Cryptocurrencies
Highlights US growth has likely peaked. Economic momentum will slow over the coming quarters as the tailwind from stimulus fades and the vaccination campaign winds down. Historically, a slowdown in US growth, as proxied by a decline in the ISM manufacturing index, has been associated with lower overall equity returns, the outperformance of defensive stocks over cyclicals, large caps over small caps, and US equities over their overseas peers. A falling ISM has also been associated with a strengthening dollar, lower Treasury yields, wider credit spreads, a decline in the US Treasury/German bund spreads, falling oil prices, and an increase in the gold-to-copper price ratio. Compared to past episodes, there are three reasons to expect the coming US slowdown to be relatively benign: First, growth is slowing from exceptionally strong levels; second, growth in many other parts of the world is still speeding up; and third, monetary policy will remain highly accommodative in the face of what is likely to be a transitory increase in inflation. We continue to maintain a positive 12-month view on global equities. Nevertheless, with global growth momentum likely to slow later this year, investors who are maximally overweight risk should pare back cyclical exposure. Crypto update: We warned that “Bitcoin is on a collision course with ESG” two weeks ago. Elon Musk’s flip-flop on allowing customers to pay for Teslas in Bitcoin is yet another piece of evidence that ESG concerns will win out. With that in mind, we are going short Bitcoin. Beware The Second Derivative US growth has likely peaked. Economic momentum will slow over the coming quarters as the tailwind from fiscal stimulus fades and the vaccination campaign winds down. According to the Brookings Institution, fiscal easing contributed nearly seven percentage points to US growth in the first quarter (Chart 1). However, fiscal policy is set to detract from growth in the remainder of the year, reflecting the one-off nature of some of the stimulus measures. Chart 1After A Strong Boost, Fiscal Thrust Is Turning Negative On the pandemic front, the number of new cases continues to trend lower in the US, thanks mainly to a successful vaccination campaign. A falling infection rate has allowed states to dismantle lockdown measures. Conceptually, it is the change in social distancing measures that correlates with economic growth. While some restrictions remain in place (especially in the educational sector), we are now well past the point of maximum loosening. How have financial markets performed during episodes of slowing US economic growth? To answer this question, we looked at the performance of various assets during periods when the ISM manufacturing index was falling and when it was rising. To add a bit more granularity to the analysis, we also looked at cases when the ISM was trending up and above 50, trending down and above 50, trending down and below 50, and trending up and below 50. As summarized in Table 1 and the Appendix Charts, the key results are as follows: Stocks tend to do best when the ISM is rising. Since 1950, the S&P 500 has risen on average by 1.51% during months when the ISM was trending higher, compared to 0.49% during months when the ISM was trending lower. The results were virtually the same if one restricts the sample to the post-1995 period. While the change in the ISM generally matters more for the S&P 500, absolute levels matter too. Since 1995, the best period for the S&P 500 was when the ISM was below 50 but trending higher (S&P 500 up 2.07%), while the worst period was when the ISM was below 50 and trending lower (S&P 500 up 0.03%). This suggests that swings in the ISM have a bigger effect on the stock market during periods of economic contraction. During periods where the ISM was falling but still above 50, the S&P 500 has delivered a positive – though far from stellar – monthly return of 0.69%. US defensively-geared equities outperformed cyclicals when the ISM was trending lower. During periods when the ISM was falling but still above 50, defensives beat cyclicals by 0.45%. Defensives outperformed cyclicals by 0.84% during periods when the ISM was below 50 and trending lower. US small caps underperformed large caps during periods when the ISM was falling. Non-US stocks also underperformed their US counterparts in a falling ISM environment. The relationship between the ISM and value/growth performance is more ambiguous. To the extent that there is one, value generally outperforms growth when the ISM is below 50. Treasury yields tend to increase, while the yield curve tends to steepen, when the ISM is trending higher. Reflecting the higher beta that Treasuries have to the global business cycle, Treasury yields generally rise more than Germany bund yields when the ISM is on the upswing. Corporate credit spreads tend to widen when the ISM is falling. Spreads narrow the most when the ISM is below 50 but rising. As a countercyclical currency, the US dollar tends to weaken when the ISM is rising and strengthen when the ISM is falling. The prices of cyclically-sensitive commodities such as oil and copper normally decline when the ISM is trending lower, although in general, the bulk of the decline in commodity prices usually occurs only when the ISM has dipped below 50. There is not much of a relationship between gold prices and the ISM. Table 1The Economic Cycle And Financial Assets Implications For Today Assuming that the ISM has peaked but remains above 50, the analysis above suggests that the S&P 500 will rise modestly over the coming months; US stocks will edge out non-US stocks; defensives will outperform cyclicals; and large caps will perform slightly better than small caps. The analysis also suggests that Treasury yields will move lower; the Treasury-bund spread will narrow; corporate credit spreads will be flat-to-wider; the dollar will strengthen modestly; and commodities will move broadly sideways. Our own 12-month view is more pro-risk than implied by the ISM analysis. There are three reasons for this: First, US growth is slowing from exceptionally strong levels; second, growth in many other parts of the world is still accelerating; and third, monetary policy remains highly accommodative. Let’s examine each assumption in turn. Reason #1: US growth is slowing from exceptionally strong levels While payroll growth surprised sharply on the downside in April, we suspect this was mainly due to pandemic-induced distortions to the seasonal adjustment mechanism used by the Bureau of Labor Statistics. Seasonally unadjusted payrolls rose by 1.1 million in April, which is broadly consistent with the strong pace of GDP growth tracking estimates. The Atlanta Fed GDPNow model points to growth of 11% in Q2. Bloomberg consensus estimates have US real GDP rising by 8.1% in the second quarter. Growth will decline to 7% in Q3 and 4.7% in Q4, but still average 4% in 2022 (Table 2). Table 2Growth Is Peaking, But At A Very High Level Chart 2Firms Will Need To Rebuild Inventories US households were sitting on $2.2 trillion in excess savings as of the end of April. This is money they would not have had in absence of the pandemic. Slightly less than half of that stockpile can be attributed to transfer payments, mainly in the form of stimulus checks and unemployment benefits. The rest stems from decreased spending during the pandemic. Not all of this money will be spent immediately. However, given the large sums involved – $2.2 trillion is equivalent to 15% of annual personal consumption – even a partial depletion of these excess savings will be enough to power consumption for the foreseeable future. Meanwhile, firms will have to boost production in order to restore depleted inventories. The inventory-to-sales ratio stands at record low levels (Chart 2). The decline in inventories pushed up the ISM new orders-to-inventory ratio in April, even as the overall ISM index slid from 64.7 in March to 60.7. The new orders-to-inventory ratio tends to lead the ISM index, which suggests that any decline in the ISM index over the coming months will be gradual. An easing of supply-side constraints should also support growth. Even though overall employment was still 5.2% below pre-pandemic levels in April, a record share of small firms surveyed by the NFIB reported difficulty in filling vacant positions (Chart 3). Enhanced unemployment benefits have eroded the incentive to find work. In addition, many schools remain partially shuttered. Chart 4 shows that mothers with young children have seen a much larger decline in labor force participation than other groups. Chart 3Firms Are Struggling To Find Workers Chart 4Mothers With Children Had To Leave The Labor Force Enhanced unemployment benefits will expire in September. As schools resume normal operations, more workers will flow back into the labor market. At the same time, some of the bottlenecks currently gripping the global supply chain should abate, allowing for increased output. Reason #2: Growth in many other parts of the world is still accelerating Chart 5Over 40% Of S&P 500 Revenues Come From Abroad Chart 6Euro Area Data Has Surprised On The Upside S&P 500 constituent firms derive 43% of their revenues from abroad (Chart 5). While Bloomberg estimates suggest that US growth will peak in the second quarter, growth in the euro area is not expected to peak until the third quarter. Mathieu Savary, who heads BCA’s European Investment Strategy service, sees upside risks to European growth estimates for the second half of this year. Consistent with Mathieu’s observations, recent economic data has been surprising to the upside in the euro area (Chart 6). Just this week, economic expectations for both Germany and the wider euro area leaped to the highest level in more than 20 years, according to the ZEW economic research institute. Growth in Japan should also pick up in the remainder of the year. Japan’s vaccination campaign has gotten off to a very slow start, with less than 3% of the population being inoculated to date. The government imposed its third state of emergency on April 25 in response to rising viral case counts. It subsequently extended those restrictions on May 11. The authorities intend to vaccinate the country’s 36 million elderly people by July, when the Olympics are set to begin. This should permit some easing in lockdown measures. Investors are worried that the Chinese economy will slow this year. The Chinese PMIs peaked in November 2020, about the same time as the combined credit/fiscal impulse reached an apex (Chart 7). Jing Sima, BCA’s chief China strategist, expects the general government budget deficit to remain at a still-ample 8% of GDP this year, similar to where it was last year. She expects credit growth to slow by 2%-to-3%, converging towards the pace of nominal GDP growth. Keep in mind that China’s credit-to-GDP ratio stands at 270%. Thus, if credit grows in line with nominal GDP growth of about 10%, this would still leave the stock of credit roughly 27% of GDP higher at the end of 2021 compared to the end of 2020. This hardly constitutes “deleveraging”. A resilient Chinese economy should buoy other emerging markets. Progress on the pandemic front should also help. The UN estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population (Chart 8). The shortages of vaccines in emerging markets could turn into a surfeit by the end of this year, something that market participants do not seem to fully appreciate. Chart 7China: Peak Stimulus And Peak Growth The rotation in growth momentum from the US to the rest of the world should put downward pressure on the US dollar. A weaker dollar, in turn, has usually coincided with the outperformance of non-US stock markets (Chart 9). Chart 8Vaccine Production Set To Ramp Up Further Chart 9A Weaker Dollar Has Coincided With The Outperformance Of Non-US Stock Markets Reason #3: Monetary policy remains highly accommodative The slowdown in US growth is coming at a time when inflation is rising. The core CPI increased by 0.9% month-over-month in April. This was the biggest monthly jump since August 1981. The year-over-year rate climbed to 3.0%, the highest in 25 years. The “whiff of stagflation” helped push the S&P 500 down this week. As we discussed last week, we are very much in the camp that expects inflation to rise significantly over the long haul. Over the next one or two years, however, we would fade inflationary fears. As the example of the 1960s illustrates, a long period of overheating is often necessary to push up inflation in a sustained manner. The US unemployment rate reached its full employment level in 1962. However, it was not until 1966 – when the unemployment rate was two full percentage points below equilibrium – that inflation finally took off (Chart 10). The official core CPI likely overstates underlying inflationary pressures. The pandemic threw all sorts of prices out of whack. Stripping out volatile food and energy prices from inflation is not enough. One needs more refined measures of inflation. Luckily, they exist. Chart 11 shows that median CPI, trimmed-mean CPI, and sticky price CPI all remain well contained. Similarly, relatively clean measures of wage growth, such as the Atlanta Fed Wage Tracker, do not point to an imminent wage-price spiral (Chart 12). Chart 10Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 11Cleaner Measures Of Inflation Are Telling A Different Story Chart 12Wage Growth Is Still Lackluster All this means that the Fed can afford to sustain exceptionally easy monetary policy. That should keep growth at an above-trend pace and continue to support to equity valuations. Investment Conclusions My “golden rule” for investing is to stay bullish on stocks unless one thinks there is a recession around the corner (Chart 13). Seeing around the corner is not easy, of course, but it is not impossible either. Chart 13Recessions And Bear Markets Tend To Overlap Last year’s recession was caused by a true exogenous shock – the pandemic. Most recessions are endogenous in nature, however. They result from growing imbalances that are usually laid bare by tighter monetary policy. One can debate the extent to which the global economy is plagued by imbalances of one form or another. But one thing is clear, monetary policy is unlikely to turn contractionary any time soon. In this environment, one should remain positive on equities and other risk assets over a 12-month horizon. Nevertheless, with global growth momentum likely to slow later this year, investors who are maximally overweight risk should pare back cyclical exposure. Go Short Bitcoin We warned that “Bitcoin is on a collision course with ESG” two weeks ago in a report entitled “How To Short Bitcoin, Or Anything Else, Without Losing Your Shorts.” Elon Musk’s flip-flop on allowing Tesla customers to pay for Teslas in Bitcoin is yet another piece of evidence that ESG concerns will win out. News that Colonial Pipeline paid hackers 75 bitcoin (nearly $5 million) in ransom further cements Bitcoin’s status as the currency of choice for criminals around the world. With all that in mind, we are going short Bitcoin as of midnight Eastern Daylight Time (EDT) using the shorting technique described in that report. The technique flips the usual risk-reward from shorting on its head. Normally, when you short a stock, your gain is capped at 100% of the initial position whereas your potential loss is unlimited. With our shorting technique, your potential loss is capped at 100% while your potential gain is unlimited. This makes shorting as an investment strategy a lot safer. APPENDIX The Economic Cycle And Financial Assets APPENDIX CHART 1A APPENDIX CHART 1B Appendix Chart 1C Appendix Chart 1D Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Dear Client, In addition to our regular report, this week we are sending a Special Report written by my colleague Lucas Laskey from BCA Research’s Equity Analyzer service titled “Is The Reopening Trade Closed?”. The report discusses the state of the reopening trade through the lens of Equity Analyzer's factor model. I hope you find the report insightful. Additionally, please join us next week on Friday, May 7, 2021 at 10am EDT as I moderate a debate between my colleagues Arthur Budaghyan, BCA Research’s Chief Emerging Market Strategist, and Robert Ryan, Chief Commodity & Energy Strategist. Titled “A Debate On Commodities,” Arthur and Bob will discuss the outlook for commodities, touching on the trajectory both DM and China/EM growth will follow, the path for the US dollar, and other cyclical and structural forces currently shaping commodity markets. During the webcast, Arthur and Bob will highlight the areas they disagree on and the reasons behind their differing views. Best regards, Peter Berezin Chief Global Strategist Highlights Bitcoin is on a collision course with ESG. ESG interests will win out. Widespread adoption of cryptocurrencies, if it were to happen, would erode the purchasing power of traditional money, while robbing governments of billions of dollars in seigniorage revenue. Governments have already begun to take steps to thwart such an outcome. Restrictions on the use of cryptocurrencies will only increase over the coming years. The rollout of Central Bank Digital Currencies (CBDCs) represents an existential threat not only to cryptos, but potentially to credit card companies and online payment processors such as PayPal, Square, Venmo, WeChat Pay, and Alipay. Shorting cryptocurrencies, meme stocks, or any other high-flying asset is risky business. Fortunately, there is a way to flip the usual risk-reward from going short on its head. Rather than facing unlimited losses and a maximum gain of only 100% of the initial position, we outline a shorting strategy that caps the loss at 100% but allows for unlimited gains. Bitcoin’s Questionable ESG Record Crypto critics have often blamed cryptocurrencies for facilitating illicit transactions and enlarging the world’s carbon footprint. There is some truth to both claims. Motivated to avoid detection, online scammers, smugglers, and terrorists have been drawn to cryptocurrencies. Cryptos have also been used to evade capital controls and conceal wealth from the tax authorities. On the environmental side, Bitcoin mining now consumes more energy than entire countries such as Sweden, Argentina, and Pakistan (Chart 1). Moreover, about 70% of Bitcoin mining currently takes place in China, mainly using electricity generated by burning coal. A lot of the remaining mining occurs in countries such as Russia and Iran with questionable governance records. Chart 1How Dare You, Bitcoin Cryptos And Inequality One criticism of Bitcoin that is less frequently mentioned is its role in exacerbating wealth inequality. We are not just talking about the small number of “whales” who amassed huge fortunes by buying or mining Bitcoin shortly after it was created. If these whales sell their coins at today’s prices and the price of Bitcoin eventually crashes, those early investors will have ended up profiting at the expense of smaller investors who bought at the top. While such a transfer of income may be unsavory, it is not much different from what happens when someone sells a high-flying stock to the proverbial bagholder just as the stock is peaking. The more interesting question is what happens if Bitcoin prices do not crash. It might be tempting to think that in such a scenario, no one would be worse off. But that is incorrect. There would still be losers, and importantly, these losers would consist of people who never bought or sold Bitcoin in their lives. To see why, ask yourself who suffers from counterfeit currency. One possibility is shopkeepers who inadvertently accept counterfeit cash and find themselves stuck with worthless money. But even if the counterfeit money is never detected, there would still be losers: Fake money dilutes the value of genuine money, making everyone who holds the genuine money worse off. Crypto evangelists like to argue that cryptocurrencies offer protection against the “debasement of fiat money.” Ironically, the widespread adoption of cryptocurrencies could produce a self-fulfilling cycle that leads to just such an inflationary outcome. If enough people decide to swap fiat currencies for cryptos, the dollar and other fiat monies could become “hot potatoes.” The price of cryptos would rise in relation to dollars. Feeling more wealthy, crypto holders would spend some of their wealth on goods and services. As long as the economy is operating below potential, this would not be such a bad thing since increased spending would generate more output and employment. However, once the output gap disappears, more spending would result in higher inflation. The purchasing power of fiat currencies would decline. The Empire Strikes Back Will governments allow such a massive transfer of wealth from holders of fiat currencies to holders of crypto currencies to occur? It seems highly unlikely. In order to entice people to hold on to their fiat currency bank deposits, central banks would have to raise interest rates. Debt-strapped governments would not like that. Governments also generate significant revenue from their ability to print currency and then exchange it for goods and services. For the US, this “seigniorage revenue” is around $100 billion per year (Chart 2). No government will want to part with this revenue. A financial system where loans and deposits are denominated in cryptocurrencies would be highly unstable. Even if the supply of each individual cryptocurrency were capped, the rise and fall of competing cryptocurrencies could still result in large shifts in the aggregate cryptocurrency money supply. Moreover, wild swings in cryptocurrency prices, both versus fiat currencies and one another, could destroy any semblance of price stability. The value of bank loans made in Bitcoin or other cryptos would experience great fluctuations. Powerless to issue cryptocurrencies themselves, central banks would not be able to provide unlimited liquidity support to commercial banks as they do now. The situation would resemble the US in the late 19th century when myriad currencies competed with one another and the financial system veered from one crisis to another (Chart 3). Chart 2Governments Will Not Part With Seigniorage Revenue Chart 3An Inelastic Money Supply Historically Led To More Banking Crises What Is It Good For? One might argue that the ultimate aim of cryptocurrencies is not to displace fiat money. Okay, but if Bitcoin can never truly function as a medium of exchange or a unit of account, what exactly underpins its utility as a store of value? At least with gold, you get an extremely rare metal, forged in the collision of neutron stars billions of years ago, that has great aesthetic value. With cryptos, you get fairy dust. In past reports, we referred to Bitcoin as a “solution in search of a problem.” In retrospect, that characterization was much too charitable. Bitcoin is a problem in search of a problem. Whereas the Visa network can process over 20,000 transactions per second, the Bitcoin network can barely process five (Chart 4). Bitcoin transactions take 10 minutes-to-an hour to complete compared to just a few seconds for most debit or credit card transactions. The average fee for a Bitcoin transaction is around $30. This fee has been rising, not falling, over the past few years (Chart 5). Chart 4Bitcoin: The Speed Of Transactions, Or Lack Of It Chart 5Bitcoin: The Cost Per Transaction Is Rising Look Out Below Table 1A Growing List Of Cryptocurrency Bans Cryptos are heading for a world of pain. ESG concerns will force companies to step back from their newfound infatuation with these magic beans. Meanwhile, governments will tighten the screws on cryptocurrencies while rolling out their own digital monies. As my colleague Chester Ntonifor pointed out last week, a growing list of countries have already moved to ban Bitcoin transactions (Table 1). In addition, most G10 central banks have outlined their own digital currency plans (Map 1). Not only will Central Bank Digital Currencies (CBDCs) squeeze out decentralised cryptocurrencies, they will also pose an existential risk to credit card companies and online payment processors such as PayPal, Square, Venmo, WeChat Pay, and Alipay. Map 1Many Central Banks Are Planning A Digital Currency The Risk Of Shorting Bitcoin These days, there is no shortage of ways to short Bitcoin. Many cryptocurrency platforms permit short selling. In addition, one can bet against Bitcoin through the futures market. To the extent that the fortunes of companies such as Coinbase are tied to the crypto market, one can also express a short view on cryptos through listed equities. Yet, shorting cryptos is a risky strategy. Cryptocurrencies do not have any intrinsic value. What you think a Bitcoin is worth depends on what others think it is worth and vice versa. At present, the value of all Bitcoins that have ever been issued is about $1 trillion. Eighteen cryptocurrencies have valuations exceeding $10 billion (Table 2). The market capitalization of all cryptocurrencies in circulation stands at $2 trillion. In contrast, the value of all the gold that has ever been mined is around $10 trillion (Chart 6). It is certainly possible that euphoric investors will push up the value of cryptocurrencies to the point that they are collectively worth more than all the gold in the world. Table 2Close To 20 Cryptos Have A Market Cap In Excess Of US$10bn Chart 6Gold Versus Cryptocurrencies To guard against this risk, one needs a prudent strategy for shorting not just high-flying cryptocurrencies, but any security whose price can rise significantly. Luckily, such a strategy exists. How To Short Without Losing Your Shorts Clients sometimes ask me what I invest my money in. The answer is that most of my liquid wealth is held in publicly traded US small cap stocks. I have been investing in this space for over two decades (prior to joining Goldman, I even wrote a blog about it). I used my knowledge of stock picking to develop an early version of BCA’s Equity Analyzer. David Boucher and his team have since transformed it into a powerful, state-of-the-art stock selection service. Table 3Don’t Be Like Melvin Shorting small cap stocks is risky business. To limit the risk, I have employed a strategy that flips the usual risk-reward from shorting on its head. Normally, when you short a stock, your gain is capped at 100% of the initial position whereas your potential loss is unlimited. With my shorting technique, your potential loss is capped at 100% while your potential gain is unlimited. To illustrate how the strategy works, let us consider shorting one particular overpriced “meme” stock that has been in the news a lot this year. I won’t single out the name of the company, other than to note that it begins with “G” and ends with “stop.” At the time of writing, this mystery stock was trading at $180 per share. Suppose you shorted 1,000 shares at that price. The basic idea is to then short 2% more shares if the price falls by 1% and cover 2% of your shares if the price rises by 1%. So, in this case, you would increase your short position to 1020 shares if the price were to fall to around $178 but cover 20 shares (leaving you with 980 shares short) if the price were to rise to $182. Table 3 shows the number of shares you would need to be short for any given price between $5 and $360. If the price of the shares were to fall to $10 (double what it was last August), the strategy would generate roughly $3,060,000 in profits.1 In contrast, if the price were to rise to $360 per share, the strategy would incur a loss of $90,000. Even if the price went to infinity, the most you would lose is $180,000. There are a number of challenges to implementing this strategy: 1) It requires frequent trading; 2) gap downs and gap ups in the price could meaningfully hurt the results; 3) it is not always possible to short a stock and even when it is, the borrowing costs could be high, etc. Nevertheless, as a “rule of thumb,” I have found this strategy to be extremely effective in mitigating risk. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Notice that the profit of $3,060,000 from going short 1,000 shares in the case where the price of the stock falls from $180 to $10 is equal to 17 times the initial short position of $180,000 (i.e., $3,060,000 divided by 180,000 is 17). This is exactly the same return that one would earn if one went long the stock and the price rose from $10 to $180. In this case, the profit would also be equal to 17 times the initial investment (i.e., $1,800,000-$100,000 divided by $100,000 is 17). Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights The (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous market fragilities. Additionally, the 65-day fractal structure of stocks versus bonds has collapsed, signalling a high probability of an exhaustion or correction over the next 65 days. Likewise, the 130-day fractal structure of bitcoin has also collapsed, signalling a high probability of an exhaustion or correction over the next 130 days. Bond yields are unlikely to go much higher; they are likely to go lower. Prefer utilities within the value segment, and prefer healthcare within the growth segment. Offices and bricks-and-mortar retail will never fully reopen. This will devastate the jobs market once the protection from government-funded furlough schemes winds down in 2021. Feature The pandemic will ease in 2021, and with it many of the restrictions on our lives. Yet when it comes to the economy and investment, the great reopening narrative for 2021 is misleading because the world economy has already largely reopened. We quickly learned that, with some adaptations, like working from home, and doing our shopping online, almost all economic activity can resume during a raging global pandemic. As a result, global profits have already rebounded very strongly (Chart of the Week). Chart of the WeekGlobal Profits Have Already Rebounded Very Strongly Manufacturing is fully open. Construction is fully open. Industrial production is fully open. Finance and most services are fully open. Looking at the world’s two largest economies, China is already beyond its pre-pandemic levels of output (Chart I-2), while the US is a mere 0.9 percent below (based on the Atlanta Fed Nowcast of 2.6 percent growth in the fourth quarter)1 (Chart I-3). Chart I-2The Chinese Economy Has Already Rebounded Chart I-3The US Economy Has Already ##br##Rebounded Offices And Bricks-And-Mortar Retail Will Never Fully Reopen In the great reopening narrative, the end of the pandemic will allow the full reopening of offices, shops, restaurants, bars, travel and leisure. But will former office workers flock back to their offices full-time, or even majority-time? Will consumers flock back to bricks-and-mortar retailers? Will firms flock back to the same extent of business travel? Our high conviction answers are no, no, and no. The reason we will not go back to the pre-pandemic way of doing things is because we have found a better way of doing things. Obviously, we will relish our re-found ability to go on holiday and to meet our fellow humans in the flesh. But do we really need to meet our co-workers every day, or even most days? Do we really need to do our shopping in person every time, or even most times? Do we really need to visit the overseas office every quarter? In 2021 and beyond, we will continue to work, shop, and interact more remotely, not because a pandemic forces us to, but because it improves the quality of our personal and working lives. It improves our standard of living. In 2021 and beyond, we will continue to work, shop, and interact more remotely. Unfortunately, there will be collateral damage. As working from home becomes mainstream, the ecosystem of city centre bars, restaurants, and shops that rely on office workers will wither. This ecosystem’s large footprint can be illustrated by a remarkable fact: the pre-pandemic populations of both Manhattan and central London were 2 million people greater during the weekday daytime than during the night-time. Likewise, as online shopping becomes the default, bricks-and-mortar retailing will go into terminal decline. This is significant because retail employs 10 percent of all workers in the US and the UK, the majority in bricks-and-mortar retail outlets. In the same way, more online meetings and fewer business trips means less employment in the travel and accommodation sectors. The common thread connecting retail and accommodation and food services is that they produce relatively little output, but account for a lot of jobs – in fact, just 8 percent of output but 20 percent of all jobs (Table I-1). Table I-1Retail Plus Accommodation And Food Services Account For 8 Percent Of Output But 20 Percent Of Jobs Hence, as these sectors wither, the good news is that the impact on economic output will be modest. The bad news is that the ultimate impact on the jobs market will be devastating. Crucially, this ultimate impact on the jobs market will only be felt once the protection from government-funded furlough schemes winds down in 2021. In time, a dynamic economy will redeploy the army of shop assistants, city centre bar and restaurant staff, and cabin crew into fast growing sectors such as healthcare and education. But a process that requires retraining and reskilling will take years not months. During this long adjustment, there is likely to be huge slack in developed economy labour markets. Given that central banks are now explicitly targeting labour market slack, these central banks will be forced to keep nominal bond yields at ultra-low levels for a very long time. The Near-Term Constraint On Bond Yields In the near term, there is an even greater force holding bond yields in check, and that force is something that central banks also explicitly target – financial stability. Higher bond yields would imperil financial stability. The global stock market is at an all-time high because valuations stand 25 percent higher than a year ago (Chart I-4). Valuations have surged because bond yields have collapsed (Chart I-5), but even relative to these ultra-low bond yields, technology sector valuations are now stretched. Chart I-4The Global Stock Market Is At An All-Time High Because Valuations Are 25 Percent Higher Chart I-5Valuations Are 25 Percent Higher Because Bond Yields Have Collapsed The (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous market fragilities. These previous market fragilities resulted in an exhaustion, or worse, a correction in the stock market in February 2018, October 2018, April 2019, and January 2020. Just as important, these points of fragility signalled that bond yields were approaching a major or minor peak (Chart I-6). Chart I-6Tech Stock Valuations Are Fragile Hence, in the early part of 2021 at least, steer towards investments that will benefit from a backing down of bond yields. This means avoiding value stocks as an aggregate, because value cannot outperform growth unless bond yields are rising (Chart I-7). However, it also means avoiding growth stocks in aggregate as the fragility lies in tech stock valuations. Chart I-7Value Cannot Outperform Growth Unless Bond Yields Are Rising A good strategy is to prefer utilities within the value segment, given that utilities benefit from lower bond yields (Chart I-8). And prefer healthcare within the growth segment, given the sector’s more reasonable valuation. Chart I-8Banks Cannot Outperform Utilities Unless Bond Yields Are Rising Stocks Are Vulnerable… And So Is Bitcoin Manias occur in markets when marginal buyers keep flooding in at a higher and higher price. (Likewise, panics occur when marginal sellers keep flooding in at a lower and lower price.) The supply of marginal buyers fuelling the strong uptrend tends to come from longer-term investors who are uncharacteristically behaving like short-term momentum traders for fear of missing out on the rally. For example, an investor with a 130-day investment horizon shouldn’t buy because of a one-day price increase. If he does, then his investment horizon has shrunk to 1-day. In this example, the strong uptrend will run out of fuel when the 130-day investors who are fuelling it are all in. This is defined by the 130-day fractal structure of the investment collapsing, meaning that its 130-day fractal dimension has reached its lower bound. If someone now puts on a sell order, there are no more 130-day horizon investors available to be the marginal buyer at the current price. Having sucked in all the 130-day investors, an investor with an even longer horizon, say 260 days, must step in as the marginal buyer. The likely outcome is a price correction because the longer-term investor is likely to buy only when a lower price satisfies his value compass. The other possibility is that the 260-day investor joins the uptrend, becoming a marginal buyer at the current price, adding more fuel to the mania. This is the less likely outcome because the longer that an investor’s horizon is, the more faithful he is likely to be to his valuation compass. Nevertheless, sometimes the valuation compass goes awry because of structural shifts or massive intervention by policymakers, allowing the trend to continue. The above describes the basis of our proprietary fractal trading system. In a nutshell, when the fractal structure of an investment collapses, the probability of a trend reversal increases sharply, and the probability of a trend continuation decreases sharply. Right now, the 65-day fractal structure of stocks versus bonds has collapsed, signalling a high probability of an exhaustion or correction over the next 65 days (see final section). Likewise, the 130-day fractal structure of bitcoin has also collapsed, signalling a high probability of an exhaustion or correction over the next 130 days (Chart I-9). Chart I-9The 130-Day Fractal Structure Of Bitcoin Has Collapsed To be clear, these rallies can continue uninterrupted if longer-term investors join the bandwagon. But this would require them to discard their valuation compasses. Hence, on balance, we think that this is the lower probability outcome. Also, to be clear, the long-term direction of both stocks versus bonds and bitcoin is up. The vulnerability we refer to is of a tactical pullback within a structural uptrend. An Excellent Year For The Fractal Trading System Among our most recent trades, overweight Portugal versus Italy achieved its 7 percent profit target, and underweight Australian construction materials (James Hardie, Lendlease, and Boral) achieved its 6 percent profit target. This takes the 2020 win ratio to a very pleasing 63 percent, comprising 18.4 winning trades versus 11 losing trades. Using a position size that delivers 2 percent for a win (and -2 percent for a loss), this equates to a 2020 return of 15 percent with a worst drawdown of -6 percent. By comparison, the MSCI All Country World index delivered a similar return of 17 percent but with a much more severe worst drawdown of -34 percent. 63 percent is a great win ratio. 63 percent is a great win ratio, but our aim is to reach 70 percent. To this end we are preparing several enhancements to the system which we will unveil in the coming weeks. Stay tuned. Fractal Trading System* As already discussed, we are targeting a tactical pullback in the MSCI All Country World Index versus the 30-year T-bond. The profit-target and symmetrical stop-loss are set at 5.8 percent. Chart I-10 The rolling 12-month win ratio now stands at 63 percent. 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 The GDP rebound creates a dissonance. If GDP is indicating a largely recovered economy, but our lives feel far from normal, is GDP really a good measure or objective for our wellbeing? We will leave a deeper discussion of this to a later date. Fractal Trading System 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 An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Chart 15...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades