Financial Markets
EM stocks should consider within a global equity portfolio. A pertinent asset allocation decision should be whether to be overweight, neutral or underweight EM within a global equity portfolio. In short, EM stocks should not be compared to EM credit or local…
Highlights Portfolio Strategy Chinese reflation, the ongoing global capex upcycle, and the Fed induced cap on the greenback with the knock-on effect of higher commodity prices, all signal that it still pays to overweight S&P cyclicals at the expense of S&P defensives. Sustained EM stock outperformance, a soft U.S. dollar, improving semi equipment operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside. Recent Changes There are no changes in the portfolio this week. Feature The SPX consolidated the 350 point advance since the Christmas Eve trough last week, setting the stage for a durable advance in the coming months. The Fed stood pat last Wednesday, and signaled a much more dovish policy stance going forward. Chairman Powell was clearly humbled by last December’s convulsing equity market and abrupt tightening in financial conditions. On that front, in the latest FOMC statement the explicit mention of patience is significant: “the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate”. A definitively more dovish Fed, which will help restrain the greenback, remains one of the three key catalysts for a durable equity market advance as we have highlighted in recent research.1 Encouragingly, our proprietary Equity Capitulation Indicator (ECI) has bottomed at two standard deviations below the historical mean (Chart 1). Over the past two decades, such a depressed level in our ECI has marked previous equity market troughs including the early-2016, 2011, 2002 and 1998 iterations. Only the GFC episode was lower, falling to three standard deviations below the mean. Clearly the late-December selling frenzy registers as another investor capitulation point and, if history at least rhymes, more gains are in store for the broad equity market. Chart 1Capitulation Chart 2 shows some other measures of breadth that corroborate our ECI’s message: investors hit the panic button and exited equities in droves in Q4. The upshot is that with selling exhausted, stocks can now stage a durable recovery as long as profits continue to expand. As a reminder, the continuation of the earnings juggernaut is the second key catalyst we identified two weeks ago.2 Midway through earnings season, SPX EPS have held up well with growth approaching 16%. For calendar 2019 we expect mid-single digit EPS growth in line with the signal from our macro driven S&P 500 EPS growth model (please refer to Chart 4 from the mid-January Weekly Publication).3 Chart 2Selling Is Exhausted A positive resolution to the U.S./China trade spat is the third catalyst we highlighted recently in order for equities to break out to fresh all-time highs.4 Related to this, China’s reflation efforts are equally important. On that front, news of quasi QE from the PBOC suggests that the Chinese authorities remain committed to injecting liquidity into their economy.5 Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (second panel, Chart 3). Chart 3Heed The PBoC Message Beyond the PBOC balance sheet expansion, the Chinese six-month credit impulse is also in a sling shot recovery. This Chinese credit backdrop is enticing and moves more or less in tandem with the SPX six-month impulse (top panel, Chart 4). Chart 4Reflating Away Two forces explain these relationships. First, China’s rise to become the second largest economy in the world along with its insatiable appetite for commodities and durable goods. Second, 40% of S&P 500 sales are international and an increasing share now originates in emerging markets in general and in China in particular. Keep in mind that the S&P cyclicals/defensives ratio is not only a high beta play on the SPX itself (top panel, Chart 3), but also an S&P global versus domestic gauge. Thus, both of these Chinese indicators also enjoy a positive correlation with the cyclicals vs. defensives tilt (bottom panels, Charts 3 & 4). With that in mind, this week we are drilling deeper into why we continue to prefer S&P cyclicals over S&P defensives and also highlight a highly cyclical index we went overweight in mid-December that has gone parabolic. Double Down On Cyclicals Vs. Defensives Early-October 2017 marks the initiation of our cyclical vs. defensive preference. Initially, this tilt jumped and peaked in mid-2018 returning 18% since inception. Since then, it has given up all of those gains and then some before troughing with the market on Christmas Eve, suffering a 6% drop since inception. Currently, the ratio has moved full circle and is back to where it was when we first recommended this portfolio bent (Chart 5). Chart 5Full Circle Should investors commit capital to this tilt at this stage of the cycle and given the current global macro backdrop? The short answer is yes. Charts 3 & 4 show that China’s reflation efforts and the fate of the S&P cyclicals/defensives ratio are closely correlated. In addition to the PBOC’s expanding balance sheet and rising Chinese credit impulse, Chinese monetary easing also benefits S&P cyclicals at the expense of S&P defensives. The Chinese reserve requirement ratio (RRR) has plummeted to the lowest point since the GFC and Chinese interest rates are also plumbing multi-year lows (RRR shown inverted, top panel, Chart 6). Chart 6China Flashing Green Tack on a resurgent currency with the CNY briefly breaking 6.70 with the U.S. dollar, and factors are falling into place for a playable rally in the cyclicals/defensive ratio. Likely, the Chinese are trying to appease President Trump by underpinning the yuan, but the Fed’s recent more dovish stance on interest rate hikes is also pushing the greenback lower. Taken together, this is a boon for the commodity exposed U.S. cyclicals that also garner a significant share of their sales from abroad (bottom panel, Chart 6). Commodity prices troughed last September, staying true to their leading properties and have been in recovery mode ever since (top panel, Chart 7). Now that the Fed has capped the U.S. dollar, more gains are in store for commodities and that is a boon for commodity producers’ top line growth prospects. Chart 7Capex Remains Healthy The demand backdrop is also enticing at the current stage of the business cycle, not only domestically, but also in China. Capital outlays remain upbeat and despite some recent turbulence, U.S. capex intentions are near multi-year highs (third panel, Chart 7). In China, recent piece meal fiscal easing announcements are far from negligible; already infrastructure spending has jumped after contracting late last year (second panel, Chart 7). Were these announcements to get supplemented by a bigger and more comprehensive package, then commodity-levered equities will excel further. A look at the relative balance sheet health of cyclicals versus defensives is revealing. Cyclicals are paying down debt and their cash flow continues to improve, still recovering from the late-2015/early 2016 global manufacturing recession. On the flipside, defensives are piling on debt. All four safe haven sectors have been degrading their balance sheets (relative net debt-to-EBITDA shown inverted, middle panel, Chart 8). Interest coverage sends a similar message: cyclicals are in excellent health both in absolute terms and compared with defensives (top panel, Chart 8). Chart 8B/S Improvement Continues Sell-side analysts have not yet taken notice of the macro tide that is turning in favor of cyclicals over defensives. Relative forward profit growth has collapsed to nil and net EPS revisions are at previous nadirs (fourth & fifth panels, Chart 9). Chart 9Oversold And Unloved In sum, if our thesis pans out that China will continue to reflate, global capex will remain vibrant, the greenback will drift lower (U.S. dollar shown inverted, top panel, Chart 9) courtesy of a dovish Fed that will push the broad commodity complex higher, then a significant valuation rerating looms for the cyclicals/defensives tilt (second panel, Chart 9). Bottom Line: Continue to the prefer S&P cyclicals to S&P defensives. We also reiterate our recent long S&P materials/short S&P utilities pair trade.6 Semi Equipment: Buy Into Strength In mid-December we boosted the S&P semi equipment index to overweight from underweight and since then this niche chip subindex has outperformed the broad market by 17%.7 Semi equipment stocks are high beta (bottom panel, Chart 10) and, while we are recommending to buy into strength, from a portfolio risk management perspective, today we are also setting a trailing stop at the 10% return mark in order to protect profits in this tactical (three-to-six month time horizon) position. Chart 10Buy Into Strength... These high-octane highly-cyclical tech stocks move in lockstep with other volatile asset classes. Rebounding emerging market (EM) stocks and FX confirm the S&P semi equipment breakout, and signal additional gains in the coming months (Chart 11). Not only do they share the high-beta status, but also semi equipment stocks garner 90% of their sales outside U.S. shores and 21% of total revenues come from China (please refer to Table 3 in our December 17, 2018 Weekly Report). Thus, the tight inverse correlation with the greenback and positive correlation with the outperforming EM stocks comes as no surprise (Chart 11). Chart 11...But Expect Heightened Vol Importantly, Taiwan and Korea are chip manufacturing hubs and semi equipment stocks are levered plays on the macro backdrops of these two economies. Recent data suggests that a turn is in the making in two key indicators in these countries, respectively. Taiwanese tech capex has likely troughed at a depressed level (middle panel. Chart 12), and Korean electronic components manufacturing capacity is now contracting for the first time since late-1997 (bottom panel, Chart 12). The latter is significant as this abrupt and sizable reining in of productive capacity will soon help arrest the fall in chip prices, which serves as an excellent pricing power proxy for the semi equipment industry. Chart 12Green Shoots Historically, relative forward profit growth and DRAM price momentum are joined at the hip. Therefore, were DRAM prices to exit deflation on the back of constrained Korean capacity, that would be a boon for relative profit prospects (second panel, Chart 13). Chart 13Analysts Have Thrown In The Towel Despite these marginal positive developments, sell-side analysts’ pessimism reigns supreme. Industry revenue and profit growth expectations trail the broad market by a wide margin and net EPS revisions remain as bad as they get. The upshot is that these lowered profit and sales growth bars will be easy to surpass in 2019 (Chart 13). With regard to technicals and valuations, oversold conditions bounced, as we posited in mid-December using history as a guide, but still remain depressed (middle panel, Chart 14). Valuations are compelling with the S&P semi equipment forward P/E trading at a roughly 40% discount to the overall market (fourth panel, Chart 13). Chart 14Technicals Remain Depressed Finally, earnings season has revealed that the bifurcated semiconductor market has staying power with semi equipment stocks (we are overweight) outperforming their ailing semi producer brethren (we remain underweight). Netting it out, sustained EM stock outperformance, a soft U.S. dollar, improving industry operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside. Bottom Line: Maintain the overweight stance in the S&P semi equipment index for a while longer, but set a trailing stop at the 10% relative return mark in order to protect profits in this tactical (three-to-six month time horizon) position. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX, KLAC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 2 Ibid. 3 Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 5 Please see Bloomberg Article, “PBOC Sets Up Swap Tool to Aid Bank Capital via Perpetual Bonds” dated January 24, 2019, available at www.bloomberg.com. 6 Please see BCA U.S. Equity Strategy Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 7 Please see BCA U.S. Equity Strategy Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps
Highlights Our non-consensus inflation and Fed views just got even more non-consensus: Media and sell-side commentators were quick to speculate about an end to the tightening cycle following Wednesday’s FOMC meeting, but we don’t see any basis for changing our stance. December and January have been a wild couple of months, … : It’s not unusual for a swing in one direction to be following by a swing in the other, but the S&P 500 went from the 2nd percentile in December to the 96th percentile in January. … and we’re turning to our equity checklist to regain our bearings: Checklists help us maintain a healthy distance from day-to-day swings and focus on the key swing factors. For now, we don’t think anything much has changed, but the scope for a repricing of the entire Treasury curve has gotten bigger: The wider the disparity between our terminal fed funds rate expectation and the market’s, the greater the potential for yields to readjust. We continue to believe markets are being complacent about inflation pressures; their presence will force the Fed off the sidelines and ultimately spell the end of the expansion. Feature Brutal arctic cold swept the Midwest and the Northeast Corridor last week as the polar vortex clamped down on Canada and the upper U.S. The weather didn’t do anything to cool investors’ revived ardor for stocks, however. After finally taking a break from its nearly uninterrupted four-week sprint from 2,350 to 2,670 (that’s nearly 14% in just 17 sessions), the S&P 500 hung around the 2,640 level that supported it repeatedly during its October, November and early December travails (Chart 1). Then came Wednesday’s FOMC statement and press conference, and the S&P even poked its head above the 2,700 level that would seem to present a fairly stiff challenge (Chart 2). Chart 12,640 Lent Support Once Again … Chart 2... Will The Next Round Number Offer A Little Resistance? What Goes On One minute born, one minute doomed/ One minute up, and one minute down/ What goes on in your mind?/ I think that I am falling down If the conditions were polar out of doors, they were bipolar on traders’ screens. As much as the clients we spoke with in January were initially skeptical about our inflation view (it’s not dead) and our corresponding Fed call (at least three or four more hikes in response to budding price pressures), several of them seemed to come around before the meeting was over. They had a lot harder time with the two-part investment conclusion that risk assets would rally while the Fed was on hold, and the economy and corporate profits were able to gain a footing, before rolling over once the data become strong enough to bring the Fed back off the sidelines. Why would investors buy into the temporary part one? We offered the view that the selloff had gone too far, and seemed to have been founded upon a premise that the Fed had either already tightened into a recession, or had gotten uncomfortably close to doing so. We expect that a Fed pause will reveal that the market’s neutral-rate estimate had been way too low. Once the economy shows signs of life, and consensus earnings estimates stop declining and begin to rise again, stocks will rise, spreads will compress, and investors will get back to chasing performance. The renewed fundamental vigor could even allow the Fed to hike rates another couple of times without inspiring a new bout of market indigestion. After this week, we are the ones scratching our heads. The committee’s post-meeting statement did change more than it has since the gradual, 25-bps-per-quarter pace of hikes took hold at the end of 2016, but early January’s procession of Fed speakers who repeated “patience” like a mantra already telegraphed an extended pause. We did not read all that much into the substitution of “will be patient as it determines … [appropriate] adjustments” for “some further gradual increases,” even if the media and the markets did. We will have more to say about the Fed’s balance sheet in subsequent research, but suffice it to say for now that we do not think it will be terribly impactful. Bottom Line: While we were surprised by the intensity of the reaction to last week’s FOMC meeting, it remains our view that the pause in the Fed’s monetary tightening campaign will give equities and corporate bonds an opportunity to rally near their late September levels. Checking And Re-Checking Our Views Among our favorite trading-desk maxims is the advice to plan your trade, and trade your plan. Checklists help us plan and help establish a repeatable process. Having a process to fall back on when rapid-fire decisions have to be made allows an investor to react to conditions as they arise without suffering from analysis paralysis, just like a seasoned trader. Checklists aren’t magic, but they can help an investor keep his/her bearings in the midst of market tides that seem to sweep all before them. Confronting the combination of December’s despondency and January’s euphoria, we return to the equity downgrade checklist we rolled out in mid-October, and last formally reviewed in mid-November. The checklist attempts to look out for threats on four fronts: a looming recession, which would bring the curtain down on the bull market; earnings pressure independent of a full-fledged recession; inflation pressures that could compel the Fed to tighten policy with a renewed sense of urgency; and unsustainably positive sentiment, which could set equities up for a fall. At the moment, only the recession category could arguably be said to be flashing yellow. Recession Watch All three factors in our simple recession indicator are moving in the wrong direction, but the yield curve is the only one at a potentially problematic level (Chart 3, top panel). It would not be a disaster for equities or the economy if the curve inverted – it is habitually early, inverting a year before a recession, on average, and six months before the S&P 500 peaks – but we don’t think it will until markets begin pricing in new rate hikes. Assuming the three-month rate won’t move until they do, the curve could only invert if the 10-year Treasury yield were to fall into the 2.40s (Chart 3, bottom panel), which would be incompatible with our constructive economic view. By the time the Fed resumes hiking, the curve should have gained some breathing room, as an economy strong enough to require further tightening merits a 10-year Treasury yield at or above 3%. Chart 3The Curve Isn’t Ready To Invert Just Yet Year-over-year growth in the leading economic indicator decelerated sharply over the last three months of 2018 (Chart 4). It is a ways away from contracting, however, and only a series of hefty month-over-month drops could make it do so this quarter. Our estimate of the equilibrium fed funds rate remains 50 bps above the 2.5% target rate and our model projects that equilibrium will rise throughout the rest of the year. If its 3.25-3.5% year-end estimate is on the money, the Fed would have to hike three or four more times by year end to provide the restrictive backdrop required for a recession. Chart 4Decelerating, But Not Contracting Checking the final item in the recession section of the checklist, a 33-basis-point rise in the three-month moving average of the unemployment rate, would require a sharp hiring slowdown and/or a significant pickup in labor force participation. The January employment report makes a drop-off in hiring appear improbable, and we are skeptical that the participation rate can keep rising in spite of the drag from retiring baby boomers. If the unemployment rate were to rise because of a rising part rate, however, it might well be more likely to extend the expansion than end it. Bottom Line: The elements of our recession indicator are deteriorating, albeit slowly. A recession may not be more than a year away, but we can’t see it occurring until the Fed turns more hawkish. Earnings Pressure We have repeatedly offered our view that the labor market is as tight as a drum in print, calls and meetings. That is good for the economy because it increases households’ ability to consume, but it will eventually squeeze profit margins and induce the Fed to remove monetary accommodation. Compensation costs shouldn’t hurt margins if they grow at or below the sum of the rate of price-level and productivity gains. If inflation grows at the Fed’s 2% target, and productivity maintains its rough 1.25% growth pace, compensation growth of 3.25% shouldn’t pose a problem, but gains exceeding 3.5% might become problematic. The total compensation series of the employment cost index ticked up to 2.9% in the fourth quarter, but an assault on 3.25-3.5% does not appear to be at hand (Chart 5). Chart 5Wages Aren’t Pressuring Margins Yet Dollar strength is a margin headwind for any company competing with multinationals, at home or abroad. After peaking in mid-November and mid-December, the DXY index has rolled over and is back to its early October level (Chart 6). The fourth-quarter blowout in spreads had us poised to check the “rising corporate yields” box, but there’s no need following last month’s reversal (Chart 7). The savings rate has recovered enough to support spending, and there’s currently no sign that consumers are about to pull back (Chart 8). We are monitoring conditions in emerging markets for spillover into the U.S., but the dollar’s decline and the broad recovery in risk assets worldwide have taken pressure off of EM corporate and sovereign borrowers. Chart 6The Dollar's Backed Off … Chart 7... And Bond Yields Have, Too Chart 8Ready, Willing And Able Bottom Line: None of our proxy indicators suggests that corporate earnings face meaningful near-term pressure, either from tighter margins or lower revenues. Inflation Pressures Inflation poses a threat to equities if it makes the Fed uncomfortable enough to pull the plug on the expansion to keep the economy from overheating, or if it makes investors uncomfortable enough to apply a significant haircut to earnings multiples. Given the Fed’s “symmetric” target, we don’t think it will get anxious about core PCE inflation unless it threatens to exceed 2.5% (Chart 9). The 10-year and 5-year-on-5-year TIPS inflation breakevens have slid in lockstep with oil prices, and are nowhere near the 2.3-2.5% range that is consistent with the Fed’s 2% core PCE target (Chart 10); they offer no hint that longer-run inflation expectations might become unanchored. CPI is the go-to inflation series for investors and the media, and with both headline and core hanging around 2%, it is well short of levels that would promote anxiety among the public (Chart 11). Chart 9Realized Inflation Remains Contained … Chart 10... And Expectations Have Only Fallen Chart 11Nothing To See Here Bottom Line: We expect that unnecessary fiscal stimulus and an extremely tight labor market will eventually produce inflation, but they’re not testing investors’ complacency yet. Overexuberance Runaway sentiment could spark a nasty correction if it sets the bar for expectations so high that stocks inevitably disappoint. BCA’s composite sentiment indicator, which aggregates the results from surveys of individual investors, professional investors and advisors, is at the lower end of its range, though not yet at levels that have often marked equity bottoms (Chart 12, bottom panel). Before falling with the S&P 500 last January, the share of consumers expecting stock prices to rise over the next twelve months had reached a level consistent with past peaks (Chart 13, bottom panel). It has since fallen to the lower end of its range, and would seem to suggest that investors had nearly given up on stocks when the January survey was taken. Chart 12Investor Sentiment Is Muted … Chart 13... And So Is The General Public’s Bottom Line: The fourth-quarter decline pushed investor sentiment from around the higher reaches of its historical range to a position well below the mean. From a contrarian perspective, washed-out sentiment could help extend the rally. Investment Implications Our equity downgrade checklist gives U.S. equities a clean bill of health. Although potential gains are lower now with the S&P 500 trading above 2,700 than they were when it was trading below 2,500 at the beginning of the year, we do not see a fundamental reason to downgrade equities from overweight. The multiple expansion required to produce a new closing high might be a stretch, but we believe the S&P 500 can advance well into the 2,800s. We upgraded corporate credit last week, and expect that spreads will narrow as the Fed stays on the sidelines. One should not expect new tights in spreads, but there is potential for investors to augment their coupon spreads with some modest capital appreciation. We dislike Treasuries, especially at longer maturities, even more than we did before last week’s bull flattening of the yield curve. With rate hikes fully priced out, the only way the 10-year Treasury yield could fall even further would be if the Fed cut rates, and that scenario is flatly incompatible with our assessment of the economy’s strength. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com
Feature The GAA DM Equity Country Allocation model is updated as of January 31st, 2019. The quant model slightly reduced the size of the underweight to the U.S. equities, but U.S. remains the largest underweight in the model and no directional changes among all the countries compared to last month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI world benchmark by 11 bp in January, with a 52 bps of outperformance from Level 2 model offset by a 17 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 118 bps, with Level 2 outperforming by 192 bps and level 1 outperforming by 40 bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, As advised in our October 2018 Special Alert, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understood would be in December but which we have not received yet. We thank you for your understanding. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com
Feature Half Way Back Since BCA went overweight global equities in late December, the MSCI ACWI index has rallied by 8% and the S&P 500 is back to only 8% off its September historical high. So far, this has been little more than a technical rally from the extreme oversold position in Q4. But with U.S. economic growth still resilient, earnings likely to grow healthily again this year (albeit more slowly than in 2018), and the valuation of risk assets (both equities and credit) no longer a headwind, we expect the rally to continue for some time, and so reiterate our overweight on equities. Recommendations True, there have been some disappointments in U.S. data in recent weeks. In particular, the December manufacturing ISM fell sharply to 54.3 from 59.3, raising fears that the U.S. is starting to decelerate in line with other regions (Chart 1). But the ISM may have been affected by the government shutdown and, overall, U.S. data still look solid, with the Citigroup Economic Surprise Index beginning to rebound, and stronger than in other regions (Chart 2). The residential housing market, which was exhibiting signs of stress last year, with existing home sales -6.4% YoY in December, is showing the first signs of stabilization, helped by mortgage interest rates that are now 50 BPs off their recent peak (Chart 3). Chart 1How Worrying Is The U.S. Slowdown? Chart 2U.S. Data Surprisingly Positive Chart 3Housing Market Should Stabilize In particular, the outlook for consumption looks healthy, with average hourly earnings growing at 3.3% YoY, consumer confidence close to an historic high, and the savings rate above 6%. Unsurprisingly, then, retail sales have boomed in recent months (Chart 4). Unless consumer confidence is dented by a repetition of the government shutdown or some other shock, consumption (68% of GDP, remember) should grow strongly this year. Add to this a residual positive impact of close to 0.5% of GDP coming from last year’s fiscal stimulus, and it is hard to imagine the U.S. going into recession over the next 12 months. Chart 4Consumption Booming The Fed will probably go on hold for now, however, given the market jitters in Q4. We are likely back to a situation like that in 2015-2016, where the Fed Policy Feedback Loop becomes the key factor for markets (Chart 5). When financial conditions tighten, with stock prices falling and the dollar appreciating, the Fed turns more dovish. However, this triggers a rally in risk assets and loosens financial conditions, allowing the Fed to start hiking again. With the tightening in financial conditions over the past six months, the Fed is likely to err on the side of caution for now (Chart 6). However, if our macro view is correct – and as inflation starts to pick up again after April, partly due to the base effect – the Fed will want to continue withdrawing accommodation over the course of this year. The Fed Funds Rate, at around 2.4% is still two hikes below what the FOMC sees as the neutral level of interest rates (the 2.8% terminal rate in the FOMC dots). We see the Fed, therefore, raising rates in June and perhaps hiking two or even three times this year. By contrast, the futures market assigns only a 25% probability of even one rate hike this year, and is even pricing in a small probability of a cut. Chart 6Tighter Conditions Mean More Cautious Fed Clearly, there are plenty of risks to the scenario of growth continuing. But those in the hands of President Trump, especially the trade war with China and the fight over funding of the wall on the border with Mexico, we don’t see as being serious impediments. Trump is fully aware that he is unlikely to be reelected in November 2020 if the U.S. is in recession by then. Every incumbent U.S. president since World War Two who fought for reelection during a recession failed to be reelected (Chart 7). The view of BCA’s geopolitical strategists, therefore, is that the White House and Congressional Democrats will agree to concessions to end the shutdown before the end of the current three-week stop-gap period. Less likely, Trump will declare a national emergency that will cause much controversy but have little impact on the economy. Our strategists also argue that there is a 45% probability of trade negotiations with China producing a result (at least a short-term one the president can boast about) before the March 1 deadline, and a further 25% probability of the deadline being extended without further sanctions being imposed.1 Chart 7Trump Won't Be Reelected In A Recession Equities: Analysts have become overly pessimistic about the earnings outlook for this year, cutting 2019 U.S. EPS growth to 7% (and only 2% YoY in Q1). Our top-down model (based on, admittedly optimistic, U.S. growth assumptions, but also headwinds from a stronger dollar) indicates 12% growth. If analysts are forced to revise up their numbers as better earnings come through, that should be a catalyst for further equity performance (Chart 8). We continue to prefer U.S. over European equities. The steady slowdown in European growth over the past 12 months has not yet bottomed, banks in Europe remain troubled, the earnings picture is less positive, and valuations relative to the U.S. are not especially attractive. We also remain underweight on EM equities: they may produce a positive return in a risk-on environment, but we see them underperforming DM as rising U.S. interest rates and a stronger USD put pressure on EM borrowers with excess foreign-currency debt. Chart 8Analysts Have Overdone Downward Revisions Fixed Income: The recent fall in U.S. Treasury yields was mainly caused by the inflation expectation component, itself very sensitive (if rather illogically so) to the oil price (Chart 9). As the oil price recovers (see below), inflation picks up moderately, and the Fed hikes by more than the market expects, we see the 10-year Treasury yield rising to 3.5% during the course of the year. BCA’s fixed-income strategists recently raised their recommendation on global credit to overweight, given more attractive spreads and the likelihood that the Fed will be on hold for the next six months.2 Their recommendation is for 3-6 months, and the Fed restarting the hiking cycle, say in June, might terminate the positive story. We are following their lead, by raising both high-yield and investment-grade bonds to overweight within the (underweight) fixed-income asset class. That means we are neutral credit in the overall portfolio. We would warn, though, that this is a somewhat short-term call: we still prefer equities as a way to play the continuing risk-on rally. Given the high level of U.S. corporate leverage, and the over-owned nature of the credit market, this is likely to be an asset class that performs very poorly in the next recession (Chart 10). Chart 9Inflation Expectations Should Recover Chart 10Corporate Leverage Is A Concern Currencies: Currencies will continue to be driven by relative monetary policy. With the growth desynchronization between the U.S. and other DMs set to continue (to a degree), we see modest further USD appreciation this year. The Fed (as argued above) will probably hike more than the market expects. But, given slow European growth, the ECB is unlikely to be able to hike in Q4 this year, as it currently is guiding for and the futures market implies (Chart 11). We see the ECB reopening the Targeted Long-Term Repo Facility (TLTRO), which expires soon. Italy and Spain have been big borrowers from this facility, and bank loan growth is likely to slow as it ends (Chart 12). A renewed TLRTO would be seen as a dovish move. Tighter dollar liquidity conditions also point to a stronger USD. U.S. credit growth continues to accelerate (to 12% YoY – Chart 13) in an environment where the monetary policy has tightened: credit growth is outpacing U.S. money supply growth by 7%. Historically this has been negative for global growth (mainly because the deteriorating liquidity is a problem for EM dollar borrowers) and positive for the dollar (Chart 14).3 Chart 11Can ECB Really Hike In 2019? Chart 13...U.S. Loan Growth Accelerating... Chart 14... Which Will Tighten Liquidity Further Commodities: The supply/demand situation for oil should improve over coming months. With Saudi Arabia and Russia committed to cut supply by 1.2 million barrels/day, U.S. shale production growth slowing given the low one-year forward price for WTI, Canada reducing production, and Venezuela on the verge of collapse (which alone could remove 700-800k b/d from the market), our energy strategists see the crude oil balance in deficit over the next four quarters (Chart 15). Given this, they forecast Brent crude rebounding to above $80 a barrel. Other commodity prices are mostly driven by Chinese demand. We see China continuing to slow, until the accumulated effects of its fiscal and mild monetary stimulus start to come through in H2 and stabilize growth. Our analysis suggests that China remains very disciplined about the size and nature of its stimulus: it is not turning on the liquidity taps as it did in early 2016. Bank loan growth has stabilized, but shadow banking activity continues to contract, as the authorities persist with their crackdown and their emphasis on deleveraging (Chart 16). Industrial commodities prices are therefore likely to weaken over the next six months. Chart 15Oil Balance In Deficit This Year Chart 16China Sticking To Credit Crackdown Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation Footnotes 1 Please see Geopolitical Strategy Weekly Report, “So Donald Trump Cares About Stocks, Eh?”, dated 9 January 2019, available at gps.bcaresearch.com 2 Please see Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis,” dated 15 January 2019, available at gfis.bcaresearch.com 3 For a detailed explanation, please see Foreign Exchange Strategy Weekly Report, “Global Liquidity Trends Support The Dollar, But…,” dated 25 January 2019, available at fes.bcaresearch.com
The hiatus in the Fed’s rates-normalization policy in 1H19 in the wake of its capitulation to financial markets, supports our bullish view on gold prices, as it raises the risk of an inflation overshoot later this year. Per the Fed’s dual mandate, inflation and employment gauges are signaling the need for tighter policy, according to BCA’s proprietary Fed Monitor. The pause in hiking fed funds raises the likelihood the Fed will find itself behind the inflation curve, as the economy enters a late-cycle phase. Gold will outperform other commodities and equities in this phase. We remain long gold as a portfolio hedge. Highlights Energy: The U.S. imposed sanctions on state-owned Petróleos de Venezuela, S.A. (PDVSA), including a ban on the company’s Houston-based Citgo remitting earnings back to the parent company. This raises the likelihood production and exports will fall sharply as we expect. Separately, Saudi Energy Minister Khalid al-Falih said the country will reduce output below its recently agreed 10.3mm b/d cap in 1H19, in line with our own balances expectation.1 Base Metals/Bulks: Neutral. Iron ore prices likely will continue to move higher, following the collapse of a wet-processing dam at Vale’s Córrego do Feijão mine. The company suffered a similar breach at its Samarco mine in March 2016, which still has not re-opened. Output will fall, if it follows through with additional dam closures. Precious Metals: Neutral. Gold prices will continue to move higher, as the Fed’s near-term capitulation on its rates-normalization policy raises the odds the U.S. central bank will find itself behind the inflation curve. (See below.) Ags/Softs: Underweight. USDA reported soybeans inspected for export to China during the week ended January 24 accounted for close to 37% of the total beans inspected. This made China the No. 1 importer of American soybeans again. Feature In February 2018, we wrote that “price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here.” In line with this expectation, we suggested remaining long gold as a portfolio diversifier and hedge against mounting equity risks. This turned out to be an accurate call. Despite losing 8.4% between January and September 2018 because of an aggressive Fed, gold rose by 7.6% in 4Q18 amid the rising equity volatility and ended the year down a minor -1.5% compared to -6.2%, -11.2% and -7.1% for the S&P 500, global equities and the CRB commodity index. This reflects the convexity in gold returns and is the reason we favored gold in 2018. Gold returns are not simply a function of the U.S. dollar and real interest rates. As highlighted in our 2019 Key Views report last December, in mature economic cycles, gold’s ability to hedge against equity and inflation risks dominate its price formation, while its correlation with the U.S. Treasury yields diminishes (Chart of the Week).2 Chart of the WeekGold's Correlation With U.S. Rates Declines As The Cycle Matures As the current cycle extends to 2019, the skewness in gold return will prove profitable. The Fed’s retreat on its quarterly rate-hike cycle only adds to our positive view, as it increases the probability the U.S. central bank falls behind the curve. Stay long gold as a portfolio hedge. Fed’s Short-Term Capitulation Strengthens Our View The recent downward revision in the Fed’s rate-hike path reinforces our positive stance on gold prices, as risks of an overshoot in inflation rises. The dichotomy in U.S. vs. rest of the world growth puts the Fed in a difficult position. The current capitulation was mainly driven by tightening financial conditions – chiefly, the rising U.S. dollar, declining stock prices, and widening credit spreads. However, under the Fed’s dual mandate, inflation and employment still are signaling “tightening-required” per BCA Research’s Fed Monitor, a model maintained by our U.S. Bond strategists (Chart 2). Since economic growth cannot remain above-trend indefinitely, short-term productive capacity constraints (i.e. capital and labor factors of production) are already binding and will force the Fed to raise rates later this year as inflation creeps up. Chart 2Growth And Inflation Signal Tighter Money Is Required As it reaffirms its data dependence, the Fed is opening the door to falling behind the inflation curve, given inflation is a lagging indicator of the price pressures that are building up in the economy (Chart 3). As a result, we expect gold’s ability to hedge against inflation will support its price in 2H19. Chart 3Inflationary Pressure Will Rise In 2019 Short-term, a Fed pause also supports gold by readjusting investors’ expectations regarding the U.S. dollar and real interest rates lower. Our bond strategists identified two previous periods where similar conditions led to a false start in the Fed hiking cycle, 1997 and 2015. In both cases, the Fed’s capitulation led to a reversal in gold’s downward price trajectory, as the market perceived the central bank was keeping its short-term policy rate at a level that was inconsistent with the so-called R-star rate or natural rate of interest – i.e., “the real interest rate expected to prevail when the economy is at full strength” (Chart 4).3 Chart 4AGold Price's Trajectory Reversed In 1997... Chart 4B Using a conceptual four-quadrant framework developed by our colleagues at The Bank Credit Analyst to describe the Fed’s behavior, we currently believe the outcome with the highest probability of being realized by the Fed’s capitulation is Policy Mistake 2 (Table 1, lower right quadrant). If we’re right, this raises the odds of an inflation overshoot above the Fed’s 2% target later this year.4 Table 1Four Fed Policy Scenarios This is not a foregone conclusion. However, generally speaking, the higher the inflation uncertainty and the higher the perception the Fed will fall behind the curve, the higher gold is bid up. Recent price action seems to corroborate this. Chart 5 shows that the recent downward revision in the median long-term fed funds rate projection coincides with a rise in gold prices. At present, gold investors are signaling that the fed funds rate is below the neutral rate consistent with R-star. Chart 5Gold Markets Signal Monetary Policy Is Accommodative Gold And The U.S. Economic Cycle Gold prices are difficult to model and predict, given the collection of time-varying, often conflicting, components determining their evolution. Its core determinants change as we move through the economic cycle. In their current late-cycle environment, inflation and equity risks – i.e., fears of a sharp correction – usually gain in importance. In this report, we characterize the market’s late-cycle phase using two metrics: (1) the fed funds rate relative to R-star, (2) the phase of the yield curve cycle.5 We have already discussed (1) in our outlook and found that when the fed funds rate is rising yet still below the estimate of R-star, gold returns are highly skewed to the upside (Chart 6).6 For (2), we compared the yellow metal’s return to other assets returns in different phases of the U.S. Treasury yield curve’s evolution. We define these yield-curve phases as follow: Phase 1: Normal (i.e., positively sloped: 10-year rates are greater than 3-month rates). The 3-month/10-year treasury slope is above 75 bps. Phase 2: On its way to flattening and returning to normal. The 3-month/10-year Treasury slope is between 0 bps and 75 bps. We divide this in two sub-phases: (a) steepening, and (b) flattening. Phase 3: Inverted (i.e., negatively sloped). The 3-month/10-year Treasury slopes is below 0 bps (Chart 7).7 Chart 7Phases Of The Yield Curve Cycle We found that: first, DM and EM equities are the best performers in the group we looked at during Phase 1, when the slope of the yield curve is steep (above 75 bps). Second, there is wide difference between the steepening and flattening sections of Phase 2. EM equities and copper experience the largest rebound once the slope’s curve steepens from below zero. Lastly, gold performs best in the flattening section of Phase 2 and, critically, it outperforms oil, copper, broad commodity indices and equities (Table 2). Table 2Gold Returns Are Positive When The Yield Curve’s Slope Flattens Our U.S. Investment and Bond Strategists believe the Fed’s policy rate will remain in the below-r-star-and-rising range, and in Phase 2 of the yield curve cycle for most of 2019. We agree, and believe our analysis indicates gold prices will increase this year on the back of these factors. Recession Fear And Equity Risks Will Drive Gold For most of 2018, investor sentiment and positioning were primarily determined by the U.S. dollar and real rates. As these variables rose last year, investors’ sentiment and positioning turned overly bearish; this pushed our Gold Composite Indicator in the oversold territory (Chart 8).8 In our view, the other (important) drivers of gold prices were ignored during that period. The end-of-year equity selloff led to a reshuffle of the core determinants of the yellow metal’s price, pushing the equity risk factor higher on the list of variables explaining its price. Chart 8Sentiment Collapsed In 1H18 Chart 9 shows gold and the U.S. equity risk premium disconnected in 2018, until the October equity selloff. In general, these variables are positively linked. When risk aversion is elevated, investors demand higher compensations for holding risky assets, and increase their demand for safe-haven assets. This pushes up both the equity risk premium and gold prices. Chart 9Gold And Equity Risk Premium Correlation Picked Up Gold’s performance in 4Q18 supports our recommendation for holding it as a portfolio diversifier in 2018, and why we continue to do so this year (Chart 10). Separately, our U.S. dollar and rates-only model moved up recently, easing the downward pressure on gold (Chart 11). While we believe these two variables’ marginal impact diminished since 4Q18, they are included in our gold “fair-value” model, which currently indicates it is fairly valued and that its support remains intact. Chart 11Upside Pressures Are Building Bottom Line: The Fed’s near-term capitulation raises the odds the U.S. economy will experience an inflation overshoot. Our fair-value model also is supportive of gold prices. We remain long as a diversification and portfolio hedge. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1 Please see “Saudis Pledge Deeper Oil Cuts in February Under OPEC+ Deal,” published by bloomberg.com January 29, 2019. See also “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone” published January 24, 2019, for our latest supply-demand balances and price forecasts. It is available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 3 Please see John C. Williams’s remarks delivered to the Economic Club of Minnesota May 15, 2018, entitled “The Future Fortunes of R-Star: Are They Really Rising?” Williams was president and CEO of the Federal Reserve Bank of San Francisco at the time, and now has the same role at the NY Fed.. We explore this further below. See also BCA Research’s U.S. Bond Strategy Weekly Report titled “An Oasis Of Prosperity,” published August 21, 2018. It is available at usb.bcaresearch.com. 4 Please see BCA Research’s The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. It is available at bca.bcaresearch.com. 5 The San Francisco Fed defines R-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target. R-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed. Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 6 We presented this analysis in BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 7 For a similar analysis applied to different asset classes, please see BCA Research’s U.S. Bond Strategy Weekly Report titled “2019 Key Views: Implication For U.S. Fixed Income,” published December 11, 2018, and The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. These reports are available at usb.bcaresearch.com and bca.bcaresearch.com. Our approach is slightly different from our colleagues’ methodology. We used a threshold of 75 bps instead of 50 bps in order to increase the sample size of the Phase 2, flattening section. This improves the accuracy of using the average as our main descriptive statistic. Note that the yield curve can remain inverted for some time before a recession occurs, this explains why equity returns are positive in Phase 3 (curve inversion). 8 Our Gold Composite Indicator has three components: (1) Sentiment, (2) Speculative positioning and (3) Technical. It is meant to assess if there is any mismatch between our fundamental analysis and investors’ sentiment and expectations. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Commodity Prices and Plays Reference Table Summary Of Trades Closed In 2018
Highlights We advocate implementing asset allocation not across EM assets, but rather relative to their DM counterparts. EM stocks should be part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is beneficial. We continue recommending below benchmark allocation to EM equities, credit and local bonds. The rebound in various EM financial markets is reaching a critical technical level where it will either stop or, if broken, will carry on for some time. In Peru, further decline in industrial metals prices and ongoing involuntary monetary tightening bode ill for share prices; continue underweighting. Feature We frequently receive questions from our clients on how they should be positioning their portfolios within EM asset classes such as equities, EM U.S. dollar bonds (credit markets) and local currency government bonds – whether they should be overweight EM stocks versus EM credit markets and domestic bonds, or vice versa. While BCA’s Emerging Markets Strategy service covers EM stocks, credit and domestic bonds and exchange rates, we do not make asset allocation calls between EM equities, EM credit and local currency bonds. The reason is very simple: in a risk-on market, EM equities always outperform EM credit and local bonds, and in a risk-off environment, stocks always underperform fixed income (Chart I-1). Chart I-1EM Stocks Versus EM Credit And Local Bonds With respect to the relative performance of EM credit markets versus domestic bonds, the performance of EM currencies is key. A large portion of total returns on EM local currency bonds comes from exchange rates (Chart I-2). Hence, when EM currencies appreciate, domestic bonds outperform EM credit markets (U.S. dollar bonds), and vice versa (Chart I-3). Chart I-2EM Currencies Are Key To EM Local Bonds Returns Chart I-3EM Local Bonds Versus EM Credit: It Is A Currency Call For investors willing to allocate across EM asset classes, a directional view on financial markets should drive allocation between equities and fixed-income. In rallies, equities should be favored, while during risk-off periods, fixed income should be preferred. It follows that investors should overweight EM credit markets versus domestic bonds when EM currencies depreciate, and tilt allocation toward local currency bonds versus EM credit markets when EM exchange rates appreciate. Recommended Approach To Asset Allocation We advocate implementing asset allocation not across EM assets, but relative to their DM counterparts: EM stocks should be part of a global equity portfolio. A pertinent asset allocation decision should be whether to be overweight, neutral or underweight EM within a global equity portfolio. In short, EM stocks should not be compared with EM credit or local bonds, but rather versus their DM counterparts. Having mentioned that, we are maintaining our underweight recommendation on EM within a global equity portfolio for now. EM sovereign and corporate credit should be part of a global credit portfolio – i.e., asset allocators should compare them with other credit instruments such as U.S. and European corporate bonds. Total returns on EM U.S. dollar-denominated sovereign and corporate bonds can be deconstructed into the total return on U.S. Treasurys and the excess return of these EM bonds over U.S. Treasurys. Investors can obtain exposure to U.S. Treasurys by owning them outright. Hence, the unique feature of EM sovereign and corporate bonds is their spreads over U.S. government bonds. EM sovereign and corporate bond spreads over U.S. Treasurys reflect issuers' ability and willingness to pay. Thereby, investors should treat EM dollar-denominated bonds as a pure credit product and this asset class should be part of a global credit portfolio. At the moment, we recommend asset allocators underweight EM sovereign and corporate credit versus U.S./DM corporate credit, in line with our short EM equities/long U.S./DM equities strategy (Chart I-4). Within credit markets, EM investment-grade and high-yield credit should be compared with their peers in U.S./DM, respectively. The reason we are negative on EM credit markets relative to the U.S. and DM universe is that the majority of EM sovereign and corporate bond issuers in Latin America and the EMEA are commodity producers. Hence, their revenues fluctuate with commodity prices, and their spreads should be under upward pressure as commodity prices drop further and EM currencies correspondingly depreciate (Chart I-5). Chart I-4EM Credit Versus U.S. Credit Chart I-5EM Credit Spreads Are Sensitive To Commodities And EM Currencies In the meantime, Chinese property companies, financials and industrials/materials remain the largest issuers of corporate debt in emerging Asia. Specifically, U.S. dollar bonds issued by Chinese companies account for 32% of the Barclay’s overall EM USD Credit index and 56% of the EM Asia USD Credit index. Crucially, Chinese corporate credit is essential to trends in emerging Asian credit markets. We are bearish on the fundamentals of Chinese corporate bond issuers due to our negative view on Chinese capital spending, particularly in the real estate sector. With respect to EM local-currency government bonds, this is an entirely different asset class with returns often uncorrelated with any other asset. Table 1 shows that EM local currency bond returns in U.S. dollars have a low correlation with most other asset classes. Therefore, adding EM local-currency bonds to a global multi-asset class portfolio will help achieve risk diversification provided an expectation of a positive return on this asset class in the long run. EM domestic bond returns are comprised of local yield carry and capital gains/losses, as well as currency appreciation/depreciation. Business cycles and monetary policies could from time to time be desynchronized across EM countries, and EM currencies could also at times diverge. In short, all of this will add idiosyncratic risk to any global multi-asset class portfolio and push out the portfolio’s efficient frontier – i.e., the portfolio could achieve higher returns for the same amount of risk (volatility). The exposure to EM local currency bonds should be altered according to the view on this asset’s absolute performance. Presently, we recommend below benchmark allocation to this asset class because we expect the majority of EM currencies to depreciate versus the U.S. dollar, the euro and the Japanese yen. The key driver of EM currencies is not U.S. interest rates but the global business cycle (Chart I-6). Odds are high that global trade will continue disappointing as China’s growth weakens further. This will lead to tumbling EM currencies and outflows from high-yielding EM domestic bonds. Chart I-6What Drive EM Currencies Within an EM local currency bond portfolio, our recommended overweights are Mexico, Brazil, Chile, Russia, central Europe, Thailand and Korea. The list of our overweights and underweight across EM stocks, credit markets, local bonds and currencies is always published at the end of our reports. Bottom Line: Global asset allocation should treat EM stocks as part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. In turn, EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is recommended given an expectation of a positive return in the long run. A Make It Or Break It Juncture The rebound in various EM financial market segments is reaching a critical technical level. At that point, it will either reverse, or will break through and carry on the upward momentum for some time: EM share prices have troughed at their three-year moving averages but are now facing resistance at their 200-day moving averages (Chart I-7). Failure to break above their 200-day moving averages would signal higher risks of a major breakdown. Conversely, a decisive break above their 200-day moving averages would suggest that the recent rebound has much farther to go. Our Risk-on versus Safe-Haven currency ratio has found support at its 6-year moving average but is now facing resistance at its 200-day moving average (Chart I-8, top panel). This ratio is highly correlated with EM share prices, and its breakout or breakdown will be an important signal for the direction of EM, commodities and global cyclical assets in general (Chart I-8, bottom panel). Chart I-7EM Share Prices Are Between Support And Resistance Chart I-8This Currency Ratio Is Key To EM And Commodities Trend A relapse from this level would be a major bearish signal, as it would confirm the formation of a head-and-shoulders pattern in this currency ratio. The latter would entail a major breakdown. A number of EM currencies such as ZAR, MXN, KRW, TWD, MYR and CNY are at a critical juncture (Chart I-9). A breakout or failure to do so will entail a major move. Chart I-9AEM Exchange Rates Are At Make It Or Break It Juncture Chart I-9BEM Exchange Rates Are At Make It Or Break It Juncture Meanwhile, the BRL may be forming an inverted head-and-shoulders pattern (Chart I-10). Hence, continuous BRL strength would signal rising odds of an extension to the rally in Brazilian markets. Chart I-10The Brazilian Real: An Inverted Head-And-Shoulder? Finally, industrial metals prices have failed to rebound and appear to be forming a head-and-shoulders formation. This pattern foreshadows considerable downside from current levels (Chart I-11, top panel). In the meantime, oil prices have bounced off their long-term moving average and might have a bit more room to advance before hitting a major resistance between $65-$70 for Brent (Chart I-11, bottom panel). Bottom Line: Our fundamental view on EM risk assets remains negative due to our expectations of further weakness in China’s growth. However, we are monitoring various signals and indicators to gauge whether the latest rebound can last much longer, which would cause us to change our stance tactically. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: Involuntary Monetary Tightening Peru’s central bank is tightly managing the country’s exchange rate. As a result, it has little control over local interest rates. The Impossible Trinity thesis stipulates that in a country that has an open capital account, the central bank can control either interest rates or the exchange rate, not both simultaneously. Provided Peru has an open capital account, its central bank can have tight control over either the exchange rate or interest rates. So long as the central bank focuses on exchange rate stability, local interest rates will fluctuate with its balance of payments (BoP). Therefore, Peru’s credit cycle and hence domestic demand swings and bank share prices are driven by BoP (Chart II-1). Negative BoP dynamics – shrinking inflow of U.S. dollars – causes local interest rates to move higher while a positive BoP leads to lower borrowing costs (Chart II-2). Chart II-1Commodities Prices & Bank Stocks Are Correlated Chart II-2Trade Balance Drives Interbank Rates We expect negative BoP dynamics for Peru going forward – metals prices will drop as China’s growth continues to decelerate, and EM countries will likely experience a bout of portfolio capital outflows. If Peru’s central bank continues to favor limited currency depreciation, its interbank rates will march higher. Chart II-3 illustrates that the pace of net foreign exchange reserves accumulation often negatively correlates with interbank rates and leads loan growth by around 12 months (Chart II-4). Chart II-3Peruvian Local Rates Have Risen Chart II-4Peru: Bank Loan Growth Will Relapse When the monetary authorities purchase foreign exchange reserves, they inject local currency excess reserves (liquidity) into the banking system. More plentiful banking system liquidity drives down interbank rates and allows banks to expand credit, boosting domestic demand. The reverse also holds true. The Peruvian central bank was able to mitigate upside in local rates amid the negative terms-of-trade shock in 2014-‘15 by conducting foreign currency swaps with banks. This swap led to an injection of local currency reserves into the system. Currently these swaps are being unwound and banks’ excess reserves are dwindling, putting upward pressure on local rates. Hence, the rise in interbank rates in the past 12 months has not only been due to negative terms of trade but also due to the expiration of foreign currency swaps. As metals prices drop and exports contraction deepens, the currency will come under selling pressure (Chart II-5). To prevent the currency from depreciating considerably, the central bank has to tighten liquidity, producing higher interbank rates. The latter bodes ill for domestic demand. Chart II-5Money Growth Is Contingent On Trade Bottom Line: We continue to underweight the Peruvian bourse because of its exposure to mining companies and banks. The former is at risk from falling industrial metals prices, while the latter will suffer from rising interbank rates. Within the mining sector, gold and silver stocks should outperform copper producers because we foresee more downside in industrial metals than precious metals prices. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. The two main tail-risks are a messy Brexit and financial market volatility, but these are not our central case. Stay overweight the Eurostoxx50 versus the S&P500. Go underweight German bunds. Go overweight the German DAX versus German long-dated bunds. Add the German DAX as a new long position to the existing long basket holdings in France, Ireland and Switzerland. Maintain the short basket holdings in Norway and Denmark. Feature Chart of the WeekThe Underperformance Of German Equities Vs. German Bonds Is At A Euro Debt Crisis Extreme! Economies do not grow in straight lines. Rather, the process of economic expansion is a never-ending ebb and flow, creating clockwork-like oscillations in economic activity. As a perfect illustration, the growth in the euro area wage bill has trended higher through the past five years and is now running at very healthy 4 percent clip. Yet this strong uptrend has been interspersed with wobbles that have occurred with a remarkable regularity (Chart I-2). Chart I-2Economies Have Regular Wobbles... The recent setback in euro area activity has spooked some economy watchers. Even the ECB has just moved its risk assessment surrounding the growth outlook to the downside. But the downgrade was largely a result of its ‘data-dependency’ which, by definition, is always backward looking. This meant that the downgrade had a negligible effect on the financial markets which are always forward looking. For the markets, there is a much more important issue: is the recent setback the start of something serious, or can we expect a bounce back? The Setback The explanation for the regular wobbles in euro area growth comes from the oscillations in global economic activity (Chart I-3). But here we need to be wary of a potentially circular argument. As Europe is a dominant component of the global economy, euro area domestic demand setbacks could themselves be the root cause of the over-arching global growth oscillations. Chart I-3...Because Of Clockwork-Like Oscillations In Global Economic Activity Recently, Italy and Germany have suffered idiosyncratic ‘country and sector specific’ setbacks. The spat between Rome and Brussels over Italy’s 2019 budget caused Italian bond yields to soar and Italian bank lending to contract viciously (Chart I-4). Meanwhile, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German vehicle exports suffered a €20 billion hit which shaved 0.6 percent from the €3.4 trillion German economy (Chart I-5). Chart I-4Italian Bank Lending Contracted Viciously, But Will Now Recover Chart I-5German Auto Exports Plunged, But Will Now Recover Despite all of this, the epicentre of the 2018 growth setback was not inside Europe, but outside Europe. The ECB correctly blames the recent down-oscillation not on domestic causes, but on softer external demand, specifically “vulnerabilities in emerging markets”. The central bank argues that once there is clarity on the exports and the trade sector, much of the euro area’s weakness will wash out. Another very important driver of European growth oscillations is the oil price. In recent years, the growth in GDP in excess of wages has perfectly and inversely tracked oscillations in the oil price (Chart I-6). The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending. Chart I-6Oil: Another Driver Of European Growth Somewhat contrary to received wisdom, one thing that does not generally drive euro area growth oscillations is the euro exchange rate. When the euro weakens, it does of course make the euro area’s exporters more competitive. But working against this, a weaker euro also raises the prices of imported energy and food, thereby squeezing euro area consumers’ real incomes. And vice-versa when the euro strengthens. Hence, while the euro’s moves do create growth winners and losers within the euro area, these tend to cancel out at the aggregate economy level. The Bounce Back The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. Regarding the vulnerabilities in emerging markets, many ECB governors argue that “everything we know says that the Chinese government is taking strong measures to address its slowdown”. Recent improvements in China’s monetary statistics provide strong evidence for this view (Chart I-7). Chart I-76-Month Credit Impulses Are Bouncing Back Everywhere Meanwhile, credit growth in the euro area itself is also accelerating, albeit modestly. This is hardly surprising given that financing conditions are very favourable. Even though the ECB has done nothing to policy interest rates, more dovish forward guidance has effectively made euro area monetary policy more accommodative: since October, core euro area 10-year bond yields are down 40 bps. And with banks’ balance sheets stronger, the ECB claims “the conditions for a continuation of credit to the economy are in place.” Over the same three month period, the crude oil price has plunged by 35 percent (Chart I-8). Draghi confirmed our observation above: lower energy prices support real disposable income for euro area households. Chart I-8Double Boost: Lower Bond Yields And Lower Oil Draghi also pointed out another positive impulse: fiscal policy in the euro area has now flipped from contractionary to slightly expansionary. As regards the idiosyncratic sector specific setbacks, the Italian 10-year BTP yield has unwound its budget spat spike, and is down 100 bps since October. It follows that Italian bank credit growth is likely to recover. And Draghi explained that “the specific episode of the car industry in Germany will soon wash out because there is going to be a rebound in the sector.” Still, two significant tail-risks could smother the bounce back: Uncertainties related to geopolitical factors and the threat of protectionism, specifically, a messy Brexit. Financial market volatility. The Investment Implications Our central case is that the tail-risks do not materialise. And that the recent combination of more favourable financing conditions in the euro area and globally, lower energy prices, fiscal thrust, and the removal of specific setbacks in Italy and Germany should engineer some sort of growth bounce back in the euro area. One important implication is that the strong recent rally in German bunds is close to exhaustion, and even vulnerable to a short-term retracement. This is supported by our trusted technical indicator warning of an imminent liquidity shortage and a corrective price reversal (Chart I-9). Go underweight German bunds on a short term horizon. Chart I-9The Rally In The German Bund Is Exhausted A mirror-image implication is that the underperformance of the German DAX relative to German long-dated bunds is now at euro debt crisis extremes (Chart I-1 and Chart I-10). This relative performance also appears technically exhausted and ripe for a reversal. As an asset allocation position, go overweight the DAX versus German long-dated bunds on a tactical. Chart I-10The Extreme Underperformance Of The DAX Will Reverse In line with the growth rebound thesis, stock market selection – through the underlying sector exposures – should now have a modest tilt towards cyclicality. Stay overweight the Eurostoxx50 versus the S&P500. Within Europe, our current long positions in France, Ireland, and Switzerland combined with short positions in Norway and Denmark do provide the required tilt towards cyclicality. Nevertheless, today we are adding the oversold German DAX to our long stock markets basket. Fractal Trading System* In line with the fundamentals-based arguments in the main body of this report, this week’s recommended trade is to go long the DAX versus the 30-year bund. Set a profit target of 2.5 percent with a symmetrical stop-loss For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations