of COVID-19 from the transmission dynamics in Wuhan, China," Nature Medicine, March 19, 2020, and Wei-jie Guan et al, "Clinical Characteristics of Coronavirus Disease 2019 in China," The New England Journal Of Medicine, February 28, 2020. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar
Feature We closed our short position in EM equities last week but still maintain our short recommendation on EM currencies. Going forward we will be looking for signs of a durable bottom in risk assets. The clash between forthcoming massive economic stimulus around the world and the unprecedented plunge in global economic activity has generated a great deal of uncertainty over the magnitude and duration of the global recession. In turn, enormous ambiguity continues to produce extreme gyrations in financial markets. The unparalleled drop in the level of business activity and uncertainty over the length of lockdowns make it impossible to determine how much stimulus is required to produce a V-shaped recovery. Notably, all these stimuli will have an effect on the real economy with a lag. In the meantime, the real economy will remain in an air pocket. Overall, financial markets will remain very volatile as they try to recalibrate the magnitude and duration of recession as well as the speed of recovery. Chart 1China: Level Of Business Activity Is Still Lower Than A Year Ago Even in China, where the authorities have been stimulating and trying hard to restart the economy following lockdowns, the level of business activity remains below last year’s levels. In particular, Chart 1 illustrates that residential floor space sold in Shanghai in the past couple of weeks remains 60% lower than a year ago. This reveals how difficult it is to reboot discretionary consumer spending and business investment following a negative income shock. Overall, financial markets will remain very volatile as they try to recalibrate the magnitude and duration of recession as well as the speed of recovery. Such heightened uncertainty warrants a higher risk premium. Given financial markets are already discounting a lot of bad news, incoming economic data will be of little use. In our opinion, investors can only rely on various market indicators to gauge the direction of risk assets. Given financial markets are already discounting a lot of bad news, incoming economic data will be of little use. In our opinion, investors can only rely on various market indicators to gauge the direction of risk assets. Review Of Indicators The following market-based indicators lead us to believe that the selloff is in a late-stage, but not over. Chart 2More Downside In This Risk-On/Safe-Haven Currency Ratio Our Risk-On/Safe-Haven1 currency ratio is in free fall but has not reached the level that marked its 2011 and 2015 troughs (Chart 2). It is still well above its 2008 level. Odds are that this indicator will drop to 2011 and 2015 levels before staging a major recovery. EM share prices, commodities and global cyclical stocks correlate closely with this ratio. A further drop in Risk-On/Safe-Haven currency ratio will be consistent with more downside in EM equities, resource prices and global cyclicals. The global stock-to-US 30-year bond ratio has crashed but is still above its 2008 trough (Chart 3). Given this global recession is worse than the one in 2008, it is reasonable to expect the ratio to drop to its 2008 level before recovering. The gold-to-US bonds ratio2 has not yet broken out of its rising channel (Chart 4). Only a decisive breakout above the upper boundary of this channel will confirm a sustainable rally in reflation plays. Chart 3Global Stock-To-Bond Ratio: More Downside Is Likely Chart 4The Gold-To-Bond Ratio Is Not Yet Confirming The Reflation Trade Meanwhile, the industrial metals-to-gold ratio has plunged below its 2008 and 2015/16 lows (Chart 5). This qualifies as a structural regime change in this indicator. Odds are that this ratio will continue to fall, heralding further weakness in global cyclicals in general and EM risk assets in particular. The relative performance of non-financial Swiss stocks versus Swedish non-financials seems to have broken below 2002 and 2008 lows The relative performance of non-financial Swiss stocks versus Swedish non-financials seems to have broken below 2002 and 2008 lows (Chart 6). Such a breakdown typically entails additional decline. The latter will be consistent with more weakness in global cyclicals versus defensives. Chart 5A Noteworthy Breakdown Chart 6Cyclicals Vs Defensives Interestingly, Chinese equity indexes have dropped less than their global and EM peers. Nevertheless, cyclical sectors within the Chinese equity universe are exhibiting very disturbing chart patterns. Chinese bank stocks appear to be in a genuine downtrend, with no immediate support (Chart 7, top panel). Property developers in the onshore A-share market have hit key resistance levels and appear to be vulnerable to the downside (Chart 7, middle panel). Finally, Chinese investable small-cap stocks have broken down, and their path of least resistance is down (Chart 7, bottom panel). Overall, the relative resilience of Chinese share prices has been due to tech and “new economy” stocks. The rest of Chinese equities have been quite week in absolute terms. Finally, the net aggregate long position in US equity futures by asset managers and leveraged funds as of March 17 was still above its 2011 and 2016 lows (Chart 8). It is reasonable to expect that the ultimate capitulation in US stocks will be consistent with a lower reading of this indicator. Chart 7Weak Internals Of Chinese Equity Markets Chart 8No Capitulation Among Investors In US Equity Futures Bottom Line: The recent rebound in EM risk assets is unlikely to be sustainable. Several important indicators are not confirming a durable rally in reflation plays. Investment Strategy Even though EM equities have become cheap and very oversold as we discussed last week, odds are that the bear market in EM risk assets and currencies is not yet over. It might be too late to sell EM stocks, but also too risky to buy them aggressively. Chart 9EM Corporate Credit And Domestic Bonds: A Bear Market, Not A Correction Provided the selloff in EM fixed-income markets commenced only a couple of weeks ago, it will likely persist as investors facing losses are forced to further trim their positions (Chart I-9). We continue to recommend staying put on EM fixed-income markets. As EM US dollar and local currency bond yields rise, EM share prices will struggle. Finally, EM currencies remain vulnerable against the greenback. We are maintaining our short in a basket of the following EM currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Reshuffling EM Equity Country Allocation We are making the following changes within a dedicated EM equity portfolio: Upgrading Peru from neutral to overweight, and Colombia from underweight to neutral. Both bourses have underperformed substantially and warrant a one-notch upgrade. Peru will - on the margin - benefit from relative resilience in gold and silver prices. The collapse in Colombia’s relative equity performance is advanced. While we are not bullish on oil prices, we are protecting our gains on the underweight Colombian stocks allocation by moving it to neutral. Reiterating our underweight allocations in both Indonesian and Philippine equities. Both bourses are breaking down relative to the EM benchmark (Chart I-10). More downside is in the cards. Readers can click here to access our latest fundamental analysis on financial markets in Indonesia and the Philippines. Maintaining our overweight positions in Korean and Thai equities. Underperformance in both bourses relative to the EM benchmark is at a late stage. We expect the relative performance of these markets versus the overall EM equity index to find a support close to current levels (Chart I-11). Chart 10Continue Underweighting Indonesian And Philippines Equities Chart 11Overweight Korean And Thai Stocks Within The EM Universe Downgrading UAE from overweight to underweight. We have been bearish on oil prices, but the speed of the collapse in crude prices has wreaked havoc on Gulf equity markets. Similarly, the speed of decline in oil prices has caused considerable tremors in Mexican and Russian financial markets. Our overweight position in Russian equities is now back to its breakeven level, but the one in Mexican stocks is deep under water. We are reiterating our overweight in both bourses but have much lower conviction on Mexican stocks versus Russian ones. We will publish an updated analysis on Mexico in the near term. Finally, we have been and remain neutral on the following equity markets relative to the EM benchmark: China, Taiwan, India, Malaysia, Brazil and Chile. We have been negative on Brazil but have not formally downgraded it to underweight. Among our underweights are also Turkey, South Africa and Hong Kong domestic stocks. The complete list of our equity recommendations is available on page 8. Our fixed-income and currencies recommendations are available on page 9 (all of our recommendations are always enclosed at the end of our Weekly Reports and are available on our Website as well). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Average of CAD, AUD, NZD, BRL, IDR, RUB, CLP, MXN & ZAR total return indices relative to the average of CHF & JPY total returns. 2 It is calculated by dividing gold prices by total return on 10-year US government bonds. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
The cyclically-adjusted PE ratio (CAPE) pioneered by Robert Shiller is a yardstick that investors cite as evidence that US equity valuations have climbed decisively in recent years. As of December 2019, the Shiller CAPE was higher than 96% of its historical…
Overweight Last summer, following our recession thought experiment report1 we upgraded the S&P hypermarkets index to overweight preparing our portfolio for the inevitable recession.2 Since then, hypermarket stocks have bested the SPX by nearly 30%. The 10-year Treasury yield recently melted to 0.31%, fully discounting ZIRP, QE5 and recession. This week’s US PMI release also made for grim reading, and it will likely be a harbinger of acute economic pain in the weeks to come. Tack on the 40% jump in weekly unemployment insurance claims, and things are falling into place for additional gains in relative share prices (see chart). Following explosive gains thanks to COVID-19 driven panic, we have also instituted a rolling 10% profit taking stop from the peak gains of 36% in the most recent Weekly Report. Bottom Line: We reiterate our overweight stance in the S&P hypermarkets index, but remain disciplined as we will obey our 10% rolling stop. The ticker symbols for the stocks in this index are: BLBG: S5HYPC – WMT, COST. Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, “Divorced From Reality” dated July 15, 2019, available at uses.bcaresearch.com.
Equity market bloodletting likely reached a climax last Thursday as indiscriminate selling pushed correlations to the extremes of +/-1. Since then however, cyclically-geared equities have shown a tentative rebound. These greenshoots are most visible in the…
Feature We are downgrading US President Donald Trump’s odds of winning election. We now consider him an underdog. Since November 2018 we had given Trump a 55% chance of victory – and when former Vice President Joe Biden clinched the nomination in the midst of the virus crisis we argued that the election was “too close to call.” Now, subjectively, we would say Trump has a 35% chance of winning. This is generous relative to history, but seems appropriate to us due to the unpredictable nature of the coronavirus pandemic (which could claim either presidential candidate), the massive US and global stimulus, and the weakness of his opponent. Trump’s approval rating has fallen, albeit slightly, amid the coronavirus pandemic (Chart 1). It is now deviating from the rising approval rating of President Barack Obama at this stage in the 2012 election cycle. Since Trump has been generally less popular than the average president (Chart 2), including Obama, this is a very worrying sign for Trump. Chart 1Virus Knocked Trump Off Track Chart 2Trump Has Zero Buffer For Loss Of Popularity It is also a worrying sign for global risk assets despite their recent collapse. Chart 3To Boost Economy, Trump Must Allow Outbreaks The risk that Trump becomes a “lame duck” president was one of our top two geopolitical risks for the year. The pandemic and recession have laid the groundwork for this risk to materialize (Chart 3). Trump becomes a liability for the stock market if he concludes that he cannot win reelection. If he seems destined to lose, he has an incentive to use the powers of the presidency in his final months to “turn the tables” and change the narrative, or to cement his legacy by achieving long-term US national interests that have negative economic consequences. For now Trump apparently believes he can still salvage the economy in time to win reelection. He is softening his tone on the need for stringent social distancing policies that are designed to “flatten the curve” of the coronavirus burden on the health system. His administration will review the tough policies on Monday, March 30 before determining whether they should be extended. Individual states have leeway to maintain lockdowns, but a loosening of federal scrutiny would allow more workers to go back to work. While Trump’s desire to restart the economy is self-interested, it is true that too long of a shutdown could create negative feedback loops in the economy. A deeper slump might have worse consequences than the virus outbreak with targeted measures to mitigate the most vulnerable populations (e.g. those over 60, those with heart disease or type-2 diabetes). The problem for Trump is that if he runs on an economic ticket, he is already doomed. Unemployment is bound to rise and laid off workers tend to show up at polls to vote against the party in power. Otherwise Trump’s only option is to run as a “war president” and try to capitalize on the population’s general unwillingness to change leaders in the thick of a crisis. This strategy could work, but then Trump must tighten rather than loosen quarantines, at least over the next month. President George W. Bush benefited from the “war president” effect: his popularity surged after the September 11, 2001 terrorist attacks and the invasion of Iraq. It fell beneath 50% over the following three years, but it recovered as the election approached and the country decided not to “change horses in mid-stream.” Franklin Delano Roosevelt after Pearl Harbor is another analogy, albeit less applicable. Richard Nixon in 1972 is only roughly analogous because the recession began the year after his reelection. For President Trump to benefit from a similar dynamic we would need to see two things. First, his approval rating would need to hold steady through the worst of the crisis – from today throughout the spring – and then improve over the summer on the back of perceived progress in handling the outbreak. Second, we would need to see the economy improve from the deep contraction expected to occur in H1, so that by October voters feel the situation is improving and the future is brightening. Loosening vigilance against the virus and causing new outbreaks jeopardizes the first imperative, while maintaining or increasing vigilance jeopardizes the second part. Few presidents have survived a recession – Trump is asking to do what no president has done since Teddy Roosevelt in 1904. Our quantitative US election model will shift decisively against Trump in April when new data becomes available for state economic indicators (Chart 4). Chart 4Quantitative Election Model Will Show Trump Defeat When Q1 Data Arrive This implies that Trump should double down on the painful isolation measures today to try to secure a victory in the battle against the virus. But then the recession is deeper – and the buck still stops with him for the initial mismanagement of the outbreak. Of course, the virus is not Trump’s fault, but it is a nationwide health crisis, and neither he nor his party can defend their record on health care. True, Biden is a weak opponent. Nevertheless a pandemic and recession would favor any opposition candidate. The burden is on Trump to surprise the world a second time. If the public becomes accustomed to the virus and the 8% of GDP US stimulus package kicks in, Trump might just pull it off, which is why we still give him a 35% chance. The silver lining for financial markets is that the 29% selloff in US equities from their peak earlier this year has already largely discounted any negative implications of a Democratic ascendancy, such as tougher regulation and higher corporate and individual tax rates. The fact that the Democratic candidate is Biden, not democratic socialist Bernie Sanders, is important because the Democrats are highly likely to take the Senate if they take the White House. Biden would reduce some aspects of Trumpian populism and rehabilitate US alliances (e.g. with Europe). However, as with Trump, trade protectionism and great power competition with China and Russia will intensify. A major underrated risk to markets this year is that Trump, running as a “war president” and facing a recessionary defeat, could adopt an aggressive foreign policy or trade policy, especially once the coronavirus outbreak subsides and a scapegoat is sought. A clash with China – including proxy battles over North Korea or Taiwan – is not out of the question. Bottom Line: We are downgrading Trump’s chances of winning reelection. However, a Biden presidency is no longer market-negative because the worst is discounted. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com