Asset Allocation
Overweight Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however, looking further out such demand destruction will likely prove transitory. The chart on the right highlights that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices. Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK. For additional details please refer to this Monday’s Weekly Report.
Highlights Analyses on Asian semis, Argentina and Russia are available on pages 7, 12 and 14, respectively. The most likely trajectory for Chinese growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets will soon focus on growth beyond the temporary rebound. In our opinion, it will be weaker than markets are currently pricing. Thus, risks for EM risk assets and currencies are skewed to the downside. A major and lasting selloff in EM stocks will only occur if EM corporate bond yields rise. In this week’s report we discuss what it will take for EM corporate credit spreads to widen. Feature The downside risks to EM risk assets and currencies are growing. We continue to recommend underweighting EM equities, credit and currencies versus their DM counterparts. Today we are initiating a short position in EM stocks in absolute terms. Chart I-1 illustrates that the total return index (including carry) of EM ex-China currencies versus the US dollar has failed to break above its 2019 highs, and has rolled over decisively. In contrast, the trade-weighted US dollar has exhibited a bullish technical configuration by rebounding from its 200-day moving average (Chart I-2). Odds are the dollar will make new highs. An upleg in the greenback will foreshadow a relapse in EM financial markets. Chart I-1EM Ex-China Currencies Have Been Struggling Despite Low US Rates Chart I-2The US Dollar Remains In A Bull Market Growth Trajectory After The Dust Settles The evolution of the coronavirus remains highly uncertain and unpredictable. As with any pandemic or virus outbreak, its evolution will be complex with non-trivial odds of a second wave. Even under the assumption that the epidemic will be fully contained by the end of March, its economic impact on the Chinese and Asian economies will likely be greater than global financial markets are currently pricing. As investors come to the realization that this initial pick-up in economic activity after the virus outbreak will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. In our January 30 report titled Coronavirus Versus SARS: Mind The Economic Differences, we argued that using the framework from the SARS outbreak to analyze the current epidemic is inappropriate. First, only a small portion of the Chinese economy was shut down in 2003, and for a brief period of time. The current closures and limited operations are much more widespread and likely more prolonged. Table I-1China’s Importance Now And In 2003 Second, China accounts for a substantially larger share of the global economy today than it did in 2003 (Table I-1). Hence, the global business cycle is presently much more sensitive to demand and production in the mainland than it was during the SARS outbreak. Global financial markets have rebounded following the initial selloff in late January on expectations that the Chinese and global economies will experience a V-shaped recovery. In last week’s report, we discussed why the odds favor a tepid recovery for the Chinese business cycle and global trade. The main point of last week’s report was as follows: with the median company and household in China being overleveraged, any reduction in cash flow or income will undermine their ability to service their debt and will dent their confidence for some time. Hence, consumption, investment and hiring over the next several months will be negatively affected, even after the outbreak is contained. This in turn will diminish the multiplier effect of policy stimulus in China. Chart I-3Our Expectations Of China’s Business Cycle The most likely pattern for Chinese growth will likely resemble the trajectory demonstrated in Chart I-3. It assumes the plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that snap-back will likely be followed by weaker growth, for reasons discussed in last week’s report. Equity and credit markets in Asia and worldwide have been sanguine because they have so far focused exclusively on expectations of a sharp rebound. As investors come to the realization that this initial pick-up in economic activity will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. Bottom Line: The most likely trajectory for Chinese and Asian growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets are not pricing in this scenario. Thus, risks are skewed to the downside for EM risk assets and currencies. The Missing Ingredient For An Equity Selloff The missing ingredient for a selloff in EM equities is rising EM corporate bond yields. Chart I-4 illustrates that bear markets in EM stocks typically occur when EM US dollar corporate bond yields are rising. Hence, what matters for the direction of EM share prices is not risk-free rates/yields but EM corporate borrowing costs. Chart I-4The Destiny Of EM Equities Is DependEnt On EM Corporate Bond Yields EM (and US) corporate bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when credit spreads are widening more than Treasury yields are falling; or (3) when both government bond yields and corporate credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for government bonds, presently corporate bond yields can only rise if credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently relies on corporate spreads. A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. From a historical perspective, EM and US corporate credit spreads are currently extremely tight (Chart I-5). A China-related growth scare could trigger a widening in EM corporate credit spreads. As this occurs, corporate bond yields will climb, causing share prices to plummet. EM corporate spreads have historically been correlated with EM exchange rates, the global/Chinese business cycle, and commodities prices (Chart I-6). The Chinese property market plays an especially pivotal role for the outlook of EM corporate spreads. Chart I-5EM And US Corporate Spread Remain Tame Chart I-6EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices First, offshore bonds issued by mainland property developers account for a large share of the EM corporate bond index. Chart I-7China Property Market Will Continue Disappointing Second, swings in China’s property markets often drive the mainland’s business cycle and its demand for resources, chemicals and industrial machinery. In turn, Chinese imports of commodities affect both economic growth and exchange rates of EM ex-China. Finally, the latter two determine the direction of EM ex-China corporate spreads. China’s construction activity and property developers were struggling before the coronavirus outbreak (Chart I-7). Given their high debt burden, the ongoing plunge in new property sales and their cash flow will not only weigh on their debt sustainability but also force them to curtail construction activity. The latter will continue suppressing commodities prices. The sensitivity of EM corporate spreads to these variables have in recent years diminished because of the unrelenting search for yield by global investors. As QE policies by DM central banks have removed some $9 trillion of high-quality securities from circulation, the volume of securities available in the markets has shrunk. This has distorted historical correlations of EM corporate spreads with their fundamental drivers – namely, China’s construction activity, commodities prices, EM exchange rates and the global trade cycle. Nonetheless, EM corporate credit spreads’ sensitivity to these variables has diminished, but has not vanished outright. If EM currencies depreciate meaningfully, commodities prices plunge and China’s growth and the global trade cycle disappoint, odds are that EM corporate spreads will widen. Given that credit markets are already in overbought territory, any selloff could trigger a cascading effect, resulting in meaningful credit-spread widening. Bottom Line: A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. The timing is uncertain, but the odds of EM corporate credit spreads widening are mounting as Chinese growth underwhelms, commodities prices drop and EM currencies depreciate. If these trends persist, they will push EM shares prices over the cliff. As to today’s recommendation to short the EM stock index, we anticipate at least a 10% selloff in EM stocks in US-dollar terms. For currency investors, we are maintaining our shorts in a basket of EM currencies versus the dollar. This basket includes the BRL, CLP, COP, ZAR, KRW, IDR and PHP. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Are Semiconductor Stocks Facing An Air Pocket? Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020 will trigger a pullback in semiconductor equities. Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-2Chinese Smartphone Demand: Further Decline In 2020 Chart II-3Chinese Households: No Urgent Need For A New Phone The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage. The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. We agree that 5G technology is revolutionary. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5). Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic? Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. The Argentine government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Argentina’s Eternal Tango With Foreign Creditors Chart III-1Downside Risks To Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com Russia: Harvesting The Benefits Of Macro Orthodoxy Russian financial markets have shown resilience in face of falling oil prices. This has been the upshot of the nation’s prudent macro policies in recent years. We have been positive on Russia and overweight Russian markets over the past two years and this stance remains intact. Going forward, Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals: Fiscal policy will be relaxed substantially – both infrastructure and social spending will rise. Specifically, the Kremlin is eager to ramp up the national projects program. This is bullish for domestic demand. Russia’s public finances are currently in a very healthy state. Public debt (14% of GDP) is minimal and foreign public debt (4% of GDP) is tiny. The overall fiscal balance is in large surplus (2.7% of GDP). The current account is also in surplus. Hence, a major boost in fiscal spending will not undermine Russia’s macro stability for some time. As a major sign of policy change, President Putin has sidelined or reduced the authority of policymakers who have been advocating tight fiscal policy. This policy change has been overdue as fiscal policy has been unreasonably tight for longer than required (Chart IV-1). Chart IV-1Russia: Government Spending Has Been Extremely Weak Importantly, the recent changes at the highest levels of government are also positive for governance and productivity. The new Prime Minister Mishustin has earned this appointment for his achievements as the head of the federal tax authority. He has restructured and reorganized the tax department in a way that has boosted its efficiency/productivity substantially and increased tax collection. By promoting him to the head of government, Putin has boosted Mishustin’s authority to reform the entire federal governance system. Given his record of accomplishment, odds are that the new prime minister will succeed in implementing some reforms and restructuring. Thereby, productivity growth that has been stagnant in Russia for a decade could revive modestly. Also, Putin was reluctant to boost infrastructure spending as he was afraid of money being misappropriated without a proper monitoring system. Putin now hopes Mishustin can introduce an efficient governance system of fiscal spending to assure infrastructure projects can be realized with reasonably minimal losses. As to monetary policy, real interest rates are still very high. The prime lending rate is 10%, the policy rate is 6% and nominal GDP growth is 3.3% (Chart IV-2). Weak growth (Chart IV-3) and low inflation will encourage the central bank to continue cutting interest rates. Chart IV-2Russia: Interest Rates Remain Excessively High Chart IV-3Russia's Growth Is Very Sluggish Finally, the economy does not have any structural excesses and imbalances. The central bank has done a good job in cleansing the banking system and the latter is in healthy shape. Bottom Line: The ruble will be supported by improving productivity, cyclical growth acceleration and a healthy fiscal position. We continue recommending overweighting Russian stocks, local currency bonds and sovereign credit relative to their respective EM benchmarks. Last week, we also recommended a new trade: Short Turkish bank stocks / long Russian bank stocks. The main risk to the absolute performance of Russian markets is another plunge in oil prices and a broad selloff in EM. On November 14, 2019 we recommended absolute return investors to go long Russian local currency bonds and short oil. This strategy remains intact. Finally, we have been recommending the long ruble / short Colombian peso trade since May 31, 2018. This position has generated large gains and we are reiterating it. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Duration: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Spread Product: Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for high-yield. Accommodative monetary conditions will ensure that the supply of credit remains ample for some time yet. This will keep defaults low and spreads tight. Monetary Policy: The Fed is in no rush to tighten policy, but has also set a high bar for further cuts. Investors should short August 2020 fed funds futures. Yields Will Move Higher … But Not Yet Chart 1A Peak In New Cases? Uncertainty about the economic impact of the coronavirus – now officially called COVID-19 – is the cloud that continues to hang over financial markets. Last week, bond yields fell when a change in the definition of what constitutes a confirmed infection caused the number of reported cases to spike. However, even after revisions, the daily number of new cases looks like it may have peaked (Chart 1). The end result is that the 10-year Treasury yield sits at 1.58%, not far from where it was last week (Chart 2). Notably, the 10-year yield continues to shrug off the notable improvement in US economic data (Chart 2, bottom panel), taking its cues instead from COVID-19 headline risk. Even if the downtrend in new COVID-19 cases continues, it is too soon to be looking for higher bond yields. For one thing, the most up-to-date economic data releases were collected during January, before the outbreak. Weaker readings during the next 1-2 months are assured, and investors may not look through the weakness given that many were already skeptical about the prospects for global economic recovery. Our read of the data is that global growth was in the process of bottoming when COVID-19 struck. We therefore expect global growth to move higher once the virus’ impact abates. In terms of timing, using the 2003 SARS outbreak as a comparable, we expect bonds to remain bid until the daily number of new cases falls to zero, at which point a sell-off is likely. Yields continue to shrug off improvements in economic data. It’s not just the long-end of the curve that has responded to COVID-19. The front-end has also moved to price-in high odds of a rate cut in the coming months. Specifically, the overnight index swap curve is priced for a 42 bps decline in the fed funds rate during the next 12 months (Chart 2, panel 2), and the fed funds futures market is pricing a 74% chance of a rate cut by the end of the summer. As we discussed last week, given that any economic impact from COVID-19 will be temporary, we think the bar for a Fed rate cut this year is quite high.1 As such, our Golden Rule of Bond Investing dictates that investors should keep portfolio duration low on a 12-month horizon.2 We also recommend shorting August 2020 fed funds futures, a trade that will earn 23 bps of unlevered return if the Fed stands pat between now and August (Chart 2, panel 3). Turning to corporate credit, we see that, so far, COVID-19’s impact on spreads has been minor. The investment grade corporate bond index spread is only 3 bps wider than at the start of the year, and the junk index spread is only 8 bps wider (Chart 3). Value remains stretched in the investment grade space, but high-yield spreads look quite attractive. The sell-off in the energy sector has boosted the high-yield index spread considerably (Chart 3, bottom 2 panels). We view this as a medium-term buying opportunity for junk. Once the COVID outbreak abates and global growth ticks higher, the oil price is bound to increase, leading to some tightening in energy spreads. Chart 2Bond Yields Driven By COVID Chart 3HY More Attractive Than IG Will Bonds Feel The Bern? Beyond COVID-19, there is one more risk on the horizon this year. Specifically, the risk that Bernie Sanders is elected President in November. This outcome is far from certain. Sanders is currently leading all other candidates in the Democratic Primary, but fivethirtyeight.com’s model puts the odds of a brokered convention at 38%.3 This means that the race is still wide open and might only be settled at the convention in July. But given Sanders’ lead, it is worth considering the bond market implications if he were to become the next President. The most obvious implication is that risk assets (equities and corporate spreads) would respond to Sanders’ agenda of wealth redistribution by selling off. This could spur a flight-to-quality into government bonds, causing Treasury yields to fall. However, that flight-to-quality won’t occur if markets also start to price-in the long-run implications of Sanders’ agenda. I.e. the fact that the redistribution of wealth from capital to labor would lower the economy’s marginal propensity to save, and likely raise inflation expectations, leading to higher interest rates. It’s important to note that there are a lot of hurdles to overcome before Sanders’ full policy agenda is implemented. First he must secure the Democratic nomination, then defeat Donald Trump in the general election. Even after that, he will still need to convince the House and Senate to pass non-watered down versions of his proposals. With such a long road ahead, we don’t think Sanders’ momentum will push bond yields higher in 2020. Rather, the risk is that Sanders’ rise keeps bond yields low in 2020 as risk assets sell off. If Bernie Sanders looks poised to win the nomination, we will consider reducing our 6-12 month allocation to spread product and increasing our recommended portfolio duration. The outlook for the Democratic Primary should become clearer after Super Tuesday on March 3. If Sanders looks poised to win the nomination we will consider reducing our recommended 6-12 month allocation to spread product and increasing our recommended portfolio duration. Bottom Line: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for junk. Though the credit cycle is far from over (see next section), we may reduce our recommended allocation to spread product versus Treasuries if Sanders’ election chances rise. Bank Lending Standards Won’t Push Credit Spreads Wider In 2020 The net change in commercial & industrial (C&I) bank lending standards, as reported in the Fed’s quarterly Senior Loan Officer Survey, is a vitally important indicator for the credit cycle. Easing lending standards tend to coincide with a low default rate and falling credit spreads, while tightening lending standards usually coincide with spread widening and a rising default rate. With that in mind, it is mildly concerning that bank lending standards have been fluctuating around neutral levels for quite some time, and have in fact tightened in two of the past five quarters (Chart 4). In this week’s report we consider whether tighter bank lending standards could pose a risk to our overweight spread product view in 2020. Chart 4Bank Lending Standards And Monetary Variables Bank lending standards are such an important credit cycle variable because they tell us about the supply of credit. A corporate default only occurs when credit supply is lower than the amount required for that firm’s survival. On a macro scale, we can think of two main reasons why lenders might restrict the credit supply: They perceive the monetary environment as restrictive. That is, they worry about higher interest rates and slower growth in the future. They perceive corporate balance sheets as being in poor health. That is, they worry that firms won’t be sufficiently profitable to make good on their debts. We find that monetary indicators do a very good job of predicting when lending standards will tighten. Looking back at the past two cycles, lending standards didn’t tighten until after: The yield curve inverted (Chart 4, panel 2). The real fed funds rate was above its estimated equilibrium level (Chart 4, panel 3). Inflation expectations were at or above target levels (Chart 4, bottom panel). Presently, all three of these monetary indicators are supportive. Some portions of the yield curve have been inverted at various times during the past year. But in general, the inversion signal from the yield curve has not been as strong as it was when lending standards tightened in prior cycles. For instance, the 3-year/10-year Treasury slope has not inverted this cycle, and it currently sits at +20 bps (Chart 4, panel 2). Further, the real fed funds rate is below most estimates of its neutral level and the Fed is signaling that it will keep it there for a long time yet. This dovish posture is justified by inflation expectations that remain well below target. It is conceivable that, despite the accommodative monetary environment, banks might be so concerned about poor balance sheet health that they are becoming more cautious with their lending. However, a survey of corporate health metrics doesn’t point to an imminent tightening of bank lending standards either (Chart 5). Chart 5Bank Lending Standards And Corporate Balance Sheet Variables In past cycles, tighter bank lending standards were preceded by: A trough in gross leverage (pre-tax profits over total debt) (Chart 5, panel 2). A peak in interest coverage (Chart 5, panel 3). Negative pre-tax profit growth (Chart 5, panel 4). A peak in profit margins (Chart 5, bottom panel). Currently, gross leverage is the only one of the above four variables that is clearly sending a negative signal. As for the other three, interest coverage and profit margins are barely off their cyclical highs, and profit growth has been fluctuating around zero for three years. If global growth rebounds during the next 12 months, as we expect, then profit growth will also move modestly higher. Bottom Line: Neither monetary nor balance sheet variables point to an imminent tightening of bank lending standards. We expect that the supply of credit will remain ample in 2020, keeping the default rate low and credit spreads tight. A Note On Falling C&I Loan Demand In addition to questions about lending standards, the Fed’s Senior Loan Officer Survey also asks banks to report whether they are seeing stronger or weaker demand for C&I loans. In response, banks have reported weaker C&I loan demand for six consecutive quarters, ending in Q4 2019. Historically, it is unusual for C&I loan demand to fall without a concurrent tightening in lending standards (Chart 6). Chart 6Explaining Weakening Loan Demand We also see the impact of weaker loan demand in the hard data. C&I loan growth has been falling since early 2019 (Chart 6, panel 2) and net corporate bond issuance had been on a sharp downtrend since 2015, before moving higher last year (Chart 6, bottom panel). So what’s going on with C&I loan demand? We can think of two reasons why firms might seek out less credit. First, they may face a dearth of investment opportunities, or alternatively, they might perceive some benefit from carrying less debt on their balance sheets. On the first point, we find that new orders for core capital goods do a very good job explaining the swings in C&I lending (Chart 7). Specifically, we see that the global growth slowdown of 2015/16 drove both investment spending and C&I lending lower. Then, both series recovered in 2017/18 before moving down again during last year’s slowdown. Surveys about firms’ capital spending plans also dropped last year, consistent with the deceleration in C&I lending, but remain at high levels (Chart 7, bottom three panels). All of this suggests that C&I loan growth will recover this year as global growth improves and the investment landscape brightens. Capital goods new orders do a good job explaining C&I lending. Corporate bond issuance has followed a different path from C&I lending during the past few years. Specifically, bond issuance slowed in 2015/16 as investment spending dried up. But it did not recover in 2017/18 the way that investment spending and C&I lending did. This appears to be a result of the 2018 corporate tax cuts and repatriation holiday. Chart 8 shows that the Financing Gap – the difference between capex spending and retained earnings – plunged in 2018 because firms suddenly received a huge influx of retained earnings. The influx came in part from the lower tax rate, but mostly from repatriated cash that had been stranded overseas. Simply, firms didn’t need to issue bonds to finance their investment plans in 2018 because they had a lot more cash on hand. Chart 7C&I Lending Follows ##br##Investment Chart 8A Negative Financing Gap Limits The Need For Debt What about the possibility that firms are demanding less debt because they are trying to clean up their balance sheets? Beyond a few anecdotes, we don’t see much support for this idea. In fact, an equity index of firms with low debt/asset ratios has been underperforming an index of firms with high debt/asset ratios (Chart 9). This suggests that there is currently little reward for firms that are paying down debt. Chart 9Firms Not Rewarded For Healthy Balance Sheets Bottom Line: Weaker demand for C&I loans is a result of the recent global growth downturn and decline in investment spending. It is not a harbinger of the end of the credit cycle. Loan demand should improve as global growth rebounds this year. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 2 For further details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 3 https://projects.fivethirtyeight.com/2020-primary-forecast/?ex_cid=rrpromo Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Stay on the sidelines on cyclicals versus defensives. While the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon. Recent Changes There are no changes to our portfolio this week. Table 1 Feature The SPX shrugged off the persistently negative coronavirus epidemic news and made fresh all-time highs last week (top panel, Chart 1). Domestic flush liquidity remains the dominant macro theme coupled with the expectation of a sizable fiscal and monetary easing out of China in the coming months. Importantly, according to the CME there is a 60% chance of a Fed interest rate cut priced in for the July 29, 2020 FOMC meeting which jumps to over 80% probability for the December 16, 2020 meeting. This is sustaining downward pressure on the 10-year Treasury yield, which in turn is boosting equities. A glum JOLTS report along with the 12-month fed funds rate discounter corroborate that additional Fed easing is likely nearing (middle & bottom panels, Chart 1). Chart 1Is A Fed Interest Rate Cut Looming? Chart 2Unsustainable Rise In “Tenuous Trio” The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently. Nevertheless, beneath the surface trouble is brewing. Chart 2 shows three asset classes rising concurrently. The “tenuous trio” as we have called stocks, Treasurys and the greenback in the past, cannot rise in tandem. When all three asset prices appreciate, it typically foreshadows equity market trouble. In this particular iteration, even the VIX is up for the year, representing a big break in historical correlations. Worrisomely, since 2018 every time the VIX and the SPX became positively correlated, the broad market subsequently suffered a setback (Chart 3). While the SPX is making all-time highs, the VIX is neither making all-time lows nor cyclical lows. Importantly, equity market volatility is staying stubbornly close to 15, slightly below the ten-year average. As a reminder, a “VIX reading of 15 means that in 30 days the S&P 500 is expected to trade between 4.3% lower and 4.3% higher than its current level”.1 Chart 3Watch Out For Vol The extreme concentration in excess returns in a handful of tech stocks is another potential trouble spot for equities that we have been highlighting recently.2 Chart 4 shows the percentage of GICS2 sectors with negative two-year relative share price momentum. The higher this diffusion rises the fewer the sectors that drive the SPX’s return. Historically, when our diffusion hits the 70% mark, it signals exhaustion in equity market returns. In fact, 70% readings in this diffusion indicator led both the 2000 and 2007 peaks in the SPX. Chart 4Heed The Diffusion Index’s Message This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Meanwhile on the economic front, the JOLTS report made for grim reading. Labor market softness was evident across the board and it was not squarely concentrated in the manufacturing sector. While this indicator only goes back two cycles, it is flashing yellow for the prospects of the broad equity market (top panel, Chart 5). Importantly, we will continue to monitor the job openings numbers as they are sending the exact opposite signal compared with unemployment insurance claims (job openings shown inverted, middle & bottom panels, Chart 5). This week we update our views on the cyclical /defensive portfolio bent and a niche industrials sub-group. Chart 5Avoid Getting JOLTed Mixed Signals We have been neutral the cyclicals/defensives ratio for the past 8 months and continue to recommend investors stay on the sidelines for a while longer. It has been particularly difficult to distinguish a clear signal from noise lately for the cyclicals versus defensives ratio. Relevant macro drivers, operating metrics and profit fundamentals, valuations and technicals all have been emitting conflicting messages and the recent coronavirus epidemic will likely make the waters murkier still. US Equity Strategy’s Global Trade Activity Indicator has turned south recently following in the footsteps of the Chinese manufacturing PMI data that ticked down and are slated to drop below the boom/bust line in the current month (top & bottom panels, Chart 6). The bond market also reflects a gloomy global economic backdrop with the global 10-year Treasury yield sinking like a stone. Such a lackluster bond market will likely weigh on relative share prices (middle panel, Chart 6). CEOs remain a depressed bunch and it is all but certain that for, at least, the next three months executives will put capex plans on the backburner. Basic resources are most at risk and keep in mind that relative capex growth was already decelerating prior to the coronavirus epidemic (top & second panels, Chart 7). Chart 6Trade Uncertainty… Chart 7… And Capex Softness Weighs On Cyclicals A soft sales backdrop coupled with inventory accumulation are firing a warning shot. Relative share prices will likely succumb to the still weak total business sales-to-inventories ratio (third panel, Chart 7). Importantly, an inventory liquidation phase will continue to exert downward pressure on relative profit margins (bottom panel, Chart 7). Chart 8Pricing Power Proxy Blues Our simple relative pricing power proxy for the cyclical/defensive ratio best encapsulates these relative selling price pressures. The CRB metals-to-gold price ratio is on the verge of a breakdown and warns that the wide gulf that has opened up between our pricing power proxy and relative share prices will narrow via a sell off in the latter (Chart 8). Nevertheless, this stands in marked contrast to the ISM manufacturing prices paid subcomponent of the Report On Business survey and actual cyclicals/defensives pricing power momentum (bottom panel, Chart 9). Chart 9The US Dollar Holds The Key Were the greenback to depreciate in the coming months as our FX strategists expect, then cyclicals selling prices would definitively regain the upper hand versus their defensives counterparts (top & middle panels, Chart 9). But, the jury is still out. Sell-side analysts remain optimistic that relative profits will stage a significant comeback in the next year, but on a short-term basis have been trimming cyclical versus defensive earnings revisions (middle & bottom panels, Chart 10). While our macro-factor relative profit growth models were staging a comeback all last year, they ticked down last month (second panel, Chart 10). Finally, relative technical and valuation conditions are both tracing out a bottom near the one standard deviation below the historical mean, a level that has marked prior recoveries in relative share prices (Chart 11). Chart 10Mixed Bag Chart 11Unloved & Undervalued Bottom Line: Most of the macro and operating indicators we track are sending conflicting messages on the anticipated direction in the cyclical/defensive ratio. Remain on the sidelines on cyclicals versus defensives, but stay tuned. Clipped Wings? Airline stocks have taken it to the chin lately on the back of coronavirus demand destruction fears, but we reiterate our overweight stance as extreme bearishness appears overdone. Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however looking further out such demand destruction will likely prove transitory. Chart 12 shows that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices (bottom panel, Chart 12). US domestic and international passenger enplanements are running near the 5%/annum growth rate and the recent rebound in the global and US services PMIs suggests that any kink in demand will likely prove short-lived (Chart 13). Chart 12Firming Cyclical… Chart 13…Demand Backdrop… Importantly, this firm cyclical demand backdrop is reflected in accelerating airline selling price inflation both on domestic and international routes (second & third panels, Chart 14). However, profit margins have yet to reflect this encouraging top line growth backdrop. The airline load factor spread (calculated as load factor minus break-even load factor) also heralds a profit margin expansion phase (bottom panel, Chart 14). Chart 14…Is A Boon For Selling Prices Chart 15Lower Fuel Costs Should Turbocharge Profit Margins Tack on the roughly 16% year-to-date drubbing in oil prices and airline profit margins will expand in 2020. This is true especially for the bulk of the industry that does not hedge kerosene costs (jet fuel shown inverted, Chart 15). The analyst community has been pessimistic about the prospects of airline stocks. Revenue and profit growth expectations are slated to tail the SPX in the coming twelve months. This sets a low bar for the industry to surpass in coming earnings seasons (Chart 16). Finally, investors have thrown in the towel, pushing relative valuations to extremely depressed levels to the tune of nearly two standard deviations below the historical mean (middle panel, Chart 17). Relative technicals are also washed out and signal that, at least, a reflex rebound is in store in the coming months (bottom panel, Chart 17). Chart 16Low Bar To Surpass Chart 17Contrary Alert: Pessimism Reigns Supreme In sum, while the coronavirus epidemic will take a bite out of airline demand in the near-term, firm consumer confidence, rising consumer outlays, recovering services PMIs, rising airline pricing power, falling kerosene prices, compelling relative valuations and oversold technicals, all signal that airlines are well positioned to regain altitude on a cyclical time horizon. Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 https://us.spindices.com/vix-intro/ 2 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, and “When The Music Stops…”, dated January 27, 2020, both available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights Portfolio Strategy Receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Lift exposure to neutral. An historical parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Recent Changes Lock in gains of 20% and augment the S&P hotels index to neutral. Table 1 Feature Equities ripped higher last week as the coronavirus scare subsided, the Senate acquitted President Trump and the PBoC and the Fed sustained the liquidity injections. From a macro perspective, bond yields have served as a suspension for the SPX, absorbing the economic shock and catapulting the broad equity market to fresh all-time highs. The usual suspects, tech stocks, led the charge as lower interest rates equate to higher multiples. Keep in mind that the SPX is trading near an eighteen-year high on a forward P/E ratio basis (Chart 1). Such investor complacency is worrisome, especially given the persistently soft economic backdrop. Importantly, the latest GDP release revealed that net exports had the largest contribution to real output growth – trumping even PCE – on the back of a collapse in imports (second & third panels, Chart 2). Chart 1Flush Liquidity Chart 2Net Exports Jump Is A Yellow Flag In fact, the quarter-over-quarter plunge in real imports is the steepest since the GFC, and on a par with both the 9/11 induced recession in the early-2000s and the Savings & Loan recession in the early-1990s (top panel, Chart 3). Historically, when imports crest they are a precursor of recession (bottom panel, Chart 3). While this may be a one quarter blip in the data as a result of the trade war, we will continue to closely monitor the US trade balance. Meanwhile, consumer outlays are also decelerating, corroborating last quarter’s real imports collapse (bottom panel, Chart 2). If this pillar of economic strength gives way in the coming quarters, it will stoke up recession fears anew and vindicate the bond market’s message. Ultimately, what matters for stocks, aside from interest rates, is EPS growth. On that front, the Street continues to expect 10% profit growth for calendar 2020 which is a tall order according to our analysis in mid-January, warning that the SPX is still 8% overvalued as per our base case EPS and multiple scenario.1 Chart 3Imports Flashing Red Chart 4Sector Contribution To 2020 SPX EPS GrowthChart 4 shows the sector contribution to profit growth for this year. The tech sector sits atop the table and leads its peers by a wide margin (Table 2). Health care and financials occupy the second and third spots. While these rankings are more or less in line with the sector profit and market cap weights, what stands out is the delta between the market cap and earnings weights (Table 2). Table 2Sector EPS And Market Cap Weights According to this valuation proxy, real estate, tech and consumer discretionary sectors are the most expensive, while energy, health care and financials are the cheapest (Table 2). As a reminder we remain neutral tech, and underweight both real estate and consumer discretionary, and overweight all three undervalued sectors: energy, health care and financials. This week we book gains and lift to neutral a niche consumer discretionary sub sector that the coronavirus epidemic has badly bruised, and update our view on the largest communication services sub-group. Crystalize Gains And Upgrade Hotels To Neutral Google trends data shows that peak interest in the coronavirus was registered on January 26 in China, January 30 in the US and one day later globally (Chart 5). These trends may change in the coming weeks, but it appears that the initial fears and interest on the coronavirus are quickly subsiding, highlighting that the worst may likely be behind us with regard to fear mongering. Thus, we are compelled to lift the hard-hit S&P hotels index to neutral and cement gains of 20% since inception. While Chinese, global and US outputs will likely take a hit in Q1, subsequently recover in Q2 in the aftermath of the epidemic and only Q3 will come in as a clean quarter, the beating down of this niche consumer discretionary sub-group is overdone. Macro headwinds are turning into mild tailwinds. Last week the ISM non-manufacturing report rebounded smartly, and consumer confidence remains resilient. The implication is that it no longer pays to be bearish the S&P hotels index (top & middle panels, Chart 6). Tack on our vibrant industry demand indicator underscoring that the two-year bear market will likely go on hiatus (bottom panel, Chart 6). Chart 5Risks Receding Chart 6Upbeat Demand A number of other indicators we track send a similar message. Relative retail sales are rebounding with discretionary sales reclaiming the upper hand (top panel, Chart 7). While overall PCE is decelerating (bottom panel, Chart 2), relative consumer outlays on hotels is picking up momentum signaling that the bar for positive relative profit surprises is low (middle panel, Chart 7). Importantly, almost all of the negative coronavirus news flow is likely reflected in the roughly 25% forward P/E discount to the broad market that the index is changing hands at. If the coronavirus epidemic is petering out, then such undervaluation is no longer warranted (bottom panel, Chart 7). Importantly, our S&P hotels EPS growth model does an excellent job in encapsulating all these moving parts and is currently signaling that relative profit growth is slated to turn the corner in the coming quarters (Chart 8). Chart 7Grim News Is Priced In Chart 8Model Points To A Turnaround Netting it all out, receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Beyond the risk of a resurgence in the coronavirus epidemic, what prevents us from upgrading all the way to an above benchmark allocation is a challenging profit margin backdrop. Chart 9 highlights that not only are industry CEOs showing no restraint with respect to labor additions, but also lodging inflation is now contracting. Taken together, there are rising odds that the S&P hotels index may suffer from a profit margin squeeze (bottom panel, Chart 9). Netting it all out, receding interest in the coronavirus epidemic, rising demand prospects, a looming profit turnaround and compelling valuations, all signal that it no longer pays to be bearish the S&P hotels index. Bottom Line: Lift the S&P hotels index to neutral and lock in gains of 20% since inception. The ticker symbols for the stocks in this index are: BLBG S5HOTL – MAR, CCL, HLT, RCL, NCLH. Chart 9Margin Squeeze Is A Risk Regulation Is Coming While most mega cap tech stocks had a better-than-expected Q4 earnings season, GOOGL and FB were left behind. We reiterate our underweight stance in the S&P interactive media & services index (we still consider them tech stocks) which serves as a great hedge to our overweight S&P software index. As a reminder we remain underweight this communications services subgroup on a cyclical basis, and since mid-December also on a secular ten-year time horizon.2 Regulation is a powerful force. President Trump is only slightly favored for reelection and there is bipartisan support to toughen anti-trust regulation, which his own Department of Justice has pursued. Republican Senator of Missouri Josh Hawley has spearheaded the assault on tech companies from the right wing, while leading Democratic presidential contenders represent the push from the left wing. Indeed, if the Democrats take power, they are likely to enact a federal privacy law following in the footsteps of California and the European Union. Such a law would face court battles but would ultimately have popular tailwinds: corporate protectionism, wealth inequality, and social demands for privacy across the political spectrum. Looking back to the early- and mid-twentieth century with regard to US government regulation aimed at protecting the consumer is instructive. What catches our attention are the Biologics Control Act, the Pure Food and Drug Act and the Toxic Substances Control Act. The first two acts affected the pharmaceutical and food industries and the third act the chemicals industry. While we do not have sector data dating back to the early 1900s, we have chemicals equity prices since 1958. The Toxic Substances Control Act of 1976 dealt a blow to chemical equity prices in absolute and relative terms (Chart 10). In fact, investments in chemical stocks were dead money for a whole decade until 1985 when they broke out in absolute terms and troughed in relative terms (Chart 10). New regulation will cast a shadow over the S&P interactive media & services index. This is true especially if a privacy law is passed, but even if it is postponed or shot down by the Supreme Court, companies will have to contend with a higher regulatory burden in order to comply with California’s and Europe’s privacy laws. Beyond the threat of privacy regulation protecting the consumer, the monopolistic power these companies exert will also come under the microscope. While we doubt the government will break up these two companies given their industry dominance, and the need to maintain international competitiveness,3 anti-monopoly probes clearly pose a big risk. This is true even under a GOP administration. During times of inequality, especially during recessions, governments will seek popularity by punishing scapegoats. The firms that are the chief beneficiaries of the business cycle will be the first in line for scrutiny. Keep in mind, Ronald Reagan’s Republican administration broke up “Ma Bell” into seven regional “Baby Bells” on January 1, 1984. Interestingly, AT&T also had the largest market capitalization in the S&P 500 in 1982. What concerns us the most is a forced sale of “crown jewel” assets as the result of a court ruling in an anti-monopoly suit. This would jeopardize the companies’ ecosystems. Imagine if Alphabet were forced to divest their Google Marketing Platform (old DoubleClick) and Google Ads, or YouTube or Google Cloud. Facebook could be forced to sell WhatsApp or Instagram. Chart 10Regulation Hurts Stocks Chart 11Risks Are Neither Reflected In Profit Estimates… All of these risks pose a threat to EPS growth and still sky-high industry profit margins. Importantly, relative profit growth is climbing at a 13% rate (middle panel, Chart 11) and coupled with the drubbing in 10-year Treasury yields, have pushed valuations to overshoot territory. As we went to print the S&P interactive media & services index was trading at a 34% forward P/E premium to the broad market (Chart 12). Similarly on a forward P/E/G ratio basis this industry is trading at roughly a 30% premium to the SPX (bottom panel, Chart 12). In sum, an historical regulatory parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Over the past year profit margins have been narrowing as costs have been creeping up for the industry, but are still more than twice the level of SPX margins (second panel, Chart 13). If federal regulation puts a price on consumer data in the coming years, especially through direct legislation, then this added cost will squeeze industry profit margins and dent profitability. Chart 12…Nor In Pricey Valuations Chart 13Margin Compression Looms The chief constraint on US government regulation is the desire to maintain international competitiveness in a world of great power competition, in which US rivals attempt to promote their own tech companies globally. However, neither colonialism nor the Cold War stopped earlier anti-monopoly crusades. Politicians primarily court domestic constituencies with such pursuits. Regulators would have to set the terms of any breakup with various interests in balance, but the point is that even a limited breakup that does not mortally wound the company would still come as a negative shock at first. In sum, an historical regulatory parallel with chemicals industry regulation suggests that the path of least resistance is lower for the S&P interactive media & services industry. Bottom Line: Stay underweight S&P interactive media & services index both on a cyclical and structural ten-year time horizon. The ticker symbols for the stocks in this index are: BLBG S5INMS – GOOGL, GOOG, FB, TWTR. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com.\ 2 Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For the Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 3 Please see BCA US Equity Strategy Special Report, “Is The Stock Rally Long In The FAANG?” dated August 1, 2018, and Geopolitical Strategy Special Report, “Surviving A Breakup: The Investor's Guide To Monopoly-Busting In America,” dated March 20, 2019, available at uses.bcaresearch.com and gps.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)
Highlights A currency portfolio comprised of the US dollar, the Japanese yen and the Norwegian krone is likely to outperform a more diversified basket over multiple macroeconomic scenarios. Our work suggests that valuation matters for currencies over the long term. The cheapest currencies in our universe are the Norwegian krone, the Swedish krona and the Japanese yen, although the pound and euro are also attractive. Tactical investors should remain short the DXY index, but also have a higher concentration of dollar-neutral trades given the uncertainty surrounding global growth. Feature A currency investor can construct a long-term portfolio based on three criteria. The first task is to figure out what macroeconomic environment she or he is residing in. During inflationary periods, “hard” currencies tend to do best, since they are usually associated with countries where the private sector is running surpluses. The lack of excess demand in these countries leads to lower inflation, which tends to boost real rates. Examples in recent history include the deutschemark during the 1970s or the Japanese yen throughout most of the ‘80s. In a disinflationary world, the high-yielders tend to be the outperformers. This is not only because the lack of an inflationary pulse leads to very positive real rates, but these are also the countries that tend to be at the forefront of the disinflationary boom, leading to rising demand for their currencies. For example, the 2000s saw emerging market and commodity currencies as the outperformers on the back of a resources boom, while the ‘90s saw the dollar rise on the back of a US productivity boom. Over the long term, a currency portfolio should include a combination of both “hard” and carry currencies. Over the long term, a currency portfolio should include a combination of both “hard” and carry currencies, with the weights adjusted based on investor preferences. For example, the risk to the world economy today remains deflation. Looking at core inflation across countries, most prints are below the magical 2% target level (Chart I-1). Inflation aside, the biggest catalyst for an investor to favor the disinflationary camp is the sequence of events we have experienced over the last two years – a trade war, Chinese deleveraging, a protracted economic expansion, bear markets in everything from sugar futures to energy stocks, and a virus outbreak. With the US 10-year versus 3-month yield curve having inverted anew, the obvious corollary is that a recession in the next few years (even of the stagflationary variety), will benefit the “hard” currencies. If we assume that the US 10-year CPI swap is a good reflection of investors’ perceptions of an inflationary versus deflationary world, then there are two crucial observations today. The first is that the British pound is the currency most attune to inflation today, while the Japanese yen thrives in deflation (Chart I-2). The second is that both the US dollar and the euro have been very indifferent to inflationary or deflationary risks over the past three years (Chart I-2, bottom panel). Using a very simple rule, an equally weighted basket of the British pound, US dollar1 and Japanese yen will make sense in this macroeconomic framework Chart I-1A Big F For Central ##br##Banks Chart I-2Inflation And Deflation Protection Are Important The Value Factor Our work suggests that valuation matters for currencies over the long term, a point we will discuss in an upcoming report. Therefore, the next challenge in building a protective portfolio is choosing currencies with the potential for long-term appreciation. While we look at a wide swathe of currency valuation models, we tend to adhere to the very simple and time-tested purchasing power parity (PPP) model. Our in-house PPP models have made two crucial adjustments. In order to get closer to an apples-to-apples comparison across countries, we divide the consumer price index (CPI) baskets into five major groups. In most cases, this breakdown captures 90% of the national CPI basket: food, restaurants and hotels (1), shelter (2), health care (3), culture and recreation (4), and energy and transportation (5). The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five subgroups grouped as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted-average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% in the US CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, compared to using the national CPI weights. Our in-house PPP models have made two crucial adjustments. The results show that the cheapest currencies today are the Swedish krona, the Norwegian krone and the Japanese yen (Chart I-3). This is good news. The Japanese yen was already favored in our simple macroeconomic framework, and so it remains in the portfolio. However, given that the Swedish krona, the Norwegian krone, and the British pound tend to be highly correlated, it may be useful to reduce the list. Of all three, the Norwegian krone has the same macroeconomic attributes as the pound (most correlated to rising nominal rates), but comes at a cheaper price (Chart I-4). And so, it replaces the British pound in the portfolio. Chart I-3Lots Of Value In NOK, SEK And JPY Chart I-4NOK And USD Remain Carry Currencies The Sentiment Factor Sentiment is difficult to measure in currency markets, since it is hard to find an exhaustive list that encompasses investor biases. Speculative positioning tends to be our favorite contrarian indicator, but has limitations as a timing tool. Meanwhile, certain currencies tend to be momentum plays, while others are mean-reversion plays. In general, when both positioning and momentum are at an extreme and rolling over, this is generally a potent signal for a currency cross. Being long Treasurys and the dollar has been a consensus trade for many years now. According to CFTC data, this has been expressed mostly through the aussie and the yen, although our bias is that the Swedish krona and Norwegian krone have been the real victims (Chart I-5). That said, long positioning in the dollar has been greatly reduced over the past several weeks. Flow data supports this view. Net foreign purchases of US Treasurys by private investors are still positive, but the momentum of these flows is clearly rolling over. This is being more than offset by official net outflows. As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Being long Treasurys and the dollar has been a consensus trade for many years now. The US dollar is a momentum currency, and the crossover between the 50-day and 200-day moving average has been good at signaling shifts in its intermediate trend (Chart I-6). Despite the recent uptick in the DXY, this still suggests downside in the coming months. Chart I-5Lots Of USD Longs Chart I-6Watch The DXY Technical Pattern So What? Chart I-7Who Will Be The Leaders In 2022? Regular readers of our bulletin are well aware that we are dollar bears. However, in constructing a currency portfolio that will stand resilient in the face of multiple macroeconomic shocks, our recommendation is an equal-weighted basket of the US dollar, the Japanese yen and the Norwegian krone. How has this protector portfolio performed over time? Not so well. Since the financial crisis, the basket has underperformed the DXY index, but has been relatively flat over the last half decade, while generating a positive carry (Chart I-7). In the aftermath of the Great Financial Crisis, positive returns on the Norwegian krone and Japanese yen offset dollar weakness, an environment that could be replayed once global growth bottoms. Obviously, this requires further research. Portfolio Calibration Our portfolio strategy for the last half year or so has focused on dollar-neutral trades, given the uncertainty that has been grappling currency markets. Most of these trades are agnostic to the three fundamental factors outlined above. Stick with them. Long AUD/NZD: This is a play on rising terms of trade between Australia and New Zealand, as well as a much more advanced housing downturn in Australia. Over the past five years, the cross has fluctuated between 1.02 and 1.12, currently sitting at the lower bound of this range. Increased agricultural exports from the US to China will hurt New Zealand at the margin, but long-term Aussie LNG imports and coal exports to China should remain relatively resilient. Long AUD/CAD: It is becoming clearer that the People’s Bank of China has a stronger incentive to stimulate its economy relative to the Fed. This will benefit the Chinese and Australian economies at the margin, and by extension the AUD/CAD cross (Chart I-8). Short CAD/NOK: A play on diverging oil fundamentals between North Sea crude and Canadian heavy oil. A swift rebound in the European economy relative to the US will also benefit this cross. Short USD/JPY: A top recommendation for the protector portfolio. It is noteworthy that this cross has a strong positive correlation to rising gold prices (and falling real rates). Long SEK/NZD: A mean reversion trade, primarily based on valuation and relative fundamentals. The latest PMI print suggests a meaningful improvement in the Swedish economy in the months ahead (Chart I-9). Chart I-8Stay Long AUD/CAD Buy ##br##AUD/CAD Chart I-9Bet On A Swedish (And European) Recovery A Tentative Bottom In Euro Area Data Short USD/NOK: A top recommendation for the protector portfolio as well as a play on rising oil prices. Ditto for the petrocurrency basket. Long EUR/CAD: A swift rebound in the European economy relative to the US will benefit this cross, similar to short CAD/NOK positions. Short CHF/JPY: Low-cost portfolio insurance negatively correlated to rising yields, and a strong positive correlation to rising gold prices (Chart I-10). Chart I-10The Yen Is Better Insurance Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 We use the USD/EUR exchange rate since the carry is positive. Returns are unhedged. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM manufacturing PMI soared to 50.9 while the Markit manufacturing PMI increased slightly to 51.9. The ISM non-manufacturing PMI increased to 55.5 and the Markit services PMI edged up to 53.4 in January. Nonfarm productivity grew by 1.4% quarter-on-quarter on an annualized basis in Q4 2019. Initial jobless claims fell to 202K from 217K for the week ended January 31st. The Johnson Redbook index of same-store sales grew by 5.7% year-on-year in January. The DXY index appreciated by 0.4% this week. In addition to coronavirus fears, a strong showing in domestic data has helped push up the USD. With the number of new coronavirus cases flattening outside of the Hubei province, it appears the rally in the DXY could end as early as mid to late-February. Report Links: Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 On Oil, Growth And The Dollar - January 10, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: GDP growth fell to 0.1% year-on-year from 0.3% in Q4 2019. The Markit manufacturing PMI moved up slightly to 47.9 while the services PMI increased to 52.5 in January. Retail sales growth slowed to 1.3% year-on-year from 2.3% in December. Core CPI inflation decreased slightly to 1.1% in January. The euro depreciated by 0.3% against the US dollar this week. While retail sales disappointed, the manufacturing and services PMI numbers beat expectations, confirming our expectations for a global growth rebound. With a European green deal on the horizon, and interest rates near the lower bound of negative territory, the euro is poised for recovery. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: The Markit manufacturing PMI declined to 48.8 from 49.3 in January while the services PMI increased to 51 from 49.4. Passenger vehicle sales continued to contract, going down 11.5% year-on-year in January. Construction orders rebounded strongly by 21.4% year-on-year in December, moving out of contractionary territory. The contraction in housing starts slowed to 7.9% year-on-year in December. The Japanese yen depreciated by 0.8% against the US dollar this week. The contraction in passenger vehicle sales can be largely attributed to extensive damage from typhoon Hagibis and typhoon Faxai. However, the Japanese economy will be buoyed by strong construction growth ahead of the summer Olympics, putting a floor under our short USD/JPY hedge. Report Links: Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased to 50 from 49.8 in January while the services PMI increased to 53.9 from 52.9. The GfK Group consumer confidence index ticked up to -9 from -11 in January. Consumer credit increased to GBP 1.22 billion in December from 0.66 billion in November. The British pound depreciated by 0.9% against the US dollar this week. In a speech delivered an hour before the UK left the European Union, PM Boris Johnson appeared defiant, rejecting EU rules on British industry and demanding a free trade agreement. Despite a decent uptick in the PMI numbers, the pound is weighed down by uncertainty about coming negotiations with the European Union. For option traders, pound volatility is set to rise. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: The Markit manufacturing PMI increased to 49.6 from 49.1 while the services PMI increased to 50.6 from 48.9 in January. Building permits grew by 2.7% year-on-year in December, moving out of contractionary territory. Exports grew by 1% month-on-month in December, slowing slightly from a growth rate of 1.3% the previous month. The Australian dollar appreciated by 0.5% against the US dollar this week. Despite concerns about coronavirus, and the bushfires, the Reserve Bank of Australia (RBA) decided to hold rates at 0.75%. The recovery in house prices now making its mark on building permits data, and the manufacturing PMI edging towards expansionary territory giving the RBA’s wiggle room in being patient. We are long AUD/NZD, AUD/CAD and AUD/USD. This makes a rebound in AUD one of our most potent bets. Stick with it. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: Building permits soared by 9.9% month-on-month in December, from an 8.4% contraction the prior month. The labor force participation rate moved down slightly to 70.1% in Q4 2019. The labor cost index grew by 2.4% year-on-year in Q4 2019, compared to growth of 2.3% in the previous quarter. The unemployment rate fell slightly to 4% in Q4 2019. The New Zealand dollar depreciated by 0.2% against the US dollar this week. With the data remaining positive and cases of the coronavirus outside the Hubei province set to peak in the coming weeks, the downward pressure on the New Zealand Dollar should ease. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been solid: The Markit manufacturing PMI increased to 50.6 from 50.4 in January. Canadian GDP growth remained fairly flat at 0.1% month-on-month in November. Imports increased slightly to C$ 49.69 billion in December 2019 while exports moved up to C$ 48.38 billion. The raw material price index grew by 2.8% in December, picking up pace from November’s reading of 1.4%. The Canadian dollar depreciated by 0.5% against the US dollar this week. The growth in Canadian exports was led by crude oil exports, which posted a monthly gain of 18% following the resolution of a rupture in the Keystone pipeline in North Dakota. However, a widening trade deficit with countries other than the US will put downward pressure on the Canadian dollar at the crosses. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: The SVME manufacturing PMI decreased to 47.8 from 48.8 in January. Real retail sales grew by 0.1% year-on-year in December, slowing from 0.5% in November. The SECO consumer climate indicator for Q1 2020 printed slightly better at -9.4 from -10.3 in Q4 2019. The Swiss franc depreciated by 0.5% against the US dollar this week. Domestically, consumer sentiment was buoyed by the general outlook on economic growth. However, the outlook for households’ own budget remains gloomy. The decrease in global volatility will undermine the Swiss franc and with an uncertain domestic outlook, stealth intervention might be on the horizon. Report Links: Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: The credit indicator, which measures growth in private sector debt, grew by 5.1% year-on-year in December, slowing from 5.6% the previous month. Registered unemployment (NSA) increased to 2.4% from 2.2% the previous month. The Norwegian Krone depreciated by 0.3% against the US dollar this week. However, the dramatic plunge in the NOK over the last few weeks, which has mirrored a similar drop in the WTI oil price, has taken contrarian investors by surprise. Our Commodity & Energy Strategists currently expect OPEC to respond with additional cuts of 500k barrels per day. In addition, if coronavirus cases peak sooner than expected, this will quicken the recovery in Asian economies, bolstering oil demand and driving up prices. Remain short USD/NOK. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly positive: The Swedbank manufacturing PMI soared to 51.5 from 47.7 in January. Industrial production contracted by 3.2% year-on-year in December, compared to growth of 0.1% the previous month. Manufacturing new orders contracted by 4.7% year-on-year in December, deepening the contraction of 1.8% in November. The Swedish Krona remained flat against the US dollar this week. As we noted last week, the Swedbank PMI has risen in lockstep with the business confidence number. It is now in expansionary territory for the first time since August of last year. Within the Swedbank survey, the sub-indices for new orders and production posted the largest gains. While the hard data on production and new orders for the month of December was disappointing, we expect it to follow the soft data upwards in the coming months as global growth concerns fade. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them. At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure. Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Chart 1The 2003 SARS Roadmap The bond market impact from the coronavirus has already been substantial. The 10-year Treasury yield has fallen back to 1.51%, below the fed funds rate. Meanwhile, the investment grade corporate bond index spread is back above 100 bps, from a January low of 93 bps. The 2003 SARS crisis is the best roadmap we can apply to the current situation. Back then, Treasury yields also fell sharply but then rebounded just as quickly when the number of SARS cases peaked (Chart 1). The impact on corporate bond excess returns was more short-lived (Chart 1, bottom panel). Like in 2003, we expect that bond yields will rise once the number of coronavirus cases peaks, but it is difficult to put a timeframe on how long that will take. The economic impact from the virus could also weigh on global PMI surveys during the next few months, delaying the move higher in Treasury yields we anticipated earlier this year. In short, we continue to expect higher bond yields and tighter credit spreads in 2020, but those moves will be delayed until markets are confident that the virus has stopped spreading. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 80 basis points in January. The sector actually outpaced the Treasury benchmark by 7 bps until January 21 when the impact of the coronavirus started to push spreads wider. As stated on page 1, we expect the impact of the coronavirus on corporate spreads to be short lived. Beyond that, low inflation expectations will keep monetary conditions accommodative. This in turn will encourage banks to ease credit supply, keeping defaults at bay and providing a strong tailwind for corporate bond returns.1 Yesterday’s Fed Senior Loan Officer survey showed a slight easing of C&I lending standards in Q4 2019, reversing the tightening that occurred in the third quarter (Chart 2). We expect that accommodative Fed policy will lead to continued easing of C&I lending standards for the remainder of the year. Despite the positive tailwind from accommodative Fed policy and easing bank lending standards, investment grade corporate bond spreads are quite expensive. Spreads for all credit tiers are below our targets (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 111 basis points in January. Junk outperformed the Treasury benchmark by 30 bps until January 21 when the coronavirus outbreak sent spreads sharply wider. Once the negative impact of the coronavirus passes, junk spreads will have plenty of room to tighten in 2020. In fact, the junk index spread is now at 390 bps, 154 bps above our target (Chart 3).3 While spreads for all junk credit tiers are currently above our targets, Caa-rated bonds look particularly cheap. We analyzed the divergence between Caa and the rest of the junk index in a recent report and came to two conclusions.4 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for 2019’s Caa spread widening that make us inclined to downplay any negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of 2019’s underperformance (bottom panel). Absent significant further declines in the oil price, this sector now has room to recover. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 53 basis points in January. The sector was only lagging the Treasury benchmark by 7 bps as of January 21, when the coronavirus outbreak sent spreads wider. The conventional 30-year zero-volatility spread widened 8 bps in January, driven by a 7 bps widening of the option-adjusted spread (OAS) and a 1 bp increase in expected prepayment losses (aka option cost). The fact that expected prepayment losses only rose by a single basis point even though the 30-year mortgage rate fell by 23 bps is notable. It speaks to the high level of refi burnout in the mortgage market, which is a key reason why we prefer mortgage-backed securities over investment grade corporate bonds in our portfolio. Essentially, most homeowners have already had at least one opportunity to refinance during the past few years, so prepayment risk is low even if rates fall further. Competitive expected compensation is another reason to move into Agency MBS. The conventional 30-year MBS OAS is 49 bps, only 7 bps below the spread offered by Aa-rated corporate bonds (Chart 4). Also, spreads for all investment grade corporate bond credit tiers are below our cyclical targets. Risk-adjusted compensation favors MBS even more strongly. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 14 basis points in January. The index was up 2 bps versus the Treasury benchmark until January 21, when the coronavirus outbreak hit. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, and Foreign Agencies underperformed by 28 bps. Local Authorities, however, bested the Treasury benchmark by 60 bps. Domestic Agency bonds underperformed Treasuries by 2 bps in January, while Supranationals outperformed by 2 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Local Authorities and Foreign Agencies, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 33 basis points in January (before adjusting for the tax advantage). They were up 39 bps versus the Treasury index before the coronavirus outbreak hit on January 21. The average Aaa-rated Municipal / Treasury (M/T) yield ratio swung around during the month, but settled close to where it began at 77% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Yield ratios have tightened a lot since then, but value remains at long maturities. Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all below average pre-crisis levels at 62%, 65% and 78%, respectively. But 20-year and 30-year yield ratios stand at 89% and 93%, respectively, above average pre-crisis levels. Fundamentally, state and local balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in January. Treasury yields declined across the curve, and the 2/10 slope flattened from 34 bps to 18 bps. The 5/30 slope flattened from 70 bps to 67 bps. Despite the significant flattening, the 2/10 slope remains near the middle of our target 0 – 50 bps range for 2020, and we anticipate some bear-steepening once the coronavirus is contained.8 The front-end of the curve also moved in January to price-in 57 bps of Fed rate cuts during the next 12 months (Chart 7). At the beginning of the year the curve was priced for only 14 bps of rate cuts. We expect that the Fed would respond with rate cuts if the coronavirus epidemic worsens, leading to inversion of the 2/10 yield curve. However, for the time being the safer bet is that the virus will be contained relatively quickly and the Fed will remain on hold for all of 2020. Based on this view, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. The position offers positive carry and looks attractive on our yield curve models (see Appendix B).9 TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent Treasury index by 75 basis points in January. The 10-year TIPS breakeven inflation rate fell 12 bps on the month and currently sits at 1.66%. The 5-year/5-year forward TIPS breakeven inflation rate fell 16 bps on the month and currently sits at 1.71%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target since mid-2018 (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. It takes time for expectations to adapt to a changing macro environment, but even accounting for those long lags, our Adaptive Expectations Model pegs the 10-year TIPS breakeven inflation rate as 31 bps too low (panel 4).10 It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor long-term inflation expectations. As a result, the actual inflation data will lead expectations higher, causing the TIPS breakeven inflation curve to flatten.11 ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 14 bps on the month. It currently sits at 26 bps, below its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector performed so well in January when other spread sectors struggled. ABS also offer higher expected returns than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends are slowly shifting in the wrong direction. The consumer credit delinquency rate remains low, but has put in a clear bottom. This is also true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 43 basis points in January. The index option-adjusted spread for non-agency CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level (Chart 10). In last week’s Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle, and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.12 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds from a risk/reward perspective (see our Excess Return Bond Map in Appendix C), and that the macro environment is only slightly unfavorable for CMBS spreads. Specifically, CRE bank lending standards are just in “net tightening” territory. But both lending standards and loan demand are very close to neutral (bottom 2 panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 34 basis points in January. The index option-adjusted spread tightened 4 bps on the month to reach 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 57 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 31, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 31, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 33 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 33 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Excess Return Bond Map (As Of January 31, 2020) Footnotes 1 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2 For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 9 For further details on our recommended yield curve trade please see US Bond Strategy Weekly Report, “The Best Spot On The Yield Curve”, dated January 21, 2020, available at usbs.bcaresearch.com 10 For further details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 12 Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation