Correlations
Highlights Remain short the DXY index. The key risk to this view is a US-led rebound in global growth, or a pickup in US inflation that tilts the Federal Reserve to a relatively more hawkish bias. Stay long a petrocurrency basket. The latest flare-up in US-Iran tensions is just a call option to an already bullish oil backdrop. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for maintaining a pro-cyclical stance. Feature The consensus view is rapidly converging to the fact that the dollar is on the precipice of a decline, and cyclical currencies are bound to outperform. This is good news for our forecast but bad news for strategy. The fact that speculators are now aggressively reducing long dollar positions, one of our favorite contrarian indicators, is disconcerting (Chart I-1). The dollar tends to be a momentum currency, so our inclination is to stay the course on short dollar positions (Chart I-2). That said, we are not dogmatic. In FX, momentum investors eventually get vilified, while contrarians get vindicated. This suggests revisiting the core risks to our view, especially in light of recent market developments. Chart I-1A Consensus Trade? Chart I-2The Dollar Is A Momentum Currency An Oil Spike: US Dollar Bullish Or Bearish? The latest story on the global macro front is the possibility of an oil spike, driven by escalation in US-Iran tensions. Our geopolitical strategists believe that while Middle East tensions are likely to remain elevated for years to come, a full-scale war is not imminent.1 This view is fomented by a few key factors. First, the Iranian response to the assassination of Qasem Soleimani was relatively muted, given no US lives were claimed. This was also reinforced by the Iranian foreign minister’s claim that the actions were concluded. As we go to press, the Kyiv-bound Ukrainian aircraft that crashed in Tehran is being characterised as an “act of God” so far. In a nutshell, this suggests de-escalation. Second, sanctions against Iran have been causing real economic pain, given rampant youth unemployment and falling government revenues. This means that Tehran will have to be strategic in any confrontation with the US, since the risks domestically are asymmetrically negative. Renegotiating a new nuclear deal seems like a better bargaining chip than an all-out war. The dollar tends to be a momentum currency, so our inclination is to stay the course on short dollar positions. The biggest risk for oil prices is the possibility of a more marked drop in Iranian production, or possibly the closure of the Strait of Hormuz, though this is a low-probability event for the moment (Chart I-3). Our commodity strategists posit that while a closure of the strait could catapult prices to $100/bbl, there are some near-term offsetting factors.2 These include strategic petroleum reserves in both China and the US, as well as OPEC spare capacity that could benefit from the newly expanded pipeline to the port of Yanbu. This suggests that a flare up in US-Iran tensions remains a call option rather than a catalyst on an already bullish oil demand/supply backdrop. Chart I-3The Risk From Iran Risks to oil demand remain firmly tilted to the upside. Oil demand tends to follow the ebb and flow of the business cycle. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers, and heavy trucks to a halt (Chart I-4). Any increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity remains a buffer but is very low, meaning any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints. Not to mention, unplanned outages typically wipe out 1.5%-2% of global oil supply. Any such occurrence in 2020 will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-4Oil Demand And Global Growth Chart I-5Opec Spare Capacity Is Low Traditionally, a pick-up in oil prices has tended to be bearish for the US dollar. In theory, rising oil prices allow for increased government spending in oil-producing countries, making room for the resident central bank to tighten monetary policy. This is usually bullish for the currency. An increase in oil prices also implies rising terms of trade, which further increases the fair value of the exchange rate. Balance-of-payment dynamics also tend to improve during oil bull markets. Altogether, these forces combine to become powerful undercurrents for petrocurrencies. That said, it is important to distinguish between malignant and benign oil price increases. There have been many recessions preceded by an oil price spike, and rising prices on the back of escalating tensions are not a recipe for being bullish petrocurrencies. That said, absent any escalating tensions or a marked pickup in global demand, which is not our base case, the rise in oil prices should be of the benign variety – pinning Brent towards $75/bbl. OPEC spare capacity remains a buffer but is very low, meaning any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints. In terms of country implications, rising oil prices will go a long way towards improving Canada’s and Norway’s trade balances. In the case of Norway, net trade fell in 2019 due to lower exports of oil and natural gas, but still stands at 5.1% of GDP. The trade balance is the primary driver of the current account balance, and the latter now stands at 4.4% of GDP. On the other hand, the Canadian trade deficit has been hovering near -1% of GDP over the past few years. Further improvement in energy product sales will require an improvement in pipeline capacity and a smaller gap between Western Canadian Select (WCS) and Brent crude oil prices (Chart I-6). We are bullish both the loonie and Norwegian krone, but have a short CAD/NOK trade as high-conviction bet on diverging economic fundamentals. Chart I-6NOK Will Outperform CAD Shifting Correlation Even though rising oil prices tend to be bullish for petrocurrencies, being long versus the US dollar requires an appropriate timing signal for a downleg in the greenback. With the US shale revolution grabbing production market share from both OPEC and non-OPEC producing countries, there has been a divergence between the price of oil and the performance of petrocurrencies. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-7). Chart I-7Shifting Landscape For Petrocurrencies This is especially pivotal as the US inches towards becoming a net exporter of oil. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. The strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar down-leg. Another strategy is to be long a basket of oil producers versus oil consumers. We are long an oil currency basket versus the euro as a dollar neutral way of benefitting from rising oil prices. Chart I-8 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Chart I-8Buy Oil Producers Versus Oil Consumers Risks To The View Above all, the dollar remains a counter-cyclical currency. As such, when global growth rebounds, more cyclical economies benefit most from this growth dividend, and capital tends to gravitate to their respective economies. This holds true for global oil and gas sectors that tend to have a higher concentration outside of US bourses. As such, one key risk is that if the S&P 500 keeps outperforming oil, as has been the case over the past decade, the dollar is unlikely to weaken meaningfully (Chart I-9). We understand this is a call on sectors (US tech especially), rather than relative growth profiles, but what matters for currencies is the impulse of capital flows. That said, improving global growth should allow EM energy consumption (a key driver of oil prices), to pick up. Chart I-9Oil Prices And The Stock Market The second risk is a pickup in US inflation expectations that tilts the Fed towards a relatively more hawkish bias. The economic linkage between US inflation and oil is weak, but financial markets assign a strong correlation to the link (Chart I-10). In our view, given that higher gasoline prices tend to hurt US retail sales, and the consumer is the most important driver of the US economy, higher oil prices can only be inflationary if the overall US economy is also robust (Chart I-11). This combination is unlikely to occur if rising oil prices are being driven by a flare-up in geopolitical tensions. Chart I-10A Rise In Oil Prices Will Help Inflation Expectations Chart I-11Gasoline Prices And US Consumption A US inflation spike in 2020 is a low-probability event. There have been two powerful disinflationary forces in the US. The first is the lagged effect from the Fed’s tightening policies in 2018. This is especially important given that the fed funds rate was eerily close to the neutral rate of interest, providing little incentive for firms to borrow and invest. This was further exacerbated by the trade war. Inflation is a lagging indicator, and it will take a sustained rise in economic vigor to lift US inflation expectations. This will not be a story for 2020 (Chart I-12). Meanwhile, the recent rise in the dollar and fall in commodity prices are likely to continue to anchor US inflation expectations downward, which should keep the Fed on the sidelines. Chart I-12Velocity Of Money Versus Inflation The gaping wedge between the US Markit and ISM PMIs remains a cause for concern. Given sampling differences, where the Markit PMI surveys more domestically-oriented firms, it is fair to assume it is also a barometer of US domestic growth relative to global output. Put another way, whenever the US services PMI is outperforming its manufacturing component, the dollar tends to appreciate (Chart I-13). Looking across global PMIs, there has been a notable pickup in Asia, specifically in Korea, Taiwan and Singapore, though weakness in Japan and Europe has persisted. This warrants close monitoring. Chart I-13The Risk To A Bearish Dollar View We continue to view further deceleration in the global manufacturing sector as a tail risk rather than our base case. Trade tensions have receded, global central banks remain very dovish, and Brexit uncertainty has diminished. This should allow global CEOs to begin deploying capital, on the back of pent-up investment spending. More importantly, the slowdown in the global economy has been driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. On the political spectrum, it has been historically rare for the Fed to raise interest rates a few months ahead of an election cycle, which should allow a weaker dollar to help grease the global growth supply chain. Any pickup in global manufacturing activity will allow the Riksbank to adopt a more hawkish bias, narrowing interest rate differentials between Norway and Sweden. Bottom Line: The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. This would be an environment in which US inflation would also surprise to the upside. So far, this remains a tail risk. Housekeeping We will soon be taking profits on our long NOK/SEK position. Reduce the target to 1.09 and tighten the stop to 1.06. Any pickup in global manufacturing activity will allow the Riksbank to adopt a more hawkish bias, narrowing interest rate differentials between Norway and Sweden. Most importantly, the cross will approach a profitable technical level in the coming weeks, on the back of our call a few weeks ago to rebuy the pair (Chart I-14). 2020 will be a year of much more tactical calls. Stay tuned. Chart I-14Take Profits On NOK/SEK Soon Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Alert "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Iran Responds To US Strike; Oil Markets Remain Taut," dated January 9, 2020, available at uses.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: ISM manufacturing PMI fell to 47.2 from 48.1 in December. However, Markit and ISM services PMIs both increased to 52.8 and 55, respectively. The trade deficit narrowed by $3.8 billion to $43.1 billion in November. ADP recorded an increase of 202K workers in December, the largest increase since April. Initial jobless claims fell from 223K to 214K, better than expected. MBA mortgage applications soared by 13.5% for the week ended December 27th. The DXY index recovered by 0.7% this week from its recent decline. Trump's speech has eased tensions between the US and Iran, making an escalation towards a full-scale war unlikely. Moreover, recent data point to a continued expansion in the US through 2020. That being said, we believe that the global growth will outpace the US, which is bearish for the dollar, but this is an important risk to monitor. Tomorrow’s payroll report will be an important barometer. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: Markit services PMI increased to 52.8 from 52.4 in December. Headline inflation jumped to 1.3% year-on-year from 1% in December, while core inflation was unchanged at 1.3%. Retail sales accelerated by 2.2% year-on-year in November, from 1.7% the previous month. The Sentix investor confidence soared to 7.6 from 0.7 in January. The expectations versus the current situation component continues to point to an improving PMI over the next six months. EUR/USD fell by 0.7% this week. Recent data from the euro area have been consistent with our base case view that the euro area economy is rebounding, and is likely to accelerate in 2020. We remain long the euro, especially against the CAD. 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 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been disappointing: The manufacturing PMI fell slightly to 48.4 from 48.8 in December; the services PMI also fell to 49.4 from 50.3 in December. Labor cash earnings fell by 0.2% year-on-year in November. Consumer confidence increased to 39.1 from 38.7 in December. USD/JPY increased by 1.2% this week. The Japanese yen initially surged on the back of US-Iran headlines, then fell as tensions faded after Trump's speech. While we don't expect a full-scale war between the US and Iran for the moment, geopolitical risks will likely persist before the elections later this year. We continue to recommend the Japanese yen as a safe-haven hedge, though our long position is currently out of the money. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Nationwide housing prices increased by 1.4% year-on-year in December. Halifax house prices also grew by 4% year-on-year in December. Markit services PMI surged to 50 from 49 in December. The British pound fell by 0.4% against the US dollar this week. On Thursday, BoE Governor Mark Carney said in a speech that “with the relatively limited space to cut the Bank Rate, if evidence builds that the weakness in activity could persist, risk management considerations would favor a relatively prompt response.” This has been viewed by the market as dovish and the pound fell on the message. In the long term, we like the pound as Brexit risk fades. In other news, the BoE has announced Andrew Bailey as the successor to Mark Carney, scheduled to take over in March 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: 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 Commonwealth bank services PMI increased to 49.8 from 49.5 in December. Moreover, the AiG manufacturing index slightly increased to 48.3 from 48.1. Building permits fell by 3.8% year-on-year in November. On a monthly basis however, it increased by 11.8%. Exports increased by 2% month-on-month in November, while imports fell by 3%. The trade surplus widened to A$5.8 billion. The Australian dollar plunged by 1.5% against the US dollar amid broad US dollar strength this week. The Aussie is the weakest currency so far this year. This is especially the case given demand destruction from the ongoing severe bushfires in Australia. On the positive side, a weaker Australian dollar could support exports and the current account as international trade picks up in 2020. The extent of fiscal stimulus will be an important wildcard for both the RBA and the AUD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly positive: House prices increased by 4% year-on-year in December. The ANZ commodity price index fell by 2.8% in December. The New Zealand dollar fell by 1% against the US dollar this week. On January 1st, China's central bank announced that it would inject additional liquidity into the economy. This is bullish for global growth along with a "Phase I" trade deal. As a small open economy, New Zealand is one of the countries that will benefit the most from a global growth recovery. We will be monitoring whether the scope for improvement in agricultural commodity prices is bigger than that for bulks, which underscores our long AUD/NZD position. 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 negative: Exports fell slightly by C$0.7 million in November. Imports also fell by C$1.2 million, which led to a narrower trade deficit of C$1.1 billion. Ivey PMI dropped sharply to 51.9 from 60 in December. Housing starts fell to 197K from 204K in December. Building permits also fell by 2.4% month-on-month in November. The Canadian dollar fell by 0.5% against the US dollar along with the decline in energy prices this week, erasing the gains earlier this year. While we expect the Canadian dollar to outperform the US dollar from a cyclical perspective, the CAD is likely to underperform against other cyclical currencies as global growth picks up steam through 2020. 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 positive: The manufacturing PMI rose to 50.2 from 48.8 in December, the first expansion since March 2019, mainly driven by increases in both production and new orders. Headline inflation shifted back to positive territory at 0.2% year-on-year in December, following negative prints for the past two consecutive months. Real retail sales were unchanged in November on a year-on-year basis. The Swiss franc was little changed against the US dollar this week, while it rose against other major currencies including the euro on the back of positive PMI and inflation data. More importantly, recent Middle East tensions have reignited safe-haven demand, increasing bids for the Swiss franc. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The unemployment rate fell further to 3.8% from 3.9% in October. The Norwegian krone has been fluctuating with the ebb and flow of US-Iran tensions and oil prices. This week it fell by 0.8% against the US dollar after Trump implied that both the US and Iran are backing off from an escalation into war. Moreover, the bearish oil inventory data from EIA managed to pull down oil prices even further. Despite the recent fluctuation in oil prices, we maintain an overweight stance on a cyclical basis based on a global growth recovery in 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 There has been scant data from Sweden this week: Retail sales increased by 1.3% year-on-year in November. On a month-on-month basis however, it fell by 0.4% compared with October. The Swedish krona fell by 0.8% against the US dollar this week amid broad dollar strength. Despite rising geopolitical tensions, we remain optimistic and expect the global economy to recover this year given the US-China trade détente and increasing stimulus from China. The Swedish krona is poised to rise with global growth and a stronger manufacturing sector. 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 Stock markets begin 2020 with fragile short-term fractal structures, which means there is a two in three chance of a tactical reversal. The bond yield impulse is now a strong headwind, which reliably predicts that bond yields are not far from a near-term peak. The oil price tailwind impulse is fading. German and European growth will lose some momentum in the first and/or second quarters of 2020. Tactically underweight equities versus bonds. But on a longer-term horizon, the low level of bond yields justifies and underpins exponentially elevated equity market valuations. Markets Are Fractally Fragile Stock markets begin 2020 with fragile short-term fractal structures. In plain English, this means that usually cautious value investors have become momentum traders, and their buy orders have fuelled a strong short-term trend. But the danger is that when everybody becomes a momentum trader, liquidity evaporates and the market loses its stability. After all, when everybody agrees, who will take the other side of the trade without destabilising the price? When everybody becomes a momentum trader, liquidity evaporates and the market loses its stability. When a fractal structure is fragile the tiniest of straws can break the camel’s back. But the straw is simply the catalyst for a potential market reversal. The straw could be, say, US/Iran geopolitical tensions escalating, or it could be something else, or there might be no straw needed at all. The underlying cause of the potential reversal is the market’s fragile fractal structure and its associated illiquidity and instability (Chart of the Week). Chart of the WeekStock Markets Are Fractally Fragile Investment presents no certainties, only probabilities. Successful investing is about identifying and playing those probabilities right. When the market’s fractal structure is at its limit of fragility, the probability that the short-term trend reverses by a third rises to two in three, while the probability that the short-term trend continues uninterrupted drops to one in three. Hence, a fractal warning of a reversal will be right two times out of three, but it will be wrong one time out of three. Still, we can accept being wrong one time out of three if it means we are right the other two times! For further details please revisit our recent Special Report ‘Fractals: The Competitive Advantage In Investing’.1 Translating all of this into current index levels, there is a two in three probability that over the next three months the Euro Stoxx 600 sees 405 before it sees 435. Across the Atlantic, there is a two in three probability that the S&P500 sees 3150 before it sees 3400 (Chart I-2). Nevertheless, a better tactical trade might be to play a short-term reversal in stocks in relative terms versus bonds. Chart I-2Stock Markets Are Fractally Fragile The Bond Yield Impulse Is Now A Strong Headwind A commonly held belief is that a decline in bond yields causes economic growth to accelerate. For example, we frequently hear bold claims such as: financial conditions have eased, so economic growth is likely to pick up. Unfortunately, the commonly held belief is wrong. What causes growth to accelerate or decelerate is not the change in financial conditions but rather the change in the change – the impulse. If the decline in the bond yield is the same in two successive periods, growth will not accelerate. For example, a 0.5 percent decline in the bond yield will trigger new borrowing through an increase in credit demand. The new borrowing will add to spending, meaning it will generate growth. But in the following period, all else being equal, a further 0.5 percent decline in the bond yield will generate the same additional new borrowing and thereby exactly the same growth rate. Therefore, what matters for a growth acceleration or deceleration is whether the bond yield change in the second period is greater or less than that in the first period. In other words, what matters is the bond yield impulse. A bond yield impulse at +1 percent constitutes a strong headwind to short-term growth. Now look at the actual numbers. The euro area 10-year bond yield stands at a lowly 0.45 percent and the 6-month change is a seemingly benign +0.2 percent. Nothing to worry about, right? Wrong. The crucial 6-month impulse equals a severe +1 percent, because the +0.2 percent rise in yields followed a sharp -0.8 percent drop in the preceding period (Chart I-3). A similar story holds in the US, where the bond yield 6-month impulse now equals +0.5 percent, the highest level in two years (Chart I-4). Chart I-3The Euro Area Bond Yield Impulse Is Now A Strong Headwind Chart I-4The US Bond Yield Impulse Is A Headwind Too A bond yield impulse at +1 percent constitutes a strong headwind to short-term growth. Hence, through the past decade, this impulse level has reliably predicted that bond yields are not far from a near-term peak (Chart I-5). Combined with fractally fragile stock markets, there is a two in three chance that equities underperform bonds by about 4 percent on a three month tactical horizon. Chart I-5When The Bond Yield Impulse Is A Strong Headwind, Bond Yields Are Near A Local Peak Yet on a longer horizon, the low level of bond yields also provides comfort to equity investors by underpinning elevated valuations. At ultra-low yields, bonds become a risky ‘lose-lose’ proposition: prices can no longer rise much, but they can fall a lot. As bonds become riskier, the much higher return required on formerly riskier assets – such as equities – collapses to the feeble return offered on equally-risky bonds (Chart I-6). Meaning that the valuation of equities resets at an exponentially higher level. Chart I-6Ultra-Low Bond Yields Justify Ultra-Low Returns From Equities As long as bond yields stay near current levels, long-term investors should prefer equities over bonds. The Oil Price Tailwind Impulse Is Fading The preceding discussion on the bond yield impulse applies equally to how the oil price can catalyse growth accelerations and decelerations. For the impact on inflation, what matters is the oil price change. But for the impact on growth accelerations and decelerations what matters is the oil price impulse. The German economy is especially sensitive to the oil price impulse. The German economy is especially sensitive to the oil price impulse. This is because its decentralized ‘hub and spoke’ structure requires a lot of criss-crossing of road traffic that relies on imported oil. Hence, when the oil price falls it subtracts from imports and thereby adds to Germany’s net exports, and vice versa (Chart I-7). But just as for the bond yield, what matters for a growth acceleration or deceleration is whether the oil price change in a given 6-month period is greater or less than that in the preceding 6-month period. In other words, the evolution of the oil price 6-month impulse. Chart I-7The Oil Price Explains Swings In Germany's Net Exports Oscillations in the oil price 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with an uncanny precision. The first half of 2019 constituted a severe headwind impulse, because a 30 percent increase in the oil price followed a 40 percent decline in the previous period, equating to a severe headwind impulse of 70 percent.2 But as the oil price stabilized in the second half of 2019, this flipped into a tailwind impulse of 30 percent (Chart I-8). Chart I-8The Oil Price Tailwind Impulse Is Fading Allowing for typical lags of a few months, this severe headwind impulse followed by a tailwind impulse explains why Germany experienced a sharp slowdown in the middle of 2019 followed by a healthy rebound which continued through the fourth quarter (Chart I-9). Chart I-9The Oil Price Impulse Explains Oscillations In German Growth However, even without any escalation of US/Iran tensions, the oil price 6-month impulse is now fading. Combined with the headwind from the bond yield 6-month impulse it is highly likely that German and European growth will lose some momentum in the first and/or second quarters of 2020. Next week, we will explain what all of this means for sector, country, and regional equity allocation in the first half of 2020. Stay tuned. Fractal Trading System* To repeat the main theme of the week, all of the major stock markets are fractally fragile. Play this by going tactically short stocks versus bonds. Our preferred expression of this is short the S&P500 versus the 10-year T-bond. Set the profit target at 5 percent with a symmetrical stop-loss. Chart I-10EUROSTOXX 600 In other trades, short GBP/NOK achieved its 2.5 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 62 percent comprising 19.7 wins and 12.0 losses. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Special Report ‘Fractals: The Competitive Advantage In Investing’, October 10, 2019 available at eis.bcaresearch.com. 2 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading System Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
The once-reliable negative correlation between gold and the USD was indefinitely suspended beginning in 4Q18 by the pervasive economic uncertainty we identified last week as the culprit holding back global oil demand growth via a super-charged dollar.1 This uncertainty is most pronounced in the U.S. and Europe vis-à-vis gold, and partly explains the performance of safe havens, particularly the USD, which has soared to new heights on a trade-weighted goods basis, and gold (Chart of the Week). So far, gold has held its ground after breaking above $1,500/oz from the low $1,200s in mid-2018, indicating investors are much more concerned about economic risks arising from economic policy uncertainty than inflation and other diversifiable risks gold typically hedges (Charts 2A, 2B). Cyclically we remain positive on gold prices on the back of a lower dollar and rising inflation pressure in the U.S. Chart of the WeekDemand For Safe Havens Soars As Economic Policy Uncertainty Rises Economic policy uncertainty in Europe and the U.S. supports gold prices. Even so, we are putting a $1,450/oz stop-loss on our long gold portfolio hedge to cover tactical risks showing up in our technical indicators. In addition, as is the case with oil demand, if the ceasefire we are expecting in the Sino-U.S. trade war materializes in 1H20 and limited trade – mostly in ags and energy – is forthcoming, demand for safe-haven assets could weaken gold prices at the margin. Fiscal and monetary stimulus globally also could revive economic growth and commodity demand, pushing global yields higher, which would put negative pressure on gold at the margin, as well, given the high correlation between real rates and gold prices. Chart 2AU.S., Euro Economic Uncertainty Correlated With Gold Prices Chart 2BU.S., Euro Economic Uncertainty Correlated With Gold Prices Highlights · Energy: Overweight. Saudi Arabia and Kuwait are on the verge of signing an historic pact to restart production from the Neutral Zone. Kuwait expects to sign the pact within 30 to 45 days. Potential production from the jointly operated fields – Khafji and Wafra – is estimated at ~ 500k b/d. Ramping up production at the Wafra field could take up to 6 months. Importantly, both countries are expected to respect their production quota mandated under the OPEC 2.0 agreement expiring in 1Q20.2 Separately, Chevron’s waiver to operate in Venezuela was extended for three months from the Trump administration this week. · Base Metals: Neutral. Chile copper production was up 1% and 11% y/y in July and August, according to the World Bureau of Metal Statistics. Earlier this week, the Union of workers at Chile’s Escondida copper mine – the world’s largest – held a strike in support of broader protests sparked by the increase of metro fare last Friday. Chile’s President suspended the fare hike on Saturday, but the protests are still ongoing and have now caused 15 deaths.3 · Precious Metals: Neutral. The gold/silver ratio fell 9% since July 2019. Our tactical long spot silver recommendation is up 3% since inception in August 2019, and our strategic long gold position is up 21%. Cyclically, we remain positive on both silver and gold prices, more on this below. A tactical pullback is possible; money managers have started liquidating some of their long gold positions, dropping by 67k contracts from September levels, according to CFTC data. · Ags/Softs: Underweight. According to USDA data, corn and soybean harvest are 30% and 46% complete, lagging behind their respective 47% and 64% five-year average pace. For corn, the USDA rates 54% of the U.S. crop good or excellent, vs. 66% a year earlier. For beans, 56% of the crop is rated good or excellent, vs. 68% last year. Separately, China announced waivers allowing up to 10mm MT of U.S. soybeans to be imported by domestic and international crushing concerns. The waivers are in place until March 2020. Feature The once-reliable negative correlation between gold and the USD will remain muted over the short-term tactical horizon – 3 to 6 months – as economic policy uncertainty continues to stoke global demand for safe havens.4 The once-reliable negative correlation between gold and the USD will remain muted over the short-term. This can be seen in the elevated correlations between the USD’s broad trade-weighted goods index with the Baker-Bloom-Davis (BBD) Economic Policy Uncertainty (EPU) indexes for the U.S. and Europe (Chart 3).5 Rising economic uncertainty – particularly since 4Q18 – has created a rare environment in which both the USD and gold trended up simultaneously and continue to move in the same direction. The implication of this is that gold’s correlation with both the USD and EPU is weaker than before because economic policy uncertainty now is positively correlated with the dollar. Chart 3Strong USD, EPU Correlation Chart 4Correlation of Daily Gold, USD Returns Also Moving Sharply Higher There is a possibility global policy uncertainty could be reduced later this year if the U.S. and China can agree on a trade ceasefire... The typically negative correlation between daily returns of gold and the USD also is weakening, moving toward positive territory (Chart 4), as both the USD and gold trend higher simultaneously (Chart 5). Chart 5Gold and USD Levels Trending Higher ...If this occurs, the risk premium supporting gold will ease, and markets will once again turn their attention to possible inflationary consequences of the global stimulus. Our short-term technical indicator is signaling an overbought gold market (Chart 6), and our fair-value model indicates gold should be trading ~ $1,450/oz (Chart 7). The latter signal off our fair-value model is less concerning, given the demand for safe-haven assets like the USD and gold now dominates gold’s typical drivers. Chart 6Gold Technical Indicators Signal Overbought Market Chart 7High USD Correlation Throws Off Fair-Value Model However, to be on the safe side, we are placing a $1,450/oz stop-loss on our long-term gold position, which as of Tuesday’s close was up 21% since inception on May 14, 2017. This is a precautionary measure, which recognizes the possibility global policy uncertainty could be reduced later this year if the U.S. and China can agree on a trade ceasefire, and global fiscal and monetary policy are successful in reviving EM income growth, which would revive commodity demand generally, pushing up global bond yields. If this occurs, the risk premium supporting gold will ease, and markets will once again turn their attention to possible inflationary consequences of the global stimulus. During that period, the monetary and fiscal aggregates we track as explanatory variables for gold prices will reassert themselves as the dominant drivers of gold prices (see below). This could produce tension between a falling USD and rising real rates as growth picks up, which would send us to a risk-neutral setting re gold, given the current high correlation between gold and real rates, which should remain strong until the Fed starts hiking rates again, most likely in 2020 (Chart 8). This is part of the reason we are including the stop-loss at $1,450/oz for our existing gold position: During this risky period going into 1H20 economic uncertainty could dissipate, and real rates could rise. Although the USD depreciation would mute these effects, rising real rates would be a risk to gold prices Chart 8Rising Real Rates Could Weaken Gold Prices Economic Uncertainty Dominates Gold’s Fundamentals At present, economic policy uncertainty overwhelms the other factors we typically use as explanatory variables when modeling gold prices. In Table 1, we collect the variables we consider when assessing gold’s fair value. At present, economic policy uncertainty overwhelms the other factors we typically use as explanatory variables when modeling gold prices. This variable broadly falls in the geopolitical risk we regularly account for in our analysis of gold markets. Table 1Fundamental And Technical Gold-Price Drivers If the uncertainty captured by the EPU indexes is resolved, we would expect the dollar to fall and the negative gold-USD correlation to reassert itself and strengthen. Checking off each of these groups, we see: · Demand for inflation hedges remaining muted over the short-term, as inflationary pressures remain weak. In line with our House view, however, we do expect inflation could move higher toward the end of next year and overshoot the Fed’s 2% target for the U.S. This would support gold prices. · Monetary and financial aggregates are working less well as explanatory variables for gold prices in a market dominated by economic policy uncertainty. The USD-gold correlation continues to be disrupted by strong demand for safe-haven assets. As inflation picks up next year, we expect nominal bond yields to rise. Real rates, however, could remain subdued, as long as the Fed is not aggressively raising rates to get out ahead of a possible revival of inflation (Chart 9). Later in 2020, the correlation between rates and gold should be supportive for gold prices – the correlation fades when the Fed tightens, which creates a demand for safe-haven assets like gold. All the same, an increase in real rates would be a risk to gold prices in 1H20. · At present, demand for portfolio-diversification assets via safe-haven assets is a powerful force in gold’s price evolution. It is worthwhile pointing out, however, that if global economic uncertainty is resolved and global growth does rebound, recession fears will diminish, thus reducing the marginal impact of geopolitical shocks. On the other hand, if the uncertainty captured by the EPU indexes is resolved, we would expect the dollar to fall and the negative gold-USD correlation to reassert itself and strengthen. Should that happen, short-term volatility in gold will rise (Chart 10). Chart 9Bond Yields Should Rise As Inflation Revives In 2H20 Chart 10Investors Expect Large Positive Moves In Gold And Silver Prices Investment Implications As India’s and China’s economic growth picks up, we expect income to grow, which would support physical gold demand in EM countries. Over a tactical horizon – i.e., 3 to 6 months – we expect global economic policy uncertainty to remain elevated. Going into 2020 – and particularly in 2H20 – we expect the USD to weaken on the back of global monetary accommodation policies and increased fiscal stimulus. We also are expecting a ceasefire in the Sino-U.S. trade war, which will revive trade somewhat and support EM income growth and commodity demand. These assumptions, which we’ve laid out in previous research, will be bullish cyclical factors supporting commodities generally. Bottom Line: A ceasefire in the Sino-U.S. trade war, coupled with global fiscal and monetary stimulus, will reduce some of the economic uncertainty dogging aggregate demand. This should be apparent in the data in 1H20. As a result, we continue to expect rising EM income growth to be cyclically bullish for commodities generally. This will allow inflation to revive – again, assuming the Fed does not become aggressive in raising rates. Chart 11EM Income Growth Will Support Demand For Gold Net, this will be bullish for gold: As India’s and China’s economic growth picks up, we expect income to grow, which would support physical gold demand in EM countries (Chart 11). Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 Please see our report entitled “Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth,” published October 17, 2019. It is available at ces.bcaresearch.com. 2 Please see “Kuwait Sees Neutral Zone Oil Pact With Saudis Within 45 Days,” published by Bloomberg.com on October 19, 2019. 3 Please see “Chile lawmakers call for social reforms as protests mount,” published by reuters.com on October 22, 2019. 4 We expect a ceasefire in the Sino-US trade war to be announced in 1H20, which will defuse – but not eliminate – an important risk for global growth in our analytical framework. We expect this will allow the relationship between the USD and gold to move back to its previous equilibrium in 1Q20 or 2Q20. 5 For more info on the Baker-Bloom-Davis index, please see policyuncertainty.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary Of Trades Closed In 2018 Summary Of Trades Closed In 2017 Summary Of Trades Closed In 2016
Pervasive global policy uncertainty continues to fuel USD safe-haven demand. This keeps the Fed’s broad trade-weighted dollar index for goods close to record highs, which continues to stifle oil demand. At present, we do not expect this pervasive uncertainty to dissipate. For this reason, we are lowering our oil-demand growth expectation slightly for this year and next. Our estimate of global supply growth is slightly lower for this year and next, as well; we continue to expect OPEC 2.0 to maintain production discipline and for capital markets to restrain U.S. shale-oil growth.1 Our price forecast for 4Q19 is $66/bbl on average, an estimate that includes a risk premium reflecting continued tension in the Persian Gulf. Our updated supply-demand balances for 2020 reduce our Brent price forecast to $70/bbl versus our earlier expectation of $74/bbl. We continue to expect WTI to trade $4.00/bbl below Brent next year. Highlights Energy: Overweight. The Trump administration likely will not renew Chevron’s waiver to operate in Venezuela when it expires October 25. This raises the likelihood the country’s oil output will fall below 300k b/d, down from the 650k b/d we currently estimate.2 Production could revive next year, if Russian or Chinese firms step in to fill the void. This is not certain, however, as the U.S. is pressing both to end their support for the Maduro regime. Separately, the Aramco IPO could occur as early as November, according to press reports. Base Metals: Neutral. Copper treatment and refining charges in Asia are staging a recovery, clocking in at $56.70/MT at the end of last week, according to Metal Bulletin’s Fastmarkets. The MB index fell to a record low of $49.20/MT in late August. Precious Metals: Neutral. Gold volatility remains elevated – standing at 15.1% p.a. on the COMEX – as markets continue to process news re a partial easing of tensions in the Sino-US trade war. Geopolitical tensions, which now encompass Turkey-US relations, remain elevated. Ags/Softs: Underweight. Uncertainty around a partial deal involving ag exports from the U.S. to China remains high, as negotiators deliberately minimize expectations of a successful outcome. The big sticking point appears to be whether U.S. tariffs on Chinese imports due to kick in in December will be removed. Feature Uncertainty arising from global economic policy risk continues to dominate commodity markets. This has been the case going on three years. While it is ubiquitous, it is difficult to isolate. In earlier research, we noted the tightening of global financial conditions – largely the result of the Fed’s rates normalization policy, which resulted in four rate hikes last year, and China’s deleveraging policy – were responsible for the sharp slowing of oil demand seen in 2H18-1H19.3 Recently concluded research allows us to extend our earlier thesis to account for the effect of pervasive global policy uncertainty over the past three years, which has dominated our analysis of commodity markets generally, oil in particular. To wit: We find a strong, positive correlation between uncertainty, as measured by the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index, and the Fed's USD broad trade-weighted index for goods (TWIBG) from January 2017 to now (Chart of the Week).4 Chart of the WeekUSD Absorbs Global Policy Uncertainty USD Absorbs Global Uncertainty Sudden policy shifts have, over the past three years, resulted in a steady increase in the level of the GEPU index. Prior to 2017, the correlations between the GEPU index and the USD TWIBG were running at 33% and 63% for the periods 2000 to 2016 and 2010 to 2016, the post-GFC period for y/y returns. However, as right- and left-wing populism gained ground globally and monetary policy generally became more “data dependent” and ad hoc at the Fed, ECB and BoJ, the GEPU and USD TWIBG indices became highly correlated, surpassing 90% (Chart 2).5 This period saw the U.S. become more and more assertive vis-à-vis trade and foreign policy, particularly in re China, Iran and Venezuela, which caused those states to implement their own policy responses. In addition, as monetary policy generally became increasingly accommodative, central banks – and policy analysts – became less certain about the effects of their policies on the broader economy (e.g., the Fed shifting away from rates normalization, the ECB’s re-launching of QE, and the BoJ’s interest-rate targeting regime). Chart 2Co-Movement In GEPU, USD TWIBG Often, commodity markets were forced to adjust to sudden policy changes – e.g., the imposition of trade tariffs against China, or the granting of waivers to Iran’s eight largest importers in November 2018 just before oil-export sanctions were re-imposed. Sudden policy shifts have, over the past three years, resulted in a steady increase in the level of the GEPU index. Increasing uncertainty translated into a steadily increasing USD TWIBG, with safe-haven demand for dollars rising, as the Chart of the Week indicates. To date, we have not decomposed the drivers of monetary conditions, particularly in re central-bank accommodation versus global economic policy uncertainty on the evolution of the USD. The GEPU index hit a record high in August 2019, while the USD TWIBG hit a record in September 2019. It is possible the effects of general policy uncertainty could be cumulative – as earlier uncertainties remain unresolved and new ones are added to the global mix (e.g., US-Turkey foreign-policy tensions now have been added to other geopolitical risks). It is entirely possible global monetary policy easing – particularly from the Fed – is accommodating safe-haven demand accompanying higher uncertainty. If the Fed were to tighten while uncertainty remains elevated the USD could rally sharply and impact commodity demand even more. Persistent USD Strength Lowers Oil Price Forecast Based on our analysis, the effects of the uncertainty we observe in the USD above are transmitted to GDP globally, which feeds through to commodity demand. As the USD strengthens, it raises the local-currency cost of commodities and the cost of servicing USD-denominated debt ex-US. In addition, on the supply side, a stronger dollar lowers local production costs at the margin, which stokes deflation globally. All else equal, these effects push oil prices lower by reducing demand and increasing supply at the margin. On the back of a stronger USD and persistent uncertainty, we are once again lowering our estimate of global demand growth. This is most pronounced in EM economies (Chart 3), but there are feedback effects into DM in the form of reduced trade volumes, which hits manufacturing economies like Germany harder than service-dominated economies like the US. On the back of a stronger USD and persistent uncertainty, we are once again lowering our estimate of global demand growth to 1.13mm b/d this year and 1.40mm b/d in 2020 (Chart 4). This is down slightly from 1.2mm b/d this year and 1.5mm b/d next year. In line with the U.S. EIA, we also lowered our estimate of 2018 demand, which has the effect reducing the level of demand we expect in 2019 and 2020. Chart 3Local-Currency Oil Costs Are High Chart 4BCA Research Supply-Demand Balances We maintain our expectation fiscal and monetary stimulus globally will revive demand, but, given the deleterious effects of global uncertainty and its effects on demand via the USD, we are moderating our position some, as the downward adjustment to consumption indicates. On the supply side, we expect KSA’s output to be fully restored by November, and for production in the Kingdom to average 9.9mm b/d in October and November. We are expecting overall OPEC 2.0 output growth of 250k b/d on average in the 2Q20 to 4Q20 interval, down from our previous growth estimate of 500k b/d. In the US, we expect shale-oil output to grow 900k b/d in 2020, versus 1.3mm b/d in 2019, which will leave overall U.S. crude output at 13.3mm b/d next year on average, as capital-market constraints continue to act as a governor on total output (Chart 5). Chart 5U.S. Shale-Oil Output Will Remain Capital-Constrained Overall, we expect global supply to finish 2019 at 100.8mm b/d and at 102.3mm b/d next year, which is down slightly from our earlier estimates (Table 1). Even with demand moderating, we expect inventories to continue to draw this year and into 3Q20 before they resume building, as the combination of OPEC 2.0 production discipline and capital markets constrain output (Chart 6). Chart 6OECD Oil Inventories On Track To Draw Table 1 Investment Implications Continued voluntary and involuntary production restraint will allow global inventories to draw despite slightly lower demand. Given our supply-demand expectations, we forecast Brent will trade lower next year, at $70/bbl on average versus our earlier expectation of $74/bbl. This is ~ $10/bbl above the median consensus. We continue to expect WTI to trade $4.00/bbl below Brent next year. Continued voluntary and involuntary production restraint will allow global inventories to draw despite slightly lower demand, which will keep Brent and WTI forward curves backwardated next year (WTI was in a slight carry earlier this week, while Brent was backwardated). We would caution that any resolution of the profound uncertainty currently dogging global markets could unleash pent-up demand that would sharply rally commodities generally, and oil in particular. This could take the form of a broad trade agreement that ends the Sino-US trade war – an unlikely, but not impossible, turn of events – or an unexpected reduction in tensions in the Persian Gulf, again, unlikely but not impossible. Bottom Line: Resolution of global policy uncertainty would revive commodity demand, as safe-haven USD demand gives way to higher consumer spending, renewed growth in global trade and investment. Until then, uncertainty will continue to hamper commodity demand growth, particularly for oil. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1 OPEC 2.0 is the moniker we coined for the producer coalition formed at the end of 2016 to regain control of production following the disastrous market-share war launched by OPEC in 2014, which took Brent prices from above $100/bbl to $26/bbl by early 2016. The coalition is led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 Please see Venezuelan oil output could be halved without Chevron waiver extension: analysts, posted by S&P Global Platts October 14, 2019. 3 Please see our report entitle Central Bank Easing Key To Oil Prices, published September 5, 2019. It is available at ces.bcaresearch.com. 4 This GEPU is a monthly GDP-weighted index of newspaper headlines containing a list of words related to three categories – “economy,” “policy” and “uncertainty.” Newspapers from 20 countries representing almost 80% of global GDP (on an exchange-weighted basis) are scoured monthly to create the index. Please see GEPU and Baker-Bloom-Davis for additional information. 5 Both series are plotted as percent changes y/y in Chart 2. For the 2017 - 2019 period, the coefficient of determination for this model is 0.81 using a regression of the USD on the GEPU. There was no statistically significant relationship between them either from 2000 to 2016, or from 2010 to 2016. Insert SOFTS text here Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
Analysis on Turkey is available below. Highlights A dovish Fed or robust U.S. growth does not constitute sufficient conditions for a bull market in EM. China’s business and credit cycles are much more important factors for EM than those of the U.S. A recovery in the Chinese economy and global manufacturing is not imminent. The common signal reverberating from various financial markets is that the risks to the global business cycle are still skewed to the downside. Feature Current investor perceptions of emerging markets are mixed. Some expect EM to benefit greatly from low U.S. interest rates. These investors view even a partial trade deal between the U.S. and China as sufficient for EM to embark on a bull market. BCA’s Emerging Markets Strategy team disagrees with this narrative. We deliberated the significance of the U.S.-China confrontation to EM in our September 19 report; therefore, we will not go over this subject here. Rather, in this report we discuss some of the more common misconceptions surrounding EM currently, and infer what these mean for investment strategies. Perception 1: The share of resource sectors (materials and energy) in the EM equity benchmark has declined substantially. This along with the expanded role of consumers and consumer stocks (Alibaba, Tencent and Baidu) in EM economies and equity markets has made their share prices less exposed to the global trade cycle and commodities prices. Reality: It is true that in many EM bourses, the weight of consumer stocks has been growing. Nevertheless, their financial markets in general, and equity markets in particular, remain very sensitive to the global trade cycle and commodities prices. Chart I-1 illustrates that the aggregate EM equity index has historically been and continues to be strongly correlated with the global basic materials stock index. The latter includes mining, steel and chemical companies. Global materials stocks also exhibit a very strong correlation with Chinese banks’ share prices. Moreover, global materials stocks also exhibit a very strong correlation with Chinese banks’ share prices (Chart I-2). The rationale for the high correlation is that both mainland banks’ profits and global demand for basic materials are driven by a common factor: China’s business cycle. Chart I-1EM And Global Materials Stocks Move Together Chart I-2Chinese Bank And Global Materials Share Prices Are Highly Correlated For example, construction in China is contracting (Chart I-3), which entails both higher NPLs for Chinese banks and lower demand for basic materials. China accounts for about 50% of global consumption of industrial metals, cement and many other basic materials. Finally, EM ex-China bank stocks also correlate strongly with global basic materials share prices. The basis is as follows: Many emerging economies export raw materials, and commodities price fluctuations impact their business cycle, exports and exchange rates. Chart I-3China: Construction Activity Is Contracting Chart I-4High-Yielding EM: Currencies And Local Bond Yields Historically, in high-yielding EM markets, currency depreciation has led to higher interest rates and lower bank share prices, and vice versa (Chart I-4). Lately, EM bond yields have not risen in response to EM currency depreciation. However, we believe this correlation will soon be re-established if EM currencies continue drifting lower. In short, China’s money/credit cycles drive not only the mainland’s business cycle, banking profits and NPLs, but also global trade and commodities prices. The latter two - via their impact on exchange rates and in turn interest rates - have historically explained credit and domestic demand cycles in high-yielding EM. Perception 2: EM stocks are a high-beta play on the S&P 500, i.e., EM equities outperform when the S&P 500 rallies, and vice versa. Reality: Since 2012, the beta for EM equity versus the S&P 500 has often been below one (Chart I-5). Furthermore, since 2012, EM share prices often failed to outpace their DM peers during global equity rallies. Indeed, EM relative equity performance versus DM, as well as the EM ex-China currency total return index, have been closely tracking the relative performance of global cyclicals versus global defensive stocks (Chart I-6). Chart I-5EM Equities Beta To The S&P 500 Chart I-6Global Cyclicals-To-Defensives Equity Ratio And EM In short, EM equities and currencies have been, and will remain, sensitive to the global business cycle rather than the S&P 500. Since 2012, the latter has - on several occasions - decoupled from the global manufacturing and trade cycles. Perception 3: EM stocks, currencies and fixed-income markets are very sensitive to U.S. interest rates. Hence, a dovish Fed will lead to EM currency appreciation. Reality: Chart I-7 reveals that EM currencies, total returns on EM local currency bonds in U.S. dollar terms and EM sovereign credit spreads do not exhibit a strong relationship with U.S. Treasury yields. U.S. interest rate expectations have a much smaller impact on EM financial markets than commonly perceived by the investment community. Overall, U.S. interest rate expectations have a much smaller impact on EM financial markets than commonly perceived by the investment community. Chart I-7EM And U.S. Bond Yields: No Stable Correlation Chart I-8China Cycle And EM Stocks Led U.S. Bond Yields On the contrary, the declines in U.S. bond yields in both 2015/16 and in 2018/19 were due to the growth slowdown that emanated from China/EM. The top panel of Chart I-8 illustrates that Chinese import growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. What is more, EM share prices have been leading U.S. bond yields in recent years, not the other way around (Chart I-8, bottom panel). Perception 4: If the U.S. avoids a recession, EM risk assets will recover. Chart I-9EM Profits Are Driven By Chinese Not U.S. Business Cycle Reality: EM per-share earnings contracted in 2012-2014 and in 2019, despite reasonably robust growth in U.S. final demand (Chart I-9, top panel). This suggests that even if the U.S. economy avoids a recession, that will not be a sufficient condition to be bullish on EM. EM corporate profits are highly driven by China’s business cycle. The bottom panel of Chart I-9 illustrates that mainland domestic industrial orders have been the key driver of EM corporate profit cycles since 2008. Perception 5: EM equities, fixed-income markets and currencies are cheap. Reality: EM stocks are not cheap. They are fairly valued. Equity sectors with very poor fundamentals have very low multiples. Hence, they are “cheap” for a reason. These include Chinese banks, state-owned enterprises in various countries and resource companies. Equity segments with robust fundamentals are overpriced. Given that Chinese banks, state-owned enterprises in various countries, resource companies, and cyclical businesses have very large market caps, EM market-cap based equity valuation ratios are low – i.e., they appear cheap. To remove the impact of these large market cap segments, we constructed and have been publishing the following valuation ratios: median, 20% trimmed mean and equal-sub-sector weighted (Chart I-10). Each of these is calculated based on the average of trailing and forward P/E ratios, price-to-book value, price-to-cash earnings and price-to-dividend ratios. EM equities relative to DM are not cheap either. Chart I-11 demonstrates the same ratios – median, 20% trimmed-mean and equal-sub-sector weighted values for EM versus DM. Chart I-10EM Equities Are Not Cheap Chart I-11Relative To DM EM Stocks Are Not Cheap Further, when valuations are not at extremes as in the case of EM equities at the moment, the profit cycle holds the key to share price performance over a 6 to 12-month horizon. EM earnings are presently contracting in absolute terms, and underperforming DM EPS. Two currencies that offer value are the Mexican peso and Russian ruble. Chart I-12EM Local Yields Are Low In Absolute Terms And Relative To U.S. In the fixed-income space, EM local bond yields are very low in absolute terms and relative to U.S. Treasury yields (Chart I-12). EM sovereign and corporate spreads are not wide either. As to exchange rates, the cheapest currencies are those with the worst fundamentals, such as the Argentine peso, Turkish lira and South African rand. The majority of other EM currencies are not very cheap. Two currencies that offer value are the Mexican peso and Russian ruble. Yet foreign investors are very long these currencies, and a combination of lower oil prices and portfolio outflows from broader EM will weigh on these exchange rates as well. Takeaways And Investment Strategy Chart I-13EM Currencies And Industrial Metals Prices EM risk assets and currencies exhibit the strongest correlation with global trade and commodities prices. Chart I-13 indicates that the EM ex-China currency total return index closely tracks commodities prices. This corroborates the messages from Chart I-1 on page 1 and Chart I-6 on page 4. China’s business and credit cycles are much more important for EM than those of the U.S. A dovish Fed or strong U.S. growth are not sufficient reasons to bet on an EM bull market. A recovery in the Chinese economy and global manufacturing is not imminent. Individual EM countries’ domestic fundamentals such as return on capital, inflation, banking system health, competitiveness and politics drive individual EM performance. On these accounts, the outlook varies among EM. Readers can find analyses on specific EM economies in our Countries In-Depth page. Asset allocators should continue underweighting EM stocks, credit and currencies versus their DM counterparts. Absolute-return investors should outright avoid EM, or trade them on the short side. Within the EM equity space, our overweights are Mexico, Russia, Central Europe, Korea ex-tech, Thailand and the UAE. Our underweights are South Africa, Indonesia, Philippines, Hong Kong, Turkey and Colombia. The path of least resistance for the U.S. dollar is up. Continue shorting the following basket of EM currencies versus the dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We are also short the CNY versus the greenback. As always, the list of our country allocations for local currency bonds and sovereign credit markets is available at the end of our reports – please refer to page 16. Take Cues From These Markets We suggest investors take cues from the following financial market signals. They are unequivocally sending a downbeat message for global growth and risk assets: The ratio between Sweden and Swiss non-financial stocks in common currency terms is heading south (Chart I-14). Swedish non-financials include many companies leveraged to the global industrial cycle, while Swiss non-financials are dominated by defensive stocks. Hence, the persistent decline in this ratio presages a continued deterioration in the global industrial sector. Where is the next defense line for this ratio? To reach its 2002 and 2008 nadirs, it will need to drop by another 10%. In the interim, investors should maintain a defensive posture. Chart I-14A Message From Swedish And Swiss Equities Chart I-15A Breakdown In The Making? U.S. FAANG stocks appear to be cracking below their 200-day moving average. The relative performance of global cyclical versus global defensive stocks is relapsing below the three-year moving average that served as a support last December (Chart I-15). U.S. FAANG stocks appear to be cracking below their 200-day moving average (Chart I-16). If this support gives, the next one will be about 17% below current levels. Finally, U.S. high-beta share prices are on the verge of a breakdown (Chart I-17). The next technical support is 10% below current levels. Chart I-16FAANG Are On The Support Line Chart I-17U.S. High-Beta Stocks Are On The Edge Bottom Line: The common message reverberating from these financial markets corroborates our fundamental analysis that a global business cycle recovery is not imminent, and that global risk assets in general, and EM financial markets in particular, are at risk of selling off further. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Turkey: Is The Mean-Reversion Rally Over? Turkish financial markets have rebounded to their respective falling trend lines (Chart II-1). Are they set to break out or is a setback looming? Chart II-1Back To Falling Trend Chart II-2TRY Is Cheap Pros The economy has undergone a considerable real adjustment and many excesses have been purged: The current account balance has turned positive as imports have collapsed. Going forward, lower oil prices are likely to help the nation’s current account dynamics. The lira has become cheap (Chart II-2). According to the real effective exchange rate based on unit labor costs, the currency is one standard deviation below its fair value. Core and headline inflation have fallen, allowing the central bank to cut interest rates aggressively. However, the exchange rate still holds the key: if the currency depreciates anew, local bonds yields will rise and the ability of the central bank to reduce borrowing costs further will diminish. Finally, private credit and broad money growth have decelerated substantially and are contracting in inflation-adjusted terms (Chart II-3). Chart II-3Money & Credit Have Bottomed Chart II-4Banks Have Been Aggressively Buying Government Bonds The recent gap between broad money and private credit growth has been due to commercial banks buying government bonds (Chart II-4). When a commercial bank purchases a security from non-banks, a new deposit/new unit of money supply is created. Banks’ purchases of government bonds en masse have capped domestic bond yields. However, if pursued aggressively, such monetary expansion could weigh on the currency’s value. Cons Presently, potential sources of macro vulnerability in Turkey are: Foreign debt obligations (FDOs) – which are calculated as the sum of short-term claims, interest payments and amortization over the next 12 months – are at $168 billion, which is sizable. The annual current account surplus has reached only $4 billion and is sufficient to cover only 2.5% of FDOs, assuming the capital and financial account balance will be zero. Clearly, Turkey needs to both roll over most of its foreign debt coming due and attract foreign capital to finance a potential expansion in its imports if its domestic demand is to recover. Critically, $20 billion of net FX reserves, excluding gold, swap lines with foreign central banks and net of domestic banking and non-banking corporations’ foreign exchange deposits, are not adequate either to cover foreign debt obligations. Even though headline and core inflation measures have fallen, wage inflation remains rampant (Chart II-5). If wage inflation does not drop substantially very soon, rapidly rising unit labor costs will feed into inflation leading to negative ramifications for the exchange rate. This is especially crucial in Turkey given President Erdogan has undermined the central bank’s credibility and is resorting to populist measures to revive his popularity. Finally, Turkish banks remain under-provisioned. Currently, the banking regulator is requiring banks to boost their non-performing loans (NPL) ratio to 6.3% of total loans.This a far cry from the 2001 episode when the NPL ratio shot up to 25% (Chart II-6). Even though interest rates rose much more in 2001 than last year, the private credit penetration in the economy was very low in the early 2000s. A higher credit penetration usually implies weaker borrowers have borrowed money and heralds a higher NPL ratio. Typically, following a credit boom and bust, it is natural for the NPL ratio to exceed 10%. We do not think Turkish banks stocks, having rallied a lot from their lows, are pricing in such a scenario. Chart II-5Surging Wages Are A Risk Chart II-6NPL Ratio Is Unrealistic Investment Recommendation We recommend both absolute-return investors and asset allocators not to chase Turkish financial markets higher. Renewed market volatility lies ahead. Given we expect foreign capital outflows from EM, Turkish companies and banks will encounter difficulties in rolling over their external debt and attracting foreign capital into domestic markets. This will produce a new downleg in the exchange rate. In turn, currency depreciation will weigh on performance of local bonds as well as sovereign and corporate credit. Stay underweight. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights European and global growth will rebound in the fourth quarter but the rebound will lack longevity. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. Equities: a tug of war between growth and valuation will leave the broad equity market index in a sideways channel. But with the higher yield, prefer equities over bonds. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225. Feature Comfort and discomfort are not absolute, they are relative. Put your hand in cold water, and whether it feels comfortable or uncomfortable depends on where your hand has come from. If your hand has come from room temperature, the cold water will feel uncomfortable. But if your hand has come from an ice bucket, the cold water will feel like bliss! The same principle applies to how we, and the financial markets, perceive short-term economic growth. After a strong expansion, a pedestrian growth rate of 1 percent feels uncomfortable. But after an economic contraction, 1 percent growth feels very pleasant. This leads to two important points: In the short term, the market is less concerned about the rate of growth per se, it is more concerned about whether the rate of growth is accelerating or decelerating. When it comes to the short term drivers of growth – bond yields, credit, and the oil price – we must focus not on their changes, we must focus on their impulses, meaning the changes in their changes. This is because it is the impulses of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth, often with a useful lead time of a few months. The Chart of the Week combined with Chart I-1-Chart I-4 should leave you in no doubt. In the euro area, United States, and China, the domestic bond yield 6-month impulses have led their domestic 6-month credit impulses with near-perfect precision. Chart of the WeekCredit Growth To Rebound In The Fourth Quarter, Then Fade Chart I-2The Euro Area Bond Yield Impulse Leads Its Credit Impulse Chart I-3The U.S. Bond Yield Impulse Leads Its Credit Impulse Chart I-4The China Bond Yield Impulse Leads Its Credit Impulse Based on this near-perfect precision, the credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. But expect much less of a rebound, if any, in China. While bond yields have collapsed in the euro area and the U.S., resulting in tailwind credit impulses, they have moved much less in China. Indeed, China’s bond yield 6-month impulse has been moving deeper into headwind territory in the past few months (Chart I-5). Chart I-5Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China It follows that a credit growth rebound in the fourth quarter will be sourced in Europe and the U.S. rather than in China. From a tactical perspective, this will favour non-China cyclical plays over China plays. But moving into the early part of 2020, expect the credit impulses to fade across all the major economies – unless bond yields now fall very sharply everywhere. Investing On Impulse Many people still find it confusing that it is the impulses – and not the changes – of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth. To resolve this confusion, let’s clarify the point. The credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. A bond yield decline will trigger new borrowing. For example, a given decline in the U.S. bond yield, say 0.5 percent, will trigger a given increase in the number of mortgage applications (Chart I-6). New borrowing will add to demand, meaning it will generate growth. But in the following period, a further bond yield decline of 0.5 percent will generate the same further new borrowing and growth rate. The crucial point is that, if the decline in the bond yield is the same, growth will not accelerate. Chart I-6A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. Conversely and counterintuitively, growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. Don’t Blame Autos For A German Recession Chart I-7German Car Production Rebounded In The Third Quarter If the German economy contracts in the third quarter and thereby enters a technical recession, the knee-jerk response will be to blame the troubles in the auto industry. But the evidence does not support this story. German new car production rebounded in the third quarter (Chart I-7). Begging the question: if not autos, what is the true culprit for the deceleration? The likely answer is that Germany recently suffered a severe headwind from the oil price impulse. Germany has one of the world’s highest volumes of road traffic per unit of GDP, second only to the U.S. (Table I-1). A possible explanation for Germany’s high traffic intensity is that, just like the U.S., Germany is a decentralised economy with multiple ‘hubs and spokes’ requiring a lot of criss-crossing of traffic. But unlike the U.S., German transport is highly dependent on oil imports, which tend to be non-substitutable and highly inelastic to price. As the value of German oil imports rise in lockstep with the oil price, Germany’s net exports decline, weighing on growth. Table I-1Germany Has A Very High Road Traffic Intensity The upshot is that the oil price impulse has a major bearing on Germany’s short term growth accelerations and decelerations. The six month period ending around June 2019 constituted a severe headwind impulse. This is because a 30 percent increase in the oil price in that period followed a 40 percent decline in the previous six month period, equating to a headwind impulse of 70 percent.1 Germany has one of the world’s highest volumes of road traffic per unit of GDP. Allowing for typical lags of a few months, this severe headwind impulse was a major contributor to Germany’s recent deceleration. Oscillations in the oil price’s 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with a spooky accuracy (Chart I-8). The good news is that the oil price’s severe headwind impulse has eased – allowing a rebound in German economic growth during the fourth quarter. Chart I-8The Oil Price Impulse Explains Oscillations In German Growth Nevertheless, a putative rebound could be nullified by a wildcard: the ‘geopolitical risk impulse’. To be clear this is not an impulse in the technical sense, but it is a similar concept: are the number of potential tail-events increasing or decreasing? For the fourth quarter, our subjective answer is they are decreasing. In Europe, the formation of a new coalition government in Italy has removed Italian politics as a possible tail-event for the time being. Meanwhile, we assume that the Benn-Burt law in the U.K. has been drafted well enough to eliminate a potential no-deal Brexit on October 31. Elsewhere, the U.S/China trade war and Middle East tensions are most likely to be in stasis through the fourth quarter. How To Position For The Fourth Quarter After a disappointing third quarter for global and European growth, we expect a rebound in the fourth quarter. But at the moment, we do not have any conviction that the rebound’s momentum will take it deeply into 2020. Position for the fourth quarter as follows: Expect a rebound in the fourth quarter. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. With a Brexit denouement, the pound could be the biggest mover and our inkling is to the upside. But we await more clarity before pulling the trigger. Equities: a tug of war between growth and valuation will leave the broad equity market index in the sideways range in which it has existed over the past two years (Chart I-9). But with a higher yield than bonds, equities are the preferred asset-class in the ugly contest. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225 (Chart I-10). Chart I-9Global Equities Have Gone Nowhere For Two Years Chart I-10Stay Overweight Europe ##br##Versus China Fractal Trading System* The recent surge in the nickel price is due to scares about supply disruption, specifically an Indonesian export ban. However, the extent of the rally appears technically stretched. We would express this as a pair-trade versus gold: long gold / short nickel. Chart I-11Nickel VS. Gold Set a profit target of 11 percent with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading Model Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Analysis on Indonesia starts below. The U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle. Ongoing weakness in the global economy – which is emanating from China/EM – will support the dollar in the coming months. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. A new trade: Long gold / short equal amounts of copper and oil. Feature Chart I-1The Dollar's Technicals Are Still Positive As we argued in last Week’s Report, emerging markets are facing a make-it-or-break-it moment. The U.S. dollar will serve as a litmus test. If the dollar pushes higher, EM risk assets will sell off. Conversely, if the greenback breaks down, EM risk assets will stage a sustainable cyclical rally. The basis of why the dollar will be a litmus test for EM risk assets is because the greenback is a counter-cyclical currency. It appreciates when global growth is relapsing and depreciates when global growth is reviving. In contrast, EM risk assets are pro-cyclical. Hence, the negative correlation between EM risk assets and the dollar stems from their opposite-reaction functions to the global business cycle. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. In particular, the dollar’s advance-decline has also been holding above its 200-day moving average (Chart I-1, top panel). Critically, our composite momentum indicator for the broad trade-weighted dollar has not declined below zero (Chart I-1, bottom panel). All of the above affirm the U.S. currency’s relative resilience. When a market exhibits resilience relative to the headwinds it is facing, it is often a bullish sign. Our EM strategy takes its cues from the fact that the greenback has softened but has not broken down. An upleg in the trade-weighted dollar is consistent with our view of a pending relapse in EM risk assets. The Dollar: Review Of Indicators There are a wide range of indicators that herald further U.S. dollar appreciation: Liquidity in the U.S. dollar interbank market has been tightening. The top panel of Chart I-2 demonstrates that the effective fed funds rate has exceeded the interest rate that the Fed pays to banks on excess reserves (IOER) for the first time since 2009 (herein the difference between the two is referred to as the spread). The bottom panel of the same chart illustrates that in the periods when this spread is rising, the dollar tends to appreciate, and when the spread is flat or falling (the shaded intervals), the greenback weakens. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. A positive, rising spread reflects a shrinking supply of U.S. dollar liquidity in the interbank market relative to demand. Notably, Chart I-3 illustrates that the dollar - inverted in this chart - is more strongly correlated with U.S. banks’ excess reserves at the Fed than with interest rates. This implies that the argument that lower rates will drive down the value of the greenback is exaggerated. Chart I-2Another Dollar Positive Factor Chart I-3Do U.S. Rates Drive The Dollar? Chart I-4Investors Are Long EM Currencies Vs. Dollar One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback (Chart I-4). Remarkably, various emerging market currencies have rebounded to major technical resistance levels but have not yet broken out, despite a dramatic decline in U.S. interest rates and the risk-on phase in global financial markets (Chart I-5). It remains to be seen whether they can stage a decisive breakout. We have our doubts. Chart I-5AEM Currencies Have Not Yet Broken Out Chart I-5BEM Currencies Have Not Yet Broken Out Finally, one aspect where we differ from the consensus is in terms of currency valuations. The U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value (Chart I-6). Often financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. Bottom Line: BCA’s Emerging Markets Strategy service maintains that the path of least resistance for the dollar is still up. Global Growth Conditions Are Still Conducive For Dollar Strength As discussed previously, the U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle (Chart I-7). Meanwhile, it is only loosely correlated with U.S. interest rates, as shown in the bottom panel of Chart I-3 on page 3. Chart I-6The U.S. Dollar Is Only Moderately Expensive Chart I-7The U.S. Dollar Is Counter-Cyclical The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. Yet, this scenario would be dollar bullish. In this case the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. So far, neither economic data nor the performance of cyclical segments within financial markets are signaling a meaningful amelioration in the global business cycle: Global cyclical sectors’ relative performance against the global overall equity index is lingering close to its December lows (Chart I-8). This measure of global cyclicals is composed of equal-weighted share prices of global industrials, materials and semiconductors. Further, this global cyclical equity index has not outperformed 10-year U.S. Treasurys (Chart I-9). It is difficult to envision a looming global economic recovery when global cyclical equities are failing to outperform even government bonds. Chart I-8Global Cyclical Sectors Have Not Outperformed Chart I-9Global Cyclical Sectors Versus U.S. Bonds The Chinese manufacturing PMI import sub-component – a leading indicator of Chinese imports – foreshadows renewed weakness in the EM ex-China, Korea and Taiwan currencies (Chart I-10). In turn, the Korean won and Taiwanese dollar are also vulnerable as China is by far their largest export destination, and their shipments to the mainland continue to shrink rapidly. Further, odds are high that the RMB will depreciate, dragging down the KRW and TWD along with it. Japanese foreign machinery tool orders and German industrial orders are in deep contraction, and have not improved even on a rate-of-change basis (Chart I-11, top and middle panels). Meanwhile, China’s imports of capital goods are contracting at a double-digit pace (Chart I-11, bottom panel). Chart I-10Chinese Imports Are Key To EM Currencies Chart I-11Global Trade Is Shrinking At A Fast Rate Chinese auto sales improved dramatically in June, but almost entirely due to hefty price discounts. Such bulky price discounts (up to 50% in certain cases) cannot go on indefinitely. Auto sales will soon tumble as these incentives to purchase expire. While U.S. growth has slowed, it is still holding up better than the rest of the world. Consistently, not only have U.S. large caps been outperforming their global counterparts, but America’s equal-weighted equity index has also been outpacing that of its global peers (Chart I-12). Broad-based U.S. equity outperformance in local currency terms versus the rest of the world denotes U.S. growth outperformance, and heralds another upleg in the greenback. Bottom Line: Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. We continue to recommend a short position in a basket of currencies such as ZAR, CLP, COP, IDR, MYR, PHP and KRW against the dollar. We believe gold has made a major breakout. The biggest risk to our dollar-bullish view is not the dollar’s fundamentals, but China’s decision to diversify away from U.S. dollars and U.S. President Donald Trump’s determination to weaken the greenback. We discussed the latter at great length in our August 30, 2018 Special Report, and will deliberate on the former below. Buy Gold / Short Copper And Oil Despite our positive view on the dollar, we believe gold has made a major breakout (Chart I-13). Pairing a long position in gold with shorts in copper and oil will likely deliver solid returns with low volatility in the next three to six months and beyond (Chart I-14). Chart I-12U.S. Equity Outperformance Heralds A Stronger Dollar Chart I-13Gold Is In A Bull Market Chart I-14Go Long Gold / Short Copper And Oil The primary reason to buy gold is not global inflation. Rather, it is due to China’s decision to accumulate the yellow metal. Unhappy with U.S. pressures and import tariffs, Chinese authorities have decided to materially reduce the share of dollars in their foreign exchange reserves. The People’s Bank of China (PBoC) holds 62 million ounces of gold. Hence, gold holdings represent only 2.8% of the $3.1 trillion stockpile of the PBoC’s total foreign currency reserves (Chart I-15). In contrast, U.S. assets account for 52%. In this regard, the Russian experience could act as a roadmap for Chinese policymakers. Hit by U.S. and EU economic and financial sanctions following Russia’s seizure of Crimea in 2014, the country decided to accelerate its diversification away from U.S. dollars into gold. Since then, the Russian central bank has continuously boosted its gold holdings, with the yellow metal now accounting for 22% of its foreign currency assets (Chart I-16). Chart I-15Chinese Central Bank's Gold Holdings Chart I-16Russian Central Bank's Gold Holdings Even if the PBoC accumulates gold at a slower pace than the Russian central bank, the former’s bullion purchases will exert considerable upward pressure on gold prices due to its sheer size. In short, odds are that China’s central bank will be buying gold on any dips. To accommodate such a large buyer, the gold price will need to surge to discourage potential demand from other buyers. In contrast to gold, China’s demand for copper and oil will be subdued from a cyclical perspective. Copper demand will be tame due to weak capital spending growth. Regarding oil, as we argued in our June 21, 2018 report titled, China’s Crude Oil Inventories: A Slippery Slope, the nation has been importing more oil and petroleum products than it has been consuming. As a result, its crude oil inventories have swelled (Chart I-17, top panel). Adding China’s aggregate crude oil inventories to the OECD’s commercial inventories reveals that global inventories have not really declined since 2017 (Chart I-17, bottom panel). Simply put, crude inventories have moved from the OECD to China. Going forward, given both underlying subdued oil demand and elevated crude inventories in China, its oil imports are likely to expand at a slower pace vs. the past five years (Chart I-18). This combined with high net long positions among global investors in crude oil makes us negative on oil prices. This downbeat view on oil differs from BCA’s house view, which is bullish on the commodity. Chart I-17Oil Inventories: China + OECD Chart I-18China's Oil Demand While we cannot rule out the risk that geopolitical tensions could escalate in the Middle East, we believe the appropriate strategy for investors should be to sell oil on strength. Besides, pairing this strategy with a long position in gold reduces potential drawdowns in the event of an outburst in U.S.-Iran tensions. Bottom Line: We recommend investors initiate the following position: Long gold / short equal amounts of copper and oil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Treading On Thin Ice Foreign investors have been rushing into Indonesian financial markets on expectations of the Fed cutting rates. As a result, Indonesian financial markets have been more resilient than we expected. While the Fed’s monetary policy is important for Indonesian financial assets, there are other critical drivers of the Indonesian economy and financial markets that investors should take heed of. Namely, global growth and domestic demand. Both factors are currently negative. Cracks are appearing in the Indonesian property market. Persisting exports contraction will keep the country’s current account deficit wide (Chart II-1). A wide current account deficit entails that the rupiah will remain heavily reliant on volatile foreign portfolio inflows. Lesser known but equally important, Indonesia’s domestic demand is anemic. Particularly, the marginal propensity to spend among businesses and consumers is diminishing (Chart II-2). Truck and passenger car sales are contracting, while motorcycle sales are edging closer to contraction (Chart II-3). Chart II-1Indonesian Exports: Double-Digit Contraction Chart II-2Indonesia: Domestic Spending Is Subdued Critically, cracks are appearing in the Indonesian property market. Residential property prices are rising only by 2% from a year ago in local currency terms (Chart II-4). Additionally, domestic cement consumption is shrinking and revenues of two MSCI-listed real estate companies are also contracting. Chart II-3Indonesia: Vehicle Sales Are Declining Chart II-4Cracks In Indonesia's Property Sector Chart II-5Non-Bank Stocks Are Not Rallying Turning to the equity market, Indonesia’s stock market breadth is extremely narrow. The rally of the past several months has been almost entirely led by a few stocks, in particular by Bank Central Asia and Bank Rakyat Indonesia. In fact, these two banks - alone - now account for around 32% of the overall MSCI Indonesia market cap. Meanwhile, the performance of non-financial stocks has been extremely poor (Chart II-5, top panel). As for small cap stocks they are now below their 2016 lows (Chart II-5, bottom panel). This has occurred due to chronically weak profitability among non-financial companies. As for banks, in-line with ongoing deceleration in the real economy, their bad-loan provisions are now rising. Additionally, the aggregate banking system’s net interest margin is still falling. These will hurt banks’ profits. On the whole, the deepening growth slump in Indonesia warrants lower interest rates. Yet, reducing interest rates when faced with a wide current account deficit could trigger currency depreciation. At a certain point – when the frenzy about the Fed’s easing subsides, investors will realize the severity of the ongoing growth downturn in Indonesia and the need for lower rates. When this occurs, the rupiah will depreciate and the currency selloff will spread into equities and bonds. Bottom Line: The risk-reward profile of Indonesian markets is not attractive both in absolute term and relative to their EM peers. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations